Federal Progressivity and State Regressivity∗

This paper develops a positive theory of taxation in a federation of states. Its main motivation is to explain two facts about tax schedules in the US. The first one is that states’ income tax rates are relatively low compared to federal income tax rates, in most cases below 5%. The second one is that the overall effective tax schedule at the state level is regressive in every state. The results show that in a federal system, income inequality between states is the crucial variable determining the federal tax rate. In fact, a positive relation exists between the inequality level and the federal tax rate, even if the income of the decisive-voter is above the mean. In such a scenario, with endogenous incomes, states’ tax rates are relatively low because of incentives considerations, even if a relatively poor individual chooses this tax. Using a new data set on nonlinear tax schedules at the state level, empirical evidence is provided that supports the hypothesis of the paper. Most notably, the data points to the existence of a significant trade-off between the progressivity of the states and federal tax schedules, explained through income inequality between the states.