The peer group effect and the optimality properties of head and income taxes

This paper studies a Tiebout model with two school districts, housing markets and peer effects to re-evaluate the optimality properties of the allocation of households to districts induced by head and income taxes. The main novel results reveal that head taxes are not superior to income taxes and that the indirect redistribution implied by income taxation is not necessarily at odds with location optimality or associated to welfare losses. Many combinations of head taxes differentiated by household type can sustain the optimal outcome as an equilibrium. While this may not be possible using differentiated income taxes, a combination of non-differentiated ones and differentiated head taxes levied on the residents of the rich district can lead to the optimal outcome and effect significant local redistribution. In turn, non-differentiated head taxes are suboptimal (unless optimality requires one of the districts to be type-homogeneous) and a combination of uniform income taxes and head taxes levied on the rich district's population can do as well as them. Moreover, non-differentiated income taxes may generate smaller welfare losses than their lump-sum counterpart, a result which clashes with the benefit view of head taxes.