where h(∙) and b(∙) are strictly increasing and strictly concave. The time endowment is normal-
ized to unity which implies labor supply Li = 1 - `i . Each household has a capital endowment
fc. Utility is maximized subject to the budget constraint
• ∙ ∙ '
ci = Ii + (wi - τ) Li + rk,
where Ii is income generated from a fixed factor (say land), wi is the wage rate in state i,
τ denotes the labor income tax rate, and r is the interest rate. The labor supply decision is
characterized by the first-order condition14
wi - τ - h' ('i ) = 0. (1)
The optimality condition implies that an increase in the net wage rate wi - τ leads to an increase
in labor supply.
Each state produces a single good with a constant returns to scale technology. Output can
be used either for private or public consumption on a one-to-one basis. For analytical simplicity
the technology is additively separable in labor li and capital ki . We should note that the results
developed in the paper are not specific to the assumption. In a note (available upon request
and posted on the author’s web-page) we outline the qualitative robustness of the results when
accounting for complementarity between labor and capital in production.
Invoking a linear production technology would generate the peculiar result that capital com-
pletely flows to the region which offers the more favorable tax treatment. To preclude the
“buy-out” result, we introduce land as a productive factor (Kuhn and Wooton, 1987). The
production technology f (Bi, li, ki) satisfies fji > and fjij < 0, j ∈ {Bi, li, ki}, where Bi denotes
the amount of productive land in state i. Furthermore, fBi j < 0, j ∈ {li, ki}, and flik = 0.
The representative firm in each state maximizes profits πi = f(ki, li) - wili - (r + ti)ki with
14Derivatives are indicated by 0 . Subscripts of functions denote partial derivatives.