Federalism, Jurisdictional Policy Choices, and Income Inequality

The paper studies the effects of federalism on primary-income (before taxes and transfers) inequality.  Jurisdictions in a federal system determine economic policies  according to their preferences.  By contrast, in a unitary system, policies are uniformly determined nationally  for jurisdictions.  A policy results in a trade-off between intended policy outcomes and incomes, and the analysis considers environmental policies to illustrate the trade-off.  More stringent environmental policies of a jurisdiction, for instance, provide higher environmental quality for its residents but decrease production and hence the wages. As policies are uniform in a unitary system, the wages are the same between jurisdictions and no inequality exists.  Income inequality is thus higher in a federal system than in a unitary system.  In reality, jurisdictions also differ in their amenity such as climate and other natural conditions.  When the jurisdiction with more stringent policies has better amenity, it attracts more individuals and lowers the wage of the jurisdiction even more.  Income inequality stems only from the difference in amenity in a unitary system, and income inequality is higher in a federal system than in a unitary system.  When the jurisdiction with more stringent policies has worse amenity, it increases the wage of the jurisdiction, tending to equalize the difference in the wages resulting from different environmental policies between jurisdictions in a federal system.  The comparison of income inequality between two systems becomes thus ambiguous.  Taken together, income inequality is on average higher in a federal system.  The paper also provides an empirical analysis of the effect of federalism on income inequality, and available evidence suggests that federalism increases income inequality.