International Tax and Public Finance, 8, 675–691, 2001.  C 2001 Kluwer Academic Publishers. Printed in The Netherlands. Tax Competition, Income Differentials and Local Public Services ERIC SMITH esmith@essex.ac.uk Department of Economics, University of Essex, Wivenhoe Park, Colchester, CO4 3SQ, England TRACY J. WEBB t.j.cornelius@swansea.ac.uk Department of Economics, University of Wales Swansea, Singleton Park, Swansea, SA2 8PP, Wales Abstract This paper examines strategic tax setting between fiscal authorities in the presence of mobile workers who locate across these jurisdictions in response to differing tax structures and congestable local public amenities. We find that the nature of the tax setting outcomes depend crucially on the proximity between cities. For “distant” cities with the same size populations, the pressure on tax rates of a more mobile workforce depends on the whether mobile workers are net beneficiaries or net contributors. If mobile workers are either high or low income earners, cities lower tax rates. If mobile workers are middle income earners, cities raise tax rates. For “close” or neighbouring cities, workers locate in one of the cities and tax rates and local public amenities are dispersed. Keywords: tax competition, migration, local public goods, coordination equilibria JEL Code: H73, H21, J61 1. Introduction International co-operation, most notably in Europe but elsewhere as well, has made con- sumers, producers and workers more mobile. Within national borders, improved technology and lower transportation costs have likewise enhanced the movement of buyers and sellers. These changes and their impact on the formulation of tax policy have generated consider- able attention amongst academics and policymakers. Indeed, the issues and policy questions raised have spawned a large and extensive public finance literature. The hallmark of many of these papers is that freer commodity trade, capital or labour mobility generates tax competition across local jurisdictions as authorities attempt to lure in business. The key point is that by altering its own tax rate, each jurisdiction is able to change both its own tax base and the tax base of other jurisdictions. The significance of these fiscal spillovers is that they are likely to result in “a race to the bottom” with low and suboptimal tax rates. 1 This paper analyses tax competition across local jurisdictions in the presence of mobile labour. Tax competition arises as each local authority levies a proportional income tax on mobile workers who consume congestable public amenities in the region where they work. The contribution of the paper is twofold. First, we explicitly allow for distance between the tax setting authorities. This distance, modelled as a transportation cost, is crucial in