Worldwide many governments rely on personal income taxation as one of their major sources of tax revenue. Casual empirical evidence suggests that, although most developed countries levy substantial taxes, particularly on higher incomes, there also exist a few countries that are characterized by no or very low income taxation. A distinguishing feature of the countries in the latter group is that they are geographically very small, as can be seen from Table 1, which presents international income tax policies and geographical dimensions of some selected countries. In the present paper, we investigate whether the geography of a country is related to its pattern of taxation. Central to our argument is the ongoing international integration in the last decades. In some cases (e.g., in the European Union) the process has advanced to the point at which all formal constraints to mobility have been abandoned. This development has also greatly improved the mobility of households across states or national borders. In contrast to the mobility of production factors, however, the effects of household mobility (migration) are not confined to budgetary consequences as taxpayers immigrate or emigrate: the inand outflow of citizens also alters policy objectives by changing the composition of the electorate in a jurisdiction. At the same time migration decisions, especially those of wealthy individuals, are based on local tax policies. Consequently, the migration of households determines fiscal policies through the interplay of two basic effects: (1) residential choices determine tax rates through a process in which a jurisdiction's inhabitants select their local policies, and (2) tax and welfare policies in each jurisdiction influence residential decisions. As we argue in this paper, this interdependency of residential and political decisions may provide an explanation for the stylized facts illustrated in Table 1. We consider a simple framework in which households differ in incomes and national tax policies are democratically determined. As a natural implication of their earning characteristics, high-income households ceteris paribus prefer to live in countries with low taxation. For ease of exposition, we refer to those countries as tax h(e)avens, in a slight perturbation of popular nomenclature. Low-income households, in contrast, are more interested in generous public spending than in low income tax rates. Ceteris paribus, they prefer to reside in countries with large welfare programs financed by substantial taxation, which we call tax hells for obvious reasons. Thus, individual preferences imply a self-selection process, which leads to the segregation of households across countries according to income classes.1 If this segregation is, in turn, supported by a national vote for low taxes in countries where high-income earners live and high taxes in countries where lower-income earners live, an equilibrium with tax heavens, populated by wealthy residents, and tax hells, populated by the less affluent, evolves. Yet, the geographical size of countries plays a crucial role in this development: first, it affects the number of a country's inhabitants (the population size). Because households sort *Hansen: Apax Partners & Company, Possartstr. 11, 81679 Miinchen, Germany; Kessler: Department of Economics, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany (
[email protected]). We thank two anonymous referees, Marcus Berliant, Dennis Epple, Christian Ewerhart, Gerhard Glomm, David Pines, Urs Schweizer, and participants in presentations at the University of Munich, the 1997 SITE meeting (Stanford), the 1997 American Econometric Society Summer Meeting (Pasadena), and the 1996 IIPF Congress (Tel Aviv) for helpful suggestions and discussions. Both authors gratefully acknowledge financial support by the Deutsche Forschungsgemeinschaft, SFB 303 at the University of Bonn. Remaining errors are our own. The views expressed in this paper should not be attributed to Apax Partners & Company. 1 The sorting of individuals by preferences across jurisdictions goes back to the famous contribution of Charles M. Tiebout (1956) on migration as a means to reveal preferences over public goods.