Diversity Taxes

Abstract

The sociological literature indicates that within diverse communities, agents create externalities on each other when they consume market goods to express their identity. We provide a model in which local governments use taxation and agents adjust social networks to address identity expression externalities. We study how diversity affects social networks and taxation, and how the existence of a tax response to identity expression externalities impacts network choice. Taxation and network adjustments can be strategic complements or substitutes depending on agents’ taste for out-group identity expression: the marginal value of taxation as a tool to regulate identity expression can be increasing or decreasing in the agent’s exposure to out-group identity expression. Based on our theoretical framework we estimate a simultaneous equations model using US city data on ethnic diversity, taxation, and segregation. The empirical results indicate that segregation decreases as city governments use taxation to regulate identity expression.

Keywords: diversity, externalities, taxation, social networks, identity economics

JEL Classification: D62, H23, H41, Z13, Z18