LAUSR

The Tax Cut and Jobs Act of 2017 capped state and local tax deductions allowing tax filers to claim only up to $10,000 on their federal tax return. We show that this new cap primarily affects households in the top percentile of the income distribution residing in high-tax, high-cost cities. We develop and calibrate a new dynamic spatial equilibrium model to evaluate the impact of this policy change on the distribution of economic activity and aggregate welfare. Young households move to cities with high agglomeration externalities to acquire human capital. These cities tend to levy high local taxes and have a high cost of living. As households grow older the human capital benefits become less relevant. Hence, households face strong financial incentives to move to low-tax, low-cost cities. The tax reform reinforces these financial incentives leading to a relocation of high-productivity households to low-cost cities. If local agglomeration effects are endogenous and depend significantly on these high-productivity households, the tax reform may generate substantial negative effects on aggregate income.