That is because it is assumed that those with higher incomes hit by the tax will just move to a lower tax jurisdiction. Instead, such taxes should lie only with the federal government and potentially states. Localities should draw their revenues from real property tax because real estate is immovable. They should also use user fees to cover the cost of certain services, matching benefits with the amount paid.
But as Scharff and Shanske note, localities around the nation have imposed income taxes, or something similar, like a payroll tax, to supplement their budgets. Having these taxes allowed some of these jurisdictions to weather the storm of COVD-19 a bit better, as many of the revenue sources localities rely upon, like user fees and transient occupancy taxes, dropped precipitously. Furthermore, localities provide necessary services; they cannot stop picking up the trash, for example, even when revenues fall. Localities also have less borrowing power than states or the federal government, partly because of their smaller tax base. And often, as the authors note, aid from the states to localities is fickle. These income taxes then provide some sort of a buffer for localities.
Scharff and Shanske take us then through the numerous local jurisdictions that have income taxes, ranging from the famous New York City income tax to states like Indiana, where almost every county imposes an income-like tax. Not all of these taxes are traditional full-bore income taxes like the federal system. Some look at only payroll or wage income. Others include certain business-related taxes that hit something akin to income. But all of them look for some sort of income-like base to expand the revenue base. And some of these taxes have been around for a while.
The prevalence and persistence of local taxes lead Scharff and Shanske to push back on the conventional wisdom. They argue that people are stickier to locations than originally assumed. The key to this analysis is agglomeration economics, or how getting people into the same place can create significant economic benefits. They note that agglomeration produces three key benefits for people there: the ability to share, where people share from the same infrastructure; the ability to match, meaning creating connections that allow people to find jobs best suited to their skills; and the ability to learn, where being in an agglomerated location helps to create both higher earning potential and better human capital.
Agglomeration thus means that local income taxes are not as inefficient as originally thought. People who benefit from agglomeration receive a wage premium and other associated benefits of these places. If they leave, they lose these benefits, and thus are often worse off. A relatively low-rate income tax likely will not reduce the major benefits that agglomeration economics provides.
Furthermore, agglomeration also comports nicely with the benefit principle justification for local income taxes. Because of agglomeration, people in certain localities have an income premium. Without the locality to provide the container for such agglomeration, such an income premium would not exist. Thus, per the benefit principle, the locality should tax such an income premium, because it is a benefit that flows from the locality’s services and infrastructure.
Additionally, unlike most other revenue sources for localities, income taxes are clearly progressive. That has additional benefits. First, it helps to allow localities that have a preference to redistribute an easy way to do that. Given that people now tend to live in more politically homogenous communities, using a local income tax could be a way for such places to express their redistributionary values. Second, even though income tax receipts fall in an economic downturn, their progressivity blunts other problems that harm the poor. For example, since many other revenue sources for localities, like user fees, are regressive, many of those at the lower end of the socio-economic ladder face greater burdens during an economic downturn. Their effective rate of payment on fees goes up as their income falls. Vital services they may need now even more than during good times, may either get cut or see an increase in the user fee rate because of budget pressure. By providing another source of income that is progressive, local income taxes blunt these problems.
Scharff and Shanske also respond effectively to many of the concerns regarding local income taxes. Perhaps the biggest is the exit concern, which is the idea that people will move out of a locality if it imposes an income tax. This concern has grown in light of the growth of remote work, which some argue undercuts the agglomeration economics justifications. But the authors cite to data that shows that while there is a significant move toward remote work, it is unlikely that most firms will move entirely to remote work. Additionally, even with the rise of remote work, many people still choose to live in localities like New York City with a local income tax because of the infrastructure and amenities. Furthermore, if the income tax has relatively low rates, the problem is somewhat less pronounced.
Overall, the piece serves as a useful foundation for future work that the authors hope to undertake on local income taxes, looking at, for example, the best way to design such taxes. Such work is sorely needed. Because of the conventional wisdom highlighted earlier, the piece and the authors’ future agenda fills a gap. By complicating the story through this piece, the authors make a compelling case that we all need to start thinking more deeply about how to have municipalities deploy this important revenue tool.
Additionally, the piece also focuses our minds on the nature of local government in the U.S. Given the importance of localities in the lives of many Americans in providing the most vital services, their powers are bounded. They are not sovereign entities like states or the federal government, and states can, and often do, preempt localities. But when it comes to budgets, when localities face a revenue crunch, the vital needs of many people fall away, and local governments run the risk of falling into fiscal disarray. Such a locality thus becomes a liability for a state in more than just needing additional dollars in state aid. Such a stressed locality could be a drain on the future economic growth and stability of the state overall.
Finally, the piece also has an important meta-lesson. Too often we foreclose certain avenues, like local income taxes, because of our assumptions. The piece serves as a reminder that we have to all, from time to time, undertake a hard look as to whether our assumptions are warranted or if they are motivated by something else.