The Contribution of Local Sales and Income Taxes to Fiscal Autonomy
In this paper, John L. Mikesell analyzes the local sales and income taxes in several U.S. states. As of 2009 the local sales tax is levied in 36 states, constituting over 30 percent of total local tax revenue in some of them. In contrast, only five states (Kentucky, Maryland, New York, Ohio, and Pennsylvania) collect local income taxes, which generate over 15 percent of local tax revenue. Among all levels of local government, municipalities are the heaviest users of local sales and income taxes. Over three-quarters of all local income tax collections and nearly 60 percent of all local sales taxes go to municipalities.
In aggregate, however, local sales and income taxes are not key municipal revenue sources. Several drawbacks lead to their infrequent use. First, some local income taxes have a flat rate and a base that excludes interest income, dividends, and capital gains, making their tax burden regressive. Second, cities that collect local sales or income taxes are competing with federal, state, and counties for the same tax bases. The overlapping of tax bases can lead to high combined marginal rates when the federal, state, and other local government rates are added together. Third, local sales tax is sensitive to interjurisdictional competition. Previous studies estimate that a 1 percent rate differential in local sales tax leads to a 3 to 7 percent decrease in retail sales.
Despite these potential problems, could the two local taxes provide additional income for municipalities in times of fiscal stress? To answer this question, Mikesell compares the buoyancy, stability, and horizontal equity of the local property, income, and sales taxes, using data for local governments that collected $1.5 billion in revenue from the local income tax, local sales tax, or both for fiscal years 1985 to 2006. He argues that if a revenue source grows steadily but slowly, it would not be useful to local governments for closing fiscal gaps during a recession. He finds that property tax collections grow more slowly but more steadily than sales and income tax revenues. Although sales tax revenue has the fastest growth rate, it is the least stable of the three taxes. In terms of reducing horizontal fiscal imbalance created by the property tax, no evidence of superiority of the income or sales taxes is found. Based on these results, Mikesell concludes that municipalities could increase revenue by adopting or increasing the local sales tax, but this would make their revenues less stable and fiscal capabilities across cities more disparate. No conclusion can be drawn for the local income tax because only a few cities have adopted this tax.
This paper was presented at the Lincoln Institute’s Land Policy Conference of 2009 and is Chapter 6 of the book Municipal Revenues and Land Policies.