Defining the income tax base involves more steps than is needed to define either the sales tax base or the property tax base. This is because of a number of adjustments designed to promote hor-izontal and vertical equity. The process involves the following steps:
1. Define gross income. This involves listing all income subject to taxation.
Here states can provide targeted relief, such as excluding from the tax base the interest income on bonds sold by local governments as well as by the state.
2. Deduct adjustments. Adjustments are reductions in gross income designed to reduce or eliminate double taxa-tion, such as with alimony payments, or the cost of earning income, such as job-related moving expenses.
Result: Adjusted gross income (AGI), the beginning point for computing taxable income.
3. Deduct personal exemptions. Some local and state governments, as well as the federal government, provide for a fixed dollar reduction in taxable income for each dependent in the household. These deductions pro-mote horizontal and vertical equity.
4. Deduct standard (or itemized) de-ductions. Usually individual income taxes provide for a standard deduc-tion: a fixed dollar amount for each category of tax filers (single, married filing jointly, married filing separately).
The standard deduction is designed to promote horizontal equity and reduce the need for retaining records on deductible expenses.
Alternatively, tax filers may itemize qualifying deductions, particularly if they have incurred deductible expenses that exceed the standard deduction.
Depending on the marginal tax bracket of the taxpayer, the deductions repre-sent significant reductions in tax liability.
Most state revenue departments pre-pare analyses of the cost of these tax expenditures to state treasuries.
Result: Taxable income, the tax base to which the tax rate(s) is applied.
5. Multiply the taxable income by the appropriate tax rate to determine tax liability. In states and the few local governments that use graduated tax rate structures, each bracket of income is subject to a separate tax rate, with higher brackets subject to progressively higher tax rates. In recent decades, states and especially local governments have gravitated toward flatter rate structures because progressive income tax rates may en-courage higher-income households to migrate to lower-tax jurisdictions.
6. Deduct tax credits. The final step is to apply any qualifying tax credits to tax liability. These dollar-for-dollar reduc-tions in liability are particularly pow-erful tools for tax policy. A number of states offer earned-income credits to working families with moderate to low income. While most credits are capped at tax liability—that is, the credit cannot be greater than the tax liability—some states allow the credit to exceed liability, creating essentially a negative income tax by providing a cash subsidy to these families.
is that the tax will drive businesses and families out of the jurisdiction. Because of the greater visibility of the income tax, such fears will be especially strong, and a proposal to adopt the tax will likely evoke even greater opposition than a proposal to adopt either a general sales tax or an excise tax. Opposition will also develop because income is already taxed by forty-three states and the federal government.
A 2003 study of four major U.S. cities found that in the case of both New York City and Philadelphia, changes in income (New York) and wage (Philadelphia) tax rates adversely affect job creation.48 Both cities rely heavily on income-based taxes, and both are surrounded by communities that do not levy the tax, creating border-city effects that give households and businesses powerful incentives to relocate to the suburban areas.
According to the authors’ analysis, between 1971 and 2001, New York City lost 331,000 jobs because of income tax increases, and Philadelphia lost 173,000 jobs because of increases in its wage tax rate.
As noted in Chapter 2 in the discussion of tax neutrality, taxes do affect business investment and job creation. It is also reasonable to expect households and businesses to be more sensitive to rate changes in the local income tax than in the property tax. While the property tax is nearly universally levied and thus unavoidable, taxpayers can more easily avoid the income tax by locating in neighboring jurisdictions where it is not levied. Regional adoption of the tax plays a critical part in building taxpayer tolerance.
In sensitive policy areas such as the adoption of a local income tax, regional precedent in demonstrating a policy’s viability is essential for its dissemination.
It is somewhat curious, however, that local income taxes have gained a level of acceptability in some of the more politically conservative areas of the nation, such as Ohio and Michigan. Whether this is the result of historical events or underlying social mores is debatable. The fact that these taxes have become accepted sources of local revenue in this part of the nation and that they seem to work effectively at providing revenue diversity makes them worth further analysis, particularly regarding their effects on local spending levels.
Conclusion
The most widely used alternative to the property tax is the general sales tax. The base for the sales tax is procyclical, meaning that tax revenue rises and falls with the business cycle, creating the potential for midyear revenue shortfalls whenever the local economy turns downward. The trend among states has been to narrow the sales tax base by exempting food purchased for home consumption and business purchases of machinery and build-ing materials. This reduces the tax’s regressivity (a gain on equity).
A fundamental requirement for an economically neutral sales tax is that state and local bases should be the same and tax rates should be uniform across the state. Studies indicate that a local sales tax lowers retail business activity somewhat, but the effect is insignificant when local rates are uniform or nearly so and adoption of the tax is nearly universal among local governments. When more than one level of local government levies the sales tax, one problem is how to divide the revenue (or rate) among the levels of government.
Excise taxes offer another alternative to reducing dependence on the property tax.
These consumption taxes are levied on specific products—gasoline, tobacco, distilled spirits, hotel rooms, utilities—at separate rates. Revenue from these taxes tends to be dedicated to purposes that benefit the taxpayer, at least indirectly. Local governments with competitive advantages, such as hotel occupancy taxes in resort communities, rely
1 Scott Drenkard, Alex Raut, and Kevin Duncan, “Sales Tax Rates in Major U.S. Cities,” Tax Foundation Fiscal Fact no. 296 (April 11, 2012), taxfoundation.org/
article/sales-tax-rates-major-us-cities.
2 John H. Bowman and John L. Mikesell, Local Government Tax Authority and Use (Washington, D.C.: National League of Cities, 1987), 51–53.
3 U.S. Census Bureau, State & Local Government Finance, Historical Data: 2007, Table 2, census.gov/
govs/estimate/historical_data_2007.html.
4 Ibid.
5 Federation of Tax Administrators (FTA), FTA Survey of Services Taxation: 2007 Update (Washington, D.C.: FTA, July 2007), 2, taxadmin .org/fta/pub/services/services.html.
6 Bureau of Economic Analysis, National Data, National Income and Products Accounts Tables, Table 1.5.5, “Gross Domestic Product,” bea.gov/iTable/iTable .cfm?ReqID=9&step=1#reqid=9&step=
3&isuri=1&903=35.
7 Kirk J. Stark, “The Uneasy Case for Extending the Sales Tax to Services,” State Tax Notes 29 (July 21, 2003): 211–232.
8 Gary C. Cornia, David L. Sjoquist, and Lawrence C. Walters, “Sales and Use Tax Simplification and Voluntary Compliance,” Public Budgeting & Finance 24 (Spring 2004): 2.
9 Author’s calculations based on data provided in Donald Bruce, William F. Fox, and LeAnn Luna, State and Local Sales Tax Revenue Losses from Electronic Commerce (Knoxville: Center for Business and Economic Research, University of Tennessee, April 13, 2009), cber.bus.utk.edu/ecomm/ecom0409.pdf.
10 Streamlined Sales Tax Governing Board, Inc., Streamlined Sales and Use Tax Agreement (adopted November 12, 2002, and amended through
May 24, 2012), streamlinedsalestax.org/uploads/
downloads/Archive/SSUTA/SSUTA%20As%20 Amended%205-24-12.pdf.
11 FTA, “State Sales Tax Rates and Food and Drug Exemptions” (January 1, 2013), taxadmin.org/fta/
rate/sales.pdf.
12 Ibid.
13 Gary C. Cornia et al., “The Effect of Local Option Sales Taxes on Local Sales,” Public Finance Review 38 (2010): 659–681; Gregory Burge and Cynthia Rogers, “Local Option Sales Taxes and Consumer Spending Patterns: Fiscal Interdependence under Multi-tiered Local Taxation,” Regional Science and Urban Economics 41 (2011): 46–58.
14 James Alm and Mikhail I. Melnik, “Sales Taxes and the Decision to Purchase Online,” Public Finance Review 33 (March 2005): 184–212.
15 Ibid., 186.
16 Robert L. Bland and Phanit Laosirirat, “Tax Limitations to Reduce Municipal Property Taxes:
Truth in Taxation in Texas,” Journal of Urban Affairs 19 (Spring 1997): 45–58.
17 Andrew J. Krmenec, “Sales Tax as Property Tax Relief? The Shifting Onus of Local Revenue Generation,” Professional Geographer 43 (February 1991): 60–67.
18 Raymond J. Ring, “Consumers’ Share and Producers’ Share of the General Sales Tax,” National Tax Journal 52 (March 1999): 81–92.
19 Harvey Cutler and Irina Strelnikova, “The Impact of the U.S. Sales Tax Rate on City Size and Economic Activity: A CGE Approach,” Urban Studies 41 (April 2004): 875–885.
20 Richard Hawkins and Matthew N. Murray,
“Explaining Interjurisdictional Variations in Local Sales Tax Yield,” Public Finance Review 32 (January 2004): 82–104.
more heavily on excise taxes because of the inelasticity of demand by consumers. Local governments may use excise taxes to discourage consumption of a product, such as tobacco, although the effectiveness of such a strategy is debatable.
Use of the local income tax remains confined largely to states east of the Mississippi River, especially in large central cities with declining property tax bases. One of the strengths of an income tax is its capacity to extend the tax reach of a city to commuters who work in the city but otherwise bear no burden for financing its services.
Because the revenue from the tax is income elastic, local governments become more dependent on the tax over time as it displaces revenue from the less elastic property tax. As a result, local governments expose their operating budgets to greater instability whenever the local economic cycle turns downward and the income tax base contracts.
Another issue concerns the administration of the tax. The most cost-effective approach involves piggybacking the local levy onto the state income tax, thereby reduc-ing taxpayer compliance costs with the filreduc-ing of only one tax return to satisfy both state and local needs. Maryland is the only state that requires local adoption of the tax, which reduces the nonneutral effects of the tax created by taxpayers searching for nontax areas in which to locate.
Notes
21 Ohio Department of Taxation, “Sales and Use Tax,” in 2012 Annual Report (Columbus: Office of the Tax Commissioner, 2012), 141–143, tax.ohio .gov/Portals/0/communications/publications/
annual_reports/2012_annual_report/2012_AR_
Section_2_Sales_and_Use_Tax.pdf.
22 Allegheny Regional Asset District, Frequently Asked Questions (2012), radworkshere.org/interior.php
?pageID=33#quest3.
23 Burge and Rogers, “Local Option Sales Taxes.”
24 North Carolina Department of Revenue,
“Effective Dates of Local Sales and Use Tax Rates in North Carolina Counties” (April 1, 2013), dornc.com/taxes/sales/levydates_4-13.pdf.
25 Amber E. Crabbe et al., “Local Transportation Sales Taxes: California’s Experiment in Transportation Finance,” Public Budgeting & Finance 25 (Fall 2005):
91–121.
26 Nebraska Department of Revenue, Current Local Option Sales and Use Tax Rates (April 2011), revenue.ne.gov/question/sales.html.
27 Sales Tax Institute, Sales Tax Rates (May 1, 2011), salestaxinstitute.com/resources/rates.
28 Colorado Department of Revenue, Colorado Sales/
Use Tax Rates (January 2011), 4, colorado.gov/cms/
forms/dor-tax/dr1002.pdf.
29 U.S. Census Bureau, State & Local Government Finance, Historical Data: 2007, Table 2.
30 Bowman and Mikesell, Local Government Tax Authority and Use, 95.
31 See City of Chicago, “Finance,” cityofchicago.org/
city/en/depts/rev/supp_info/tax_list.html.
32 Global Business Travel Association, gbta.org/Pages/
default.aspx.
33 Ibid., 2009 Travel Tax Report.
34 FTA, “State Motor Fuels Tax Rates” (January 1, 2011), taxpolicycenter.org/taxfacts/Content/PDF/
gas_rates.pdf.
35 U.S. Census Bureau, State & Local Government Finance, Historical Data: 2007, Table 2.
36 Edward Huang et al., Transportation Revenue Options: Infrastructure, Emissions, and Congestion, Discussion Paper 2010-13 (Cambridge:
Belfer Center for Science and International Affairs, Harvard Kennedy School, September 2010), belfercenter.ksg.harvard .edu/files/
Transportation%20Revenue%20Options%20
Workshop%20Report%202010%20for%20web .pdf.
37 Todd Goldman and Martin Wachs, “A Quiet Revolution in Transportation Finance: The Rise of Local Option Transportation Taxes,” Transportation Quarterly 57 (Winter 2003): 19–32.
38 U.S. Census Bureau, State & Local Government Finance, Historical Data: 2007, Table 2.
39 FTA, “State Excise Tax Rates on Cigarettes”
(January 1, 2013), taxadmin.org/fta/rate/cigarette .pdf; FTA, “State Tax Rates on Distilled Spirits”
(January 1, 2013), taxadmin.org/fta/rate/liquor.pdf.
40 FTA, “State Excise Tax Rates on Cigarettes.”
41 Jidong Huang and Frank J. Chaloupka IV, “The Impact of the 2009 Federal Tobacco Excise Tax Increase on Youth Tobacco Use,” National Bureau of Economic Research (NBER) Working Paper 18026 (Cambridge, Mass.: NBER, April 2012), nber.org/papers/w18026.
42 Jerry G. Thursby and Marie C. Thursby, “Interstate Cigarette Bootlegging: Extent, Revenue Losses, and Effects of Federal Intervention,” National Tax Journal 53 (March 2000): 59–77.
43 Patrick Fleenor, “How Excise Tax Differentials Affect Cross-Border Sales of Beer in the United States,” Tax Foundation Background Paper no. 31 (May 1, 1999), taxfoundation.org/article/how- excise-tax-differentials-affect-cross-border-sales-beer-united-states.
44 FTA, “State Real Estate Transfer Taxes,” FTA Bulletin (February 16, 2006): 3–5, taxadmin.org/
fta/rate/B-0306.pdf.
45 James Alm and William H. Kaempfer, “Who Pays the Ticket Tax?” Public Finance Review 30 (January 2002): 27–40.
46 Joseph Henchman and Jason Sapia, “Local Income Taxes: City- and County-Level Income and Wage Taxes Continue to Wane,” Tax Foundation Fiscal Fact no. 280 (August 31, 2011), taxfoundation.org/
article/local-income-taxes-city-and-county-level-income-and-wage-taxes-continue-wane.
47 U.S. Census Bureau, State & Local Government Finance, Historical Data: 2007, Table 2.
48 Andrew F. Haughwout et al., “Local Revenue Hills:
Evidence from Four U.S. Cities,” NBER Working Paper 9686 (Cambridge, Mass.: NBER, May 2003), nber.org/papers/w9686.
1. Highway financing is a major issue confronting local and state governments. Until about fifteen years ago, the states relied primarily on revenue from a dedicated tax on motor fuel sales (gasoline and diesel) to fund highway construction and maintenance. Projections now show that revenue from this tax will not even sustain highway maintenance in the near future. As an alternative, states have shifted much of the funding for highway construction to tolls on users.
States have even sold rights to tollways to private firms or other government entities to fund new highway construction in the state.
a. What effect does the shift from a dedicated tax to tolls have on equity, economic neutrality, and administrative and compliance costs?
b. Cities and counties also have a role in highway construction and usually use general revenues to match grants from the state and/or federal government. Discuss the merits of and
obstacles to allowing a locally piggybacked tax onto the state and federal motor fuels taxes.
What are the economic merits of local governments shifting to tolls on local highways?
2. Considerable controversy has recently surfaced over including Internet sales in the general sales tax base. The issue is complicated by the fact that access to the Internet is not uniformly distributed among income groups in the United States. The taxation of Internet sales raises all the classic issues of equity, economic efficiency, and administrative feasibility.
a. What are the equity issues involved in including Internet sales in the general sales tax base?
b. What are the issues in economic neutrality raised in taxing such sales?
c. Including Internet sales in the general sales tax base raises complex administrative issues.
Discuss those issues. What levels of government, if any, should tax Internet sales? What compliance costs are created if Internet sales are included in the tax base?
d. Would you recommend that Internet sales be included in the general sales tax base, taxed separately as an excise tax (and if so, should revenues be earmarked and for what purpose), or excluded from taxation? Why?
3. Fill in the blanks with the concepts listed below:
exported income elastic
administrative feasibility efficient
inelastic
regressivity tax pyramiding taxable nexus market value
a. Including food in the sales tax base increases _______.
b. The income elasticity of excise taxes, especially on sumptuary goods, tends to be ______.
c. Hotel/motel occupancy taxes are easily ________ to nonresidents.
d. A use tax is levied on goods sold by vendors with no __________ in the state.
e. A gross receipts tax on all businesses tends to cause __________.
f. Among consumption taxes, a value-added tax scores relatively high on equity and market (economic) efficiency but low in terms of _________.
g. Excise taxes are narrow based and thus tend to be less________.
h. Severance taxes are ad valorem in that they are based on _______ at the time of extraction.
i. The general sales tax is _______, which means that revenue yield increases during periods of economic growth but shrinks quite rapidly during economic downturns.
REVIEW QUESTIONS
4. The diagram below shows the stages in the production process and more theoretical “stages”
of household spending on consumables and on leisure. Below the production line, indicate what consumption tax from the list best fits with each stage in the production process.
a. Tax on household spending on consumption b. General sales tax
c. Use tax
d. Tax on household spending on leisure (vacations, boats, athletic events, etc.) e. Motor fuels tax
f. Severance tax g. Gross receipts tax
REVIEW QUESTIONS
Stage of
production Producer Distributor Wholesaler Retailer Final buyer
Household consumption
Household leisure Consumption
tax
107