The Local Decision to Tax: Evidence from Large U.S. Cities

There is no more hotly contested political issue in large United States cities than the setting of the rates of local taxation--and for good reasons.Local taxes determine both the levels of a city's public services and exactly who pays for those services.As an economic issue, local taxation is important too.From the perspective of economic efficiency, local taxation may have significant consequences, both for resource allocation within the city between taxed and untaxed activities and for the location of economic activity across communities.'Economic fairness may be influenced as well, particularly since local taxes take a significant share of household income and such local government services as education, health care, and housing can be important determinants of long-run economic opportunity.2With increasing policy interest in the possible advantages of decentralizing the United States public economy, it is important--perhaps now more than ever--that we understand the economic and political forces which shape these local decisions to tax.One contemporary issue in particular has heightened interest in the process of local revenue choice among U.S. economists and policy-makers: the possible removal of the deductibility for state and local taxes when calculating U.S. federal taxable income.The debates surrounding the 1986 Tax Reform Act focused in large measure on the advantages and disadvantages of dropping local tax deductibility.Removal was thought to be an important source of new federal revenues which could support broad reductions in overall tax rates.Removal might also increase the progressivity of the federal tax code and eliminate an inefficient subsidy to the local public sector.Opponents contended that removal would not generate new revenues and might well reduce tax fairness and allocative efficiency.3To resolve the issue it is 1Wildasin (1986) provides an excellent introduction to this literature.2For a discussion of fairness in the local public economy, see Inman and Rubinfeld (1979).3Supporters include the initial proponents of broad-based tax reform; see McLure and Zodrow (1987) and Courant and Rubinfeld (1987) for the arguments.Analyses which question these arguments can be found in Cherrnck and Reschovsky (1986) and Feldstein and Metcalf (1987).1&1L3 important to understand just how state and local taxes might be affected.Unfortunately, most of the research which did address this question was forced to assume an elasticity of local taxes with respect to federal deductibility.At the time, there simply were no compelling empirical studies available on the determinants of local tax policy.This paper seeks to provide such a study.Two ingredients are necessary: a model of local revenue choice and a data base with sufficient variation in the institutional, political, and economic variables of interest to estimate the model.Section II describes the model.In contrast to the usual model of local fiscal choice which focuses on a single representative voter, this study seeks to explicitly consider the redistributive nature of local revenue choice.Section III estimates the model.In contrast to one year cross-section studies of local revenue choice whose estimated coefficients may be biased because of omitted government-specific 'fixed effects" (see Hausman and Taylor (1981)), this study develops a large panel data base of 41 cities over twenty-five years which allows unbiased estimation of the model's coefficients.A "fixed-effect' or 'within-group' estimator is employed.Section IV then addresses the effects of removing deductibility on taxation in our sample cities: what is likely to happen to local revenues, local spending, and federal tax receipts with the loss of deductibility?Section V offers a concluding observation on this research. II. The Analytics of Local Revenue Choice A. The Basic StructureWithin larger U.S. cities, the local decision to tax is a decision made subject to constraints.First, local taxation must be decided within the bounds of a local political process.Competing coalitions within the city--the rich, the middle class, the poor, and local business interests--all seek to influence the final decision to tax.Second, the mobility of resources within the local and regional economy limit the ability of the city to raise revenues; taxable resources may simply leave the taxing jurisdiction or, for those residents who remain, the taxed activity may be curtailed.Third, state law may restrict the local community to the taxation of only well-defmed activities or resources, often further limited to a pre-specified rate of taxation.This