The fiscal federalism literature has long recognized that the mobility of capital and labor counsel toward the use of benefits taxes, like property taxes and fees, at local levels to avoid distortions in the location and amount of economic activity. The strength of this accepted wisdom on tax assignment has changed slightly since the so-called “first-generation theory” of fiscal federalism, but the general notion remains strong that local jurisdictions should not impose income taxes on local business activity, because of the risk of losing tax base. And in an era where workers and businesses are more mobile than ever, a tax on local workforces and business income would seem to be on a particularly poor footing.
In The Surprisingly Strong Case for Local Income Taxes in the Era of Increased Remote Work, Erin Scharff and Darien Shanske provide a compelling counter narrative to this accepted wisdom. In doing so, Scharff and Shanske contribute significantly to the fiscal federalism literature and to the current debates about how the ease with which labor and capital can move in the modern world should shape how governments fund their operations, both within the United States and globally.
Income taxes within the United States are of course underinclusive of actual income, and tax scholars broadly recognize that the federal income tax operates more like a wage or consumption tax for many taxpayers. The use of the term “income tax” is thus a bit of a shorthand. This point applies equally at the local level, and Scharff and Shanske’s article catalogues a variety of local impositions that fall within their ambit of “local income taxes.” The authors’ detailed discussion of these different local income tax structures demonstrates the wide variety of local income taxes that exist and introduces the taxes’ different legal structures, histories, importance, and challenges.
To critique “local income taxes” without understanding these differences misses a lot. A local income tax need not be a highly progressive tax that piggybacks on the breadth (or narrowness) of the federal income tax. A more targeted local payroll tax, for example, can raise revenue on a similar base while leveraging administrative efficiencies, and it counts as an income tax (or at least not a benefits tax) in the authors’ analysis.
The wide range of potential income tax instruments is important, but the question remains regarding whether local jurisdictions can impose income taxes without losing their tax bases. With so many localities from which to choose, why would any taxpayer work or locate in a jurisdiction imposing such a tax? Here, Scharff and Shanske answer largely with the economies of agglomeration, a concept recognizing that businesses and individuals benefit from being near one another. The economies of agglomeration help to explain the historic inter- and intrastate migration toward large population centers despite the higher costs that often attend those moves. Recognizing these economies, Scharff and Shanske argue that local jurisdictions may indeed be able to charge for access to their markets consistent with the benefits principle of taxation. Income taxes can approximate benefits taxes if properly structured. The benefits tax/income tax distinction is a false dichotomy.
The ultimate question underlying much of Scharff and Shanske’s article—and the question confronting governments worldwide—is the extent to which remote work and electronic commerce have reduced, or will continue to reduce, agglomeration benefits and thus shift how workers and workplaces will locate their operations in the medium and long term. The authors seem to share my own intuition that the current concerns over massive remote-work fueled migration should be moderated and evaluated rather than be used as reason to philosophically abandon the income tax.
As many of us have experienced after the surge of required remote work during pandemic-related work closures, connections still matter. And community still matters. Analyses of the best uses of different taxes by local governments should not assume that every, or even a majority, of jobs will be fully mobile and responsive to local taxes independent of other factors. The market may shake out very differently.
Scharff and Shanske’s article also accurately notes that discussions of tax assignment should also consider interests beyond efficiency. The authors focus specifically on equity and revenue stability as local interests that might counsel in favor of properly designed local income taxes. On the issue of equity, Scharff and Shanske brush against a deeper literature evaluating the distributional effects of traditionally accepted local funding sources like the property tax. They also reference local fines and fees, which can be targeted at low-income taxpayers and have racially disparate effects. Traditional benefits taxes may be “efficient,” but they can also result in inequitable funding measures that may not be offset with the type of state or federal grants that are often a part of economic analyses in the fiscal federalism literature. Thinking more broadly about income taxes as potential benefits taxes may help to address equity in that regard.
Revenue stability also matters a great deal at the local level, where borrowing is not as much of an option to help smooth spending as at the federal level. Scharff and Shanske particularly note the impact that revenue volatility can have on progressive local spending. Local revenue shortfalls often lead to regressive results through spending cuts, and evaluating the potential for mildly progressive local income taxes in this regard is critically important for those interested in the overall distribution of local government taxes and services.
Beyond theoretical concerns about the best tax base, the authors also address the very real and multiple administrability, constitutional, and other policy-based concerns raised in the existing literature. Here, Scharff and Shanske draw upon their knowledge of different taxing regimes like unemployment taxes and corporate income tax apportionment rules to analyze potential approaches to local income taxation that would best balance administrability for taxpayers with local governments’ needs for revenue to fund local services. These are all important topics, and the authors do an admirable job of addressing current challenges to their arguments, of considering the existing literature challenging local tax choices, and of setting the stage for future work in this area.
Scharff and Shanske conclude their article with brief consideration of the role of the states in helping local governments and a limited discussion of basic implementation principles, but the key work of this article is in providing a counter narrative to the existing literature by being open to the potential role of local income taxes in the local tax mix of the future. My own intuition is much like the authors’. The contours of the economy of the future and where the dust will settle on remote work are unknown. Local jurisdictions, however, have current needs, and their spending will continue to create agglomeration benefits that support the imposition of appropriately designed local income taxes.
