Effects of local tax structure

In his Urban Notebook (no permalink) Otis White notes one side effect of local reliance on sales taxes for revenue -- a greater willingness of public officials to subsidize Wal-Mart and other high-volume retail establishments.

How does the sales tax affect the judgment of local officials? Consider the survey of city managers in California a few years ago that asked them to rank the kinds of developments they’d most welcome in their cities. Overwhelming choice: retail. At the bottom was industrial, followed by housing. In other words, cities wanted you, if all you wanted to do was shop. But if you wanted to work or buy a home, keep moving, pal.

This brings to mind an argument in favor of (brace yourself) the property tax -- at least for local municipal services.

There is empirical evidence that the relative values of public services and local taxes are capitalized into home values. In other words, a community with low crime, good streets, and a speedy and capable fire department will tend to have higher property values (other factors -- including taxes -- being equal) than one with high crime, pothole-filled streets, and an incompetent fire department. By the same token, an increase in property taxes with no corresponding increase in the value of public services will tend to lower property values.

So, how does this make an argument in favor of property taxes? Well, many of the services that affect property values are provided by local governments -- counties and municipalities. (To my anarcho-capitalist friends: I know it doesn't have to be that way, but that's the way it is now.) Property owners have a financial interest in monitoring the performance of local officials in performing these services. One way to accomplish this monitoring is by talking to their city council representatives, voting in city elections, and attending city council meetings.

Another way to encourage good performance is by aligning the financial incentives of the property owners and the local officials; arrange things so that local officials get more revenue when they provide good service that increases property values and less when they provide poor service. Enter the property tax: it seems particularly appropriate for funding public services that are intrinsically connected to property value, such as police and fire departments, streets maintenance, etc. The local government becomes a partial claimant on increases (or decreases) in property values.

If a city or county relies primarily on sales taxes local officials face a different set of incentives. Rather than being primarily concerned with factors that effect property values, they may be more concerned with factors that affect location decisions by retailers. According to this theory, a city that relies heavily on sales taxes may provide a less appealing place to live than one that funds the appropriate services through property taxes.

The plural of "anecdote" is not "data," but here is an anecdote anyway. In Missouri, unlike some other states, municipalities have a lot of lee way in deciding (subject to voter approval) to levy sales rather than property taxes. Consequently, the cities that can (those that are geographically situated to attract a retail base) tend to have relatively high sales taxes and relatively low property taxes. Voters support that tax mix since it allows them to export a large portion of their tax burden onto non-residents.

The city nearest to where I used to live (Poplar Bluff, Missouri) was one of those that relied very heavily on sales taxes. From 1990 to 2000, Poplar Bluff's population decreased by 2% while that of Butler County increased by 5.4%. To the extent that population changes indicate a communities desirability as a place to live, P.B. city officials aren't doing a really good job.

At any rate, if we are going to have certain publicly-funded services then I'd make the case that those that are intrinsically linked to property values* should probably be funded with property taxes.

If you're interested in this sort of thing, you might consult Economic Analysis of Property Rights, by Yoram Barzel and Fischel, W.A. (2001). Homevoters, Municipal Corporate Governance, and the Benefit View of the Property Tax. National Tax Journal, 54, 157-174.

* I don't include education in that group since school quality isn't intrinsically linked to property value; the relationship is rather an artifact of the way we fund schools.

Posted by Chip on May 21, 2004 at 08:26 AM
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I would also note that those cities/counties/etc. which rely more heavily on sales taxes are far more likely, it seems, to engage in eminent domain abuse in order to expand that sales tax base.

One way to curtail such excesses might actually be to adjust the sales/property tax mix so that more revenue comes from property taxes and less from sales taxes.

I've been pondering the question about how to alter the incentives for local governments so that eminent domain is strongly discouraged, but yet development can still occur. The issue really boils down to the fact that these lesser neighborhoods eventually have no say (financially) in this process. The cost of services oftentimes greatly exceeds the amount collected from that neighborhood to provide such services.

It's actually worse than that, however, since those neighborhoods often have the least expensive (and hence effective) services which leads to further deterioration. Once that downward spiral sets in, it's very hard to stop.

OK, I'll stop rambling now, since I've delved rather far from the original topic.

Posted by: Allen Glosson at May 21, 2004 09:17 PM