Local Revenue Hills: Evidence from Four U.S. Cities

For two of the cities for which the authors have employment data -- New York and Philadelphia -- the effect of tax increases is to reduce city jobs. In 1970, New York City had 5.28 percent of the nation's jobs. By 2001 it had 2.88 percent. Similarly, Philadelphia lost 173,000 jobs between 1971 and 2001 because of increases in city wage tax rates.

During periods of fiscal crisis, as in FY 2003, predicting the effects of local tax increases on revenues is essential if state and municipal leaders are to design credible strategies for balancing short- and long-term budgets. In Local Revenue Hills: Evidence From Four U.S. Cities (NBER Working Paper No. 9686), co-authors Andrew Haughwout, Robert Inman, Steven Craig, and Thomas Luce estimate the effects of local taxation on local economic activity in four large U.S. cities: Houston, Minneapolis, New York City, and Philadelphia. With those estimates, the authors compute each city's revenue hill: the path of marginal tax revenues in relation to tax rates.

The authors find that Houston, New York City, and Philadelphia are near the peaks of their revenue hills. Minneapolis remains comfortably down its revenue hill, allowing it significant additional taxing capacity. In all four cities, the marginal tax dollar fails to deliver a full dollar of public service benefits, suggesting that distributive local politics may be setting those cities' budgets.

For two of the cities for which the authors have employment data -- New York and Philadelphia -- the effect of tax increases is to reduce city jobs. In 1970, New York City had 5.28 percent of the nation's jobs. By 2001 it had 2.88 percent. The job situation reflects in part the statistically significant negative effect of income tax rate changes: taxes rose from a top marginal rate of 2 percent to 4.66 percent in 1994 before dropping to 3.592 percent in 2001. The authors predict that the city's total job loss because of increases in city income tax rates would have been 490,000 jobs, but Mayor Giuliani's 1994 tax cuts restored 160,000 of those jobs for a final, tax-induced decline in city employment of about 330,000 jobs.

Similarly, Philadelphia lost 173,000 jobs between 1971 and 2001 because of increases in city wage tax rates. However, the authors estimate that without Mayor Rendell's wage tax cuts begun in 1996, Philadelphia's job loss would have been an additional 30,000 jobs. The New York City and Philadelphia experiences lead the authors to conclude that lowering city taxes is likely to be a cost-effective way to increase city employment.

The recent cuts in New York and Philadelphia's income and wage taxes do mean lost tax revenues and presumably lower public services for city residents, but the added city jobs offer an important compensating benefit. The end result is a smaller public sector, but a larger and arguably more productive private city economy.

The authors conclude that a city's revenue capacity is limited by the mobility of its residents and businesses. Houston and Philadelphia have nearly exhausted their revenue capacity. Mayor Bloomberg's recent increase in city property tax rates has moved New York City to the top of its revenue hill. Only Minneapolis can raise significant new revenues from taxes. Interestingly, Houston can raise a modest amount of additional revenues by lowering its property tax rate; the city is just beyond the peak of its revenue hill.

For Houston, New York, and Philadelphia, balanced city budgets will require the city to hold new spending to the rate of inflation. The authors' study reveals a fundamental tension between the interests of city public employees, poor households within the city, and city taxpayers. Tax increases unmatched by tax-financed compensating benefits for taxpayers -- whether property owners, consumers, or firms -- will drive those taxpayers from the city. Property values fall, business sales decline, and the city's tax base shrinks. To protect city economies, a dollar of taxes paid must be matched by at least a dollar of public service benefits. That was not the case in any of the sample cities, though nearly so in Minneapolis.

-- Les Picker