Econ Matters: Should we pay attention to earnings tax proposition in Columbia?

In about one quarter of the largest cities in the United States, city governments have implemented an earnings tax. Generally speaking, the tax base consists of income earned by people living in the city and wages earned by people working in the city or profits earned by those owning businesses in the city.
In November 2010, Missourians will vote on Proposition A. If the proposition is passed, cities in Missouri that have not implemented an earnings tax will not be allowed to implement one, and voters in the two cities that have the earnings tax, Kansas City and St. Louis, must subsequently vote on whether to maintain the tax. The amendment provides a 10-year phase-out if either city rejects the earnings tax at the poll or fails to vote.
Cities and their suburbs compete in a variety of ways. Each political subdivision within a Metropolitan Statistical Area differentiates by services such as school quality and parks, and each defines what it will tax and the rate applied on this tax base. In addition, infrastructure, especially highways, establishes the difficulty that suburbanites face in getting from their town to other parts of the MSA. The highways are generally geared toward bringing people from suburbs to the hub of the main city in the MSA. Transportation systems aim to get people to the central business district.
Overall, urban sprawl owes, in part, to transportation infrastructure and to the competition between cities and suburbs in terms of amenities offered. In other words, it is easy enough to travel 20 miles downtown to work and still enjoy the schools, parks and other attributes that exist in my suburb.
First, I present some evidence on the economic outcomes associated with earnings taxes. I collected data on the tax rate for 101 cities across the country as well as the income for the main city and the entire MSA.
Only 24 of the 101 cities had positive earnings tax rates. I found a negative correlation between the ratio of income in the city to income for the MSA and the tax rate.
This correlation needs to be explained. In my view, one can account for the finding as follows: People realize a lower after-tax return to labor and business ownership by locating in the city compared with locating in the suburbs. On the margin, when people weigh the various attributes of locating in the city or locating in the suburbs, the evidence suggests that people seek to avoid the earnings tax by sheltering income in the suburbs where the after-tax return to labor and business ownership is higher.
Economic theory recognizes that the exodus will not be 100 percent avoidance. Some people prefer being close to the cultural activities that tend to be agglomerated in the main city. They like the older houses, or their businesses benefit from proximity to the central business district. The point is that the earnings tax is negatively correlated with the composition of the city relative to its suburbs, and the compositional effect can be accounted for by recognizing the negative impact the tax has on after-tax returns to labor and business ownership.
The non-economic rhetoric is quite interesting to me. Opponents of Proposition A tell us that eliminating the earnings tax will decimate the state’s two largest cities. In Kansas City, about $190 million of services will have to be cut if the earnings tax is eliminated. In St. Louis, about $130 million services will have to be cut.
Such statements smack of fear mongering. The question that leaps to my mind is this: Do we have so little hope in the abilities of our public servants that they could not solve a change in revenues over 10 years?
I admit that the solution would be daunting if these servants did not have the practices of 77 other major cities that collect revenues from sources without relying on an earnings tax. In other words, Kansas City and St. Louis do not have to re-invent the wheel with respect to creating a structure of taxes and fees that will realize about the same revenues as they collect now.
The economic arguments presented here are one factor affecting people’s decision on how to vote, and the economics might not be the deciding factor. The main purpose of this column is to point out that different tax structures yield different economic outcomes. It is important to know the tradeoffs.
For Columbians, there is one critical, open question: After we decide on the size of the city government’s expenses, what is the tax base and tax rate that will do the least harm to Columbia citizens? As I understand the evidence, if I lived in Ashland, for instance, and I was thinking strategically, the thought would cross my mind to get Columbia to implement an earnings tax.