This series will breakdown three major factors to consider when evaluating taxes in your community: (1) revenue adequacy, (2) equity, and (3) compliance/administration costs. Each of these factors will be discussed in their respective sections. An appreciation of these factors can help local government decision makers better understand what tax structure is most prudent for a given community.
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Revenue Adequacy considers the growth potential of a given tax and its ability to support general government functions. Taxes differ in their growth potential. Some taxes are more sensitive to economic conditions than others, thus making revenues derived from these taxes less stable. Many taxes have a limited tax base or have a rate that’s capped by law that reduce a tax’s ability to raise revenues.
The two predominant taxes local governments levy in PA are the property tax and the earned income tax. In terms of revenue adequacy, earned income taxes have a greater potentially for growth with job gains and wage growth during economic booms and are prone to rapid decline in recessions. In contrast, property tax revenues have less growth potential as property values remain relatively stable and do not change as drastically due to economic cycles.
The realty transfer tax is an example of tax that has revenue adequacy limitations due to a limited tax base and rate that’s capped by statute. The realty transfer tax base is effectively the value of properties sold in your municipality. While this number may change due to real estate market conditions, administrators cannot plan on market conditions and sale volume being consistently favorable. In addition, the realty transfer tax rate is capped by statute at 1 percent and subject to sharing with your school district. This limited base and restricted rate affect the revenue adequacy of the realty transfer tax.
A key to assembling a responsible revenue plan to support your municipal operations is akin to investing for retirement: diversification. It’s a good idea to have a mix of taxes—covering different tax bases, some more prone to economic cycles with higher growth potential, and others more stable and steady—to mitigate overall risk to municipal revenue streams.
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Tax equity considers a taxpayer’s ability to pay a tax and whether a tax payer’s effective tax rate (ETR) increases or declines with income. Taxes are typically considered regressive, progressive or proportionate.
An effective tax rate (ETR), used to classify a tax in terms of equity, is calculated by dividing the total amount of a tax paid by the tax payer’s total income. For example, a taxpayer who pays a yearly total of $3,000 in sales taxes and has an annual income of $40,000 has an effective tax rate of 7.5 percent (3,000 ÷ 40,000).
Effective Tax Rates and Tax Classifications
Effective tax rates are used to classify taxes in terms of equity. There are three general tax classifications:
- Regressive Taxes – With a regressive tax, the ETR declines as an individual’s income (ability to pay) increases. These taxes disproportionately impact those with less ability to pay.
- Progressive Taxes– In contrast to a regressive tax, the ETR of a progressive tax increases as a taxpayer’s income or ability to pay grows. Progressive taxes place more of the tax burden on those with higher incomes and a greater ability to pay.
- Proportionate Taxes – A proportionate tax has an identical ETR for all tax payers regardless of income level and thus impacts all income classes the same.
Now, let’s consider some examples of these three types of taxes and provide a local government context.
A classic example of a progressive tax is the federal Income tax. The federal income tax is bracketed with higher rates applying as a taxpayer’s income, or ability to pay, increases. These brackets increase the effective tax rate for tax payers with higher incomes.
Local government context: there is debate on overall equity of the property tax, a major revenue source for most PA local governments.
Those claiming the property tax is more progressive assert the correlation between owning property/property values and income. Generally speaking, property ownership and property values are a proxy for an individual’s ability to pay a tax. Some say that property taxes are more like consumption taxes since property taxes are shifted forward to renters and therefore are not progressive, and disproportionately impacts individuals on fixed incomes. There’s no real consensus, but it’s likely that property taxes are less progressive than most incomes taxes and more progressive than traditional consumption taxes such as sales taxes.
Sales taxes are considered regressive because they result in a higher effective tax rate for those with less ability to pay. To illustrate this, we’ll use the following hypothetical scenarios involving two taxpayers: Taxpayer A and Taxpayer B.
- Taxpayer A is single and earns $35,000 a year. He spends $15,000 each year on goods subject to a 6% sales tax and therefore pays $900 each year in sales tax. Taxpayer A’s effective tax rate is 2.6% ($900 ÷ $35,000).
- Taxpayer B is single and earns $100,000 a year. He has more disposable income and spends $30,000— twice as much as Taxpayer A—on goods subject to a 6% sales tax. Taxpayer B pays $1,800 a year in sales tax and yet has just a 1.8% effective tax rate ($1,800 ÷ $100,000).
Or in other words, Taxpayer B’s effective tax rate is 30% lower than taxpayer A’s despite a greater ability to pay based on his higher income.
Local Government Context: the local service tax allows municipalities to collect a total of $52 a year for those employed in their community, deducted during payroll. The LST could be considered regressive in that the tax does not change based on income (except for an exemption for those making less than $12,000 annually) and therefore has a disproportionate impact on lower income individuals.
A proportionate tax, in terms of equity, is a tax in which the ETR does not change based on income or ability to pay. So, it is not considered regressive or progressive.
A good example of a proportionate tax is the local earned income tax (EIT). This tax uses a uniform rate, so in theory, employees that earned higher or lower annual wages should have the same effective tax rate with the EIT. This assumes that both taxpayers’ total yearly income is taxable under the EIT.
Horizontal equity, another tax equity consideration, refers to the principle that individuals with similar incomes should pay a similar amount in taxes.
Horizontal equity becomes a factor when taxpayers earn income or receive income from different sources. For instance, a taxpayer that makes $50,000 from investments (capital gains) will pay less than a wage earner making $50,000 subject to the federal income tax as capital gains are taxed at a lower rate.
Local government context: In PA, retirement income is exempt from the local earned income tax. Therefore, a resident receiving $50,000 a year on a pension will not pay any earned income tax compared to the resident who earned $50,000 in wages that are taxed at the rate set by the municipality.
Overall tax equity should be a factor when assembling your tax plan for your community. However, local governments are generally confined by state laws to certain taxes and tax structures and generally have little ability to impose new taxes that are not enabled by the state or to modify existing taxes to make them more progressive unless the authority to do so is provided via statute. For example, a municipality is not able to increase the earned income tax above its cap of 1.5% and cannot add additional rates that apply to those who earn more or less income.
Administration & Compliance
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The third factor that should be considered when setting any tax policy is compliance and administration cost.
This factor contemplates the following questions:
- How much does it cost to collect and administer a given tax?
- How much of a financial burden does complying with the tax pose on residents and businesses?
Tax compliance and administration cost should be considered because every dollar spent on collection and administration of a tax is effectively one less dollar the tax raises to support municipal operations. In addition, every dollar a resident or business spends in effort to comply with a local tax is an additional cost associated with the tax.
A simple example of a local tax in PA where collection/administration is a factor is the mechanical devices tax. This tax, enabled by Act 511, allows a municipality to collect a percentage of gross receipts from juke boxes, pinball machines, video games, and other coin-operated amusement machines in operation within the jurisdiction of a municipality imposing the tax.
The revenues raised from this tax may not be justifiable given the resources required to annually administer (register new machines) and collect the tax from businesses that have mechanical devices in operation. Municipalities with this tax on the books should try to calculate the net tax revenue they receive when factoring in administration costs and consider repealing the tax if net revenues are not sufficient to justify levying the tax.
Compliance cost considers the time and resources required of those being taxed to comply. This effectively is an additional financial burden on the subject of the tax that should be considered.
For instance, complicated tax structures that require professional staff or consultation services to file tax returns or complete tax forms, audits, etc. add additional effective cost to residents and businesses subject to such taxes. As a general rule, municipalities should look to keep tax compliance as simple as possible for residents and businesses and should look to provide helpful resources to aid in tax compliance efforts.
PA local governments are controlled by state law on what types of taxes they can impose, taxation limits, and in some cases how such taxes are to be administered. Nonetheless, compliance and administration costs should still be considered by governing bodies when exploring taxation options. Along with equity and revenue adequacy, compliance and administration cost is another important factor for municipal officials to contemplate when reviewing municipal tax options.