Critical Issues in State-Local Fiscal Policy, Part 2:
A Guide to Local Option Taxes
November 1997
Return to Fiscal Partners
A Checklist of Issues for Evaluating Local Option Taxes
The expansion of local taxing authority may have important implications for individual taxpayers, businesses and the economy. Listed below are key policy issues that legislatures may need to consider when determining whether to grant additional taxing authority to local governments.
Local Accountability and Flexibility
Local option taxes improve accountability to taxpayers by placing taxing and spending decisions closer to the people. This may be especially important in geographically large states that encompass regions with divergent political views. Local option taxes allow voters, either directly or through their representatives, to choose whether to increase taxes to pay for services that state taxpayers may be unwilling to fund.
Limits on State Revenue Options
Once local option tax provisions are in place, removing or modifying them is difficult because of the revenue impact on local governments. For example, Colorado, Georgia and North Carolina decided to reduce the tax burden on the poor by eliminating food from the state sales tax base. Due to the potential local revenue loss, however, food was not exempted from the local sales tax base. Local option taxes also will increase combined state-local tax rates, possibly limiting states' flexibility to raise tax rates in the future. State policymakers should consider how granting local taxing authority could affect future state tax system modifications.
Administrative and Compliance Costs
States should recognize that poorly designed local option tax structures will increase administrative and compliance costs for taxpayers and local governments alike, which, in turn, may adversely affect a state's economic competitiveness and business climate. Local option tax structures that grant local and municipal governments the autonomy to establish separate tax bases, exemptions and collection activities will increase taxpayer compliance costs and confusion.
On the other hand, assuming local option taxes are permitted by the legislature, uniformity among such taxes will benefit localities and taxpayers alike. Local option tax systems that are added to existing uniform, statewide tax bases minimize compliance costs for taxpayers and preserve the state government's ability to maintain control over the state's economic competitiveness and business climate as a whole. In addition, mandated uniform statewide exemptions and exclusions—and a homogeneous tax form that allows taxpayers to report and remit local option taxes at the same time as the state level tax—will lead to a more efficient, effective and equitable tax system.
Uniformity also will reduce the potential for competition among localities that want to attract new or expanding businesses, and a single set of tax rules will reduce the costs and hazards of litigation for all parties. Finally, local tax structures that are centrally administered by the state will minimize administrative expenses for local governments. In many states, local option taxes are collected for local governments by the state for a small administrative fee.
Balance
One principle of a high quality revenue system is balance. Balance means that states have a roughly equal mix of income, consumption and property taxes. Balance allows states to keep rates as low as possible in any one tax, minimizing the potential that the tax system will distort economic behavior. Balance also improves the stability of state-local revenue systems by distributing the tax burden to various types of economic activity. States must consider how granting local option taxation will affect the balance of the state-local tax system.
Responsiveness to Economic Growth
Economists use the term elasticity to describe the responsiveness of a tax—or a tax system—to personal income growth. Elastic sources increase more quickly than personal income, while inelastic sources increase more slowly than personal income. Income taxes are typically the most elastic state-local revenue source, while excise taxes typically are the most inelastic. State policymakers should consider whether the local option tax source will produce the long-term revenue growth necessary to finance the programs being funded by local governments. Authorizing an inelastic revenue source to pay for high-growth programs like jails or health care may lead to budget problems in the future.
Fiscal Disparities
There will be disparities in the tax base available to finance services any time local rather than state taxes are used. The primary reason that states have expanded their role in funding education is to alleviate these disparities. Although property tax disparities receive a good deal of attention because of their school financing role, other tax sources actually may create larger fiscal disparities. When evaluating the use of local option taxes, state policymakers should consider whether a local option tax alternative will improve or exacerbate the fiscal disparities among local governments in the state.
Inter-local Competition
Just as states compete with one another on the basis of tax policy, local option taxes may lead to competition among local governments. This competition may create an adversarial relationship between cities and suburbs, as both try to use a competitive tax policy to lure businesses and residents. Such competition does not improve the state's overall economic performance and may divert resources from more productive uses. Competition also may place poorer localities and inner cities at a disadvantage in relation to their wealthier neighbors because property wealth usually is correlated with income and consumption. Thus, local governments with strong property tax bases may have less need for revenue and can levy local option taxes at lower rates than their poorer neighbors.
Progressivity and Regressivity of the State-Local System
State decisions about the type of local option taxes authorized can significantly alter the progressivity of the state-local tax system. In our federal system, the federal government makes extensive use of the income tax but levies few consumption taxes. By default, state and local governments must rely primarily upon property and consumption-based levies that are regressive. Policymakers should consider whether a proposed local option tax alternative will increase or decrease the regressivity of state-local systems.
Statewide vs. Enumerated Local Option Taxes
States differ on whether all local governments or only those that meet certain criteria may levy local option taxes. In some states, only the largest cities or counties may levy taxes, while other states grant statewide authority. States that grant authority broadly may help minimize the tendency for tax rates to be higher in larger cities.
Voter Approval
States vary considerably on voter approval requirements for local taxes. It is not uncommon for a state to require voter approval for some local taxes but not others. Voter approval requirements make it more difficult for local governments to levy or increase a tax and may delay imposition of a tax until the next election. Also, if voter approval is required for some local levies but not others, the local governing body may choose the path of least resistance and impose taxes that do not require voter approval. On the other hand, voter approval requirements force local governing bodies to carefully justify tax increases. Such requirements tend to minimize the number of times that local governments seek rate increases, creating a more stable tax climate.
Federal Deductibility
State and local income and property taxes are deductible from federal adjusted gross income, while sales and other consumption taxes are not. Federal deductibility can reduce the tax price of income and property taxes, particularly for those taxpayers who face high federal income tax rates. Shifting from deductible to nondeductible local taxes will increase the amount of federal taxes paid by state residents.
Federal "devolution" is prompting states to assume responsibility for programs currently funded by the federal government. At the same time, states are taking a new look at the division of tax and service responsibilities between state government and county, municipal and other local governments. With increasing frequency, local governments are asking legislatures for authority to levy local option taxes.
This report provides an overview of state-local tax systems and reviews the current status of local option taxing authority in the states. It also highlights key policy questions that legislators may want to consider when deciding how much taxing authority to grant local governments.
Participating Legislators and Legislative Staff
Senator Charles Horn, Ohio
Representative Willie Logan Jr., Florida
Senator David Nething, North Dakota
Senate President Tom Norton, Colorado
Delegate Howard P. Rawlings, Maryland
Representative Ann Rest, Minnesota
Paul Dlugolecki, Executive Director, Senate Minority Appropriations, Pennsylvania
Ted Ferris, Staff Director, Joint Legislative Budget Committee, Arizona
Jamie Franklin, Staff Administrator, Legislative Research Commission, Kentucky
Harry A. Green, Executive/Research Director, Advisory Commission on Intergovernmental Relations, Tennessee
Robert Keaton, Director, Senate Office of Fiscal and Policy Development, Louisiana
Stephen A. Klein, Legislative Fiscal Officer, Joint Fiscal Office, Vermont
Alan Kooney, Legislative Budget and Finance Officer, New Jersey
Abraham Lackman, Secretary, Senate Finance Committee, New York
Philip Leone, Director, Joint Legislative Audit and Review Commission, Virginia
Leo Memmott, Legislative Fiscal Analyst, Utah
Dennis Prouty, Director, Legislative Fiscal Bureau, Iowa
Stephen Price, Staff Director, House Appropriations Committee, Missouri
Gary Olson, Director, Senate Fiscal Agency, Michigan
Peter Schaafsma, Executive Director, California Debt and Investment Advisory Commission
Representatives of the Foundation Fiscal Partners
American Federation of State, County and Municipal Employees: Marcia Howard, Economic Policy Analyst, Department of Public Policy; Marie Monrad, Associate Director, Department of Public Policy
Committee On State Taxation: Douglas Lindholm, Legislative Director, representing AT&T, Ford Motor Company, American Express, The Coca-Cola Company, and General Electric
International Council of Shopping Centers: Russell Pratt, Staff Vice President; Richard Warren, Director of State Relations
National Education Association: Joseph A. Falzon, Research Specialist; Janis Hagey, State Policy Affairs Coordinator; Ed Hurley, Research Specialist
National Soft Drink Association: Kevin Perry, State and Local Affairs
NCSL Foundation for State Legislatures: Jerry Sohns
Philip Morris Management Corporation: Derek Crawford, Director, Government Affairs Planning; John Dunham, Fiscal Issues Manager
Return to Fiscal Partners or see part 1: Sorting Out State and Local Responsibilities
This book was published in November 1997; this page was reviewed in December 2003.
Email mailto:statetax-info@ncsl.org?subject=A Guide to Local Option Taxes for more information.
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