City Wage Taxes: In the U.S., very few cities tax income derived from wages while the national government imposes considerable taxes on wages (through both payroll and income taxes)—and then passes some of those revenues back to city governments.
A: In this exercise, we will consider the reason for this difference in local and national tax policy — and why city governments might in fact be “employing” the national government to levy wage taxes and then have the national government return them to cities.
(a) Consider first a national labor market. While workers and firms can move across national boundaries to escape domestic taxes, suppose that this is prohibitively costly for the labor market that we are analyzing. Illustrate demand and supply curves for domestic labor (assuming that supply is upward sloping). Indicate the no-tax equilibrium wage and employment level and then show the impact of a wage tax.
(b) Next, consider a city government that faces a revenue shortfall and considers introducing a wage tax. Why might you think that labor demand and supply are more elastic from the city’s perspective than they are from a national government perspective?
(c) Given your answer to (b), draw two Laffer curves—one for tax revenue raised in a city when the tax is imposed nationally and one for tax revenues raised in the same city when it is imposing the tax on its own. Explain where the peaks of the two Laffer curves are relative to one another.
(d) How do your answers to (b) and (c) most likely contain the answer to why cities do not typically use wage taxes to raise revenues?
(e) Suppose you are a mayor of a city and would like to impose a wage tax but understand the problem so far. How might it make sense for you to ask the federal government to increase the wage tax nationwide—and then to give cities the additional revenue collected in each city?
(f ) Of those cities that do have wage taxes, most are relatively large. Why do you think it is exceedingly rare for small cities to impose local wage taxes?
(g) Does any of this analysis depend on whether there are wealth (or income) effects in the labor market?
B: Suppose that labor demand and supply are linear—with ld = (A−w)/α and ls = (w −B)/β.
(a) For a given per-unit wage tax t , calculate the employment level and tax revenue.
(b) Consider two scenarios—scenario 1 in which (A−B) is large and scenario 2 in which (A−B) is small. What has to be true about (α+β) in scenario 1 relative to scenario 2 if the no-tax equilibrium employment level is the same in both cases.
(c) Suppose one scenario is relevant for predicting tax revenue from your city when it is collected nationwide and the other is relevant for predicting tax revenue when the wage tax is collected just in your city. Which scenario belongs to which tax analysis?
(d) Find the tax rate t at which government revenue is maximized.
(e) Demonstrate that the scenario appropriate for the tax analysis when only your city imposes the wage tax leads to a Laffer Curve that peaks earlier.
(f) As cities get small, what happens to (A −B) in the limit? What happens to the peak of the Laffer Curve for a local city tax in the limit?