Commentary / Koleman Strumpf
Addicted to the wage tax: No matter where you go, Pa. towns and cities take a nibble.
By Koleman Strumpf
Last year, 2,416 Pennsylvania cities, boroughs and townships charged a local wage tax. As a comparison, the next highest total was 559 in Ohio.
How did local wage taxes become such a prominent feature of the commonwealth's fiscal landscape? The answer lies not in a particular Pennsylvania affinity for wage taxes but rather in the singular way in which the tax is collected.
Pennsylvania has adopted a so-called "residential priority tax credit" system. Under this rule, individuals pay wage taxes first to their community of residence. If they work in another community, they are liable only for workplace wage taxes in excess of what they owe at home. For example, a resident of Cheltenham Township (which has a 1 percent wage tax) would pay no workplace wage taxes if he works in Bristol Township (which has a one-half percent tax). Alternatively, if this person worked in Chester (which has a 1.7 percent tax on nonresidents) he or she would pay 0.7 percent of his wages to Chester.
This system of tax credits virtually ensures that all communities will enact a wage tax. Suppose there is a region where only the central city levies a wage tax. In this case, commuters from the surrounding suburbs will be liable for all of the city's tax. For these commuters, a new wage tax in their home community does not cost them anything: They simply pay taxes at home rather than at work. So when there is a central city levy, the surrounding suburbs can generate "free money" from a wage tax that imposes no burden on their residents.
This explains the typical pattern of taxation in Pennsylvania, where wage taxes start in big cities and spread quickly like a virus in the surrounding suburbs.
The Philadelphia area is different because of the city's special tax priority over suburban commuters. Because Philadelphia's wage tax is so high, currently a little over 4 percent on nonresidents, commuters don't pay wage taxes in their home regions if one is levied.
This means there is no free money for the Philadelphia suburbs. Those who commute into the city don't have to pay two wage taxes - but their local municipalities lose the revenue those commuters would pay in local wage taxes. Levying a wage tax is therefore a more difficult decision for a Philadelphia suburb than, say, a Pittsburgh suburb (since the Pittsburgh region does not feature such odd rules). Philadelphia's tax priority helps explain why most of the only 155 communities in Pennsylvania that don't charge wage taxes are located in its metro area.
What is the economic effect of these local wage taxes? With Philadelphia, the experience seems to have been unambiguously bad. From 1969 to 1992, the city tax rate on residents spiraled from 2 percent to nearly 5 percent. At the same time, there was a mass exodus of jobs and people from the city. These two effects formed a vicious cycle: The increased rates drove the tax base out of Philadelphia, and to keep raising tax revenues the city further increased the tax rate. And repeat.
True, these trends could simply reflect some common third factor, such as a growing middle-class dislike of big cities. Robert Inman and colleagues at the Wharton School, however, have shown that the wage tax can directly explain the loss of roughly 100,000 jobs from Philadelphia over the period 1969 to 1985. While this pattern has paused with the current economic upturn and the largely symbolic reduction of the wage-tax rate under Mayor Rendell, higher wage taxes and job losses are likely to resume when more normal economic times return.
In the suburbs, the wage tax has had a mixed effect. On the good side, the suburbs have benefitted from the flight of firms and people from Philadelphia. You merely have to drive down City Avenue or Route 202 to see evidence of that. At the same time, it is not clear whether the suburban governments have been using their own wage tax collections wisely. Despite the common promise to use new wage-tax revenues for property-tax relief, total taxes often increase following a new levy. For example, when Plymouth Township enacted a wage tax in 1991, its overall tax collections went up by nearly 50 percent.
While the suburban wage tax is an irritant to many residents, its economic consequences are small because it typically cannot exceed a low 1-percent rate. Still, it seems likely that the wage tax will continue to spread within the suburbs. Without a simultaneous reduction in property taxes, the new wage taxes are likely to accelerate the movement of people and jobs away from the urban core of the Philadelphia area.
Koleman Strumpf (firstname.lastname@example.org) is an assistant professor of economics at the University of North Carolina at Chapel Hill.
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