Local income tax

Local Income Tax

A local income tax is a levy imposed by a municipal government, such as a city, county, or school district, on the income earned by individuals or businesses within its jurisdiction. This form of taxation falls under the broader category of Public finance, as it represents a method by which local authorities generate Revenue streams to fund public services like education, infrastructure, and public safety. Unlike federal or state income taxes, local income tax rates and regulations can vary significantly from one locality to another, impacting residents and non-residents who work within the taxing area.

History and Origin

The imposition of income taxes at the local level is a relatively modern development in the history of Taxation in the United States. While federal income taxes gained prominence after the ratification of the 16th Amendment in 1913, local governments traditionally relied more heavily on property and sales taxes. The Great Depression, however, created a severe strain on municipal budgets, leading to a search for new revenue sources.

Philadelphia became the first major U.S. city to implement a local income tax in 1939, driven by the urgent need to avoid bankruptcy due to declining property tax revenues¹³. Following Philadelphia's pioneering move, the concept gradually spread to other cities and counties. For instance, cities in Ohio, Kentucky, Missouri, and Michigan adopted similar taxes in the 1940s and 1960s¹². Today, local governments in numerous states utilize some form of local income tax to diversify their financial base and fund local services¹¹.

Key Takeaways

• Local income tax is levied by cities, counties, or school districts on income earned within their boundaries.
• These taxes provide essential revenue for local public services and can complement or replace other local revenue sources.
• Rates and rules for local income taxes vary widely by jurisdiction, affecting both residents and non-residents.
• Local income taxes contribute to the overall Tax burden on individuals and businesses.
• They can offer local governments greater Fiscal autonomy and stability in their funding.

Formula and Calculation

The calculation of local income tax typically involves applying a specified tax rate to an individual's or entity's Taxable income or Earned income within the jurisdiction. The specific formula can vary based on whether the local tax mirrors the state's definition of income or has its own unique rules regarding Deductions and exemptions.

A simplified formula for local income tax is:

[
\text{Local Income Tax Due} = \text{Taxable Income} \times \text{Local Tax Rate}
]

Where:

• Taxable Income: The portion of income subject to the local tax, which may be gross income, adjusted gross income (AGI), or earned income, as defined by the local ordinance.
• Local Tax Rate: The percentage or flat fee set by the local taxing authority.

Interpreting the Local Income Tax

Understanding a local income tax involves examining its rate, the definition of income it applies to, and how it interacts with other taxes. A higher local income tax rate generally means a greater portion of an individual's or business's earnings will go towards local government services, increasing their overall Tax burden. Conversely, in jurisdictions with lower or no local income tax, other taxes like Property tax or Sales tax may be higher to compensate for revenue needs.

Some local income taxes are flat rates, meaning everyone pays the same percentage, while others may be structured progressively, with higher earners paying a greater percentage. The interpretation also involves considering whether the tax applies only to residents or also to non-residents who commute into the jurisdiction for work. This distinction can influence where individuals choose to live and work.

Hypothetical Example

Consider an individual, Sarah, who lives in a town without a local income tax but works in the city of Metropolis, which imposes a 1.5% local income tax on all Earned income. Sarah's annual salary is $60,000.

1. Determine Taxable Income: For simplicity, assume Metropolis's local income tax applies directly to her gross earned income. So, her taxable income for local purposes is $60,000.
2. Apply Local Tax Rate: The local tax rate in Metropolis is 1.5%.
3. Calculate Local Income Tax: $$\text{Local Income Tax} = \$60,000 \times 0.015 = \$900$$

Therefore, Sarah would owe $900 annually in local income tax to Metropolis. This amount would typically be deducted from her paycheck through Withholding tax, similar to how federal and state income taxes are collected. This example illustrates how a local income tax directly impacts an individual's take-home pay, regardless of their residential location, if they work within the taxing jurisdiction.

Practical Applications

Local income taxes serve as a crucial component of local government finance, demonstrating several practical applications:

• Diversifying Revenue: They provide an alternative or supplementary source of revenue beyond property and sales taxes, which can be particularly vulnerable during economic downturns or changes in consumer spending habits¹⁰.
• Funding Local Services: The revenue generated directly supports essential local services such as public schools, police and fire departments, road maintenance, and parks.
• Tax Exportation: In some cases, local income taxes levied on non-residents who work in the jurisdiction can "export" a portion of the tax burden to individuals who do not reside there, reducing the financial load on local residents⁹.
• Economic Development: Local income tax policies can be designed to attract or retain businesses and residents, though their impact on economic growth is a subject of ongoing study⁷, ⁸.

For detailed guidance on how local taxes interact with federal tax obligations, individuals can consult official resources such as publications from the Internal Revenue Service (IRS). The IRS provides various Publications (e.g., Publication 525, Taxable and Nontaxable Income) that offer insights into what constitutes taxable income and how certain state and local taxes may be deductible⁵, ⁶.

Limitations and Criticisms

While local income taxes offer benefits, they also face several limitations and criticisms:

• Complexity and Compliance Burden: The existence of numerous local taxing authorities, each with potentially different definitions of taxable income, rates, and filing requirements, can create a complex and burdensome compliance environment for taxpayers and businesses operating across multiple jurisdictions⁴. This complexity can lead to increased administrative costs for both local governments and taxpayers.
• Economic Impact: Concerns exist regarding the potential for local income taxes to discourage economic development or lead to residents and businesses relocating to areas with lower tax burdens. Research suggests that high local taxes can potentially deter growth, particularly if the revenues are not used to improve public goods and services², ³.
• Equity and Fairness: The progressive or Regressive tax nature of local income taxes varies. While some argue they can be more Progressive tax than Sales tax or Property tax, others criticize flat-rate local income taxes for disproportionately affecting lower-income individuals.
• Inter-jurisdictional Competition: Localities may engage in tax competition, lowering rates to attract residents or businesses, which can lead to a "race to the bottom" and reduced overall revenue for public services.

Local Income Tax vs. State Income Tax

The primary distinction between a local income tax and a State income tax lies in the level of government that imposes and collects the tax, as well as the geographical scope of its application.

A state income tax is levied by an individual state government on the income of its residents and often on non-residents earning income within that state. These taxes are generally broader in scope, applying statewide, and their rates and structures are determined by state legislation. Most states in the U.S. impose an individual income tax, and it typically constitutes a significant portion of state government revenue.

In contrast, a local income tax is imposed by a sub-state government entity, such as a city, county, school district, or other municipality. Its jurisdiction is much more geographically limited, applying only within the boundaries of that specific local authority. While some local income taxes may piggyback on state income tax calculations, many have their own distinct rules and collection mechanisms. Not all states permit local income taxes, and among those that do, the prevalence and specific forms of these taxes vary widely from minor flat fees to percentage-based levies.

FAQs

What types of income are typically subject to local income tax?

Local income taxes generally apply to earned income, such as wages, salaries, and commissions. Some jurisdictions may also tax net profits from businesses or other forms of income like interest and dividends, but this varies significantly by locality.

Do all cities and counties in the U.S. have a local income tax?

No, only a minority of states authorize their local governments to impose an income tax. Within those states, only certain cities, counties, or school districts choose to levy such taxes. For example, as of recent data, local governments in 16 states tax income in some form¹.

Can I deduct local income taxes on my federal tax return?

Yes, local income taxes paid are generally deductible as an itemized deduction on your federal income tax return, subject to certain limitations. For individuals, the deduction for state and local taxes (SALT) is capped at $10,000 per household. This deduction can reduce your overall Tax burden at the federal level.

How do I know if I owe local income tax?

You typically owe local income tax if you live or work in a jurisdiction that imposes one. Your employer may Withholding tax from your pay, and your W-2 form will show any local taxes withheld. If you are self-employed or work in a different jurisdiction than where you reside, you may need to proactively understand and fulfill your local tax obligations.

What is the difference between a local income tax and a local services tax?

A local income tax is typically a percentage of your earned income or Taxable income. A local services tax (sometimes called an occupational privilege tax or emergency and municipal services tax) is often a flat, small per-employee tax levied on individuals who work within a municipality, regardless of their income level, up to a certain maximum amount.