An optimal tax rate for local government: How high is too high?

In the U.S., local government practitioners are seeking a way to keep property tax rate relatively low; while at the same time providing the best possible local public service including better public infrastructure, safety, and education to attract new businesses and residents. Based on Paul Samuelson’s condition, the optimal tax rate is the one that is correspondent with the marginal level of public consumption. The aim of this paper is to test an optimal tax theory and inform local practitioners regarding a set of potentially useful key factors when considering whether their local taxes are too high. Conventional wisdom suggests that relatively high taxes discourage immigration of new residents and businesses; while relatively low taxes or no tax encourages the immigration.  This is not necessarily the case since the local tax rate is not the sole factor determining new business and resident relocation. Wellisch and Hulshorst’s (2000) assert that in addition to private factors such as land and labor prices, local public factors can influence tax rate levels. Local public factors are defined as an accumulation of changes over time that generate comparative advantage for a jurisdiction, and eventually create a pattern of relatedness of those productive factors across industries (Shirotori, Tumurchudur & Cadot, 2010). This study uses public finance data including local property tax rates, direct taxes on firms and local sales tax rates as well as economic development data including public and human capital stocks and productive land from cities in the United States to test Wellisch and Hulshorst’s (2000) theory. The results inform academics and practitioners how each of the factors in Wellisch and Hulshorst’s (2000) model interact with one another to determine the level of tax rates. The validated model of optimal taxation can also be used to simulate the optimal tax rate for local governments based on their local public factors, the presence or absences of direct taxes on firms and sales taxes.