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An Introduction to State and Local Public Finance
Thomas A. Garrett and John C. Leatherman

II. Funding State and Local Government - State and Local Taxes

Each state and local government in the United States uses a variety of taxes to raise the revenues necessary to meet required expenditures. These taxes include the sales tax, personal income tax, property tax, excise taxes, and the corporate income tax. In addition to choosing between different taxes, the tax rates vary across state and local governments. The combination of taxes and tax rates used by each state or local government is termed the tax mix. This section first presents an overview of the major sources of state and local government tax revenue. The reader will see that individual state or local governments differ greatly in their reliance on each tax as a source of revenue. This is primarily due to varying economies of scale in the provision of goods and services and differences in voters’ tax preferences across localities and states. After providing an overview of the major tax sources for state and local governments, each of the five major taxes used by state and local governments is discussed as are other common sources of state and local government revenue.

A. State and Local Government Revenue

Traditionally, state and local governments use five types of taxes to raise revenues. These taxes include the general sales tax, the personal income tax, the corporate income tax, the property tax and excise taxes (taxes such as alcohol and tobacco taxes and the motor fuels tax). Although these five taxes are all used by both state and local governments, the importance of each tax in contributing to total tax revenues differs between both levels of government.

i. State Government Revenue

In 1998, state governments generated almost $475 billion in state tax revenues. Tax revenues by state are shown in Table 1. Considering total taxes, it is not surprising that high population states like California, New York, Texas and Florida generated the most tax revenues. However, on a per capita basis things appear much different. Connecticut, Delaware and Hawaii generated the most tax revenue per person, while tax revenues per capita in some higher population states are near the lowest in the nation.

General sales taxes have historically been the greatest source of revenues for state governments. In 1996, over 37 percent of state revenues came from general sales taxes. Personal income taxes were second in importance to the general sales tax, followed by the corporate income tax and excise taxes on alcohol, tobacco and motor fuels. Individual source state tax revenues as a percent of total state tax revenues from 1950 to 1996 are shown in Table 2.

Although sales taxes have been the greatest revenue source for state governments, the personal income tax has increased in importance in recent years, now only contributing slightly less to total revenues than the sales tax. Corporate income tax revenues as a percentage of total tax revenues have remained relatively constant except for a slight increase in the 1980s. Alcohol, tobacco and motor fuel taxes have become a less significant portion of total state tax revenues over time. As previously mentioned, this is primarily a result of these taxes not being linked to inflation as are the other three taxes. Unlike local governments, the property tax currently contributes a very smaller percentage to overall state tax revenues, although historically this percentage has been higher. The property tax only accounted for about two percent of total state tax revenues in 1996. States’ decreasing reliance on the property tax is reflected in the falling percentages of other tax sources shown in the last column of Table 2

ii. Local Government Revenue

The major tax revenue sources for local governments are quite different than that of state governments. The predominant source of tax revenue for local governments has been the property tax. In 1996, the property tax accounted for 74 percent of local government tax revenues. Recall the property tax accounted for only two percent of state tax revenues. Local governments also rely on general sales taxes, but much less than state governments. Sales taxes currently account for about 15 percent of local tax revenues. The personal income tax is also a smaller percentage of local tax revenues than state tax revenue, with only about five percent of local tax revenues coming from personal income taxes. Local governments receive about five percent of total taxes from excise taxes, whereas state governments receive approximately 15 percent of tax revenues from excise taxes.

B. The Sales Tax

A general sales tax imposes the same tax rate on the purchase of all commodities. Another common name for a general sales tax is the retail sales tax, as the tax applies to most retail sales. The sales tax is considered an ad valorem tax because it is levied as a percentage of the sales price. Although this is the true definition of a general sales tax, it is important to realize that the sales tax really only applies to most commodities rather than all commodities. Many state and local governments exempt services, food, and prescription drugs from the sales tax. However, because the tax applies to most consumption goods, the term general sales tax is used.

i. State Sales Taxes

As of 1999, only five states did not have a general sales tax. These states were Alaska, Delaware, Montana, New Hampshire and Oregon. Sales tax rates in the other forty-five states and the District of Columbia range from three percent to seven percent. Colorado has the lowest sales tax rate at three percent, while Mississippi and Rhode Island both have sales tax rates of seven percent. State sales tax rates as of 1999 are shown in Figure 1.

ii. Local Sales Taxes

Thirty-one states have a local-taxing option which allows local governments to levy a local sales tax in addition to the state sales tax. In this case, the total sales tax the consumer pays is the state sales tax rate plus the local sales tax rate. Local rates are usually less than the state rate. In Kansas, for example, local sales taxes range from 0.25 percent to 2.25 percent (city plus county), whereas the state sales tax rate is 4.9 percent. Local sales taxes are collected with state sales taxes at the time of purchase and are remitted to the state, usually on a monthly basis. The state then returns the local portion of the sales tax collected back to the originating local government. In essence, the state government acts as the tax collector for local governments.

iii. Generating Sales Tax Revenues - Issues for State and Local Governments

As shown previously in Table 2, sales tax revenues have been an increasing percentage of total state tax revenues. Not only have states placed an increasing reliance on sales tax revenues, sales tax revenues themselves have increased over the past several decades. In 1960, sales tax revenues were roughly one percent of GDP, whereas by 1996 sales tax revenue neared four percent of GDP. State and local governments can increase sales tax revenues two ways: 1) by expanding the tax base, which is the activity being taxed (general consumption or retail sales in the case of the sales tax), or 2) increasing the tax rate. As most state and local sales taxes already apply to general consumption, expanding the tax base would not significantly increase revenues, although removing certain exemptions would increase sales tax revenues. Initial sales tax rates for many states ranged between two and three percent. However, the need for additional revenues forced states to double or triple their initial sales tax rates to the current levels shown above in Figure 1.

By law, a state is not allowed to collect sales tax revenue from an out-of-state seller. Sales taxation requires in-state ‘nexus,’ or physical presence of both buyer and seller in the state. So, for example, if a consumer in New York purchases a product in Oklahoma, the state of New York cannot by law require Oklahoma to collect New York sales tax on the purchase. The purchase is thus not subject to any sales tax. Compensating use taxes are used by states to collect tax revenues from out-of-state purchases. Use tax rates are the same as the sales tax rate. Use taxes are usually imposed on the consumption or storage of tangible personal property within the state, regardless of where the property was purchased. So, for example, if a consumer buys a vehicle from another state, the consumer does not have to pay the home state sales tax since the purchase was made out-of-state, but the buyer is legally required to pay the home state use tax on the purchase since the product will be used in the home state. Unfortunately, most consumers are not aware of the use tax and their responsibility in remitting it. Also, unlike businesses which are routinely audited, evading the compensating use tax is relatively easy because of the low probability of detection. Thus, compensating use taxes are usually only collected on large-ticket durable purchases such as cars, boats, etc. that can be easily documented and traced.

a. Taxing Electronic Commerce

As state and local government rely heavily on sales tax revenues, the explosion of electronic commerce, often called e-commerce, in recent years has created significant concerns for local retailers and state and local government officials. Only totaling several billion dollars in 1996, the National Governors Association (NGA) estimates that e-commerce will grow to over $300 billion by 2002. Local retailers and state and local governments tend to favor taxing electronic commerce. Local merchants fear the increased competition from Internet shopping, and state and local governments project large sales tax revenue losses (over $20 billion according to NGA) due to consumers purchasing products on-line rather than locally. Opponents of taxing the Internet argue that the Internet is the last remaining sector of the economy where free trade is present. They attribute the rapid growth in e-commerce and technology to the fact that there are no major taxes on e-commerce to hinder growth. They suggest that e-commerce is just another form of competition for local retailers, and as such local retailers should devise strategies to remain competitive in an electronic marketplace. Furthermore, opponents of taxing electronic commerce argue that state and local governments should become more fiscally responsible rather then relying on the Internet to provide extra tax revenues.

The biggest fear of state and local governments is the loss in sales tax revenue due to increases in e-commerce. Traditionally, the sales tax is collected at the point of purchase. A well-defined nexus, or physical presence, is required for a state or local government to collect sales taxes. To levy and collect sales taxes in any state requires that both the buyer and the seller be physically located in that state. According to the Interstate Commerce clause of the U.S. Constitution, if the seller is in a different state than the buyer, the buyer’s state cannot by law attempt to collect sales tax from the out-of-state seller. Notice, however, that the nexus problem applies not only to Internet commerce, but mail order purchases as well.

To overcome the nexus problem many states impose a use tax that is equal in value to the state’s sales tax rate. When a remote seller does not collect a state’s sales tax, consumers who make remote purchases are required to pay a use tax on the value of their remote purchase. In Kansas, a use tax is imposed "for the privilege of using, storing, or consuming within this state any article of tangible personal property." (K.S.A. 79-3703). Unfortunately, collecting use tax revenue from consumers is a problem, regardless of whether consumption occurs locally or on-line. Because most businesses are aware of this use tax and are subject to audits, the reporting and collection of use tax from businesses is not a problem. What is a problem is that most consumers are not aware of the use tax so the tax revenue goes uncollected. Furthermore, there is little incentive for consumers to remit this tax, as enforcing this tax at the individual consumer level would be next to impossible. So although most states have a use tax to overcome the nexus problem arising from the sales tax, the ignorance of consumers regarding the existence of this tax, the high costs of enforcing this tax and the extremely low probability of detection from not remitting the tax all currently make the use tax an ineffective alternative to collect lost sales tax revenues.

One question is why state and local governments have become so concerned about revenue losses from e-commerce when they have been facing a similar problem with mail order purchases. State and local governments are concerned with tax losses due to e-commerce because, unlike mail order, e-commerce is projected to increase dramatically in the near future. While mail order sales reached $55 billion in 1998 (U.S. Census Bureau Monthly Retail Sales), e-commerce is projected to reach over $300 billion by 2002. With $300 billion in untaxable electronic commerce, the $20 billion loss in sales tax revenue translates into about a ten percent loss in state and local government tax revenues.

Although the projections for e-commerce and sales tax revenue losses are quite large, retailers and state and local governments should be aware of several factors leading to a possible over-estimation of e-commerce and tax revenue losses (see Goolsbee and Zittrain, 1999, 413-428; McClure, 1997, 731-749; Hellerstein, 1997, 593-606). First, the National Governors Association’s e-commerce projections include business-to-business sales. Whether or not businesses buy from each other on-line is irrelevant because any sales between businesses are tax exempt, regardless of the medium in which the purchase occurs. Second, just because a consumer purchases a product on-line does not automatically imply that the product substituted for a locally sold product. The Internet has made available to consumers a greater variety of products, many of which are not available locally. If a consumer purchases a product that he could not buy locally, then local retailers and local governments are not losing any revenues. Using data from the Forrester Research Company, (Goolsbee and Zittrain, 1999, 413-428) empirically tested whether Internet sales divert retail purchases away from local retailers. They found no significant evidence that on-line shopping substitutes for local retailing.

Another reason for the possible over-estimation of revenues losses is a failure to consider the type of product purchases. The Boston Consulting Group (BCG, 1998) reports that roughly 40 percent of business-to-consumer e-commerce involves purchases of food, apparel, travel and financial services. In the majority of state these purchases are exempt from the sales tax. So any substitution between local consumption and on-line consumption of these items will not result in a revenue loss for state and local governments. Of the remaining 60 percent of e-commerce, almost half is comprised of computer sales (BCG, 1998). Many on-line computer sellers already pay sales tax because they have in-state repair services, thus creating nexus. Also, not every on-line computer purchase came from a local retailer - some purchases were made through mail-order, in which case no tax collection was required anyway. However, while local governments may not lose sales tax revenues in the usual amounts projected, they may lose revenue from other sources, i.e. property taxes (loss of establishments) and income taxes (fewer employees or employees with lower incomes) if consumers substitute from local commerce to electronic commerce.

Despite the possible over-estimation of revenue losses, state and local governments are concerned that if e-commerce continues to grow and no tax plan is in place, it will be increasingly difficult if not impossible to levy taxes on the Internet. There are several additional problems state and local governments face in taxing the Internet. The Internet Tax Freedom Act (ITFA) enacted by congress in 1998 placed a three-year moratorium on levying new taxes on the Internet. The ITFA has recently been extended until 2006. The purpose of the ITFA was to allow the Internet and Internet technology to grow and remain unimpeded by taxation and regulation. An important point, however, is that the ITFA only prevents new taxes from being levied on e-commerce. Officials fear that new taxes would discriminate against certain parties involved in Internet commerce and technology, while leaving other areas of Internet technology untaxed. The ITFA does not apply to sales and use taxes because these are not new taxes for those state and local governments already having sales and use taxes. So, state and local governments could levy state and local sales and use taxes on e-commerce. The problem is the Interstate Commerce clause of the U.S. Constitution, which currently prohibits states from collecting revenues from out-of-state sellers (the nexus problem) and the inability of states to enforce and collect use tax on consumer purchases.

Technological constraints and the vast number of taxing jurisdictions are two other problems facing state and local governments. Even if taxation of out-of-state sellers was possible, how do state and local governments collect the tax revenue? Sellers would have to know the location of the buyer and the state and local tax rates in the buyer’s state and community. Currently there are over 6,400 different tax rates in the United States. Determining the tax for every single buyer at the time of purchase would place a huge cost on sellers. Also, one basic principle of taxation is that taxation should only occur if compliance costs are low. If compliance costs are high, then there is a greater chance of tax avoidance. As of now there is no low-cost method for determining a buyer’s tax rates at the time of an on-line purchase. This may not be a problem in the future, however, as plans for tax rate database software exist. With this software, sellers would be given all applicable tax rates after the buyer enters his or her delivery address. The software would automatically compute the tax based on the buyer’s address.

E-commerce and Internet taxation will undoubtedly continue to be important issues for state and local governments as well as local retailers. Questions remain as to magnitude of tax revenue losses and the impact of e-commerce on local retailers. On a simpler level, the question of whether the Internet should be taxed at all is at the heart of many debates on taxing e-commerce. Officials will have to deal with the Interstate Commerce clause of the Constitution to gain the opportunity to tax out-of-state sellers. Even if state and local governments could legally tax out-of-state sellers, an efficient method of tax collection needs to be developed to prevent tax avoidance.

b. Cross-Border Shopping

There are nearly 87,000 state and local government taxing jurisdictions in the United States. Thirty-one states have a local sales tax option which gives counties and cities the authority to levy local sales taxes in addition to the state tax rate. Within a state and across cities and counties one will encounter different tax rates. The proximity of regions having different tax rates produces a situation where the economic activity in one region is dependent on the tax activity or tax policy change occurring in nearby regions. If a sales tax change occurs in one region, then all neighboring regions can be impacted by the change, even if these regions made no change in their own sales tax policies. This dependence is primarily due to cross-border shopping, which occurs because economic agents in one region adjust their behavior in response to a tax change and the impacts of this behavioral change spill over into neighboring regions.

Many studies have been conducted to examine the degree to which sales tax differentials between regions cause cross-border shopping and a resulting revenue gain or loss. Mikesell and Zorn (1986) examined the impact of a sales tax increase (0.5 percent) in a small city in Mississippi relative to surrounding areas in which the tax remained at 5 percent. They found that the tax rate differential caused a significant reduction in sales within the city, namely a one-half percentage rate differential caused a 1.1 percent decrease in city sales. Fisher (1980) examined the impact of tax rate differentials between Washington, D.C. (higher rate) and the surrounding Maryland and Virginia suburbs (lower rate). He found that the tax rate differential had no impact on overall sales between the regions, but did have a negative and significant impact on food sales. Every one percentage point increase in the rate differential between Washington. D.C. and the suburban area was predicted to cause a seven percent drop in food sales in Washington, D.C.

The general impact of cross-border shopping can be shown graphically. Consider the market for gasoline in two neighboring regions A and B, both selling gasoline in a competitive market. This scenario is depicted in Figure 2. Before the imposition of any tax (or tax change), the markets in both regions are in equilibrium at price P₀. Now, suppose area A decides to a levy a per unit tax on gasoline. The imposition of a tax by area A is shown by the decrease in the supply curve (Supply₁) for gasoline in area A. Now, the price of gasoline in area A is higher (P₀ + t) than before the tax, and the quantity of gasoline sold is now lower. One of the basic principles of tax analysis is that individuals attempt to change their behavior to avoid a tax. Given the price increase in area A, some consumers will substitute gasoline in area A with the now lower-priced gasoline in area B. This substitution from A to B increases the demand for gasoline in area B shown by Demand₁. Substitution will continue from A to B until the tax inclusive price of gasoline in area A, P₀ +t, is equal to the price of gasoline in area B, P₁, assuming no transportation costs, product differentiation, or information costs between the two regions. When these prices are equal, there no longer remains an incentive for consumers to substitute between products.

What Figure 2 shows is that a tax increase in one area actually leads to a price increase in neighboring areas. Although taxes were not raised in area B, the imposition of a tax in area A caused a substitution from area A to B, thus increasing the demand and the price for gasoline in area B. This highlights an important aspect of local public finance - prices and product availability in one region are dependent upon tax policy and price changes in neighboring regions.

Not only are one region’s prices impacted by neighboring tax changes, revenues to a local government can also be impacted. As shown in Figure 2, the tax increase in area A led to an increase in the price of gasoline and the quantity of gasoline sold in area B. With an increase in the quantity of gasoline sold, area B would experience an increase in gasoline tax collections if a tax is in place, as gasoline taxes are levied per gallon. Also, if gasoline was subject to the sales tax, sales tax revenues would increase in area B because the price of gasoline increased in area B. Although area B did not increase taxes on gasoline, the tax increase in area A resulted in a higher price and quantity of gasoline sold in area B, thereby increasing gasoline tax revenues and sales tax revenues, if both applicable. Thus, a locality’s tax revenue, in addition to prices and quantity sold, are also dependent on any tax change occurring in a neighboring region.

C. The Personal Income Tax

States have increased their reliance on the personal income tax as a source of revenue more than any other tax. As shown above in Table 2, personal income tax revenues accounted for less than 10 percent of state tax revenues in 1960 and more than 30 percent of state tax revenues in 1996. As of 1999, seven states did not have a personal income tax on earnings. These states were Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Two states, New Hampshire and Tennessee, only tax dividend and interest income. Not only have states increased their reliance on the personal income tax, income tax revenues as a percentage of GDP increased from less than one percent of GDP in 1960 to more than three percent of GDP in 1996. Thus, the amount of personal income tax revenues received by states has also increased dramatically over the past several decades.

Personal income tax rates and income brackets for each rate vary greatly across states. Income brackets refer to a certain range of income that is taxed at a certain rate. As a simple example, a state may have two income brackets, one ranging from $0 to $25,000 and the other ranging from $25,001 and higher. The tax rate for the first bracket might be five percent and may be ten percent for the second bracket. Some states have a flat tax rate, meaning all income is taxed at the same rate.

i. The Marginal Tax Rate

The marginal tax rate (MTR) measures the additional tax liability for every additional dollar in income. Marginal tax rates are adjusted by state and local officials (as well as federal officials for the federal personal income tax) to influence personal income tax revenues. In fact, the dramatic increase in personal income tax revenues generated by states is a result of increases in marginal tax rates over time. Marginal tax rates are computed as:

where is the Greek letter Delta and means "change in." MTR is simply the change in tax liability due to a change in taxable income, or the additional tax owed for each additional dollar in taxable income. Marginal tax rates and tax brackets for a sample of state are shown in Table 3.

To see how marginal tax rates and income brackets are used to compute an individual’s overall tax liability, consider the following tax schedule for a hypothetical state.

According to the above tax schedule, the individual’s first $10,000 is taxed at 10%, his next $40,000 is taxed at 15%, his next $20,000 is taxed at 20%, and any income over $70,000 is taxed at 25%. So, for his first $10,000 each additional dollar between $1 and $10,000 is taxed at 10%, each additional dollar between $10,001 and $50,000 is taxed at 15%, and so on.

Suppose an individual is earning $60,000 a year. What is his tax liability? Based on the above schedule, his first $10,000 is taxed at 10%, so his tax liability for his first $10,000 is $1,000 ($10,000 × 10%). His next $40,000 is taxed at 15%, so his tax liability for his next $40,000 in income ($50,000 - $10,000) is $6,000 ($40,000 × 15%). To this point the first $50,000 of the individual’s $60,000 has been taxed. He has $10,000 remaining ($60,000 - $50,000) which is taxed at 20%. His tax liability for the remaining $10,000 would be $2,000 ($10,000 × 20%). His total tax liability is simply found by adding the tax liabilities for each income bracket: $1,000 + $6,000 + $2,000 = $9,000. So, an individual earning $60,000 a year and facing the above tax schedule would pay $9,000 in personal income taxes.]

ii. The Average Tax Rate

The average tax rate (ATR) is simply a measure of an individual’s tax liability as a percentage of his income. The ATR is computed as:

For example, if an individual owes $5,000 in state personal income taxes and has a taxable income of $40,000, his ATR is 12.5% ($5,000 For example, if an individual owes $5,000 in state personal income taxes and has a taxable income of $40,000, his ATR is 12.5% ($5,000 ÷ $40,000) × 100. Having ATRs across individuals allows a comparison of which individuals are paying a higher or lower percent of their income in state personal income taxes.

iii. Tax Incidence

Tax incidence refers to which individuals bear the burden of a tax after the economy has adjusted to changes caused by the taxes. In general, incidence is concerned with the revenue burden of the tax, namely which groups of individuals are paying a larger percentage of tax revenue than other groups. An important point in tax incidence analysis is that taxes cause changes in individuals’ behavior. Those individuals bearing the ultimate burden of the tax may be different than the individuals on whom the tax was initially levied. The more a group of individuals is willing to change their behavior to avoid the tax, the smaller the burden of taxation will be for those individuals. For example, if a tax is levied on a group of individuals, say buyers of gasoline, but a portion these individuals alter their behavior by consuming no gasoline (thus avoiding the tax), then the burden of taxation falls on those individuals still consuming gasoline.

Although incidence tells us which groups bear the burden of the tax, evaluating incidence in terms of good or bad or high or low is done by comparing the incidence of a tax relative to something else. The most common method of comparison is to compare the incidence of one tax to that of another tax that raises the same amount of revenues. This is called differential incidence. Another method of comparison is that of budgetary incidence, which considers the incidence of a tax only after the revenue benefits of the tax (such as income transfers, educational benefits) have been considered.

a. Regressive, Progressive and Proportional Taxes

Once the economy has adjusted to changes in prices caused by the tax and the final tax burden is known, the burden of the tax is sometimes characterized by its impact on the income distribution. The terms regressive, progressive, and proportional are often used to define the burden of taxation on income distributions. A tax is considered regressive if the burden of taxation decreases with income, that is, higher income individuals spend a smaller percentage of their income on the tax than lower income individuals. For a progressive tax, the burden of taxation increases with income, meaning higher income individuals spend a greater percentage of their income on the tax than lower income individuals. Finally, a tax is considered proportional if the burden of taxation remains the same over all levels of income. Under a proportional tax, each income group spends an equal percentage of their income on the tax.

Although these definitions seem straightforward, there remains some uncertainty about the impact of a tax on the income distribution. The income distribution could refer to current income or to lifetime income. Depending on which definition of the income distribution one uses, the conclusions regarding regressivity, progressive, and proportionality may be different as incomes generally increase over one’s lifetime. Studies by Pechman (1985) and Fullerton and Rogers (1993, chapter 1-7) compute the tax incidence in terms of the income distribution for the major taxes used in the United States. Pechman, using current income, finds that sales and excise taxes are regressive, the property tax and corporate income tax tend to be proportional or slightly progressive, and the personal income tax is progressive. The regressivity of sales and excise taxes is not surprising as lower income individuals tend to spend a higher portion of their income on consumption goods (which are the tax bases for sales and excise taxes) than wealthier individuals. The proportionality or progressivity of the other taxes are a result of political manipulation. In terms of lifetime income, the tax incidence of these taxes differs slightly. Fullerton and Rogers, using lifetime income rather than current income, find that, as does Pechman, sales and excise taxes are regressive. They also find the personal income tax to be moderately progressive. However, Fullerton and Rogers find that the corporate income tax is regressive for the lowest income individuals when considering lifetime income. They also find the property tax is regressive for the lowest income individuals, proportional for middle income individuals, and progressive for the wealthiest individuals. Clearly, although the methodologies used by both authors provide similar conclusions, determination of tax incidence does to some degree depend upon one’s definition of income.

D. The Corporate Income Tax

Unlike other revenue sources, corporate income tax revenues have remained a relatively constant proportion of total state tax revenues. Only during the 1980s did corporate income tax revenue contribute to a significantly larger percentage of state tax revenues. In addition to being a relatively constant percent of total state tax revenues, corporate income tax revenues have remained a small percentage of GDP, comprising 0.4% of GDP in 1960 and 0.7% of GDP in 1996. As of 1999, six states did not have a corporate income tax. These states were Michigan, Nevada, South Dakota, Texas, Washington and Wyoming.

The corporate income tax is structured the same as the personal income tax, except the marginal tax rates are slightly higher and, of course, the income brackets are larger. Unlike the personal income tax, thirty-two states have a flat corporate income tax rate, meaning there is a single tax rate for all levels of corporate income. Although this flat rate may appear proportional, deductions and exemptions can create a progressive corporate income tax even with a constant marginal tax rate.

E. Excise Taxes

An excise tax is a tax that is levied on a specific commodity, such as alcohol, tobacco and gasoline. Excise taxes are also called selective sales taxes. Unlike general sales taxes, excise taxes on the above commodities can also be a fixed amount per unit sold rather than a percentage of the total sales price. For example, an excise tax on gasoline is, say, 30 cents a gallon, or the excise tax on cigarettes is 50 cents a pack. The vast majority of states and those local governments given a local tax option have excise taxes on alcohol, tobacco, and gasoline. In fact, most states have different tax rates for beer, liquor, and wine; cigarettes and other tobacco; and gasoline and diesel fuel. In addition, not only do a majority of states have excise taxes, many of the commodities taxed under an excise tax are also subject to the general sales tax. Excise taxes for selected states and commodities are shown in Table 4.

Of all state tax revenues, excise tax revenues have been a decreasing percentage of total state tax revenues. Furthermore, the amount of excise tax revenues collected has fallen from 1.6% of GDP in 1960 to less than 1% of GDP in 1996. This decrease in state excise tax revenues is because excise taxes are not linked to inflation. One way to increase excise tax revenues is to increase the excise tax rate. However, as prices continually rise this would require an unending increase in excise tax rates or a broadening of the tax base. Clearly, constant increases in excise tax rates would be quite unpopular with the public, thus explaining why state and local officials do not continually increase excise tax rates. As a result, states have decreased their reliance on excise tax revenues and moved to other available revenue sources, such as the sales tax, personal income tax, and corporate income tax.

F. Property Taxes

The property tax is the predominant source of revenues for local governments. In 1996, nearly three-quarters of local government revenue came from property taxes, whereas the property tax only accounted for two percent of total state tax revenues. Property taxes are usually paid annually, although quarterly and monthly payments are also common. Local governments tax residential property, commercial property, and agricultural property. Not only are the property tax rates on these properties different, tax rates across cities and counties are different.

i. Computing the Property Tax

Unlike sales and income taxes, computation of the property tax liability is much more difficult. Although the computation of property taxes can differ across states, most states follow a common model. Property tax rates are based on the appraised market value of one’s property, the assessment rate, and the mill levy. The first step in property tax collection requires an appraisal of one’s property. This property appraisal is done by a city or county official and is an appraisal of the market value of one’s property. Local governments then have an assessment rate which is used to determine what percentage of the property’s appraised value is taxed. The percentage of the property’s appraised value is termed the assessment value, which is simply the appraised value times the assessment rate. Once the assessment value is determined, the final tax owed is determined by the mill levy. One mill is equal to 1/1000 of assessed value. The final property tax owed is computed by multiplying each $1,000 in assessed value by the mill levy. Mill levies vary by city and county, but a range of 90 to 150 mills ($90 to $150 in tax for every $1,000 in assessed value) is common. Officials can increase property tax revenues by increasing the assessment rate, the mill levy, or both.

To understand how property taxes are computed, consider the following example for a homeowner whose home is appraised at $150,000:

ii. Advantages and Disadvantages of the Property Tax

As all property owners are subject to the property tax and the tax is the predominant source of local government revenues, plans to change property tax rates are usually met with much public debate and local media attention. Although debate surrounding the property tax involves the mill levy and the assessment rate, the property tax has one main advantage and one main disadvantage that are frequently raised during property tax debates. The main advantage of the property tax is that it provides a much more stable source of revenue over other taxes. Revenue stability is important as state and local governments rely on tax revenues to fund goods and services. Revenues from personal income taxes, corporate income taxes, and sales taxes move with economic conditions. In recessionary periods, individuals consume less goods, thus reducing sales tax revenues. Also, because individuals are consuming less, corporate and personal incomes fall which reduces personal and corporate income tax revenues. In turn, tax revenues from these sources rise during an economic expansion. Unlike consumption and income, property tax revenues are immune to short-run changes in economic conditions because assessed values are not impacted by economic changes. As local governments rely on property tax revenues much more than state governments, local governments have a more stable revenue source than state governments.

The primary disadvantage of the property tax is the unequal treatment of individuals in terms of market value. All property is not appraised annually due to the massive administrative costs that would be involved. The problem of market value and unequal treatment comes into play when, for example, one individual’s home is appraised at a higher value but another individual’s home, while having the same true market value, is not appraised. Therefore, although the true market value of both homes may be the same, the individual whose home was appraised at a higher value will pay higher property taxes. This problem also occurs frequently during the selling of a home which requires a current property value appraisal. If two homes were both appraised at $100,000 three years ago, and one homeowner decides to sell his house which is now appraised at $115,000, the new homeowner will pay higher property taxes than the person whose home is still appraised at $100,000, even though the appraisal value for this home should now be $115,000.

G. Other Revenue Sources - Intergovernmental Revenues, User Fees and State Lotteries

Besides the five major tax sources discussed above, state and local governments receive revenues from other sources as well. One important source of total state and local revenues is the contribution of funds from the federal government. Funds exchanged between levels of government, usually from the federal government to state governments or from state governments to local government, are called intergovernmental revenues. In 1996, nearly 20 percent of total state revenues consisted of intergovernmental revenues from the federal government.

User fees are another source of state and local government revenues. User fees are payments for the use of a publicly provided service, such as state parks, sewage and water services and toll roads. Tax dollars are used for the fixed start-up costs, such as road paving, building construction, etc. However, user fees are then used to cover the variable costs of operation once projects are completed. In some instances revenues from user fees may exceed the variable costs of operation and may serve as a source of general fund revenue for state governments.

An additional revenue source for state governments in recent years has been state lotteries (see Clotfelter and Cook, 1989; Borg, Mason and Shapiro, 1991). Since New Hampshire introduced the first state-operated lottery in 1964, thirty-seven states and the District of Columbia were operating a lottery as of 2000. In most states, lottery adoption occurs through a public referendum (see Hersch and McDougall, 1989; Garrett, 1999). In 1997, lottery sales in the United States topped $35 billion, or roughly $120 per capita. For each lottery ticket purchased, a portion of the purchase price (usually a one-dollar purchase price) is used to cover prize payouts, administrative costs, and retailer commissions. After covering all expenses, the portion remaining with the state is termed net lottery revenue. Net lottery revenues are roughly 30 percent of total lottery sales, totaling about $12 billion in 1997. Net lottery revenues are used to fund various social programs within a state. In Pennsylvania, net lottery revenues are allocated to senior citizen care, whereas West Virginia divides its net lottery revenues between tourism and education. Other states like Ohio, Illinois and Florida allocate 100 percent of their net lottery revenues to education. Historically, net lottery revenues account for only about three percent of total state revenues. However, increasing fiscal pressures and a growing public opposition to increasing tax rates have made lotteries a more popular avenue for generating revenues in recent years.

H. Conclusion

This section discussed trends in state and local government revenue and the various taxes used by state and local governments to raise revenues. The section began by providing evidence on state and local government revenue collections, sources of revenues from various taxes, and state and local governments’ changing reliance on various taxes. Time was spent discussing revenue issues involving electronic commerce and cross-border shopping. The remainder of the section focused on the five main taxes used by state and local governments to raise revenues, as well as a discussion on tax incidence. The following section of the chapter deals with principles of tax analysis and discusses several important issues state and local officials should use when evaluating a tax. Two popular models for optimal taxation are also presented in the next section.

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