About one in four large cities in the United States has an earnings tax. I attempt to quantify the relationship between the earnings tax rate and the growth rate of cities relative to their metropolitan statistical areas (MSA). I find that cities with an earnings tax tend to have a significantly lower ratio of city income to MSA income than those without them.
These findings are particularly relevant to Missouri because Missouri’s two largest cities have an earnings tax. I compare changes to major economic indicators in St. Louis, Kansas City,and Springfield and find that Springfield is losing ground to its suburbs, but not nearly as rapidly as St. Louis and Kansas City in terms of income and employment. I then extend the analysis, estimating the relationship between the earnings tax rate and the city-to-MSA income ratio using a cross-state dataset. The cross-state evidence indicates that a city with a one-percent earnings tax rate will, on average, have a five-percentage-point lower city-to-MSA income ratio than a city with no earnings tax. Thus, the evidence points to a substantial relocation occurring in those cities that adopt an earnings tax.
The economics is quite straightforward. By adopting an earnings tax, a city gives businesses and residents an incentive to locate production outside the city. People go where they will obtain the highest after-tax return on their labor or investments. In order to raise the return, people locate more productive capacity outside the city limits in order to avoid the tax burden. This incentive effect can account for why the city share of per capita income is smaller in cities with earnings taxes than without.
The bottom line is that city earnings taxes do matter. Cities that wish to increase their rate of economic growth should consider reducing or eliminating their earnings taxes.
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