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FRBSF

WEEKLY LETTER

October 4, 1985

Local Payroll Taxes and Local Employment
In recent years, more and more U.S. cities have
imposed municipal income or payroll taxes. In
general, cities ena.ct such taxes during fina.ncial
crises to supplement traditional local revenue
sources such as property taxes, sales taxes, and
transfers from state and federal governments.
Labor taxes have several advantages over the more
traditional revenue sources but they are frequently
opposed by business and political leaders who
argue that they drive firms and employment out of
the taxing city. This Letter argues that a local tax on
labor income is unlikely to cause a substantial
employment loss to the taxing city, particularly if
the city has unique characteristics that attract certain types of firms.

Existing local payroll taxes
Existing U.s. municipal income tax structures vary
widely, but four western jurisdictions have opted
for a simple payroll tax structure. In these localities,
firms pay tax according to their payroll expenses,
and individuals have no direct tax liability. San
Francisco and Los Angeles impose payroll taxes of
1.5 percent and 0.75 percent respectively. In
Oregon, the Tri-County (Portland) and Lane
County (Eugene) Transit Districts impose payroll
taxes of up to 0.6 percent. Each of these jurisdictions is surrounded by localities that impose no
such tax.
This Letterfocuses on San Francisco where the tax
rate is relatively high and data are readily available.
The payroll tax was first imposed in San Francisco
in 1970, at the rate of 1 percent. The rate went up
to 1.1 percent in 1977 and, in the wake of Proposition 13 (which limited property taxes), rose again
to 1.5 percent in 1980.

Local payroll tax incidence
Three different conceptually "pure" situations
allow economists to analyze effects of an increase
in taxes. One assumes that each dollar of additional tax revenue is matched by a dollar of additional government spending. Another holds that
increases in revenue from one tax are matched by
decreases in revenue from another tax, and the
third assumes that a tax could be increased with no

corresponding spending increase or tax reduction.
The actual situation is likely to be a mixture of
these three theoretical cases, but each provides
important insights into a complex issue.
If tax increases are matched with increased spending on public services, firms may treat the additional tax cost as the payment for additional municipal services. For example, higher tax payments
may be accompanied by improved transportation
for employees, or better streets, lighting, sewerage,
or police protection. Only if the firm calculates that
the additional benefits are not worth the extra
cost, will it have an incentive to leave the taxing
city. In general, if taxes are used to provide public
services, firms should want to leave a city only if
the city provides (and charges for) more or fewer
services than businesses would freely purchase, or
if the city provides an unfavorable mix of services.
Tax rates that are either lower or higher thal1
optimal in this sense may result in incentives to
leave the city.
In fact, firms are unlikely to receive public services
equal in value to the taxes they pay. One reason is
that there are too few cities, and hence too few tax
and public service combinations, from which to
choose. A firm that would optimally spend $2000
per year on street lights may be forced to choose
between available options of $1 000 and $3000.
Another reason most firms do not receive benefits
equal to their tax payments is that residents as well
as firms pay taxes and receive benefits from public
spending. Nevertheless, to the extent that higher
taxes are offset by increased public services, firms
have no incentive to leave the taxing jurisdiction.
Next, consider the situation when a payroll tax is
imposed with no corresponding changes
elsewhere in the local treasury. In that case, the
overall tax burden has increased. In general, the
burden will be distributed in part to the owners of
firms, but also to workers in the form of lower
wages and to consumers in higher prices. The distribution of the real burdens of diff~rent taxes
among workers, property owners, and consumers
is a matter of some dispute among economists.
The most common assumption is that workers bear

FRBSF
much of a newly imposed local payroll tax in the
form of lower wages. (In an environment of rising
wages, this reduction will show up in a lower rate
of increase than would have been the case in the
absence of the tax.)
In addition, the prices of some goods and services
produced locally rise and the prices of land and
buildings fall slightly. These latter assets are no
longer as valuable to firms since using them in the
city entails a tax liability. For a firm with no fixed
assets, the lower costs for labor and rent (for land
and structures) mitigate the impact of a higher tax
rate. A firm that owns fixed assets, however, does
not benefit from lower land and structure costs
because it suffers a windfall loss in its asset values.
Finally, consider the case in which payroll tax
increases are matched by property tax decreases.
The effects in this case depend on the impact of
the property tax as well as that of the payroll tax.
Most tax analysts agree that a reduction in a single
city's property tax rate results in a relatively large
reduction in the prices of goods and services produced in a locality, a more moderate increase in
property values, and a much smaller effect on raising wages and prices of other productive
resources. Thus, the net effect of reducing the
property tax and increasing the payroll tax should
be lower wages and higher values for property
(land and structures). The higher output price due
to the labor tax and the lower output price due to
the property tax should approximately offset each
other.
Since each of these three situations can be present
in an actual payroll tax increase, the net effect on a
firm's decision to move depends on a number of
factors - how much and what extra public services are provided, if there are compensating
changes in other tax rates, and what reductions in
wages and changes in property values occur as a
result. Each of these potential accompaniments to
higher payroll taxes reduces the impact of the tax
on firm costs, and therefore dilutes the effect of
the tax on the firm's employment decisions.
Would firms leave?
There are several reasons to expect that payroll
taxes such as those imposed in western cities do
not cause large employment losses. Most important of these is that the tax has a relatively small
effect on firm costs.

First, public services provided with tax revenues,
and lower labor and property costs which result
from the tax itself, mitigate the impact of the tax
on firm" costs.
Second, in practice, local payroll tax rates are quite
low - almost always less than 2 percent. In addition, not all firms in the city are required to pay the
tax. Nonprofit organizations and government
agencies are exempt from most local taxes.
Moreover, banks and insurance companies in
California are exempt from all local non property
taxes. Since they pay special state levies, they are
exempt from additional state or local taxes. Under
the San Francisco tax, businesses with payroll tax
liability of less than $2500 per year also pay no tax.
These exemptions reduce taxable payrolls and
hence expected employment loss.
Third, if other differences exist between the taxing
city and other jurisdictions, the firm's location decision cannot be made based on payroll taxes alone.
Some localities have geographical or economic
features that enhance productivity. Such cities may
be able to "get away" with a higher tax rate than
cities without such advantages. Indeed, firms in
attractive cities typically incur higher costs for such
items as space and labor, regardless of the city's tax
structure. In cities with these advantages, firms
that can increase the prices of the goods and services they sell can remain profitable. Job losses are
therefore likely to be concentrated among firms
unable to sell their products at a higher price.

The evidence
Given these general expectations, it should be
difficult to isolate tax effects on San Francisco
employment. Statistical evidence from multiple
regression analysis, which controls for long-run
trends, reveals no statistically significant detrimental effect on San Francisco employment from the
payroll tax. Two graphical examples give a flavor of
these results.

If the San Francisco payroll tax does have a strong
effect on employment, then tax rate increases
should have been followed by reductions in San
Francisco employment, relative to employment
levels without a payroll tax. Over time, San Francisco employment has grown, but employment in
outlying areas has grown faster as jobs have
followed people to the suburbs. Therefore, San

San Francisco Employment, 1966 - 1982
SAN
FRANCISCO
SHARE

0.45

UNTAXED
SHARE

.....

0.80

SF employment as proportion
of Bay Area employment
(All industries)

r

0.75
0.40

0.70

0.35
0.65

Tax=O

0.30
1966

1968

Tax = 1.0

1970

1972

1974

1976

1978

1980

0.60
1982

Franc:isco's share of Bay Area (Alameda, Contra
Costa, Marin, San Francisco, and San Mateo counties) employment has fallen. This is consistent with
a long-run national trend toward more decentralized employment. If, beyond these long-run
trends, the payroll tax causes firms to leave San
Francisco for less costly Bay Area locations such as
Oakland or Concord, then San Francisco's share of
Bay Area employment should have fallen more
after the tax rate increases.
The chart plots the San Francisco share of Bay Area
employment from 1966 to 1982 (left vertical
scale), the last year for which city-level data are
available. Vertical lines show years in which the
payroll tax rate was increased. While the trend is
that employment share fell during the entire
period, there were no sudden drops following tax
increases. Neither did the rate of decline seem to
have increased after the tax rate rose.
If the payroll tax reduces employment significantly,
a higher tax rate should also lead untaxed employment in San Francisco to grow relative to employment in taxed sectors. Within the category of
financial services, banks and insurance companies
are exempt from the tax, while real estate firms,
stock brokerages, and holding companies must pay

the tax. If the tax has a strong effect, the untaxed
share of San Francisco's financial employment
should have grown larger over time, particularly
folloWing tax increases.
Using the scale on the right, the chart also plots the
share of untaxed financial employment in total San
Francisco financial employment over the same
time period. The untaxed share of financial
employment does not appear to have risen after
tax increases. In fact, the erratic movements of the
curve bear no apparent relationship to tax changes.

Conclusions
The above evidence suggests that the payroll tax
may not have been as important a cause of
employment loss in San Francisco as some believe.
Indeed, in various surveys aimed at determining
,why firms have left San Francisco, few firms cited
the payroll tax as a major factor. More important
determinants include the cost and availability of
space. This is not to say that the payroll tax has
had no effect on firms' decisions. On the contrary,
there is anecdotal evidence that some firms have
decided against establishing in San Francisco
because of the payroll tax. Nevertheless, the number of firms (and jobs) that have located elsewhere
because of the tax may be smaller than some
critics of the tax have argued. That is not to say
that the actual employment loss should not be of
concern.
It is not clear how these findings might generalize
to other cities. On the one hand, San Francisco's
tax is large relative to other western payroll taxes.
Everything else being equal, San Francisco's losses
would be larger than the effects in other locations.
On the other hand, San Francisco is also a unique
city, both in terms of the vitality of its financial and
business service sector and in terms of its physical
beauty and charm. These factors may make San
Francisco employment less vulnerable to the tax
than employment in many other cities.

Carolyn Sherwood-Call

Opinions expressed in this newsletter do not necessarily reflect the views. of the management of the Federal Reserve Bank of San
.
Francisco, Or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding

9/11/85

9/4/85

194,704
175,557
50,946
64,444
35,715
5,436
12,022
7,125
200,236
48,383
32,677
14,247
137,606

-

45,405

-

38,048
23,678

Change from 9/12/84
Dollar
PercenF

Change
from

-

-

300
239
533
201
67
5
104
43
3,267
3,146
480
232
111

12,207
11,966
1,456
3,422
6,013
377
135
107
7,185
1,196
4,111
1,602
4,386

6.6
7.3
2.9
5.6
20.2
7.4
1.1
1.5
3.7
2.5
14.3
12.6
3.2

51

7,393

19.4

-

113
1,195

Period ended

Period ended

9/9/85

3,129
1,753

8/26/85

Reserve Position, All Reporting Banks
Excess Reserves (+ l/Deficiency (-)
Borrowings
Net free reserves (+ l/Net borrowed( -)
1
2

3
4

5
6
7

2
16
18

91
25
66

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes
government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change

u.s.

-

7.5
7.9