Tuesday, April 15, 2008

Cities and taxes

The Free Exchange has a post about how city residents get taxed at higher effective rates, as uniform federal taxes do not account for the higher cost of living in cities. It therefore flags off a debate about the utility of a cost of living adjusted tax rate.

While the point about higher cost of living and uniform tax rates is well taken, this argument ignores the dimension of the much higher individual welfare gained by living in cities. This welfare can be both in terms of personal convenience and a better lifestyle, and the more important professional advantages that come with living close to the workplace.

It is more appropriate to therefore argue that, if the gains in individual welfare by living in a city is less than the burden imposed by the higher cost of living there, then uniform taxes fail the fairness test. On the contrary, if the individual welfare gains exceed the incremental burden of higher cost of living, then a uniform tax regime may actually be favoring city residents.

If individual welfare is the demand side variable and cost of living the supply side one, then the interaction between them produces an equilibrium which determines who are likely to live in the cities and who prefer the suburbs. Clearly, those who place a very high premium on the advantages of a city life, will prefer to live in cities, even if the cost of living is high. Similarly, those who cannot afford the high cost of living will fore go the conveniences of a city life and settle in the suburbs.

Going by this logic, residentially congested cities would appear to be ones providing disproportionately high enough individual welfare than the incremental burden of cost of living. In other words, these cities have lower effective rates of taxation than their suburbs. Similarly, the more suburbanized cities suffer from higher effective taxes which disincentivizes residents from settling in the city center. Of course, this is a simplified ceterus paribus analysis, but nevertheless provides useful insights.

Now, I am personally inclined to believe that in many developed countries, the costs of living in cities is much more than the individual welfare gained, thereby incentivizing people to commute from the suburbs. Or conversely, the presence of good public transport and cheaper and larger housing, encourages more people to settle in the suburbs. In contrast, in many developing countries, the cost of living is much less than the individual welfare gains of living in cities, thereby encouraging an exodus to the city. Conversely, the poor public transport and smaller differential between land costs and housing rentals between the city and suburbs, means that residents do not have the incentive to move to the suburbs.

From a regulatory perspective, there may be case for higher taxes on the more congested cities, so as to offset the higher individual welfare and decongest it. Conversely, lower taxes will help densify the sparsely populated cities. But the problem with this approach lies in identifying what is the appropriate residential density. As Eco 101 would teach us, this may be more efficiently located by the market itself. The possible incentive distortions that can be triggered off by regulatory approaches are many and have serious consequences.

However, there is an economic case to be made in favor of ensuring the minimum number of users for the construction and sustenance of a world class civic infrastructure and public services. But this too is a minefield given the widely varying differences in the individual willingness of different residents to pay user charges for these services.

Either way, it is surely an interesting challenge to tailor fiscal policies for cities. The incentives and disincentives are too numerous and exhibit a complex interplay, that makes it very difficult to structure efficient, distortion-free policies. I had argued in a previous post about how good public transport can alter a lot of incentives and bring about significant demographic and social transformation in any city.

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