Higher local authority taxes reduce employment in existing firms, according to research by Gilles Duranton, Laurent Gobillon and Henry Overman. But their study, published in the September 2011 issue of the Economic Journal, also finds that local taxation has no effect on the entry of new establishments. This is probably because landlords have to lower rents in high tax local authorities to continue to attract tenants.
Professor Overman comments on the implications for the UK, where local government finance is currently being debated:
”Our results suggest that the UK government may be right to worry that local taxation can negatively affect local employment.
”One important caveat, however – our results can”t tell us whether local authorities would actually set such high taxes. They only provide a warning about the negative employment effects of doing so.”
The UK government recently made clear that it has no intention of allowing local councils to set their own business tax rates. This is partly a political decision, but the bigger issue is that it”s not clear what would be the effects of full localisation.
There are several main fears. One is a race to the bottom – local authorities undercutting their competitors and undermining the tax base. Other fears relate to the opposite scenario. Would some councils set very high tax rates and waste the revenues on useless programmes and bureaucracy? Would these very high tax rates bring more pain to firms already struggling in the face of the recession?
This research assesses the extent to which the second set of fears is justified by developing new empirical methodologies to identify the effects of local taxation on the location and growth of firms.
The issue has been the focus of an extensive body of theoretical research and this study is not the first to consider these issues empirically. Evidence from the 1960s and 1970s suggested that there was no effect of taxes on firm location decisions. Work focusing on the 1980s suggested a negative relationship and a number of subsequent papers have confirmed that finding.
But previous research has failed to resolve a central problem when assessing this impact. Specifically, there are many things about firms and local authorities that we do not observe, so any correlation between taxes and firm growth needs to be interpreted cautiously because some third factor (for example, the remoteness of the location) might explain both. In addition, tax setting may be driven by firm choices rather than vice versa – that is, taxes
may be high because employment is low.
The methodology used in this study solves these problems by using firm level data and comparing changes over time for firms located on either side of local authority boundaries. Comparing sites close to local authority borders eliminates major differences (because closely located sites are assumed to be similar). Comparing firms over time makes it possible to identify ”good” and ”bad” firms and so eliminate problems due to the sorting of
firms. In other words, these techniques help eliminate things about local authorities and firms that are unobserved and which may be responsible for the correlation between taxes and firm growth.
Finally, using the electoral make-up of the local authority to predict local taxes (some political parties consistently set higher taxes) means that the researchers can adjust their results to allow for the possibility that taxes might be high because employment is low. Using the methodology to study the impact of the UK”s business rates between 1984 and 1989, the researchers find a negative significant relationship between employment and
taxes. Higher local authority taxes lower employment in existing firms. In contrast, local taxation has no effect on the entry of new establishments, probably because landlords have to lower rents in high tax local authorities to continue to attract tenants.
”Assessing the Effects of Local Taxation Using Microgeographic Data” by Gilles Duranton, Laurent Gobillon and Henry Overman is published in the September2011 issue of the Economic Journal.
Gilles Duranton is at the University of Toronto. Laurent Gobillon is at the Institut National d’Etudes Demographiques in Paris. Henry Overman is director of the Spatial Economics Research Centre at the London School of Economics (http://spatialeconomics.blogspot.com/).
