What Determines the Level of Local Business Property Taxes? 
Conventional economic theory intuitively holds that local business property taxes, which account for over one-third of the state and local taxes that firms pay, should be efficiently structured in order to recover the exact cost of providing public services to these firms. However, this conceptual thinking does not accord with observed geographic and over-time variation in business taxation. To better explain these discrepancies, the author develops an alternative theoretical model with heterogeneous firms, some of which are more profitable than others in certain locations. This model more precisely captures observed business tax revenues and its implications are empirically tested using a nationally-representative database of effective tax rates for commercial property and owner-occupied housing. The alternative model better reflects the political and policy tradeoffs that local government officials face between balancing the need for government revenue while maintaining an attractive profit-making environment for businesses and attracting firms that will supply jobs for their constituents.
Key Findings
- Contrary to the conventional wisdom suggesting that different levels of business taxes can be explained by variations in government spending on public services provided to businesses, the alternative model suggests that business taxes vary with the market power that government decisionmakers possess. Business taxes will be higher in cities where firms have more profitable opportunities, though the actual business tax rate will also depend on the degree that local officials want to attract jobs and firms to the city.
- Decisionmakers may find it preferable to set business tax rates that are not equal (either higher or lower) to the cost of providing public services to these firms. A tax rate that exceeds the cost of providing public services may be an optimal choice for maximizing the welfare of a city's residents. Conversely, a tax rate that does not fully recover the cost of providing services may also be appropriate in some instances.
Implications
The alternative model provides clues about how to rationalize the seemingly incongruent facts of cities imposing high business property taxes while also offering an extensive array of incentives and/or subsidies in order to attract businesses to locate there. While the local economic, fiscal, historical, and political conditions present in a given city ultimately help determine its level of business taxation, there is empirical evidence to support the idea that a city will exploit its competitive advantage and use property taxes to extract some of the economic profits businesses gain by locating there. This alternative model could be extended in a number of potential directions, for instance, to allow for a nonzero profit constraint that varies across cities, time, or industries; public goods benefitting households; regional tax competition; and a tax on households.