Local Taxation and Economic Incentives

Swedish municipalities and regions have incentives to raise taxes more than what is optimal from society’s point of view, according to economists Thomas Aronsson and Magnus Wikström. It also seems as if this tendency is reinforced by the municipal equalization system. At the same time, the two researchers argue in a new SNS report, there are mechanisms operating in the opposite direction, and it is currently not clear as to which incentives play the dominant role.

The municipalities, regions, and national government largely collect their tax revenues from the same tax base. This means that when, for instance, a municipality increases its tax rate, the tax bases at the regional and national level are ultimately affected as well. However, this is something that local decision-makers do not necessarily take into account.

“Decision-makers in municipalities and regions tend to underestimate what we economists refer to as the marginal cost of public funds, thus choosing a tax rate that is too high. There are several different policy options available for reducing or completely eliminating these distortions,” says Thomas Aronsson, professor of economics at the Umeå School of Business, Economics and Statistics, Umeå University.

This problem would disappear if the national government was the only level allowed to levy taxes. However, there are also benefits associated with local taxation, as many of the public services financed by tax revenues are decided upon and carried out by municipalities and regions.

“Another possibility for the national government would be to use matching grants/penalties in order to affect the incentives at the municipal and regional levels, thereby inducing the correct assessment of the marginal cost of public funds,” says Magnus Wikström, also professor of economics at the Umeå School of Business, Economics and Statistics, Umeå University.

The researchers also point out that the system of municipal income equalization may result in individual municipalities and regions opting for higher tax rates since they are largely compensated through the equalization system.

In a comparison between various potential tax bases, the authors conclude that only the taxation of labor income is suitable for the local level. This is because we need tax bases capable of generating significant revenues, which are also reasonably evenly distributed between municipalities and between regions. Since the assessed values of properties are very unevenly distributed, the researchers point out that a potentially reintroduced property tax should exist at the national level.

This report is published within the framework of the SNS research project Taxes in a Globalised World.