Introduction
There are many uncertainties in the business world. One certainty, however, is the legal need to pay taxes. In this article, we will be delving into the complexities of local and municipal taxes. However, before we explore more, we must first answer an important question: Why do we pay taxes? The complexity of the tax code has made it difficult to discern where exactly our taxes are going and how it affects the day-to-day activities of everyday people.
Philosophy of Taxation
While taxation seems to be an endless leak in everyone’s wallets, there are societal benefits to taxation. Government programs funded by our taxes are critical to serving people across the country and guide economic influencers towards activities benefiting society. To encourage our country’s growth and ideals, the government can contribute funds into projects that further our nation’s prosperity, whether it be funding for NASA’s cosmic ventures, improving our national forests to encourage conservation efforts, or subsidizing health care for families that are experiencing hardship. American tax dollars also go towards protecting citizens from bad actors trying to make a quick buck off of their obliviousness by funding government organizations such as the FDA who protects our food, the SEC who protects our financial markets stability, or the CDC who protects our health from improperly tested and dangerous medicines. Without these kinds of organizations, everyday people are exposed to risks that they wouldn’t be aware of without expert knowledge in the respective fields.
While federal taxes fund high level economic activities, local and municipal taxes are more likely to affect your immediate surroundings. Local and municipal taxes fund public services such as education, libraries, and emergency services.
Local taxes typically take the form of real estate and personal property taxes, but there are some cities that tax income directly. There are two main reasons why property taxes can make more sense than taxing wages directly. First, property taxes are a more stable revenue source for the locality. Taxes on income fluctuate depending on how the overall economy is doing. During periods of high unemployment, the total taxes on wages can be drastically reduced which could result in underfunded programs or even potential removal of programs if money runs dry. Second, property taxes are a better representation of who is using the services the taxes are going towards. In some localities, taxes are based on where the employee is working rather than where they live. This would result in employees who commute getting taxed despite not utilizing the services the taxes are going towards such as the school district or libraries in that city.
How are Local/Municipal Taxes Collected?
There are two main ways that local and municipal governments collect tax along with a hybrid method.
Direct Collection
The municipalities take full control of collecting, administering, assessing, and enforcing the income tax. By taking full control, there is a much larger amount of time and resources required to have a well-functioning tax system.
Piggyback Method
The more prominent method for collecting taxes for local governments as it allows them to join in on the current state tax system. By doing this, they avoid a large amount of additional work by utilizing an already functioning system which allows the locality to save money and resources to funnel into the programs the taxes are meant to go towards.
Hybrid Method
The hybrid method is for states that mix both the direct and piggyback method. Oftentimes the hybrid method uses state definitions of income while local governments are still the ones collecting and administering the taxes.
What are Local/Municipal Tax Rates?
The rate at which you are taxed can vary greatly depending on where you are located. There are three main ways that they are determined.
Flat Rate
Take the gross wages and multiply by a set percentage to get the local tax. For example, if you make $1,000 on a paycheck and the local tax is a flat rate of 3%, then you would have to pay $30 ($1,000 x 0.03 = $30) from that paycheck towards local taxes.
Dollar Amount
For the dollar amount, you pay a set amount that is unaffected by the amount that you make. For example, let’s say that the locality taxes at a rate of $5. You make $1,000, and your coworker makes $500. You will both end up paying $5 out of your paycheck, which would effectively make your tax rate 0.5% ($5 / $1,000 multiplied by 100) and your coworker’s rate 1% ($5 / $500 multiplied by 100)
Progressive Rate
A progressive rate is the same as what the federal government taxes citizens at. This tax structure uses an increased tax rate based on the amount of income that you use. For example, let’s say that you make $1,000 a paycheck and your coworker makes $500. Through the progressive tax, people making $500 and less are taxed at 12% and every dollar above $500 is taxed at 22%. With these parameters, you would end up paying $170 (The first $500 you make is taxed at 12% and the other $500 is taxed at 22%, which looks like this: $500 x 0.12 = $60, and then $500 x 0.22 = $110.) You then combine the amounts $60 + $110 = $170). Comparatively, your coworker will be taxed $60 ($500 x 0.12 = $60).
Examples of Cities with Local Tax
In St. Louis, Missouri, there is a flat rate of 1% of earnings tax. Denver, Colorado has a dollar tax of $5.75 monthly local tax for employees earning $500 or more. New York City uses progressive rates, with four brackets from 3.078% to 3.876%. In some states, such as Indiana, each county has its own local income tax. With such stark differences in taxes from state to state, it is crucial that you do the research for your locality to ensure that employee profiles are correct before their first paycheck.
Added Complexity
As mentioned earlier, local taxes add a level of complexity to who exactly is benefitting from the programs that the tax revenue is going towards. This is called the “spillover effect” where people are commuting (or, more commonly in this digital age, working from home) from different states and municipalities. When this occurs, the taxes the employees are paying have little to no benefit for those workers. Another level of complexity exists if the locality the business is in assesses a tax as well as the locality the remote worker is in. In some cases, these taxes are prorated between the two localities. Another consideration is that local taxes can cause a flight of businesses if the overall assessment of taxes is too great in the jurisdiction they are currently operating within. They may determine it is cost effective to relocate to a new location with lower taxes. This is an issue that both businesses and localities must contend and balance with, though it is not unique to income taxes.
How is Your Business Affected?
Having employees in localities that assess a local/municipal income tax can add a level of complexity to your payroll. If not properly researched, you could end up underpaying taxes which would result in a large, unexpected tax bill and fees when you are audited. Finding out whether your employees need to include local taxes can be a sizeable undertaking if you have a large area where your employees live. Some websites, such as ADP, allow you to look up rates, but you would need to double check to make sure that the rates are up to date and apply to your employees.
Conclusion
Making sure that you are compliant in the tax realm can be a daunting task, even without local taxes involved. With proper research, you can stay on top of local taxes and reduce your overall headache in the event of an audit. If you have questions on how local/municipal taxes affect your business, Volpe Consulting & Accounting would be happy to assist!
If you’d like some assistance with your taxes, payroll, or other financial endeavors, or would simply like more information, we’d appreciate the opportunity to help you.
Sources:
https://taxfoundation.org/research/all/state/local-income-taxes-2023/
https://mosey.com/blog/what-is-local-tax/
https://www.investopedia.com/articles/tax/10/history-taxes.asp
