Controlling Tax Competition in Cleveland’s Suburbs

October 27, 2006

Some suburbs of Cleveland are contemplating a collusive agreement that would have governments sharing tax revenues in order to try and alleviate the localities from engaging in certain forms of tax competition. From the Plain Dealer:

Turf-minded Cleveland suburbs are poised to do what seemed impossible: Share income taxes when a company pulls up stakes in one community and sets them down in another.

The Cuyahoga County Mayors and City Managers Association overwhelmingly agreed Thursday to have winning and losing communities split the taxes of transplanted workers for up to five years.

With few corporations moving into Northeast Ohio, cities and villages have scrapped over those that shuffle within the region. Supporters say sharing taxes will let the cities and villages work together on economic development.

The vote was 24-2, with three abstentions. The group has 57 members, but in such a politically divided county, the result was cause for advocates to celebrate.

“The status quo is not working,” Shaker Heights Mayor Judy Rawson, one of the plan’s authors, told the group. “If we don’t move to a new regional model, we’re going to fail, and we’re going to fail together.”

The plan applies to companies with payrolls of at least $500,000 a year. The mayors and city managers also intend to negotiate caps on property-tax breaks given to companies and abolish rebates on income taxes. (Full Story)

Could this type of collusive agreement actually improve societal well-being? The answer depends on the current size of government in the localities. If the size of each of the current governments exceeds its socially optimal level, then tax competition that leads to lower tax rates across the board and thereby a smaller government in each locality would improve overall societal welfare. This means that this collusive agreement would decrease welfare or maintain it at a lower-than-optimal level under the condition of a currently inflated government size.

On the other hand, if governments are all currently at their optimal size, then imposing this type of limitation on the prisoner’s dilemma (i.e. limits on tax competition) can actually improve societal well-being. This is because each locality has an incentive to lower its tax rates in order to lure more business activity into its district, some of which comes at the expense of the other locality. The other locality rationally responds by lowering its taxes too. In the end, all localities would have lower taxes, but because we were previously at the optimal size of government, the prisoner’s dilemma of everyone lowering taxes actually made overall societal welfare worse. Therefore, this collusive agreement, assuming it were enforceable, would prevent the prisoner’s dilemma and actually improve overall societal welfare.

With regards to the suburbs of Cleveland, we are not in position to judge whether these specific governments are too small or too large or just right. But in general, as has been shown by history, governments around the world and at all levels tend to become larger than their optimal level as a result of many factors. So in general, tax competition tends to make society better off.

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