Federal income tax is the enemy of urbanism

Finishing my dissertation this year has forced me to come out of my troll-cave and interact a lot more with my econ department. And that has been a very good thing! There is so much cool economics going on at the University of Michigan that I didn't even know about that I've decided to start blogging about it.

Today's interesting nugget comes from UMich prof David Albouy, for whom I briefly worked as a research assistant a few years back. A lot of David's work is in urban economics, which - although I decided not to do my dissertation on it - is an area dear to my heart. I view the deterioration of America's big cities over the past 40 years as a national tragedy, especially after seeing how well big cities work in countries like Japan and Korea. Fortunately, urban economists like Albouy and Ed Glaeser have been leading an intellectual charge for more urban-friendly policies. 

David has zeroed in on one way in which our government stacks the deck against cities: Income tax. Here's the original paper, and here's a recent writeup in the New York Times. The basic idea is this: Income tax rates are based only on your dollar income, not on how much purchasing power your income represents. Since prices (especially housing prices) are higher in big cities, an income of, say, $60,000 will buy you a lot less in San Francisco than it will in College Station, Texas. But someone who earns $60,000 will pay the same taxes in SF as she would in College Station. This provides a big incentive to move from the big city to a small town.

The point is not just that this is unfair (as the Times article contends), but that it's inefficient for our economy. Why? Because people are productive when they live in big cities. Take a worker out of San Francisco and plunk her down in College Station, and chances are that she will add less value to the economy. 

There are several reasons that this is true. The first is transport costs; if our hypothetical worker makes Christmas tree ornaments for a living, then if she lives in San Francisco, she's going to be very near to a whole lot of paying customers. But if she lives in College Station, she's going to have to ship a lot of her Christmas ornaments to customers in Houston (two hours away) or Dallas (three hours away). That costs money, and reduces the worker's productivity. Transport costs are probably the reason we have cities in the first place.

Another reason is knowledge spillovers. A lot of cities are "industrial clusters". If our Christmas tree ornament maker lives in SF, she will be smack dab in the middle of the center of the U.S. technology industry. This means that she may hang out with engineers who will teach her how to design ornaments more efficiently using powerful software, or how to find customers and suppliers more effectively using the Web. And she may also interact with a bunch of art and design people, for whom SF is also somewhat of a mecca. That will also tend to increase her productivity, by keeping her on top of new trends and ideas in the design world.

So when the federal government levees the same percentage tax on San Franciscans that it levees on people in College Station, it is discouraging high productivity. Just how much this hurts our economy is anybody's guess, though David Albouy takes a crack at an estimate in his paper; the numbers come out substantial, though not huge. But the policy implication is clear: one way to help reverse America's urban decay, and to boost our economy over the long term, would be to tax people in big cities at lower rates.