How two local jurisdictions can approach post-pandemic tax policy
It was the best of times (tourism return, hybrid workforces help fill (some) offices, residents return to downtown living), but it was also the worst of times (inflationary strain, pension costs, hybrid work sustaining low office occupancy and the end to federal pandemic assistance). The COVID pandemic and its aftermath had significant effects on state government finances. Those effects have been discussed at great length in these pages and elsewhere. Discussed less frequently is local government budgetary and tax policy. States have largely weathered the fiscal threats created by a global shutdown. Local governments however continue to face a myriad of problems; many of those problems existed before the pandemic.
This article discusses two different tax policies in American cities on either coast. While the proposals in each may seem dramatic, the underlying problems that they seek to resolve are not. The success and sustainability of these policies, including the creativity of local governments to derive revenue, could serve as a template for cities forecasting shortfalls as broad economic uncertainty on the local level persists.
Post-pandemic tax policy: a tale of two cities
The City of Salem needs revenue. It will have a projected $19.4 million deficit by fiscal year 2028. Although that may not seem like a lot given the city’s $749.6 million current total budget, most municipal expenses do not radically change from year to year (aside from catastrophic externalities like global pandemics). City spending on public safety, health care, and transportation generally adhere to forecast or rise incrementally and consistently, but rarely fall resulting in budgetary surpluses.
According to city officials, Salem is underfunding police, fire, and homelessness services. The causes of the shortfall are falling commercial property tax revenues, rising prices of city goods and services, and depleted federal funds from the American Rescue Plan Act.
Salem cannot impose a local sales tax, leaving the city with limited revenue raising options. To close its budget gap, the city recently enacted the Safe Salem Payroll Tax, an employee-paid payroll tax on work performed within the city limits. The tax is .814% of wages and self-employment earnings, except those earning minimum wage. The tax is paid by the employee but collected and remitted by the employer. The city estimates that it will raise about $28 million a year. The tax is effective July 1, 2024 and will end in 2031 unless voters extend the law by July 1, 2031. Recently, petitioners have collected enough signatures to put the fate of the new tax on the November ballot, so the new tax may be short-lived.
On the other side of the country, Boston faces a different problem. Like many big cities, Boston has an acute shortage of affordable housing. It is growing increasingly difficult for middle-income workers to live in America’s largest cities; it is simply too expensive.
One of the primary causes of a lack of affordable housing is surprisingly simple - inadequate supply. But the post pandemic world presented Boston with an opportunity. At least 15% of the city’s commercial real estate office space is vacant as the hybrid and remote work models continue to sustain, especially in urban centers. Most city officials do not think that will improve. Remote employment has shaken the commercial real estate markets.
Boston is developing a pilot project that will dramatically reduce property taxes for owners who convert vacant office space into residences. The city believes that turning office buildings into apartments and condos would help solve the housing supply problem. Under the project, the city will enter into agreements with commercial property owners that will reduce the tax from $24.68 per $1,000 of value (the commercial rate) to $10.74 per $1,000 of value (the residential rate). The rate could be further reduced by as much as 75% for up to 29 years. Similar programs have been discussed in many of the nation’s largest cities including New York City and Washington, D.C.
A sign of the times
The problems faced by Salem and Boston are not unique. They are shared by hundreds of municipalities of varying population and geography. While many cities have rebounded from the depths of the pandemic financially, many continue to face uncertainty. Cities with heavy reliance on commercial real estate taxes and local income taxes will face challenges as remote employment increases vacancy rates and consequently lowers property values. The challenge is particularly acute for cities, like Salem, that do not have access to local option sales taxes.
Larger cities, with more diverse and robust tax bases, have weathered the pandemic better than small- and mid-sized cities. But the problems of large cities remain serious. Rising crime, falling commercial real estate values, and increased demands on other services have put financial strains on large cities as well.
Cities often have options to address financial shortfalls. They can increase available taxes. This tends to be difficult both politically and because of interjurisdictional competition. Cities can reduce spending. But currently there is more demand for public services which makes significant budget cuts nearly impossible.
Cities can try new policies as they have in Salem and Boston. In analyzing the two cities’ approaches, Salem’s new payroll tax represents unsound policy. There are two major problems with Salem’s tax. First, wage taxes are by definition regressive. Wealthy and high-income earners will often have significant investment income not subject to the tax. However, everyone working a job for more than the state’s $14.20 minimum wage will. Low-income earners will pay a greater percentage of their income in wage taxes than the wealthy due to the narrow tax base, and regressive nature of the tax. The narrow tax base, at the very least, calls into question whether a broad-based tax would be a better solution for revenue earmarked for public safety and homelessness services.
Second, while the tax will be paid by employees, there will be burdens placed on the employers. The new ordinance requires businesses to collect and remit the tax to the city. While government officials rarely acknowledge it, there will be an administrative cost to the business community. Small businesses will be particularly impacted without guidance and assistance from the city. Moreover, the tax, although not terribly high, will ultimately affect labor markets within the city. Some employees will ultimately choose to work outside the city limits. It is not surprising that the Salem business community has begun an effort to place a measure on the ballot to repeal the tax.
While addressing a different post-pandemic dynamic, the Boston experiment with respect to converting vacant office space into residential housing is on much sounder footing. About 15% of the city’s commercial office space is empty. If it remains at that level, and many believe it will, commercial real estate values will continue to fall. Even with property owners negotiating more favorable terms to entice tenants to remain, the nature of how commercial real estate is valued through an income approach may do little to help sustain the city’s property tax coffers.
That said, collecting property taxes at the residential property tax rate rather than to risk continually falling commercial values may create a new and sustainable revenue stream while bringing in more earners. The pilot project may help solve one of the most vexing issues faced by large cities – affordable housing. Converting office space to residential apartments or condos will increase supply. And increasing supply ultimately leads to lower prices.
No one should be naïve. Converting office spaced to residential apartments is expensive. Those converted offices may very well turn out to be very pricey condo. But unless the basic principles of economics no longer apply, increasing supply will lead to lower prices overall. Using the tax code to nudge that along is a very good policy idea.
The lesson of these two cities? It is a far, far better idea to address the coming municipal revenue crunch now than to wait until businesses and employees have gone elsewhere.