SEMINAR 10 February 2012: David R. Agrawal, University of MIchigan

The Tax Gradient: Do Local Sales Taxes Reduce Tax Differentials at State Borders?

Abstract

Geographic borders create a discontinuous tax treatment of retail sales and encourage cross-border shopping by residents of high-tax states. But do municipalities' local option taxes smooth these discontinuities? In a model where towns within a federation maximize revenue and compete in a Nash game, equilibrium local tax rates decrease from the nearest high-tax border and increase from the nearest low-tax border. Using driving distance from the state border and data on all local sales tax rates in the United States for 2010, I empirically test whether tax rates follow the pattern predicted by this theoretical model. Local tax rates on the low-tax side of the border are significantly higher than on the high-tax side of the border, reducing the differential in state tax rates at the border by more than half. Consistent with the model's prediction, a 100 mile increase in distance from the nearest high-tax border lowers local tax rates by 15% of the average local rate. Local taxes fall most rapidly closest to the border and when the differential of state tax rates is largest.

JEL: H21, H25, H73, H77, R12

Keywords: Sales Taxes, Cross-border Shopping, Tax Competition, Local Taxes, Borders, Fiscal Federalism