My friend David said, "This has bothered me for a while. Why don't taxes take cost of living into account? I am bothered that someone making the same I do that's living in the middle of nowhere pays the same as I do."
Months ago, I promised to respond. This is my response.
First I will examine the assumption David makes that taxes don’t take cost of living into account.
There are many kinds of taxes. Income taxes and sales taxes are the ones with which we’re most familiar, and I assume David’s comment was primarily about income taxes. But, do income taxes take cost of living into account? I think that there are two different kinds of arguments that they do:
1) Argument from progressive nature of tax code - Basically, the tax code allows for different sized deductions that do factor in cost-of-living. For example, mortgage interest income is deductible from taxes. Mortgage interest income is higher where housing prices are higher, and housing prices are a major contributor to overall cost of living. So, if you make $100,000, would owe $35,000 in taxes, but save $5,000 due to your mortgage, and then move to a more expensive place and start saving $10,000 due to a larger mortgage interest, then, in a sense, the net taxes you pay are 'including' the cost of living (at least the cost of housing). It's important that this deduction comes off the "top" of your income, because that means that the more you earn (until you are sufficiently far into the highest tax bracket), the more these deductions are "worth" to you.
Sales taxes are less progressive. The rate is the same for everyone. Still, though. where the cost of living is higher, the sales taxes are ALSO a larger amount in terms of absolute dollars. One way in which there is some progressivity is that the major purchase category for which sales tax is not charged (basic food items) constitutes a larger portion of the spending for lower-income individuals. Nonetheless, sales taxes generally exemplify David's statement. If you move somewhere more expensive, you pay more in sales taxes, even though it also costs you more to live in that place.
2) Argument from cost-of-living determining salary. Returning to income taxes for a moment, it is important to consider that income taxes are based on your salary. If it costs 10% more to live in a place, but you also get paid 10% more, in some sense the taxes should not "need" to factor in cost-of-living. To really do this calculation correctly, and be precise, you'd have to look at net taxes (because there are different rates and different deductions, depending on income), but in theory, this would work, and no further adjustments would be needed once you adjusted the salary to compensate for cost-of-living.
What this really means, as far as answering David's point is: "That person living in the middle of nowhere *doesn't* make the same amount as you." Let's say you earn $60,000 per year in San Francisco. That guy out there in Des Moines who earns $60,000 per year is probably one level higher than you in the corporate hierarchy. He's probably saying, "I can't believe this guy who's one level lower than I am makes the same amount I do!" If he said this, though, he'd be wrong, because his standard of living, at the same salary, actually is higher.
#2 brings up a tricky point in this whole topic - there are three independent levels of taxation: federal, state, and local. This makes it hard to figure out exactly what 'fair' means. Some taxes differ from place to place. Others (like most federal) don't. This does make it confusing because the 'local' part of a sales tax might be different in different locales, but the 'state' part might be the same. In fact, the 'wealthier' counties/cities, with higher costs of living, probably also tend to have the higher taxes. This, like all progressive taxation, is 'fair' in one sense and 'unfair' in another.
Taxes can be based on property, sales, use, business profits, value addition, income, or other factors. In each case, there will tend to be an extent to which these taxes automatically adjust for cost-of-living differences and an extent to which they don't. Sales taxes, for example, do a mediocre job of aligning with cost-of-living differences. Imagine two people, earning the same income, and buying the exact same stuff, in two different places. The stuff simply costs more in one place than another. The person in the more expensive place will pay more in taxes than the person in the less expensive place. Property taxes are similarly mediocre. Property taxes punish people where values of assets are going up and reward those where values of assets are going down. Income taxes and corporate profit taxes (which are similar in their function and structure), probably do a little better job of adjusting for cost-of-living differences, but are still imperfect.
One more complication is to look at the usage of services. A big city might use more or less services, per capita, than a small town. The cost of providing a sewer, for example, is lower in a big city than in a rural area per capita ceteris paribus. Therefore, the taxes paid for such a thing should be lower. In reality, though, because the land used to build a sewer system is so much more expensive in the city than the country, taxes end up being higher in the city despite the fact that the cost of living (to which the cost of land is a contributor) is already higher.
Finally, there is another point I should make. For the most part, I think incomes adjust for costs of living, and so income taxes don't need to. But there are places/instances where taxes and costs-of-living are out of whack. We still have to ask ourselves, though, if we should do anything about it. Let's say that in some sense, David's situation is 'unfair' and he pays a 10% penalty for living in a certain place. We could change this, by lowering the taxes in that area to compensate, but that would just make the problem worse (even more people would flock to this magical place, driving costs up further). So, instead, we must trust the market to solve these problems. What David should do is demand more income from his employer to cover the taxes. If they refuse, he should move. Eventually, this will force companies to locate where the cost of living is lower.
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