The role of local tax revenues for growth and cohesion

October 2024

Local taxes play a crucial role in promoting economic growth and competitiveness at local and regional level. As the level of government closest to businesses and citizens, local authorities have the potential to create an environment encouraging economic development. The ability to raise revenue through local taxation not only provides funding for essential services, but also incentivises municipalities to support local businesses and economic activities. Given the increasing need to boost competitiveness, this could also be relevant to the future of EU Cohesion Policy, particularly in the context of the 'cash for reform' debate.

Local taxation and economic growth

The importance of local taxes in stimulating economic growth has been highlighted in a recent JRC ‘Science for Policy Brief’ on local taxes on economic activity in municipalities in EU member states (Si apre in una nuova finestra).

In short, municipalities across the EU use a variety of local taxes to finance their activities and stimulate local economic development. The main taxes linked to economic growth include corporate income tax (CIT), local business tax (LBT), personal income tax (PIT) and local commercial property tax (LCPT) on property used for business purposes. These taxes are often directly linked to the economic performance of local businesses and the productivity of workers:

• Corporate income tax (CIT): CIT directly taxes the profits of businesses and serves as a reflection of the economic vitality within a community. When local governments receive revenue from this tax, they are incentivised to support and grow local businesses, as more profitable businesses lead to higher tax revenues. This can motivate councils to improve infrastructure, reduce red tape and offer business-friendly policies.

• Local business tax (LBT): Levied on the total economic activity or profits of local businesses, LBT works in a similar way to CIT. Its main advantage is that it directly links the local government's budget to the success of the businesses within its jurisdiction. This encourages local authorities to create conditions that encourage business expansion and attract new investment.

• Personal income tax (PIT): Although PIT is usually levied where individuals live rather than where they work, it is still an important reflection of economic productivity. Higher employment rates and better wages increase the amount of PIT collected, benefiting local budgets. Municipalities can use this revenue to reinvest in the local economy by improving services and public goods, which further supports competitiveness.

• Local commercial property tax (LCPT): This tax, levied on commercial property, is directly linked to business infrastructure. Although LCPT revenues can be slow to respond to changes in economic activity due to the stability of property values, they provide councils with a steady stream of revenue that can be reinvested in long-term economic projects such as industrial parks, transport networks or business innovation centres.

The link between local tax revenues and economic growth is particularly evident in countries where municipalities receive a significant share of tax revenues from local businesses. According to the JRC research, member states with a higher share of these revenues experienced stronger economic growth between 2015 and 2019 compared to those with a lower share. This suggests that local taxes not only help fund essential services, but also create a virtuous circle of growth and investment at the local level.

Why municipalities need the right to tax revenues from local economic activity

Allowing municipalities to collect and retain revenues from local economic activities is essential for several reasons, argues the JRC research.

• Direct economic development incentives: When municipalities benefit directly from local economic activity through taxes such as CIT, LBT and PIT, they have a clear incentive to promote business-friendly policies. The more successful local businesses are, the more tax revenue municipalities will collect, which can be reinvested in further local development efforts. For example, in countries such as Germany and Denmark, local governments have benefited from a share of CIT and LBT revenues, creating a strong incentive for local authorities to support economic initiatives and improve infrastructure.

• Tailored local solutions: Local governments are better placed than regional or national authorities to identify and address the specific needs of businesses in their areas. From solving administrative bottlenecks to improving local transport or education systems, municipalities can respond more quickly and effectively. This localised approach allows for innovative solutions and encourages competition between municipalities, further boosting competitiveness and growth.

• Fiscal autonomy and accountability: Giving municipalities the right to tax revenues from local economic activities promotes greater fiscal autonomy. This in turn increases accountability, as local governments become more responsible for their own financial health. By linking part of their revenue directly to the economic success of their region, local governments are more likely to pursue effective and sustainable development strategies.

An illustrative example is Spain, where studies have shown a positive relationship between fiscal decentralisation and economic growth at the municipal level. The ability to manage local tax revenues allows municipalities to respond to their specific challenges, especially in less economically developed areas. Other examples include Ireland and Poland. In both countries, local government receives substantial revenues from taxes on the local economy.

However, not all EU countries provide municipalities with the same degree of fiscal autonomy. In some cases, local tax revenues are pooled at national or regional level and redistributed without taking into account the contribution of individual municipalities. Examples are Italy and Greece, where local authorities have virtually no tax revenue from business. In Italy, local authorities can levy a maximum surcharge of 0.8% on income tax, while in Greece they can levy nothing at all. This can lead to inefficiencies, as municipalities may not have a direct financial incentive to support local business development. Ensuring that local governments have the autonomy to benefit from economic activity within their borders is key to promoting local and regional competitiveness.

Should tax revenues from local economic activity be an issue in the 'cash for reform' debate for future EU cohesion policy?

As the debates the future of Cohesion Policy have started, and in particular the idea of 'cash for reform', it is worth considering whether empowering municipalities with the right to retain tax revenues from local economic activities should be part of the debate. The concept of 'cash for reform' links EU financial support to structural reforms at national and regional level (see discussion about enabling conditions in a previous blog post (Si apre in una nuova finestra)). Promoting fiscal decentralisation and increasing the autonomy of municipalities over local tax revenues could be a useful reform in line with the objectives of Cohesion Policy.

There are several reasons why this could be an effective reform:

• Aligning economic incentives with cohesion objectives: Linking tax revenues from local economic activities to cohesion policy could encourage municipalities to adopt reforms that promote long-term economic competitiveness and reduce regional disparities. Allowing municipalities to retain a larger share of taxes from economic activities within their jurisdiction would encourage them to pursue growth-oriented policies. This could lead to more dynamic local economies and reduce regional disparities across the EU.

• Tackling regional disparities: One of the key objectives of Cohesion Policy is to reduce disparities between regions. By giving municipalities more control over their finances, particularly in areas with high potential for economic growth, local governments can better address the specific challenges they face. This could be particularly relevant for lagging regions that need tailor-made strategies for economic development. Poorer regions that succeed in attracting investment or increasing business activity can retain some of the tax revenue, allowing them to fund more projects aimed at closing the development gap with wealthier areas.

• Encourage sustainable reforms: Fiscal decentralisation encourages municipalities to adopt local policies and changes that are both economically and socially sustainable. Rather than relying solely on external funding, municipalities would be motivated to create self-sustaining, competitive local economies that continue to generate revenue through business success.

As the European Commission considers the future direction of Cohesion Policy, particularly in the wake of the need to increase competitiveness, growing regional disparities and the pressures of the green and digital transitions, the idea of linking local fiscal autonomy to economic reform could become a valuable tool. By promoting local competitiveness and accountability, this approach would complement the overarching objectives of economic and social cohesion, ensuring that all regions and communities can benefit from sustainable growth.

Conclusion

Local taxation has a key role to play in supporting economic growth and competitiveness at local and regional level. Municipalities that retain the right to raise revenue from taxes on local economic activity are better placed to create a business-friendly environment, encourage innovation and invest in infrastructure. As the EU considers the future of its Cohesion Policy, in particular the 'cash for reform' mechanism, linking tax autonomy to economic reforms could be an effective way of incentivising municipalities to pursue sustainable and growth-oriented policies. This approach would not only support economic development but also contribute to reducing regional disparities, which is closely aligned with the core objectives of EU cohesion policy.

by Kai Böhme