How COVID-19 could kill Philly’s wage tax and take down the city’s finances

It is the start of the public sector budget season. This one may be unlike any we have seen.

For the City of Philadelphia, the economic and tax revenue problems created by the pandemic could develop into a full-blown financial crisis, as the city’s massive dependence on the wage tax may no longer be feasible. How the city handles the revenue issues created by its tax structure will go a long way to determining its economic future.

That Philadelphia’s myriad of taxes is a horror show is hardly anything new. Nearly a decade ago, I wrote a column that ended: The city’s tax structure must be changed, and the process should begin now.” The more things change, the more ... .

And conditions did change – actually, twice – over the last eight years. First, baby-boomers and Millennials decided that high-density, amenity-rich locations, such as Philadelphia, were where they wanted to live. Population grew, so did property values, the city became a desirable place for businesses to locate, and tax revenues increased at a solid enough pace that the financial situation actually started to look good.

And then the pandemic hit and those helpful trends started reversing.

Density became a threat. Key demographics driving the city’s renaissance, baby boomers and millennials, began to question whether they wanted to live near so many others.

At the same time, work-from-home was forced upon businesses. A surprising discovery was that the office was not the only place where business activity could be accomplished efficiently and productively.

And so, the city’s tax revenues took a dive.

Although it isn’t clear the extent to which the reversal in household and business locations will be sustained, Philadelphia has to be concerned that a significant portion of those changes will wind up becoming permanent. If that happens, given the way Philadelphia raises revenue, a major financial crisis is not unthinkable.

The problem is that the city’s tax structure is weighted in all the wrong ways.

The largest source of income derives from the wage tax, which both residents and commuters pay. In fiscal year 2020, out of the $3.6 billion collected for the General Fund, $1.6 billion, or about 45%, came from taxing income.

The wage tax is now under attack from two directions. First, if density is out, household in-migration will slow and out-migration will accelerate. That could reverse the recent increases in population and resident taxpayers.

Second, if work-from-home is sustained, the number of commuters will drop. Although the city may try to limit the damage, if employees live and work outside the city, the tax revenue will disappear.

How much is at risk? Roughly 40% of the wage tax revenue, or about $650 million, comes from commuters.

It would not be surprising if at least 15% of the employees who had been commuting to the city wind up working outside Philadelphia. That would mean $100 million in revenue could be at risk — and that could be a low-ball estimate.

Going forward, the dependence on the wage tax is probably the greatest danger to the city’s finances.

But there are many other tax concerns. The movement out of high-density work locations has enormous implications for “microeconomies” that exist only because of the concentration of activity created by the large number of firms and employees located in the city.

With lowered employment in the city’s workplace centers, firms that cater to those companies could face significant declines in demand. There are estimates that a drop of 10% to 15% in traffic could drive many out of business and put their employees out of jobs, lowering wage taxes, sales taxes and property values.

Property tax revenues, which constitute nearly 10% of raised revenue, are also uncertain.

Businesses that reduced their city-based employment can shrink their real estate footprints. That reduces the demand for office space, lowering rents and property values. Look for owners of commercial real estate to file for lower valuations and reduced property taxes.

The potential property tax loss may not be large, as commercial property constitutes only about 20% of property tax revenues, but it will add to the looming financial shortfall.

Slower or negative population growth could damage residential property values. Both home price increases and new construction could slow, limiting the rise in tax revenues.

Where the real estate slide could really hurt is in the realty transfer tax. In the last fiscal year, it raised $320 million, or almost 9% of the general fund revenue. The reductions here could be especially hurtful.

The pandemic has altered, for the worse, key trends that had been powering Philadelphia’s growth. These are not temporary or cyclical changes.

Although almost every tax is impacted by the outward movement of households and businesses, the city’s key source of revenue, the wage tax, is most vulnerable.

Just as vehicle fuel economies and electric vehicles led to the emptying of highway trust funds, the loss of density as an attractive force could drain much money from the city’s coffers.

Philadelphia’s financial situation is already dire as revenues are down by double digits this fiscal year. If the next federal stimulus bill contains major funding for state and local governments, the city could skate through the rest of the year. But when households, businesses and governments have to stand on their own, the reliance upon the wage tax could be brought home.

Philadelphia is hardly alone in facing pandemic-generated financial issues. Either Philadelphia must find a way to diversify and modernize its tax structure or the nation must figure out a new way to help cities face this kind of challenge.

Joel L. Naroff is president and chief economist of Naroff Economics.