NYC Partnership Tax Retreat Shows Change Must Come at State Level

New York City’s decision to step back from a proposed partnership tax model that would have deviated from the state’s highlights a broader reality about municipal governance: Municipalities operate under the shadow of state control, particularly when it comes to taxation, both legally and functionally.

Proponents of tax overhauls should focus on lobbying state governments rather than throw their support behind local initiatives that are almost certain to fail.

Any statutory authority a city possesses is constrained by the need to align with state policies. This takes the form of practical challenges to tax policy administration, the risk of capital flight, and limitations imposed by state oversight.

Municipalities can face substantial resistance or obstacles when they attempt to chart their own policy paths, particularly in areas such as taxation. For cities such as New York, any major reforms need to happen at the state level, where ultimate control over all local tax policies resides.

New York City initially proposed a slate of corporate tax policies that would have differed from those at the state level. An overhaul of corporate partnership taxation, which involved the city using its own unincorporated business tax rules to allocate partnership income, arguably was the most significant of these proposed policies.

The policy would have shifted away from the state’s methods of computing taxes owed—which could broadly be classified as taxing based on where services are consumed—and toward the UBT method of sourcing receipts, based on where services are performed. This would have created significant headaches for tax preparers and filers.

Commenters quickly raised concerns, questioning the city’s ability to reconcile UBT rules with its own business corporation tax framework, which would seemingly have had overlapping control. The legal and practical difficulties of applying two distinct tax frameworks to the same underlying base were of particular concern.

The city ultimately acquiesced to uniformity with state policy because of these issues, along with an overarching question of whether the city had the statutory authority to modify partnership income taxation.

New York City recognized the administrative benefit of consistent calculation methodologies between state and municipal tax policies—from reduced cost of compliance for businesses to avoidance of enforcement and rulemaking complexities. By aligning with the state’s rules, it tacitly acknowledged the limitations of municipal authority to tax (despite asserting otherwise).

The city’s decision reflects the necessity for municipalities to operate within the bounds of state law, even where there may be room for potential innovation. Deviations in policy at the municipal level can provoke a strong response from taxpayers, particularly when those changes increase compliance or tax burdens because of added jurisdictional layers of calculating taxes.

Also, more political abstraction from municipal, state, and national governments leads to more mobility of taxed capital. If you raise taxes too much inside the city’s borders, merchants will relocate just beyond them.

New York City’s initial proposal threatened to push corporate partnerships to relocate their operations or structure their partnerships differently, avoiding the new calculation and potential higher tax burden in the process.

The pushback against the added complexity and administrative overhead of a separate city-level partnership tax calculation came with a credible threat of capital flight. Consistency and uniformity may have won the day on paper, but capital mobility is likely winning the war.

Beyond the risk of capital flight, cities derive their ability to tax from state-granted statutory authority, which inherently limits their capacity for tax overhauls or hikes without state approval. Some states have passed legislation explicitly limiting local governments’ authority to tax. For example, in Wisconsin, local governments face state caps on property tax revenue, despite arguments that this limits local governments’ ability to respond in fiscal emergencies or pursue local tax initiatives.

States can also split the power to tax between municipalities and voters. Colorado’s Taxpayer Bill of Rights, enacted in 1992, imposes strict limitations on the ability of local governments to raise taxes and increase spending. Any new tax, rate increase, or significant spending increase must be approved by voters.

Proponents argue this moderates government growth and helps keep taxes low, while opponents say it hinders responses to public investment needs at the local level, leading to tough budgetary decisions.

The trajectory of New York City’s proposed taxation model was always going to end in state-level pressure; the only question was whether the requirement to conform would be implicit or explicit. The situation illustrates how even when a municipality technically wields statutory discretion in tax matters, its policies are subject to pressure for uniformity with state policies.

Challenges of capital mobility, compliance costs, and state oversight create an environment where local tax policies must remain within a small window around existing state policy. Local governments operate with a narrow degree of autonomy in tax matters, with states maintaining significant control over policies affecting taxpayers within their borders.

The message seems clear: Municipalities, even those as large as New York, tax at the pleasure of the state. If meaningful reform is to take place, it must come from state legislatures, not through city-level initiatives.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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