What are local taxes?
Local taxes are income taxes imposed by local governments. Separate from federal and state income tax, local taxes are generally imposed on people who live or work in the locality. The term “local taxes” is a broad one that can apply to many different types of localities such as cities, counties, school districts, municipalities, jurisdictions, and more. Some local taxes are paid by the employee, some by the employer, and some by both. They can be imposed as a percentage of salaries or wages, a percentage of federal or state tax, or flat amounts. Similar to federal and state taxes, some individuals can be exempt from local taxes such as military or low-income individuals.
Nexus means “connection.” In the tax world, nexus refers to a business’s connection between a taxing jurisdiction, such as a state, county, township, etc. If a business is said to have “nexus,” it means the business has a tax presence in that jurisdiction. Nexus applies to both sales tax and payroll tax. We’ll focus on nexus as it comes to payroll tax.
Revenue generated from local taxes is used for a variety of purposes. Designed to complement or replace other revenue sources such as property, sales, business, and lodging taxes, some local taxes fund operating budgets, others fund short-term projects. Depending on the state, local income taxes are levied on different types of income such as all income, earned income, or interest or dividend income. Resident and nonresident rates are frequently used as local governments recognize that nonresidents receive fewer benefits from the levied taxes.
When it comes to payroll withholding, if a business has nexus in a state, the employer is subject to the withholding laws of that state. In this scenario, the employer may have to withhold income tax for an employee’s state of residence even though he or she performs no services there just because the employer has nexus in that state.
There are only 17 states in the United States that levy some type of local tax, but nearly 5,000 taxing jurisdictions! Local taxes are most prevalent in the northeastern part of the United States, with three-quarters of all local income tax jurisdictions located in Ohio and Pennsylvania. All counties in Indiana and Maryland have local income taxes, with Maryland levying the highest percentage at an almost 3 percent of adjusted gross income statewide average in 2020. Only 190 counties across five states levy income taxes: Indiana (all 92), Kentucky (73 out of 120), Maryland (all 23), Alabama (1 out of 67), and Iowa (1 out of 99).
Municipalities form the bulk of the remaining local taxing jurisdictions with almost 4,000 municipalities levying an income tax. (Again, most of these municipalities are in Pennsylvania and Ohio.) School districts make up 954 more income tax jurisdictions, with Ohio and Pennsylvania claiming a combined 671 school districts, Iowa 279 and four other districts outside of Ohio, Pennsylvania, and Iowa leveraging local taxes. Lastly, there are four special districts that have a local income tax—New York and Oregon transportation and port authorities.