State Tax Follies

This article appeared in on July 10, 2003.

Critics of the Bush tax cuts once claimed the economic benefits from lower federal taxes would be offset by higher state and local taxes. But that depends on where you live and whether your state is raising taxes (bad news) or cutting spending (good news).

For the nation as a whole, the idea that increased state tax rates might neutralize lower federal taxes was always nonsense. Very few states are raising income or sales tax rates, and the few sliding down that treacherous slope already have the worst tax systems in the country. In fact, seven states reduced income tax rates last year — Hawaii, Maryland, Massachusetts, Michigan, North Carolina, Oklahoma and Rhode Island.

From 1991 through 2001, state taxes rose by 4.2 percent a year in real, inflation-adjusted terms, according to the Tax Foundation. Real incomes of taxpayers rose more slowly, by 3.5 percent a year. In California, real incomes grew by only 3.2 percent a year, yet tax receipts grew by 5.4 percent a year. This was an unsustainable trend: State taxes could not possibly keep rising faster than taxpayers’ incomes indefinitely, or taxpayers’ after-tax incomes would fall continually until there was nothing left.

From 1999 to 2001, many states and cities made lavish spending plans on the basis of a temporary revenue windfall from stock options and capital gains. Spending by state and local governments rose 4 percent in 1996, 4.4 percent in 1997, 5.4 percent in 1998, 7 percent in 1999, 8.2 percent in 2000 and 8.1 percent in 2001. That, too, was an unsustainable trend: State and local spending could not keep rising by 8 percent a year because at that rate it would double every nine years and eventually account for 100 percent of GDP.

These are facts. What we usually hear are opinions. USA Today thus began a recent survey on state finances with the National Governors Association whining about “the worst financial crisis since World War II.” What else did the governors expect after allowing state spending to grow so much faster than the incomes of taxpayers?

USA Today focused on the 10 most populous states, finding only one (Texas) that plans to cut spending from general funds by even a dollar. On the other hand, income tax rates have already been increased in Arkansas, Nebraska and New York, with California Gov. Grey Davis eager to join that list (and perhaps subconsciously eager to collect on that state’s greatly increased unemployment benefits).

California’s taxes are already bad enough — with an income tax rate of 9.3 percent on incomes above $38,291, a 10.4 percent tax on financial institutions and a 7.25 percent sales tax. California’s problem is runaway spending, and the right thing to do about that is to do the right thing. A “Citizens Budget” produced by the Reason Foundation and Performance Institute offers a perfectly sensible list of $18.2 billion in spending cuts, in addition to the governor’s modest proposal — enough to balance a two-year budget and leave room for a badly needed reduction in the state’s punitive income-tax rates.

The Tax Foundation ranks states according to their tax climate for business. By their impressively rigorous analysis, states with the very worst tax systems are Mississippi, California, Arkansas, Ohio, Nebraska, Hawaii, New York, Maine, Minnesota and Louisiana. At least three of those 10 — Arkansas, Nebraska and New York — have been busily making the worst state tax systems even worse. Ohio, too, if you count an increase in the sales tax (both income and sales taxes were raised in New York and Nebraska). California is close to making the same mistake.

No amount of federal aid could deter the legislators of these four or five states from their determination to tax their economies into oblivion. On the contrary, those state officials are among the most likely to use their slice of the newest $20 billion of federal slush funds (a payoff in the tax bill) to sustain unsustainable spending plans until after the next election.

The best tax systems on the Tax Foundation’s list include those of Wyoming, New Hampshire, Nevada, Colorado, Alaska, South Dakota, Florida, Washington, Oregon and Tennessee. Note that six of these 10 have no tax on individual income and four have no tax on corporate income.

How states collect taxes can be nearly as important as how much they collect. Sales and excise taxes, so long as they are not uncompetitive with neighboring states, are somewhat less harmful than income taxes because you can delay the tax by saving. User fees, such as college tuitions and road tolls, make sense. Steeply progressive income tax systems, by contrast, seriously wound state economies because they repel skilled mangers and professionals and the companies that depend on them.

In 1998, The Journal of Public Economics published a critical study by Martin Feldstein and Marian Vaillant, asking, “Can State Taxes Redistribute Income?” The answer is “no.”

States like California, New York, Oregon and Vermont that try slapping high tax rates on high income just end up exporting people with unusual talent and skill (that’s why Tiger Woods moved from California to Florida). Remaining managers and professionals become scarcer and therefore more valuable. Before-tax salaries and fees are higher in high-tax states, Feldstein and Vaillant found, to attract and retain qualified executives, physicians and the like. State taxes supposedly aimed at the rich end up being a burden on everyone else. State consumers end up paying more for professional services, and state businesses become less competitive because they have to pay higher managerial salaries than states with little or no income tax.

The fundamental “crisis” of the states is that government spending in most states has increased far more rapidly than the incomes of taxpayers. States that face the problem by cutting spending and tax rates are certain to prosper, just as Ireland did after slashing national spending and tax rates. Higher tax rates are no solution to the unaffordable spending schemes of overtaxed states like California and New York. On the contrary, high tax rates are a symptom of excess spending and a major cause of inferior economic performance.

Alan Reynolds is a senior fellow with the Cato Institute.