Investors.com
Keeping Taxes Low At State Level Is Key To Growth
By Rex Sinquefield and Travis H. Brown
Posted 07/17/2012 

State taxes impact economic performance more than most people imagine. While the majority of attention is paid to the federal tax code, the evidence suggests that state taxes are just as important in determining economic competitiveness and often mean the difference between economic success and failure. 

The level and form of state taxation varies greatly, from no-income-tax states such as Florida and Texas to states like Hawaii and Oregon, which have the highest personal income tax rates in the nation (11%). 

Similarly, economic performance over the last decade has varied dramatically among the 50 states, with Illinois, California and New York performing very poorly, while Texas flourishes. Differences in state tax policies help explain this record. 

The U.S. economy, in the words of Federal Reserve Chairman Ben Bernanke, is heading for a massive tax cliff. The expiration of the 2001-2003 tax cuts, the expiration of the payroll tax cut and new taxes enacted as part of ObamaCare will completely upend the existing federal tax code. 

Given this state of affairs and the political gridlock in Washington, D.C., the best one can hope for is the extension of some of the existing tax rates and the avoidance of a disastrous, massive tax increase in January 2013. 

The chances for substantive tax reform that would make the U.S. more competitive are slim, given the administration’s preoccupation with tax “fairness” and demonizing the rich. On the other hand, state taxes are ripe for reform, and many governors around the country are leading the charge to reduce or do away with their state income taxes all together. 

Tax reforms happening at the state level are much more likely to succeed than anything coming out of Washington D.C., and the evidence shows that cutting state personal income taxes can have a dramatic impact on economic performance. State tax reform is, therefore, the best chance to improve the competitiveness of the United States in this global race for jobs and prosperity. 

There is ample evidence of the impact that state income taxes have on economic performance. Taxpayer data from the IRS Division of Statistics shows that during the last 15 years, Texas and Florida have gained $20.7 billion and $84.3 billion in annual adjusted gross income (AGI) due to migration, respectively. During the same time period, New York, California and Illinois have lost $58.6 billion, $32 billion and $26.3 billion of annual AGI, respectively. 

Nine states today do not levy a broad personal income tax, while two of those nine tax only dividends and interest. Altogether, the nine states without a personal income tax have gained $146 billion in annual AGI, while the nine states with the highest income taxes have lost $124 billion. This translates to $26.7 million gained per day for the no income tax states, and $22.6 million lost per day for the highest tax states. 

Critics claim that migration has nothing to do with taxes, that it occurs for other reasons such as climate or “long established migration patterns.” Yet great weather hasn’t helped Hawaii, which has lost almost $300 million in AGI over the last 15 years. Similarly, if “migration patterns” are responsible, why is Nevada, which has no income tax, gaining wealth, while its neighbor California, which has some of the highest taxes, losing wealth? 

The correlation between wealth migration and tax policy can even be seen in the Dakotas, with North Dakota (which has an income tax) consistently losing wealth to South Dakota (which does not impose a state income tax). The differences in economic performance between the states are profound and cannot be explained by anecdotes. 

Wealth lost by a state is wealth lost forever. Individuals pay not only state income taxes, but also sales taxes, property taxes and various other government fees. When taxpayers leave, they take with them not only this year’s income but also the present value of all future income and taxes, not to mention the impact that their consumer spending would have on the local economy. 

Similarly, when businesses decide to leave, they take jobs with them. Over the last 15 years, New York State lost $58.6 billion in annual AGI. When using a 5% discount rate, the present value of this lost income is over $1.1 trillion, while New York City’s entire operating budget in 2011 was only $65.8 billion, according to its budget office. 

While in any given year the gains or losses due to taxpayer migration may seem small, this impact becomes huge when compounded over time. 

There is ample academic literature looking at the connection between state taxes and economic performance. A recent study by W. Michael Cox and Richard Alm, titled “Looking for the New New World,” looked at IRS migration data and found a strong correlation between marginal state tax rates and the migration of taxpayers. 

From 2004 to 2008, the study found that every 1% increase in the state income tax rate lowered net migration by about 4,500 people per year. In other words, Texas (with its no-income-tax state policy) should outperform Oregon (with its 11% state income tax) by almost 50,000 net new taxpayers per year — or 500,000 over a decade. 

The findings are entirely consistent with the experience of no-income-tax states and are corroborated by other data sources. For example, the U.S. Census Report on Geographic Mobility/Migration shows the no-income-tax states gaining a net of 1.2 million people due to migration from 2005 to 2009, while the highest tax states lost 2.2 million people during the same time period. 

Data from the Bureau of Economic Analysis tells a similar story when it comes to employment — no-income-tax states created more than 2 million net new jobs over the past decade, while the highest tax states actually lost more than 500,000 jobs. 

Finally, a study by Arthur Laffer looked at each state that introduced an income tax after WWII and found that in each of the 11 cases, the state’s economic growth rate relative to the rest of the country declined after the new tax was enacted. The probability that having a state income tax is good public policy is very small, and the evidence points overwhelmingly in the direction of reducing marginal tax rates on income. 

Governors and activists around the country are leading the charge on reducing and eliminating state income taxes. States such as Oklahoma, Kansas and Missouri are all considering proposals to reduce or eliminate their state income taxes in an attempt to join the high growth states such as Texas and Florida. 

At the same time, others are doubling down on their failing policies. Illinois Gov. Pat Quinn recently raised the state income tax, while Californians will vote in November on an initiative seeking to raise the top tax rate to 13.3% and regain the inauspicious status of “most taxed state in the country.” 

The coming changes to the federal tax code in 2013 loom large, but it’s the changes happening at the state level that will have a major impact on the economic performance of the United States. Given the political realities in Washington D.C., the probability of comprehensive tax reform is small. It’s the states that offer the best hope for real tax reform. 

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