Originally published by Bloomberg Law on July 31, 2023.
There’s been a profound shift in state tax policy over the past couple of years. According to the Tax Foundation, 27 states have reduced personal and/or corporate income tax rates since the start of 2021. A few of them—Iowa, Georgia, Arizona, and Mississippi—were even more aggressive, enacting flat taxes, meaning tax reform as well as tax relief.
Ironically, the widespread enactment of right-leaning tax policy at the state level was made possible in part by left-leaning spending policy in Washington. Presidents Donald Trump and Joe Biden pushed through several trillion dollars of new spending, with a significant amount of that new money being directly sent to state governments.
Many states responded to that largesse with big spending increases, but others decided to lower tax rates. Biden’s so-called stimulus legislation tried to preclude the latter outcome, but without success.
Because red states have led the way, it’s easy to assume that the wave of tax cutting has been driven by ideology and partisanship. That’s part of the story, but don’t overlook the role of tax competition, which happens when lawmakers lower tax rates to attract new economic activity—or to keep existing jobs and investment from leaving.
States want to make sure they attract—or at least don’t lose—rich people. Upper-income taxpayers pay a disproportionate amount of taxes (just like they pay the lion’s share of federal taxes), and states that attract such residents are fiscal winners. States that suffer an exodus of such people are fiscal losers.
IRS data shows that high-tax states such as California, New York, and Illinois are losing tens of thousands of successful residents to low-tax states, with zero-income-tax Florida being a preferred destination. But what really matters from a fiscal perspective is that those tens of thousands of people leaving higher-tax states account for tens of billions of dollars of taxable income.
This is a dangerous trend for the nation’s high-tax states. Simply stated, a government needs an acceptable ratio of people pulling the wagon versus those riding in the wagon. Otherwise, as former British Prime Minister Margaret Thatcher famously warned, they’ll “run out of other people’s money.”
The outlook for high-tax states is even worse when you consider that upper-income taxpayers no longer have the ability to fully deduct their state and local tax payments when filing their federal taxes. That deduction was an implicit subsidy for high-tax states, but it was curtailed as part of the 2017 tax legislation. This creates an added incentive for well-to-do residents to migrate to red states from blue states.
Is tax migration something to applaud? Ideology largely drives the answer to that question. Folks on the left have a dim view of tax competition because it restricts the ability of politicians to raise taxes and redistribute money. By contrast, people on the right like tax competition for the same reason.
Tax competition already is a big issue on a global basis. Governments around the world felt pressure to lower personal tax rates after Thatcher and former President Ronald Reagan slashed tax rates starting more than 40 years ago. The global shift to lower tax rates has been significant, with the average top tax rate in industrialized nations dropping by about 25 percentage points. And the same thing also happened with corporate tax rates.
Some folks on the left complain that tax competition produces a race to the bottom, depriving governments of revenue. International evidence, however, casts doubt on that concern.
According to OECD data, receipts from taxes on personal and corporate income, measured as a share of economic output, are significantly higher today than they were back in 1980. It will be interesting to see whether the tax-cutting states in America enjoy a similar Laffer Curve-type response.
For high-tax states, there’s no potential windfall. Instead, they face a grim future as more and more taxpayers do a cost-benefit analysis and decide whether they get enough value from government to justify punitive income tax rates (topping out at more than 10 percent in California, New York, and New Jersey). Based on current trends, expect a growing number of those taxpayers to “vote with their feet.”
