Tax Analysts Blog

Income Redistribution Has No Place in State Tax Systems

Posted on Feb 13, 2013

Although 2013 is yet young, tax reform has been a hot topic. States have been particularly active in discussing a variety of tax reforms. The proposed reforms have included decreased reliance on income taxes and increased reliance on consumption taxes (i.e. the sales tax). But with that proposal comes the discussion that doing so would decrease the progressivity of state tax systems and, therefore make state tax systems less fair.

But let’s really be fair (yes, pun intended). Reducing the progressivity of a state tax system by increasing a state’s reliance on the sales tax does not mean the state is overtly trying to cater to the rich and tax the poor. Reducing reliance on the income tax and increasing reliance on the sales tax can improve the stability of a state’s revenue stream. And because states have to balance their budgets every year, revenue stability is very important.

It is also important to remember that redistribution of income, to the extent that it should be a goal at all, must be done at the federal level. It should not be accomplished by state and local governments and there are several reasons for this.

For one, there is the issue of taxpayer mobility. If a taxpayer doesn’t like the income taxes in state A, the taxpayer can move to state B, where tax conditions may be more favorable. Of course this distorts economic choices, and studies have shown such a move ineffective in increasing overall net wages. As detailed by a 1994 Harvard study, empirical findings have shown that gross wages adjust rapidly to a changing state tax environment.

According to the study if a state increases its income tax, the gross wages in the state will adjust until the net wages are equal to that available in other states. Put differently, if a state increases its income tax rate, the gross income of employees in that state would increase so that the after-tax wages are the same across the board. The net wages are independent of a state’s tax system. Following that logic, then, if state taxes cannot adjust net wages, efforts by a state to effectuate income redistribution will be unsuccessful.

There are other reasons that a more progressive system may not function efficiently at the state level, including that the cost of hiring highly-skilled employees increases in a progressive tax system while the cost of lower skilled employees is reduced. This means firms may err on the side of hiring the lower skilled employee, which may not be the best choice.

All of this is very simplified and a treatise could be written on the subject. But when talking about state tax reform, it is important to remember that state tax systems are different than the federal tax system, and what may be perceived as unfair on the part of the federal government may simply be sound tax policy for a state government.

Of course, states still engage in income redistribution, but the reason for that is likely political, not economic. What politician wants to campaign on a regressive tax system platform?

Read Comments (5)

Eric HillFeb 13, 2013

You bring up many valid points. I am curious as to why you think a tax system
mostly based on sales tax can improve the stability of a state’s revenue
stream. When times get tough people and companies cut back on non essential
spending. And many states reduce or eliminate sales tax on essentials such as
electricity, food, and prescription drugs for example. Wouldn't an income tax
on high income individuals, whose incomes are less likely to be eliminated or
reduced, be more stable?

David BrunoriFeb 13, 2013

Cara, That was an excellent post. Whatever one believes about redistribution,
it is hard to argue against the notion that it should take place at a
centralized, national government level.

Cara Griffith's pictureCara GriffithFeb 13, 2013

Eric-
The short answer is that high income individuals are just as likely to lose
their jobs or see a reduction in income during hard economic times as any one
else. So while it seems to make sense that a consumption tax might be less
stable than an income tax, the flip is actually true. Consumption is more
stable than income. People buy, in good times and in bad. When income falls,
people tend to use credit or dip into savings to maintain as close as possible,
their current consumption levels.

AMT buffFeb 21, 2013

"Following that logic, then, if state taxes cannot adjust net wages, efforts by
a state to effectuate income redistribution will be unsuccessful."

This is true if "unsuccessful" encompasses any of the following:
1. Wages will rise to offset the tax rate, or
2. High-wage jobs will leave the state, or
3. Firms operating in the state will become less competitive due to inability
to attract and retain high-wage employees, leading to economic decline (cf. LA
Lakers vs. Miami Heat), or
4. Some combination of the above.

"All of this is very simplified and a treatise could be written on the subject."

What's stopping you? Let's see it! Please include an explanation of what useful
purpose state governments serve now that the federal government has taken
control of almost everything for which the states were once responsible.
Couldn't we save a ton of money by eliminating state government entirely? Other
modern countries do fine without that extra layer of government.

Ed McLenaghanMar 5, 2013

Cara, If you haven't already, I'd suggest reading a more recent papers that
call Feldstein/Vaillant's findings into question: Andrew Leigh's 2005 paper
(http://papers.ssrn.com/sol3/papers.cfm?abstract_id=743546) and Howard
Chernick's 2008 paper
(http://cupop.columbia.edu/files_cupop/imce_shared/Chernick_Paper.pdf). Leigh
finds that states with higher income inequality tend to enact
more-redistributive tax systems, and Chernick finds no impact on own-state
growth (which would be an inevitable consequence of the adjustments indicated
by Feldstein/Vaillant) from increasing the progressivity of state and local
taxes.

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