2017 Tax Burden by State

What state and local tax instruments are most fair? Least fair?

Tax fairness is not easy to define and probably is subjective. In the economics textbooks, economists measure fairness in taxation in two ways, mainly (1) vertical equity and (2) horizontal equity. Vertical equity means people with a larger income / wealth should pay a higher tax rate on their income / wealth. (But as I said, this is also subjective because one might feel that the flat tax rate -- also called a proportional tax -- is most fair since everyone bears the same tax rate.) Horizontal equity means the tax system should not discriminate people with the same income. That said, sales tax and fees are the least fair tax instruments; property tax and income tax are relatively fairer.

What’s the relationship between state tax burden and economic growth?

The common belief is that lower tax burden will boost economic activities that will grow the economy. Existing studies show so much conflicting evidence. Although we really need to be careful about types of taxes we are talking about, a recent study published in National Tax Journal makes a conclusion that the effect of tax revenues on personal income growth can change over time. Between the 1977-1991 period, the effect is negative: greater tax burden is associated with higher income growth. However, the effect is not there and even positive in more recent years (the authors look at the 1992-2006 period). That means greater tax burden either had no effect on personal income tax or helped income growth.

More complicated is that authors find that higher marginal tax rates (the tax rate on your last dollar earned) have no effect on unemployment and has very small effect on firm formation. Overall, it is difficult to generalize “state tax burden and economic growth,” and the evidence is weak for the common belief that lower tax burden is good for economic growth.

(P.S. Even if less tax burden leads to greater income growth, it is important to examine who benefited any tax cut and who benefited from the income growth, because growth and distribution of income are two different questions.)

Should states and localities tax property at different marginal rates like income?

It is an interesting question that would require a long discussion. Putting political feasibility aside, the discussion must start with why we would “need” progressive property taxation and need to consider the fiscal federalism (specifically, the role of property taxes in the U.S. economy).

What makes some state and local taxes systems better able to weather economic downturns?

First, specific types of taxes are no better than others to deal with economic downturns. Thus, revenue diversification is one of the keys. States heavily reply on sales and state income taxes for their services (while local governments rely on property taxes). Both income and sales taxes are volatile with the economy. But among those two, income tax is more volatile than sale tax. These differentials in elasticity (changes in revenue from each type of taxes with the changes in economic growth, e.g., how much sales tax increases with a 1% of economic growth?) must be studied for a careful financial planning.

What state and local tax instruments are most fair? Least fair?

I believe the fairest tax system is one with a broad base and a low rate, such as a sales tax that taxes most goods and services, or a broad based business tax such as a value added tax. The least fair taxes are those that tax low income persons more (as a % of income) than high income persons, such as a narrow sales tax. I believe the fairest tax is a graduated income tax.

What’s the relationship between state tax burden and economic growth?

My view is that state taxes have little impact on economic growth. There are two main reasons for this. First, state taxes are generally a low % of a business’s revenue, and second, low taxes mean less spending on programs that can stimulate economic growth such as education and infrastructure. A state tax cut does little but take money out of taxpayers pocket (those who benefit from state services) and put it in another person’s pocket, generally higher income persons who are less likely to spend the money. A recent article in the National Tax Journal (The Relationship Between Taxes and Economic Growth at The State Level, December, 20150) concluded that the impact of taxes on economic growth are very small.

Should states and localities tax property at different marginal rates like income?

No. Most state constitutions, including Michigan, prohibit differential taxation of property. There is some correlation between home values and income but some groups such as senior citizens could be taxed out of their homes by such a tax system.

What makes some state and local taxes systems better able to weather economic downturns?

A broad based, low rate tax system would do best during an economic downturn. Basically for the same reason one should have a diversified stock portfolio as some sectors are always hit harder than others. The most volatile tax is the corporate income tax, so any state that relies too much on this tax will be hit harder during a downturn. As an aside, Michigan has gone in the wrong direction, switching in 2012 from a broad based business tax to a corporate income tax. Michigan has one of the most volatile economies because of our heavy reliance on autos and the next time we have a downturn corporate tax receipts could drop 30 to 40% or more.

What state and local tax instruments are most fair? Least fair?

A low flat tax is most fair. High progressive taxes are least fair.

What’s the relationship between state tax burden and economic growth?

High marginal tax rates reduce economic growth. People vote with their feet and move to low tax states.

What makes some state and local taxes systems better able to weather economic downturns?

Having low marginal tax rates with a broad base is the best system for getting through recessions.

What state and local tax instruments are most fair? Least fair?

Fairness is often based in part on perspective. In my opinion, the “most fair” state and local instruments are those that have a strong correlation in imposing the tax / cost on those who utilize the specific government service. For instance, an admission fee for a local zoo -- those who choose to attend the zoo pay the cost (or at least a larger portion of the cost) to maintain the zoo. Another example is a gasoline tax with the revenue being utilized to maintain the roadways -- the correlation being obvious. Taxpayers who purchase gasoline for their vehicles also utilize the streets.

The least fair state and local tax instruments are, in my opinion, those that extract resources from taxpayers who do not wish to utilize the corresponding resources. For instance, in my locality, there is a “required” recycling fee (tax) that every household pays, whether they utilize the local recycling pick up services or not.

What’s the relationship between state tax burden and economic growth?

When something, anything, costs more, people consume / use less of it. So if the state and local tax burden is significant, businesses and individuals will look to operate and live elsewhere. There is a cost / benefit analysis that we all perform, and some taxpayers will find that level of tax burden unbearable at a lower level. I believe that there is a strong inverse correlation between tax burdens and economic growth. This works in reverse as well, when a state or local governmental unit provides tax breaks (abatements for example) that often generates economic development.

Should states and localities tax property at different marginal rates like income?

States and localities already do tax property at different marginal rates -- for instance, personal residences are typically taxed at lower rates (homestead rates and exemptions) than business property. Whether they should, is an open question.

What makes some state and local taxes systems better able to weather economic downturns?

Reliance on relatively recession resistant sources of income -- real property taxes; non discretionary transaction taxes; and prudent fiscal planning to have a “rainy day” reserve. Additionally, instilling confidence in the taxpaying base that their tax dollars are being spent prudently is critical.



The opinions of Mr. O'Brien are his opinions and not necessarily those of the University of Notre Dame

What state and local tax instruments are most fair? Least fair?

Least fair is likely the sales tax. It does not allow for any discrimination for ability to pay and because it comes in small payments is largely transparent to the taxpayer. Efforts to make it more sensitive to income levels by removing some purchases like food only creates more problems. The reduction in the base eventually leads to, or at least is correlated, with higher rates makes the tax even more regressive.

The fact that services are largely omitted from the base suggests that higher income groups pay a smaller share of their income on their purchases. The purchase of services increases as income increases. The sales tax can be make less regressive by allowing a credit against the income tax that is driven by income levels.

Most fair is the income tax. It allows a reduction in the tax base by accounting for the cost of doing business and the cost of living.

User charges are also fair. The fee is only paid when the consumer decides to purchase the service or good. User charges can also be adjusted for income levels.

What’s the relationship between state tax burden and economic growth?

This question can only be answered by looking not only at the tax burden, but also the level of public services. High taxes are never viewed positively, but neither are marginal public services. New move-ins don't start their look for a home by asking which area has the worst schools. The individuals and families that states and cities are trying to attract want good schools, good public facilities, and a safe place to live. All of those services require a reasonable level of taxes. Public services appear to be "normal" goods is the sense that as income level increase citizens want more services.

Should states and localities tax property at different marginal rates like income?

No. All property should be taxed at the same level. Once a state starts to use different approaches to assessing property types, the slope gets very slippery and the slide is towards treating certain properties unfairly. For example, taxing public utilities at a higher rate may be politically popular, but in the long run the consumer faces higher rates on electric, gas, and telecommunication purchases. But the higher rates are not transparent. It is the same with taxes on businesses. Eventually the reduction in the valuation of certain classes of property results in higher rates for others.

What state and local tax instruments are most fair? Least fair?

The answer depends, of course, on one's conception of fairness. If one believes (as I do) that individuals with higher incomes should pay a higher percentage of their income in tax, then the fairest tax instruments are progressive individual income taxes. With the corporate income tax, some of the burden falls on workers -- no one is sure how much. It's also hard to know who exactly bears the burden of property taxes: some (but how much?) of the tax will be capitalized into property values and rents. And it's very hard to implement a progressive tax on consumption (or sales) at the state or local level.

What’s the relationship between state tax burden and economic growth?

Good question. A number of studies find that the effect of higher taxes on growth at the state level is relatively small. But the answer is likely to depend on context. If states raise taxes and use the revenue to make prudent investments in education and infrastructure, then that can fuel growth.

Should states and localities tax property at different marginal rates like income?

Probably not. Imagine that Family A has one home worth $1 million, while Family B has a primary residence worth $500,000 and a vacation home worth $500,000. With a progressive property tax, Family A would pay more in property tax than Family B, because the tax on $1 million would be more than twice the tax on $500,000. I don't see why that's a good thing.

Maybe we could have a progressive property tax that's keyed to the total value of all the real estate that a person owns, rather than a tax that's based on the value of any particular lot. But people own real property in multiple jurisdictions, and it's easy to shift title from one person to another (e.g., put the house in your child's name).

What makes some state and local taxes systems better able to weather economic downturns?

Any tax based on income, sales, or property values will collect less during downturns because income, sales volume, and property values fall during downturns. And that's not necessarily a bad thing: during a downturn, we want to put more money into the hands of households and businesses. A potential fix is for states and localities to build up rainy day funds during boom times so they can operate at a deficit during recessions. But the temptation to spend more or cut taxes during a boom is very strong. Rainy day funds require political discipline.

What state and local tax instruments are most fair? Least fair?

A better question are which state / local taxes are the simplest, most transparent, and least economically damaging. Simple taxes reduce paperwork. Transparent or visible taxes inform citizens of the “cost of government.” And of course, we want to damage productive activity as little as we can. For local taxes, I like property taxes because they are highly visible and fairly simple. However, the rate should be made equal for all property parcels (residential, commercial, industrial) to reduce distortions.

What’s the relationship between state tax burden and economic growth?

High marginal tax rates reduce productive behavior (working, investing, starting businesses) and increase unproductive behaviors (avoidance, evasion). Also, most economists think consumption-based taxes (like sales taxes) are less economically damaging than income taxes. So the best state-level tax is a flat rate general sales tax. It’s transparent, equal, and least harmful to the economy.

However, governments do lots of things that harm economic growth: high taxes, overregulating, corruption, excessive welfare, corporate welfare, labor union laws, encouraging excessive litigation.

Should states and localities tax property at different marginal rates like income?

No. All property (residential, commercial, industrial) should be taxed at the same low rate compared to value. Also, local governments should not impose tax on business machinery and equipment because such taxes are very damaging to capital investment, which ends up harming workers.

What makes some state and local taxes systems better able to weather economic downturns?

A flexible economy with a minimum of regulations so that resources can be re-allocated quickly to new areas of growth.