State and local governments, like the federal government rely on tax revenue to fund their budgets. Unlike the federal government that relies almost entirely on income and payroll taxes, state governments rely on a mix of sales tax, property tax and income tax revenue. The exact formula is left almost entirely to the State’s discretion.
It is clearly outside of the scope of this Blog to develop a uniform theory of the optimal state tax regime. Rather, I wanted to point out some interesting observations regarding the relationship between state and local income tax and state and local sales tax.
Seven US States do not currently levy income taxes: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Residents of New Hampshire and Tennessee have the lowest effective state income tax as residents only pay tax on dividends and income from investments but not on ordinary income. This begs the question, given the choice of living in an income tax state or not, who would live in a state with an income tax?
Louisiana Governor Bobby Jindal as recently as 2013 argued for eliminating Louisiana’s income tax claiming that “States with no income taxes are outperforming other states in terms of economic growth and population growth.” Policymakers in several other states, including Kansas, Michigan, Nebraska, Ohio and Wisconsin, have either cut their state’s income tax or are considering eliminating them altogether. They’re driven by the same line of thinking: Cutting the income tax will boost take-home pay for everyone. It’ll make the state more attractive than its neighbors, drawing new businesses, creating jobs and sparking an influx of talented workers.
Gov Jindal’s argument does make intuitive sense, but ignores one of the fundamental nuances of the tax code: Income tax can be progressive while sales tax can be regressive. In other words, states can adjust income tax rates to tax wealthier individuals more heavily, but there is no practical way to shift the sales tax burden from the poor to the wealthy.
No. In fact, the seven states that do not have any state or local income tax imposed have an average combined state and local sales tax rate of 6.4% while the other 43 states have an average state and local sales tax of 7.09%.
No, again. The seven states that do not levy state or local income tax have an average debt per capita of $3,333, while the remaining 43 states have an average debt per capita of $3,865.
There are two important factors commonly overlooked when casually discussing the choice between income tax and sales tax. First, we need to look at the sales tax bases—the basket of transactions that the sales tax applies to in a given state. Many states don’t tax “groceries,” but a many states also classify soda and candy as a grocery.
Secondly, Most states do not comprehensively tax services. The first sales tax was enacted in Mississippi in 1930 as a reaction to falling property tax revenues during the Great Depression. At the time, the consumer economy was predominantly transactions of goods. As a result, when the drafters wrote the sales tax statute, it only applied to transactions of tangible personal property, the goods sector. Forty-four states and D.C. followed Mississippi in enacting sales taxes in the following decades, and all but three (Hawaii, New Mexico, and South Dakota) for the most part adopted a goods-only tax structure.
This was a sufficiently broad base for a few decades, but since then the American economy has transformed to include far more services. Services now represent approximately two-thirds of consumption, and largely go untaxed by state sales taxes.
For more insight, see the chart below detailing State and Local Tax Revenue by Source for Fiscal Year 2007
If anyone has a specific question regarding states choices between income tax revenue and sales tax revenue or the consequences of such allocations, please post a comment.