The Income Tax Rebellion: Can It Work?

The loudest collective rallying cry from governors this year is not over the usual themes of growing jobs and having a more competitive economy. This year, the buzz is all about the race to zero.
by | January 31, 2013

As state legislatures kicked off their sessions this year, the loudest collective rallying cry from governors was not over the usual themes of growing jobs and having a more competitive economy. This year, the buzz is all about the race to zero.

Ten governors, all Republican, are proposing or are expected to propose an income tax cut in their states this year and of those 10, three are proposing nixing it entirely.

By and large, the proposals swap out the income tax for a broader sales tax base at a higher rate. Although this doesn’t mark the first time a governor has proposed the idea, the level to which governors are talking about this kind of swap is unprecedented. said Scott Drenkard, an economist for the Tax Foundation.

“This year it really is the income tax rebellion and a lot of states are latching onto it,” Drenkard said.

Here are the big three:

Louisiana

Gov. Bobby Jindal and his advisors are looking at a plan to eliminate the corporate and personal income tax in favor of expanding the sales tax rate to services and raising the rate to 7 percent. The current rate is 4 percent.

Nebraska

Gov. Dave Heineman wants to eliminate the corporate and personal income tax in favor of reducing business exemptions to the sales tax. Nebraska’s income tax rate of 6.84 percent is higher than every one of its neighbors (Iowa, Kansas, Missouri, Colorado and Wyoming).

North Carolina

Gov. Pat McCrory’s administration has floated before the legislature eliminating personal and corporate income taxes while broadening the sales tax base to more services. The state’s corporate income tax rate is 6.9 percent and the highest personal income tax rate is 7.75 percent.

The heads of the remaining seven states (from Kansas, Indiana, North Dakota, Ohio, Oklahoma, South Carolina and Wisconsin) either have a proposal to cut the state income tax or are mulling ways to do so. The specificity of plans run the gamut -- Kansas Gov. Sam Brownback has proposed keeping a controversial sales tax to pay for an income tax cut that would reduce the state’s income tax rates by up to one-third over four years. Oklahoma Gov. Mary Fallin has simply said she plans to urge lawmakers to pass a one-time cut in the state’s top income tax rate or 5.25 percent.

Opinion varies as to how attractive the notion of tax-free income is. Carol O’Cleireacain, an economic advisor and a member of the State Budget Task Force, said she doubted that the prospect of a tax-free income would be the sole driver of a resident’s or business’ decision to move to a state. More often, that factor is rolled into the overall determination of quality of life.

“You kind of get what you pay for,” she said, referring to the idea of reduced taxes. “There are people for whom the tax and service provision is not very important. And there are people for whom the public service provision is very important: things such as public transportation, medical care, state universities.”

But Drenkard said of the foundation’s 26 studies on the subject, corporate and income taxes consistently rate as the most destructive to economic growth. “With [a higher] income tax, there’s disincentive toward creating new wealth,” he said.

Still, relying more (or entirely) on state sales taxes is a tricky endeavor. Raising sales taxes is generally seen as unfair to low-income families because they cannot avoid purchasing essential items, so end up giving a larger share of their income to the tax increase. Additionally, the U.S. economy has become increasingly driven by services, which are not taxed, over goods, which are taxed.

“You’re relying on a shrinking base,” O’Cleireacain said.

Expanding the sales base to include services would address both of those issues. However, getting that idea past the powerful lobbies that advocate for the affected industries is another question. In 1987, the Florida Legislature enacted an expanded sales tax on services like including advertising, legal, accounting and construction services. The move was met with enormous outcry. Major corporations like Coca-Cola and Procter & Gamble canceled or reduced their advertising in the state to protest the tax while business groups canceled at least 60 conventions they had booked in the state. The tax lasted just six months until it was repealed and the legislature instead voted to raise the sales tax from 5 percent to 6 percent, a rate that is still in effect today.

And even if there is more political will today to attempt such a feat, economics also dictate whether such a tax swap will work. Among states that don’t have an income tax, Alaska, Texas, South Dakota and Wyoming rely heavily on oil-related revenues to buoy their budgets. Drenkard pointed out that a state that has a greater reliance on income tax as a share of its budget will have a harder time letting it go.

Of the three proposals, he says Louisiana’s has the best chance of passing because of its balance. He also notes that income tax makes up 16.8 percent of that state’s annual revenue. By contrast, income tax revenues in North Carolina, which has a similar plan, make up 30.2 percent of the budget.

Justin Marlow, associate professor of public affairs at the University of Washington, said he thought Kansas’ plan of phasing in a reduced income tax was the most “realistic.” But on the whole, he added, such proposals typically sound good until taxpayers begin to realize the cost.

“It can be a really popular message but when you get to modeling out what it really means in most states, you get to the reality that it means massive cuts in things like state parks, in education, [and other services],” he said. “You end up losing the popularity you would have gained in the first place.”

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