Should states use tax breaks to woo seniors?

We’ve all seen the articles in Forbes, Kiplingers, or U.S. News trumpeting the best states to live in retirement. A key measure for them all: Low taxes. What you may not know is that states actively compete with one another to provide tax breaks to older residents—especially to wealthy seniors.

This competition is similar to the way states use tax subsidies to woo businesses. It may not make much sense, but it sure is trendy.  

For instance, in 2010 the Georgia legislature voted to exempt nearly all retirement income from tax starting in 2016. Last year, the governor of Maine proposed making all pension income tax-free.

Not all states are headed in this direction. Michigan, which is in deep financial distress, recently rolled back some generous tax exemptions for pension income. But nearly every state offers some tax breaks for seniors.

Why? Many seniors have plenty of money to spend including Medicare dollars, and Social Security and pension benefits. Just as important, they use relatively few state and local services:  The elderly don’t need K-12 education and spend relatively little time in jail. And their health care is largely funded by the federal Medicare program.

This tax race for seniors is described in a fascinating new paper that Karen Smith Conway of the University of New Hampshire and Jonathan Rork of Reed College presented last week at a Tax Policy Center/UCLA Law School conference on state taxes.

States offer seniors three buckets of tax breaks. They exclude some or all Social Security benefits from tax; grant seniors extra deductions, exemptions, or credits; and exempt at least some pension income from tax. Combined, these preferences cost states more than $24 billion annually. The biggest beneficiaries: middle- and upper-income elders–the very people states want to keep or attract.

For instance, Conway and Rork found that 12 states offer a modest tax exemption for pension income, three exempt income of $70,000 or more, and five exempt all pension income from tax.  

Conway and Rork quote Georgia Gov. Sonny Purdue, who said his state’s plan to eliminate taxes on retirement income “will help attract retirees to our state and make our economy even stronger.”  

Is he right? Do low taxes attract seniors and are they worth the revenue cost?

Lots of prior research suggests Purdue is engaged in little more than wishful thinking. Last year, fewer than one percent of seniors moved from state to state after age 65 for any reason. And very few appear to do so to reduce their taxes.

This limited mobility may result in another major downside for states. About 70 percent of seniors will eventually require long-term care services in old age, and 20 percent will need this assistance for five years or more.

Many are middle-income seniors who spend down their assets on personal care and eventually become eligible for Medicaid. About one-third of Medicaid dollars are spent on long-term care services and the program is a growing burden on state budgets.

Thus, while states may benefit in the short-run from attracting a few relatively young, healthy, and wealthy pensioners, they may end up paying a substantial price when middle-income seniors become frail, go broke, and require Medicaid long-term care services.

When that happens, states such as Georgia may regret giving up revenue to subsidize seniors. Of course, the price for that mistake will be paid by some future governor who has the misfortune of serving years from now.