The drawbacks of using states as tax-reform laboratories

With Washington apparently stuck in gear on taxes, it may be tempting to see the states as leading a way to reform, Gordon writes, but the idea of states as laboratories for federal tax reform is fundamentally flawed. 

With state finances gradually improving, some Republican governors are turning their attention to fundamental tax reform.  Louisiana Governor Bobby Jindal has proposed replacing his state’s personal and corporate income taxes with higher sales taxes.  Nebraska’s Dave Heineman and North Carolina’s Pat McCrory would do something similar, broadening the sales tax base and perhaps including some previously tax-exempt services.

With Washington apparently stuck in gear on taxes among other issues, it may be tempting to see the states as leading a way to reform.  Unfortunately, some of the proposals currently circulating – and the idea of states as laboratories for a fundamental federal tax reform —are fundamentally flawed. 

First, as my Tax Policy Center colleague Ben Harris has noted, income-sales tax swaps would be regressive – or hit low income household the hardest.  This is because low income households must dedicate a greater share of their income to consumption to achieve a basic standard of living and more of their consumption tends to go toward goods (which are taxed) versus services (which are typically not).  These households also often benefit from income tax rebates which presumably would be wiped out along with the tax.

Another key issue is whether states would go after currently untaxed services.  Most states have already picked off easy targets like tuxedo rentals and tattoo parlors.  As pointed out by the Tax Foundation’s Joe Henchman, it’s a much heavier lift politically to tax professional services of lawyers, accountants, and real estate agents.  Just ask lawmakers in Maryland, Michigan, and Florida who enacted new sales taxes on some services but were forced to repeal the levies in the face of industry backlash. 

It is unclear whether states without an income tax would be able to raise adequate revenue to provide the services that individuals and businesses value.  Proponents of tax swaps often point to modestly higher growth in states without a personal income tax.  But these comparisons are misleading. States without income taxes usually have strong alternative tax bases like energy (Texas, Alaska, and Wyoming) or gambling (Nevada). 

More broadly, states are not the federal government.  The usual argument for a federal consumption tax – that it would spur investment by reducing future tax penalties on savings – does not apply in an open economy where people may respond to higher sales taxes by doing more shopping online or in neighboring states.  The federal government can afford to worry less about tax flight.  It is simply much easier to cross state rather than national borders to avoid taxes unless you’re a professional athlete or, well, Gerard Depardieu.  At both government levels, higher rates can also prompt flat out tax avoidance or cheating.

Proponents of sales-income tax swaps are correct in noting the income tax’s one major flaw:  volatility.  An overreliance on income taxes can put states on a revenue rollercoaster and make them very sensitive to economic downturns. This is a particular problem in states where income tax rates rise sharply with income or where individuals get more income from variable sources like stock options and capital gains. 

However, states can address these problems by doing a better job managing their budgets.  For example, they could improve their rainy day funds and park more money there when times are good.  They might also reconsider rules that make it prohibitively costly to raid these funds in a bad economy.

In other words, switching from income to consumption taxes may sound like music to federal policymakers’ and some economists’ ears.  But another equally resonant sentiment, especially among the latter group, is to upgrade fiscal infrastructure when the opportunity cost is low.  Translation:  fix the roof when it’s not raining.