Republican governors across the U.S. are engaged in an income tax-cutting frenzy, moving to reduce or even eliminate individual income taxes in their states. The changes will increase economic growth and reduce the size of government, they say, and their plans are drawing strong praise from conservative stalwarts.
Unfortunately, the architects and supporters of these plans are laboring under two misunderstandings -- both of which undercut arguments in favor of their efforts.
First, most of these "cuts" are more properly understood as tax swaps, with the lost income-tax revenue almost always offset by higher sales or property taxes. Kansas Governor Sam Brownback, for instance, plans to partly offset his proposed income tax cut by making permanent a "temporary" sales tax increase that was set to expire this year. Louisiana Governor Bobby Jindal similarly wants to pay for an income tax cut with a sales tax increase.
Second, these tax cuts are politically possible largely because they're financed by the federal government. Governors may be lessening their state's bloat, but they're doing so at the expense of all U.S. taxpayers.
Here's how: Taxpayers who itemize deductions on their federal tax return have long been able to claim state and local income-tax payments and property taxes. That may be good for their budget, but such itemized deductions cost the U.S. about $1 trillion each year.
For the past several years, taxpayers have also been able to deduct sales taxes instead of income taxes. This change was part of the 2009 stimulus package, and the provision was extended through 2013 as part of the law passed late last year to avert the fiscal cliff.
As one would expect, the sales-tax deduction has been embraced, particularly in the nine states that currently have no (or very limited) income tax. In Texas, for instance, nearly 21 percent of all taxpayers claimed the sales-tax deduction, and in Tennessee, which has the highest sales tax in the nation, 20 percent of taxpayers claimed it, according to Internal Revenue Service data. The annual cost of the sales tax deduction is about $3 billion, according to the Congressional Research Service.
The tax break has no doubt made the recent round of tax swaps more politically palatable. After all, it's really nothing more than a federal subsidy for states, which is why it has long been blamed for encouraging states to raise taxes. Politicians know many taxpayers will be able to deduct some of the increase from their federal tax bill.
So what's the problem, you ask, in simply swapping one tax for another? There are several.
Sales taxes are among the most regressive taxes, in that they take a larger portion of income from lower- and middle-class families. A report by the left-leaning Institute on Taxation and Economic Policy finds that poor families pay eight times more of their income in sales and excise taxes than wealthy families, while those in middle income pay five times more. The report also finds that five of the 10 most regressive states "derive roughly half to two thirds of their tax revenue from sales and excise taxes, compared to a national average of roughly one third."
And make no mistake -- when a state reduces or eliminates its income tax, it ultimately increases sales or property taxes. A report by the Center on Budget and Policy Priorities finds that states with no income taxes have property taxes that are 8 percent to 12 percent above the national average and sales taxes 18 percent to 21 percent above the national average. (Property taxes are set by localities, which often raise them after state income tax cuts to offset the revenue losses that trickle down.)
The regressive nature of sales taxes is compounded by the fact that the tax deduction largely benefits wealthier taxpayers, who are more likely to itemize their deductions and pay higher marginal rates, making the deduction that much more valuable.
The biggest problem with this tax-swap strategy, however, may be that it won't last: The state and local tax deduction is caught in the budget-deficit crosshairs and could wind up being eliminated or greatly reduced as part of broader tax reform. Several tax-reform panels, including commissions in 1985 and 2005, have called for abolishing the deduction, and some members of Congress are toying with capping deductions at a set amount.
Such a move would be good for the federal budget deficit, but would essentially raise taxes on millions of taxpayers. It would also make it much harder for governors and other state politicians to "cut taxes." Or even to pretend to.
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