The Economic Impact of State Income Tax Elimination

Executive Summary

For years, no-income-tax states like Texas, Tennessee, and Florida have often led the pack in attracting and retaining residents looking to put down roots where they do not have to split ownership over the fruits of their labor with state government. In particular, of the 9 states that currently have no personal income tax, 5 of them rank amongst the top 10 states in terms of GDP growth over the past decade and 4 of them rank amongst the top 10 states in terms of net migration rates from other states.[1] At the other end of the spectrum, high-income-tax states like California, New York, and New Jersey have suffered a population exodus as people vote with their feet and wallets. Perhaps seeing Texas, Tennessee, and Florida as models, an increasing number of states with income taxes have indicated an interest in transitioning away from the income tax through some combination of belt-tightening and finding less damaging forms of tax collection.

This paper studies the economic impacts and feasibility of states phasing out their income tax. Recognizing that states have to collect tax revenue somehow, the analysis here studies two different scenarios. In the first scenario, the state pursues full revenue replacement by broadening the sales tax, leaving the baseline forecasted growth of total tax revenue unchanged. In the second scenario, the reform combines a broader sales tax base with a limit on spending growth that maintains government services at current levels instead of allowing their continued expansion.

The quantitative analysis in this paper is done on an individual state-by-state level, studying the impact of these two reform scenarios on key economic outcomes like GDP, wages, business startup activity, and the migration of high-income taxpayers. This paper also reports the sales tax rate needed to accomplish the reform under each scenario (base broadening only; base broadening coupled with spending growth limits).

Key insights distilled from the economics literature include:

• Income taxes are more economically damaging than sales or property taxes;
• The harmful economic effects of state income taxes include outmigration, brain drain, stifled innovation and entrepreneurship, and reduced GDP;
• The harmful fiscal effects of state income taxes include revenue volatility with "feast and famine" cycles, with states often gaining little or no new tax revenue from income tax hikes because of the negative economic effects they unleash.

Key findings from CEA's analysis of state income tax phase-outs include:

• A 1 to 1.6 percent increase in the level of GDP for the average state;
• A 16 to 19 percent increase in new startups for the average state;
• A $4,000 increase in the average wage;
• A significant influx of new high-income taxpayers;
• An average state sales tax rate of under 8 percent under full revenue replacement with no limits on spending growth;
• An average state sales tax rate of 6.2 percent under a scenario with spending growth limits.

[1] Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming have no state personal income tax of any sort. Washington has no state personal income tax except on capital gains for certain high earners.