`Soak the Rich' Fallacy

By , Stephen Moore is director of fiscal policy studies at Cato Institute.

`TAX Fairness'' is now the rage in the nation's state capitals as it has been for many months in Washington. To conquer mushrooming state budget deficits, many governors and legislators, Republicans and Democrats alike, insist that more tax revenues are imperative. The question inevitably arises, who should pay? The debate has been fueled by a well-publicized document from the Citizens for Tax Justice suggesting that ``virtually every state taxes its poor and middle-income families at rates significantly higher than those faced by the richest families.'' The group's prescription: states should make their income tax systems more progressive.

Although it has been 15 years since any state introduced an income tax, Connecticut, New Hampshire, Tennessee, and Texas - four of the 10 remaining states without an income tax - are now considering one. Meanwhile seven other states are contemplating raising their income tax rates to balance budgets and make tax codes ``fairer.''

One might think that in the wake of recent events, lawmakers would regard income taxes as political poison. It was less than a year ago that New Jersey governor James Florio rammed through the state legislature a $1.5 billion ``soak-the-rich'' income tax increase. That program, which raised the top marginal tax rate to 7 percent, one of the highest in the nation, won accolades from special-interest groups, most notably the education establishment, and much of the media.

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Yet things haven't worked out quite as planned. New Jersey is still bankrupt. Its real estate market is in a depression, and unemployment and business failures are skyrocketing. Entrepreneurs are leaving the state for a less hostile tax environment. A 1990 economic analysis by the New Jersey-based economics consulting firm Polyconomics, which predicted New Jersey's growth would be 3 percent lower than it otherwise would have been by 1992 thanks to the ``progressive tax,'' is so far turning out to be rig ht on the mark. And Mr. Florio may now be the most unpopular politician in America.

Part of the problem for Florio and other governors is a severe backlash among taxpayers against new state taxes of any kind. Per capita state taxes almost doubled (from $658 to $1,150) between 1980 and 1989, and quadrupled (from $249 to $1,150) between 1970 and 1989. State revenues now consume 8.4 percent of GNP - the highest level ever and up from 5.0 percent in 1960. With the typical middle-income family today paying over $4,000 in state and local taxes, voters are starting to say enough is enough.

But what of the familiar refrain that the ``rich'' aren't paying their fair share of state taxes? State income taxes as a share of total state taxes were 6 percent in 1950, 8 percent in 1960, 12 percent in 1970, 16 percent in 1980, and over 18 percent in 1990. Moreover, with few exceptions, the states with income taxes have raised their highest rates, not lowered them, over the past 20 years.

It is true that most states' income tax structures are not highly progressive. That is, the high rates that are imposed on the wealthiest taxpayers are generally also imposed on middle-income families, and in some cases lower-income families, as well. Yet here is the catch for state governments: it is of little benefit and probably very harmful to overtaxed middle- and lower-income families to impose even higher tax rates on the very rich - although they may seem to be an enticing target.

The reason can be summarized in three words: interstate tax competition. As New Jersey and other high-tax states have painfully discovered, when income tax rates are raised on businesses and wealthy individuals, businesses and individuals flee to states with lower tax rates. That inevitably causes significant contraction of the tax base of high tax states and a ratcheting of the tax burden down the income ladder to the very middle-income families who were supposed to benefit.

Recent studies almost all conclude that low-tax states tend to economically outperform high-tax states and that progressive state income taxes are the most economically destructive of all taxes. For instance, a study by the Joint Economic Committee of Congress concluded: ``Progressive taxation not only lowers the rate of economic growth compared with proportional or regressive taxation, but in the process hurts the very persons that progressive taxes are designed to help: the poor.''

Those who are skeptical of economic studies might consider some of the striking anecdotal evidence. Census Bureau population data show that, on average, every day between 1980 and 1989, 1,000 people each day packed their bags and moved from the 10 states that raised their tax burdens the most. In the 1980s, people voted for lower taxes not at the ballot box but with their feet.

Iowa, for instance, is now suffering because it has one of the Midwest's highest income taxes. In a recent study entitled, ``The Iowa Exodus: Why are People Leaving the State?'' the Iowa Tax Education Foundation interviewed former Iowans who moved out of the state in the 1980s. The survey results indicate that ``Iowans leave for a variety of reasons. Job opportunities, Iowa's overall tax situation, and the Iowa personal income tax appear to play the largest role in people's decision to leave.''

The ``soak the rich'' tax strategy that is gaining political momentum in state capitals seems alluring on the surface. But the experience of Iowa, New Jersey, New York, Massachusetts, and many other deficit-ridden states is hardly encouraging. The unmistakable lesson from these states is that a progressive state income tax may be the unfairest tax of all.

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