Looking for Common Ground in the State Income Tax Debate

Josh Barro of Bloomberg News wrote a thoughtful commentary on our recent report on ways to address income tax volatility.  While we differ with some of his conclusions, we’re encouraged that he agrees that states shouldn’t replace state personal income taxes with expanded sales taxes and that property taxes are an important part of state and local tax systems.

A number of states are debating whether to eliminate or significantly reduce their income tax, under the misguided notion that such a change could reduce revenue volatility dramatically.  But swapping income taxes for sales taxes would reduce significantly the revenues available to fund schools and other public services — without improving volatility much.

We agree with Barro that Louisiana Governor Bobby Jindal’s proposal — which he recently shelved —to replace the state income tax with a greatly expanded sales tax was “ill-conceived.”  And both we and Barro note that more local reliance on property taxes would reduce volatility.  Laws like California’s Proposition 13 that restrict the ability of local governments to levy adequate property taxes make the problem worse.

But, we do disagree with Barro on some important points.

We’re more optimistic than he is about the prognosis for making improvements to rainy day funds and other reserves.  Certainly, it’s politically difficult to put money aside when revenues are growing and states face many unmet needs.  However, many states did just that in the periods prior to the last two recessions.  In addition, several states have already improved their rainy day funds since 2009, as we explained in a recent paper.  Georgia, Oklahoma, South Carolina, and Virginia have raised the cap on the size of their funds, while Hawaii, Massachusetts, and Washington have made it easier to replenish their funds.

Barro criticizes our suggestion that oil- and gas-producing states consider increasing their reliance on severance taxes in conjunction with other measures to address volatility.  While the jury may be out on the degree to which severance taxes are counter-cyclical, in many cases they don’t follow the same pattern as income and sales taxes collections.  In addition, the country’s production of natural gas is widely expected to grow over the next 30 years, offering states a growing revenue source while potentially offsetting some volatility in other taxes.

Finally, we also disagree with Barro’s assertion that smoothing revenue collections through the use of temporary rate increases in bad times coupled with rebates in good times would hurt a state’s economy.   On the contrary, a temporary tax surcharge could focus on high-income taxpayers, who are unlikely to spend less as a result, and prevent spending cuts that would slow economic growth.  In good times, tax rebates would leave the underlying tax structure intact and thus wouldn’t magnify state revenue problems that result when the economy declines.  Together, these strategies would make revenues more stable, providing the dollars needed to fund the ongoing costs of state services without sacrificing long-term growth.

Debates over the role of the state income tax are likely to continue, so it’s critical to continue these discussions — and to understand the consequences and the alternatives to cutting a vital component of state tax systems.