Budget

State Income Taxes Stifle Economic Growth

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With new state-level taxes on the table across the nation, Mercatus scholar warns of past experiences

By Daniel M. Rothschild

With states facing revenue shortfalls of historic proportions, legislatures are seeking new ways to raise funds. Washington voters will consider one of these measures this November: should the Evergreen State become the first state in two decades to create a personal income tax?

If enacted, Initiative 1098 would impose a 5 percent income tax on individual incomes between $200,000 and $500,000 per year, with a 9 percent tax levied on incomes of more than $500,000. The income levels at which these brackets apply are doubled for married couples. With a so-called top marginal tax rate of 9 percent, Washington would go from being one of nine states without a personal income tax on wages to a state with one of the highest marginal tax rates.

Supporters of the initiative, who include Microsoft founder Bill Gates’ father, William Gates Senior, believe that the initiative will raise approximately $1.7 billion per year. Some of the money would be set aside for state property tax relief and reducing the business and occupation tax paid by businesses on their revenues.

But economist Matthew Mitchell of the Mercatus Center at George Mason University warns that this may not be as attractive a proposition as it might sound.

“The likely impact of an income tax in Washington will be higher levels of government spending and ultimately less economic growth,” said Mitchell.

Mitchell points out that in comparison with most states, Washington has not increased its spending significantly faster than private sector growth in recent years.

“The lack of an income tax is a key factor in keeping spending under control and overall tax burdens at a level slightly slower than the national average,” said Mitchell.

Additionally, as the brackets proposed by Initiative 1098 are not indexed to inflation, they will apply to more and more households in coming years.

Only one other state has established a personal income tax since the late 1970s. Facing mounting budget deficits, Connecticut established an income tax in 1991 with a top marginal rate of 4.5 percent. During this period, Alaska was the only state to eliminate its personal income tax.

The Mercatus Center’s Eileen Norcross traced the history of New Jersey’s personal income tax in a paper she co-authored entitled “Institutions Matter: Can New Jersey Reverse Course?” According to Norcross, New Jersey first created its income tax in 1976 to supplement education spending and reduce fast-rising property tax burdens. The tax was initially levied at the rate of 2 percent on incomes up to $20,000 and 2.5 percent on incomes above that. By 2008, it had increased to a top rate of 10.75 percent.

“Much like in Washington, New Jersey’s income tax was marketed as a way to reduce other taxes,” said Norcross. “But over time it increased taxes and spending.”

Norcross points out that between 1971 and 2008, New Jersey’s state spending doubled as a percentage of total state income.

“Voters should be wary of tax plans that promise to reduce one tax while raising another,” said Norcross. “As New Jersey shows, states can go from having moderate taxation to very high taxation in just a few years.”

The nonpartisan Tax Foundation ranks New Jersey has having the highest state-local tax burden in the country, with the average Garden State resident paying $6,610 in state and local taxes.

“As a result of New Jersey’s high tax burden, it’s getting to the point where there’s nothing left to tax,” said Norcross. “Cutting spending and reducing long-term obligations are the only policies left.”

Meanwhile, across the country, Washington’s restrained spending and pro-growth business climate could be undercut by implementing a personal income tax.

“A personal income tax would take away Washington’s competitive edge relative to other states,” said Mitchell, “and it would likely make the government there much larger.”

Daniel Rothschild is a Visiting Adjunct Scholar with the Pelican Institute for Public Policy and the Managing Director of the Mercatus Center’s State and Local Policy Project at George Mason University.