After months of infighting in its legislature, Mississippi passed a bill (House Bill 1) earlier this month to eliminate its state income tax. This will make Mississippi the tenth state to eliminate its state income tax. With the exception of the state of Washington, the other eight states are red states: Alaska, Florida, Nevada, New Hampshire, Tennessee, South Dakota, Texas, and Wyoming. The Mississippi Center for Public Policy, which is a free-market, conservative think tank, was happy because it believes that eliminating the state income tax will be a magnet for growth. Does this theory play out in practice or is this simply a free-market fantasy that will come back to bite Mississippi later?
When thinking about government budgeting, there are two basic components: tax revenue and spending (expenditures). Taking a look at Mississippi, an important question is how they will deal with taxing and spending as their income tax phases out over the next decade. Will Mississippi increase other tax rates to compensate for the revenue loss?
I have some concerns for Mississippi specifically. Other states have better mechanisms to compensate for a lack of income tax, usually through consumption taxes. Florida can sustain its economy with tourism, agriculture, and healthcare. Texas and Alaska have large oil reserves. Nevada has Las Vegas. Mississippi has historically relied on more labor-intensive industries combined with a lower labor force participation rate, lower educational attainment rate, and higher poverty rate.
There are also general concerns about relying on the sales tax in lieu of the income tax. As the National Conference of State Legislatures (NCSL) brings up, the average sales tax breadth, which is the percent of the economy included in the sales tax base, was higher in the 1970s than it is now, i.e., 49 percent versus 30 percent. This lower sales tax breadth has been combined with a higher sales tax rate. To make sales tax a viable replacement, the sales tax would need to be high enough and applied to enough of the state economy to generate adequate revenue.
So if Mississippi cannot completely compensate for revenue losses with consumption taxes, will Mississippi get its spending under control? That would be nice, but I am concerned about Mississippi's ability to cut budgetary spending because Mississippi has not shown budgetary restraint in recent years. On the other hand, Mississippi has the fourth lowest dependency on the income tax out of all states.
Looking at the Financial State of the States report from think tank Truth in Accounting, I am not surprised that three out of the five states in the best shape do not have an income tax, whereas the states in the worst shape (especially in terms of per capita debt levels) are amongst the states with either the highest income tax rates or well above average. The American Legislative Exchange Council (ALEC) shows some data in its Rich States, Poor States report that income rates and progressivity factor into the equation. Clearly, the income tax rate is not the only factor in fiscal health. However, it would be naive to think it does not play any major role whatsoever, especially given net migration patterns in which those living in higher-tax states are heading for lower-tax states (Census).
A longitudinal study from the Cato Institute examined income taxes from 1964 to 2004. The conclusion was that states with higher income taxes "stifled economic growth, entrepreneurialism, and access to capital (Poulson and Kaplan, 2008)." So maybe the Mississippi Center for Public Policy is right. Even if Mississippi is not in the best of shape right now, maybe that lower income tax could attract investment and more talented labor to build Mississippi's economy into a formidable one.
However, I do not think that the answer is a simple "yes or no." As I have brought up before, good tax policy is not as simple as "tax cuts good, tax hikes bad." If a state is looking to avoid some of the less desirable aspects of an income tax, then there needs to be an alternative that is fiscally sustainable.
As the Council on State Taxation (COST) details in its extensive report, the U.S. sales tax system deviates from the three main components of an optimal consumption tax: (1) a harmonized and broad-based consumption tax on household goods and services; (2) an exemption (or credit) for business inputs; and (3) centralized and simplified tax administration. COST ultimately recommends a hybrid federal/state government consumption tax similar to that of Canada.
Regardless of how states go about it, I will say this to conclude. If states are going to transition from relying on income tax to consumption taxes, they need to be sure they have a source of revenue that is adequate to replace the income tax and can do without creating economic distortions or administrative issues. Aside from the restructuring of tax systems, there would need to be a reassessment of government spending. Otherwise, the potential for state economic instability is real.
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