State governments across the country are flush with cash. As the Covid-19 recession began in the spring of 2020, observers feared that state-government revenues would collapse. But after a minor decline in the second quarter of 2020, state and local tax receipts rebounded sharply, rising 1.9 percent over the whole of 2020 and by 10 percent in 2021.

The windfall in state revenue is a consequence of the strong economic recovery—and of unprecedented transfers from the federal government. While state coffers swelled with revenue, they also received huge amounts of federal aid. The CARES Act, passed in early 2020, along with a subsequent relief package passed in December 2020, provided a total of $400 billion in help to state and local governments. Though it was obvious by then that state governments were already seeing surpluses, Congress passed the American Rescue Plan in March 2021, providing an extra $350 billion in aid to states and localities. Including these federal transfers, total revenue for state and local governments swelled by 10.9 percent in 2020 and by 13.7 percent in 2021—the largest surge in state and local revenue in 48 years.

With such a windfall, states spent more but still ended up with record budget surpluses. State and local government spending increased by 7.3 percent in 2021, yet by early 2022 all 50 states were in surplus, with 29 states boasting one of at least $1 billion. In addition to running surpluses, states have seen labor markets tighten, with unemployment falling to record levels while millions of job openings have gone unfilled. At the same time, the migration of people and businesses from high-tax to low-tax states accelerated during the pandemic.

Thus, many states have begun cutting taxes. Though the federal government has imposed restrictions on using the federal aid money for tax cuts, revenue is fungible, and states’ own-source funds are also growing rapidly. Twenty-nine states enacted significant tax cuts in 2021, and 33 have passed or are considering major tax changes in 2022. Georgia, Idaho, Indiana, Iowa, Kentucky, Mississippi, and Utah have already reduced individual income taxes. While the details of the reforms vary, they have typically led to a flattening of the income-tax structure. Some of the changes, like those in Iowa and Kentucky, are part of a long-term plan aimed at reducing or possibly eliminating the state income tax.

But while the economic and fiscal climate seems ripe for tax reform, some of the more ambitious reform plans have been stymied. Each of us has been involved in efforts to undertake fundamental tax reform by eliminating the state income tax in our home states (Mississippi and Wisconsin, respectively). While these plans have received broad support, they have also met with resistance, offering lessons for future reformers.

States must balance important trade-offs when designing a tax system. The government must generate revenue to provide services to the public, but taxes distort the economy by reducing incomes or raising costs. An optimal tax policy would yield the required revenue while impeding economic activity as little as possible. Because taxes on both labor income and savings reduce investment, a system based on consumption taxes has significant advantages to one based on income taxes.

Governments often fail to heed this advice. Policymakers tend to overstate revenue losses from tax reductions, as they estimate the impact of tax changes naïvely, anticipating no behavioral changes or increased dynamism from lower taxes. Moreover, most states impose both a sales tax and an income tax, worsening the distortionary effects of taxation. When both income and consumption are taxed, a given dollar of income gets taxed first, when it is earned, and then later when the remainder is used for consumption. Since the federal government also taxes income, state-level income taxes compound the distortionary effects. And because income taxes fall heavily on pass-through businesses, they can reduce business investment in much the same way that a corporate tax does for corporations. These distortions can be especially large for those with high incomes.

Mississippi considered a gradual elimination of its income tax in 2021, when lawmakers proposed the Tax Freedom Act. The legislation would have increased the personal exemption to exclude a growing number of residents from the income tax in conjunction with realized revenue targets. Within a decade, the policy would have eliminated the income tax entirely. To replace the forgone revenue, the law proposed to increase the state sales tax from 7 percent to 9.5 percent, while also increasing excise taxes on tobacco, vaping products, and vehicles. The one exception to the sales tax increase was a proposed reduction to 4.5 percent in the sales tax imposed on groceries.

Though this bill passed the Mississippi house, it never became law. Neither did a simplified version of the proposal that passed the house in 2022 with bipartisan support. Instead, a compromise between the state house and senate resulted in a more modest reform, exempting income up to $10,000 from taxation and reducing the top tax rate from 5 percent to 4 percent over the next three years. Ultimately, lawmakers failed to transition from a system that taxes both income and consumption to one that taxes only consumption.

In Wisconsin, with a divided state government, the situation was different. A tax reform proposal authored by one of us considered the hypothetical effects of an immediate elimination and a six-year phaseout of the state’s income tax. Income taxes in Wisconsin are higher and account for a larger share of the state budget than in Mississippi. The Wisconsin proposal would have increased the state sales tax from its current 5 percent up to 8 percent, resulting in a substantial net tax cut while transforming the state’s tax structure.

When the plan and analysis were released in December 2021, they received broad support from business and political interests in Wisconsin. To date, however, no state politicians have endorsed the plan or drafted legislation to implement it. This reticence may reflect mundane political calculus. But it may also have stemmed from opposition to the sales-tax hike, which would be needed to fund the state government absent a massive spending reduction. Shortly after the rollout of the reform proposal, a state senator released his own plan to get rid of the income tax. Yet he proposed only to cut income-tax rates without enacting commensurate hikes, apparently on the hope that such cuts would boost economic activity enough to generate additional revenue. While tax reform has a beneficial dynamic impact on spending, very rarely do tax cuts fully pay for themselves.

Though neither proposal passed, both would have brought economic benefits. With a colleague, one of us analyzed the original tax reform proposal that originated in the Mississippi House of Representatives in 2021. The Mississippi proposal was approximately revenue-neutral, with the increased sales tax compensating for nearly all of the forgone revenue from the elimination of the income tax. Furthermore, the proposal would have increased real gross domestic product in Mississippi by $371 million per year. Thus, despite being approximately revenue-neutral, the reform would have generated significant economic benefits—even assuming conservatively that the reform would not have any effect on the economic growth rate or on net migration into Mississippi from those fleeing higher-tax states.

The Wisconsin plan, by design, was not revenue-neutral, and would lead to an average net tax cut of roughly $1,700 per household. This would precipitate a long-run reduction of 12.6 percent of state tax revenue, roughly half the revenue loss that would be estimated if one ignored the behavioral and dynamic effects of the reform (as state agencies typically do). But the estimated economic effects of the tax reform in Wisconsin were substantial. The reform would boost state output by roughly 1 percentage point per year for each of the first five years, with a total long-run output gain of 7.9 percent. The Wisconsin economy would be about $28 billion larger after the reform than otherwise. In a time of tight labor markets, the reform would have led to an employment gain of 6.9 percent, or about 175,000 jobs. The plan would also increase after-tax income by 9.4 percent, fueling a rise in consumer spending of about 7.2 percent.

What can we learn from these proposals? Some critics argued that eliminating the income tax while simultaneously raising the sales tax was akin to robbing Peter to pay Paul. Conventional wisdom maintains that any tax system that generates the same amount of revenue is unlikely to bring positive economic effects, overlooking the benefits of removing distortions to economic activity.

While income-tax cuts give benefits to all taxpayers (or at least no losses), changing the composition of taxes generates winners and losers. Though the majority of taxpayers came out ahead in both of the proposals, some individuals could face a higher tax burden, at least initially.

The proposals’ distributional effects affected their political palatability. Since higher-income households pay the majority of income taxes, they would see the most gains from eliminating the income tax; lower-income households and retirees typically consume a larger share of their income, and this spending would have been subject to a higher rate. Still, the proposals did exempt food and other necessities from the sales tax (as in Wisconsin) or lowered the sales tax on such goods (as in Mississippi), while leaving alone current low-income support plans, including Wisconsin’s relatively generous EITC program. To overcome this political hurdle, lawmakers could offer to strengthen such programs or to enact other measures such as “pre-bates” (lump-sum transfers to credit against sales-tax payments) to provide further support for lower-income households.

Others raised objections that were examples of “dispersed benefits and concentrated costs.” For example, retailers were concerned about higher sales taxes on their revenues, even as consumer spending would have increased. The proposals tried to minimize such political frictions by leaving the sales-tax base essentially unchanged, though the tax code is riddled with inefficient exemptions lacking economic justification. For example, in Wisconsin less than half of all personal consumption is subject to the sales tax, with most services, in particular, being exempt. A strong economic argument could be made to broaden the sales tax base but doing so would surely invite intense lobbying by the affected sectors and potentially sink any reform efforts.

Additional factors made politicians themselves less likely to support the reforms. First, the planning horizon for state legislators is relatively short: it lasts until the next election. While the reforms generated substantial long-run gains, transition costs and delays in adjustment meant that the full benefits would not be felt by many voters during the current election cycle. The promise of future economic gains competed with the short-term political costs of a tighter budget or charges of favoring the wealthy.

Second, the elimination of the income tax also eliminates a main source of political favors. The income-tax code contains numerous deductions and exemptions that confer special benefits to certain constituencies. These proposals not only threatened to remove these existing benefits but also foreclosed the prospect of granting future favors through the income-tax code.

As our own experiences suggest, even well-designed tax reforms that would benefit a state can be hard to enact. Nonetheless, reasons for optimism remain. States increasingly seem to recognize that tax codes need updating.

North Carolina is a prime example. The state reformed its tax code in 2013 and again in 2021. In 2013, North Carolina had the highest tax rates on both individual and corporate income in the southeastern United States. In 2013, the state eliminated its progressive income tax (switching to a flat tax) and lowered the tax rate on income. Lawmakers expanded the standard deduction and capped itemized deductions. At the same time, they committed to a schedule of tax-rate reductions in the future if revenue targets were met. These triggers were reached in 2014 and 2015, and the state then lowered the flat rate. Lawmakers also gradually reduced the corporate income-tax rate, from 6.9 percent in 2013 to 3 percent in 2017. In 2021, the state passed a law that will lower the flat rate on individual income taxes to 3.99 percent and completely eliminate the corporate income tax by 2030.

Iowa, too, enacted significant reforms. Like North Carolina, its changes also came with a phased-in plan for future reductions based on tax triggers. Its new law will move the state from a system with nine tax brackets on individual income to a single flat tax of 3.9 percent in 2026 and will reduce its corporate tax rate as well. Neither state has fully eliminated the income tax, but each demonstrates that structural change is possible.

States compete to attract workers and businesses. Evidence of the significant economic benefits of tax reform will encourage more such efforts as states try to maintain or improve their competitiveness. Under these conditions, more sweeping proposals might get another hearing.

Photo: mediaphotos/iStock


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