A recent study published by the Cato Institute suggests the new GOP tax reform will add pressure to state governments with high taxes. Among the numerous reforms in the recent Republican-backed tax law is a $10,000 cap on state and local tax (SALT) deductions. Before the tax reforms, there was no limit to the amount of state and local taxes people could deduct from their federal taxes.
The study suggests that since the SALT deduction cap went into effect, states with higher tax rates have experienced higher out-migration rates. Understanding why this out-migration exists and what it means for state and local tax policy first requires an understanding of some public finance theory.
Unlike goods and services produced by private business, though, determining the “price” for government services is not straightforward. A restaurant can look at a balance sheet and find when a price is too high for its burgers or when it can charge more for fries. A state cannot so easily isolate when a resident likes one public offering but not another. Taxes are the single price for all the amenities a state has, regardless of whether the taxpayer uses them.
Economist Charles Tiebout famously made this connection over sixty years ago in a theory now known as the Tiebout choice model, which described taxes as the price of living within certain political boundaries influenced his contemporaries since the article’s publication. One of the key conclusions drawn from the Tiebout choice model is that residents will “vote with their feet,” leaving a place when they are are dissatisfied with how much they have to pay relative to the benefits of living there. In other words, the number of people entering or leaving a jurisdiction is a good proxy for how desirable its package of taxes and amenities is.
This is, of course, an imperfect proxy since people can move for a variety of reasons. California’s weather has nothing to do with government services, but people flock there for its pristine weather and industry hubs, such as Silicon Valley and Hollywood. Furthermore, some demographics, such as younger, single residents, are more likely to move.
But fiscal policy does have a tangible effect on people’s moving patterns. In 2016 alone, the 25 highest-taxed states and the District of Columbia lost a net 286,431 households and $33 billion of taxable income to the 25 lowest-taxed states. Notably, states with high taxes relative to their neighbors tend to have a net loss of migrants to states with lower tax rates. For example, California experienced a net out-migration of over 25,000 households in 2016, and the main recipients of those migrants were Texas, Washington, and Nevada, all states with below-average tax burdens and no state income tax.
SALT deductions swallow some of the costs high-tax states pose. For example, if a state were to increase its income tax by $1,000 for families in the 35 percent federal income tax bracket, the deduction brings federal taxes down by $350, meaning these families would only face an effective cost increase of $650. Effectively, the SALT deduction subsidizes non-federal taxes.
With the SALT deduction now gone, taxpayers will have to bear the full brunt of their states’ income taxes, intensifying interstate tax competition. With the increased personal deduction, a number of taxpayers in high-tax states may not necessarily see their tax bill rise, but without the federal government cutting the costs of state taxes, other states will become cheaper. For high-income taxpayers, for whom the personal deduction does not impact their living decisions, this effect is even more pronounced.
State governments with high tax rates have already expressed worry about how losing the SALT deduction might worsen out-migration. The Democratic New Jersey legislature passed “millionaire taxes” five times under Republican governor Chris Christie, but after the GOP tax reform, they have backed down, with their new Democratic governor claiming New Jersey residents are “taxed out.”
Out-migration poses economic problems for states, especially when those leaving take hefty incomes with them. In New York, which leads the nation in net out-migration, the top 1 percent of income earners account for 41 percent of state income tax revenue. Half of California’s income tax revenues come from their top 1 percent of income earners. If the new federal tax law influences high-income out-migration even marginally, high-tax state budgets could suffer.
Losing the SALT deduction threatens to worsen high-tax states’ out-migration problem. In effect, the SALT deduction distorted the prices of living in different states. Now that it is gone, mobile residents are more likely to hold states accountable. If these states wish to compete, they will have to govern efficiently and frugally so they can keep taxes down.
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