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At the forefront of many states' tax discussions is cutting the income tax. In this article, Policy Matters Ohio's Zach Schiller discusses reductions in Ohio's income tax and why they may not have made sense.
By Zach Schiller
Zach Schiller is research director at Policy Matters Ohio, a nonprofit research institute. He previously was a reporter at BusinessWeek and The Plain Dealer in Cleveland.
From Nebraska to Georgia, debate has raged over whether to cut state income taxes. Ohio's income tax, the second-largest source of state revenue and the only major tax based on the ability to pay, has been under attack for years. It has been slashed by a third over the past decade or so, and more proposals to reduce it further can be expected, just as in other states.
However, new evidence on the national scale, as well as Ohio's own decade of experience, have sharply contradicted the notion that lower income taxes are linked to economic prosperity.
A new study finds that most of the richest people choose where to live based on something other than state tax rates. This research severely undercuts claims of tax-cut supporters that the income tax causes the richest residents to flee to states with lower tax rates. Researchers at Stanford University and the U.S. Treasury Department examined all tax returns for million-dollar income-earners across the country over 13 years—45 million tax records in all—and found that such tax flight occurs, “but only at the margins of statistical and socioeconomic significance.”
The authors concluded that, “The most striking finding of this research is how little elites seem willing to move to exploit tax advantages across state lines in the United States.”
Nor are many of the most highly valued private companies flocking to low income tax states. Policy Matters Ohio recently took a look at where some of the highest-profile startup companies are located, to see if state income taxes played a role. Such companies as Uber, Airbnb, Snapchat and Pinterest, dubbed “unicorns” by Wall Street, have been valued by their investors at $1 billion or more.
We found that by far the largest number of these companies—a whopping 55 of the 87 U.S.-based firms on a list compiled by the Wall Street Journal in April—are located in California. That state has by far the highest top income tax rate in the country, at 13.3 percent. Another 10 are in New York State, which has a top rate of 8.82 percent, ranking it 6th highest in the nation. A paltry five unicorns are based in states without income taxes (Florida, Washington and Texas).
Clearly, income taxes aren't an impediment to these high flyers.
For a variety of reasons, as experts at the Center on Budget and Policy Priorities (CBPP) have noted, cutting taxes is no prescription for economic vitality. While some might wonder at this, it's really not that surprising. Companies can only thrive where there are well-trained workers, good transportation, and strong markets. Those require public investment in schools, infrastructure, worker training, and services.
Some of these firms will never meet their investors' high expectations and will instead fizzle out. The valuations mark just one point in time; already, some of them have run into trouble. And of course, a lot more goes into regional economic success than where these high-profile businesses happen to establish themselves.
However, like the recent study on millionaires, their locations are one more sign that arguments for lower income taxes may sound simple and convincing, but have little basis in fact.
This is also borne out by recent experience at the state level, including in Ohio.
California, pilloried by tax cutters for its income tax rates on high-income earners, has been a national leader lately in job and output growth. Kansas, meanwhile, has experienced poor economic growth and persistent budget problems since its Legislature slashed taxes, something Gov. Sam Brownback said at the time would be “like a shot of adrenaline into the heart of the Kansas economy.” In July, Standard & Poor's downgraded Kansas's credit rating for the second time in two years, from AA to AA-, leaving Kansas below 41 other states.
One of the key elements in the Kansas cuts was the elimination of state income tax on business income from partnerships, limited liability companies, S Corporations and others known as “passthrough entities” because the income is taxed as it passes through to its owners. The theory is that eliminating such taxes will be a tonic to business owners, who will invest in the companies, add employment, and help grow the economy.
But in fact, as CBPP's Michael Mazerov has detailed, there's little reason to think that such cuts will lead to an entrepreneurial boom. Instead, they are “ wasteful, costly and unfocused.” Most businesses try to serve a local market and have little interest in trying to be the next Google. The vast bulk of business owners who benefit from such tax breaks don't employ anyone. Most owners are self-employed, with no reason to hire anyone; passive investors who don't make hiring decisions; or working on the side in addition to their jobs. Moreover, the savings for most is so small that it isn't nearly enough to hire anyone (even as in total the expenditures are very costly for states). In Ohio, which tried the same idea, albeit in less drastic form, the average tax savings in 2014 from the deduction was about $1,050, with most claiming far less than that.
Business owners in general hire or expand when there is a growing market for their products or services, not because they have more cash in their wallets from lowered taxes. And overall, the results of the new tax break in Ohio have been weak. The initial tax break, approved in 2013, did not produce overall job gains for the state or a significant increase in employment at small businesses that were hiring for the first time. According to the U.S. Bureau of Labor Statistics, such small Ohio businesses in 2015 were hiring fewer new employees than comparable small companies were a decade earlier, when major cuts in income taxes were enacted. Still, Ohio's business income tax break was vastly expanded last year and could cost upwards of $800 million a year when fully implemented.
This tax break also violated a tenet of sound taxation: That businesses and peoples with similar assets and income should be taxed alike. Say you work as an employee of a landscaping business and pay income tax on your earnings. If you instead did the identical job, but as a contractor working for your own one-person company, you could use this deduction to avoid all Ohio income tax on the first $250,000 in income. The special treatment for passthrough income was created and expanded despite being roundly criticized by such disparate entities as CBPP and the Tax Foundation.
The business income deduction is just the latest example in a more than a decade-long move to cut income and business taxes in the state. In 2005, Ohio legislators wore lapel pins sporting “21%,” for the proposal of then-Governor Bob Taft to cut the state income tax by that amount. One might wonder at the percentage: It was aimed at lowering the top rate on income above $200,000 below 6 percent.
The Ohio General Assembly approved that, along with a major reduction in business taxes. It eliminated the state's corporate income tax and a major local tax on business property, replacing the two with a new tax on business gross receipts that raises about half the revenue. To help pay for the cuts, the Legislature also boosted sales and cigarette taxes—a step repeated in more recent years. Even aside from the big new business income tax break, overall, the state has cut income tax rates by a third since 2005. The cuts were temporarily halted during the recession but then resumed.
Ohio is a case study of the theory that consumption taxes should replace income taxes to boost the state economy. The sales tax has replaced the income tax as the state's largest source of tax revenue after decades when the reverse was true.
How have we done? Poorly. Between December 2005 and the same month a decade later, Ohio added a measly 40,000 jobs, for a growth rate of just 0.7 percent, compared to the national average of 5.9 percent. Unemployment fell, but the labor force shrank by more than 200,000. Real median household income fell even more than the U.S. average between 2005 and 2014.
The shifting composition of Ohio's taxes has meant a shift, too, in who pays for state and local government. According to an analysis by the Institute on Taxation and Economic Policy of the major tax changes between 2005 and 2014, the most affluent 1 percent of Ohioans saw an average annual cut in their tax bill of $20,000, while the bottom three-fifths of state residents as a group are seeing an increase (that excludes additional tax changes in 2015, but they further reinforce this disparity).
Despite the tax cuts, Ohio has been able to build up a $2 billion state rainy day fund, bolstered by the diversion of funds that previously had gone to aid local governments and a stronger national economy. But critical indices of community well-being lag: a recent public health assessment noted that several national scorecards place Ohio in the bottom quartile of states for health, and the state's performance on population health outcomes has steadily declined relative to other states over the past few decades. College education is even more unaffordable, and student debt higher, than the unenviable national averages. Public transit service is being cut in Cleveland, and fares raised, even as hundreds of millions of dollars are needed statewide to replace existing equipment and meet future needs, according to a state transportation department study.
Tax-cut proponents, however, are looking the other way. You can expect another round in the tax debate when the Ohio General Assembly convenes early next year.
Copyright © 2016 Tax Management Inc. All Rights Reserved.
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