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Myth and Reality on State Income and Sales Taxes

May 6, 2015 at 2:15 PM

I wrote recently that proposals by governors in Maine and Ohio to shift their states’ revenue mix away from income taxes and toward sales taxes ― by cutting the former and raising the latter ― would do more harm than good.  Here I want to debunk a myth associated with these tax shifts: the claim that “If you move towards a consumption-based sales tax, all economists will tell you that’s the best way to achieve economic growth,” as one tax-shift proponent put it.  

Here’s the reality: there is no consensus among economists on whether relying less on income taxes will improve economic growth.  Some economic studies (see here and here) have found the opposite — that state income taxes don’t harm state economies while state sales taxes do

Moreover, economists who argue that greater reliance on consumption taxes will help the economy usually aren’t studying actual state taxes.  Instead, they contrast a hypothetical, comprehensive national consumption tax with a hypothetical, comprehensive national tax on income. That’s very different from actual state sales and income taxes.

For example, all state sales taxes exempt many goods and services, making them much narrower and weaker than the theoretical national sales tax these economists usually model.  And real-world sales taxes apply to many business purchases in addition to household ones — something these economists’ theories don’t imagine.  

State income taxes are also very different from the ones in economists’ theories.  Economists who favor taxing consumption rather than income argue that income taxes discourage saving and investment.  But most real-world state income taxes contain large incentives for savings and investment to help offset any such effect, like “529 accounts” to promote college savings and accelerated write-offs of business equipment purchases.

In addition, some arguments for a national consumption tax don’t apply to state taxes. For example, while encouraging more saving might benefit the national economy, a state considering shifting toward a consumption tax can’t be sure of capturing the benefits.  That’s because many of the financial institutions holding residents’ savings likely operate in national or even international capital markets and will lend or invest the money out of state.