May 24, 2016

States Can Pursue Tax Reform While Federal Government Dawdles

Adam Millsap

Assistant Director, L. Charles Hilton Jr. Center for the Study of Economic Prosperity and Individual Opportunity, Florida State University
Summary

To better understand what it takes to pass comprehensive tax reform at the state level, new research published by the Mercatus Center at George Mason University examines five recent cases: Utah, Rhode Island, Michigan, Kansas and North Carolina.

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Federal tax reform has been an important election issue in the U.S. for many years and for good reason – complying with the federal tax code costs Americans over $200 billion per year. In 2015 it cost the average person $110 and eight hours to prepare their tax return. Both Hillary Clinton and Donald Trump – the likely 2016 presidential nominees – have plans to reform the tax code, but regardless of which one becomes the next president they may have to work with a congress that they don’t see eye to eye with. While this doesn’t make sweeping federal tax reform impossible, it does make it more difficult.

Thankfully there are plenty of reforms that state governments can implement that will make Americans’ lives better, even if we remain stuck with the convoluted federal tax code. To better understand what it takes to pass comprehensive tax reform at the state level, new research published by the Mercatus Center at George Mason University examines five recent cases: Utah, Rhode Island, Michigan, Kansas and North Carolina.

The legislature in all five of these states passed comprehensive tax reform bills over the past 10 years and each instance provides insight into what it takes to accomplish a task that has eluded the federal government for years.

But before we can critique a state’s tax reform we need to know what good tax policy looks like. Adam Smith wrote about the characteristics of good tax policy in his famous Wealth of Nations and his insights remain relevant. Good tax policy should minimize distortions by having low rates and few deductions or exemptions, be easy to understand, be equitable, and be effective at raising necessary revenue.

Success in Utah

Of the five states studied, Utah’s 2006 reform appears to have been the most successful. The income tax was simplified from six brackets to one and many deductions were eliminated, which made it less distortionary and easier to understand. The study also notes that Utah was able to improve the efficiency of its tax system without experiencing severe drops in revenue.

According to the study, Utah’s tax reform was successful because its supporters were able to identify key stakeholders and include them in the reform process. This ensured that any reform that reached the governor’s desk had broad support. The study also points out that Utah has had a relatively high level of economic freedom for many years. This is a sign that the institutions and cultural attitude required for comprehensive tax reform were in place.

Problems in Kansas

Contrary to Utah’s experience, Kansas’ 2012 tax reform was more problematic. While the number of tax brackets was reduced from three to two and several tax credits were eliminated in order to broaden the base, Kansas’ reform also created a major distortion by exempting some business income from taxation.

This reform has allowed some businesses to avoid income taxes altogether which encourages others to mimic that behavior in order to minimize their tax own tax burden. One such example is University of Kansas basketball coach Bill Self, who is primarily paid through his business entity that is exempt from state income taxes. The distortion in Kansas’ tax code incentivizes this behavior.

Another problem with Kansas’ tax reform is that the decline in tax revenue due to the reform was not matched by a similar decline in spending. This has resulted in budget deficits. In Utah and the other cases studied tax reform was accompanied by reductions in state spending, which is crucial for maintaining a balanced budget.

Comprehensive tax reform is easier under a unified government

More generally, the study notes that in three of the five cases the state government was unified in terms of political party: In Utah, Kansas, and North Carolina both the executive and legislative branch were under the control of Republicans. The study highlights this as evidence that comprehensive tax reform is easier under a unified government. Since the federal government is rarely unified for long it’s not surprising that federal tax reform has been more difficult to achieve.

Most people think of Republicans when they think of tax reform, but the experiences of Rhode Island and Michigan show that Democrats are also receptive. In Rhode Island, Democrats controlled both branches of the legislature but not the governor’s mansion, while in Michigan power was split between Democrats (Governor and House) and Republicans (Senate) leading up to reform.

Regardless of who the next president is, comprehensive federal tax reform will take time. But while we are waiting state officials can act to simplify their tax codes to reduce distortions, increase transparency, and – if done correctly – make tax season a little less painful.