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How the Trump Tax Cuts Sharpen State Competition

Tax cuts are generally to be welcomed, because they allow people to keep more of their money and provide some constraints on further expansion of the state. But tax cuts are even better when they provide good incentives to individuals and institutions as well. Judged by that standard, the best feature of the Trump tax cuts was the $10,000 cap on the deductibility of state and local taxes. It advanced one of the Constitution’s most important structures for good government—competitive federalism.

Deductibility of state taxes deadens that competition, because it allows states to slough off some of the costs of taxation to citizens in other states. Moreover, it allows states to avoid accountability for the taxes they impose. Given high federal tax rates in some brackets, high income tax payers end up paying only about sixty percent of the actual tax imposed. The federal government and thereby other tax payers effectively pick up the rest of the tab.

If there is any doubt about its effectiveness, just consider the outrage of governors of high-tax states. Governor Andrew Cuomo of New York has blamed it for an exodus of people from New York and a resulting decline in state tax revenues. That’s probably a bit of an exaggeration. Even without the ceiling on the deduction, high-income tax payers had a reason to leave a place like New York City that can take more than 10 percent of their income. But this change deepens the pain and does add to the number of people voting with their feet.

It is true that the ceiling makes some taxpayers pay more, but its dynamic effect is to make it less likely that state and local taxes, particularly highly visible state income taxes, will be raised and more likely that they will be cut. High-income tax payers in suburbs will now be more likely to vote on the issue of  taxes than on cultural attitudes. A test case for this will come in my state of Illinois where the new Governor, J.B. Pritzker, wants to get rid of the state constitutional provision mandating a flat tax. With the elimination of the ceiling, taxpayers now recognize that they will have to bear the full brunt of the high income tax rates that he wants to impose and are more likely to call on their representatives to vote down the amendment.

To be sure, some Democratic members of Congress have called for the elimination of the ceiling on state and local tax deductibility. But they may have difficulty following through, given that the benefits of elimination would go almost entirely to high income tax payers and thus undermine their mantra of soaking the rich.

This tax change should be just the beginning of federal efforts to sharpen competition among the states. Other changes include allowing states to experiment more in programs where costs are shared with the federal government, like Medicaid. Even more radically, if the federal government provides money to the states, it could so more by per capita block grants that allow states to choose what programs to embrace.

The market for governance among the states that federalism creates will never work as efficiently as product markets, because the cost of leaving a state is higher than choosing a different product.  But federal law could make it work a lot better than it does.

Reader Discussion

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on February 26, 2019 at 14:31:57 pm

Ok, I share a large part of McGinnis’s perspective here. But for old time’s sake:

Tax cuts are generally to be welcomed, because they allow people to keep more of their money and provide some constraints on further expansion of the state. But tax cuts are even better when they provide good incentives to individuals and institutions as well.

I favor sending appropriate incentives, too. So let’s stop permitting deductibility of business expenses. Right now, firms have an artificial incentive to pad executive pay, and to create perks such as fancy headquarters and business trips, because they can deduct these expenses from their earnings. Why not eliminate these deductions—or, perhaps, cap them? Let firms compete on a level playing field, without such tax subsidies.

[I]f the federal government provides money to the states, it could so more by per capita block grants that allow states to choose what programs to embrace.

1. How would this policy—a “per capita block grants that allow states to choose what programs to embrace”—differ from just letting states raise and spend their own money as they see fit?

Well, because fed income tax is progressive, it would tax rich people more heavily than poor people, regardless of state. Thus, it would tend to raise money from rich states—which tend to be blue states.

And it would distribute these fund to populous states, which tend to be—blue states. (Or, to state this another way, the LEAST populous states—the Wyomings, Alaskas, and Dakotas—tend to be red states.)

Still, I expect that blue states are richer than they are populous. So I’d guess this policy would have the net effect of transferring wealth from blue to red. That would be different then just letting each state raise its own revenues.

2. How would this policy differ from current federal spending? A disproportionate share of federal spending goes to poor states, old states, and states with a disproportionate share of agriculture/federal forests/military facilities. Those tend to be red states. So, as compared with the norm of federal spending, I’d guess that per capita block grants would transfer LESS revenues from blue to red than most federal spending does. If we replaced most current forms of government spending with per capita block grants, I expect that many red states would scream.

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nobody.really
on February 26, 2019 at 15:49:48 pm

[…] John O. McGinnis rightly applauds the intensified jurisdictional competition unleashed in the United…. […]

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Some Links - Cafe Hayek
on February 26, 2019 at 18:31:16 pm

Ummmmh!!!!

You forgot to mention a very BIG BLUE state - Calleyfornia wherein we find fully 40% of welfare recipients. This should surprise no one as Calley-fornia advertises its willingness to provide free medical and welfare to illegal immigrants and also advertises itself as a Sanctuary state.
Hey combine that with rather mild winters and, Surprise, Surprise, we find an influx of indigents into the golden State.
How does that figure into your calculations on money going to red states?

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gabe
on February 27, 2019 at 08:56:01 am

End business expensing? Why not end the corporate income tax instead?

No more cheating, no more compliance costs, no more bureaucracy dedicated parsing the records of businesses, higher returns to shareholders, more revenue for capital improvements and R&D, better working conditions for employees.

If we are going to dream, dream BIG...

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OH Anarcho-Capitalist
on February 27, 2019 at 10:36:39 am

How does that figure into your calculations on money going to red states?

California has many admirable social policies, and these policies may indeed attract a certain number of indigent people. California also has a high cost of living, which may indeed repel many low-income people. The net effect of these and other factors is that California is the 11th LEAST federally dependent state.

We’ve previously talked about the problem of trying to make statistical/quantitative conclusions based on some atypical (but noteworthy) example. Scott Alexander has an entertaining post on this topic entitled “Cardiologists and Chinese Robbers.”

Bottom line: You can't make reliable conclusions about large phenomenon based solely on atypical but noteworthy examples.

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nobody.really
on February 27, 2019 at 13:51:12 pm

It may be costly to leave a state; but companies don’t have to move to your state if the taxes are too high.

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Peter Aiello

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.