Reforming a state tax code in order to provide relief, economic growth, and create a more competitive economic climate is difficult. A major reason for this difficulty is tax rate reduction is in direct conflict with numerous policy interests that demand new or additional spending. Rather than reducing rates and reforming the tax code, it is often easier to approach tax policy through creating new or expanding existing tax credits and exemptions. Nevertheless, states across the nation are proving tax reform is worth the effort. North Carolina serves as the gold standard for state tax reform and they have successfully lowered their individual and corporate income tax rates and the sales tax since 2011. The Tar Heel state has proven that “restrained state spending coupled with sound tax reform delivers faster economic and personal income growth.”
Tax policy can go in multiple directions. Tax reform can be revenue neutral, meaning revenue will remain unchanged as one tax is lowered, another is raised to keep balance. Tax reform can take a more pro-growth approach, this is where tax rates are lowered and state revenues are reduced, but new revenues are created as a result of economic growth. Another possibility is reforms from an existing tax can help lower rates for another tax. As an example, broadening the base of the sales tax can be used to generate more revenue, which then can be used to lower income tax rates. An alternative would be an increase in the sales tax rate with the new revenues going to lower income tax rates. Regardless, tax reform is not an easy process, but it is necessary for a state to have a more competitive economy and to ensure that individuals and businesses can keep more of their hard-earned income.
Tax reform is a process and at times, it can be a slow. Tax rates may not always be able to be lowered as quickly as desired and it may take multiple approaches; that is, one tax rate is lowered, and once that goal is met, other taxes can be lowered. This can be accomplished through a comprehensive approach or by one tax reform bill at a time.
Prudence is vital for any tax reform. A legislator from North Carolina correctly described tax reform as an “evolution, not a revolution.” An Indiana legislator advised other state policymakers to “act boldly and implement slowly.” Both North Carolina and Indiana have enacted different yet successful tax reform and relief measures which can serve as models for other states. Arkansas commissioned a study of various ways to improve their tax code and they brought in not only tax policy experts to share their expertise, but also legislators from various states to share what worked and what did not work. As a result, Arkansas has been able to enact some pro-growth tax reforms.
Government spending is at the heart of tax policy. Most states require a balanced budget, so policymakers need to be aware of larger economic trends. It is a reality that cannot be ignored. Over 70 percent of Iowa’s budget is consumed by education and Medicaid spending. This provides little room for other spending priorities and makes reducing tax rates more difficult. Tax reform will require spending to be prioritize, and hopefully in the process, budget reforms are developed.
Kansas serves as the best example of the consequence of cutting tax rates and increasing spending. The increase in spending, combined with a downturn in oil and agricultural prices, all helped to create a fiscal crisis. Jonathan Williams, Chief Economist for the American Legislative Exchange Council (ALEC), stated that Kansas provides several lessons for policymakers:
Most notably, broad-based tax relief must be paired with responsible prioritization of spending. After all, taxes and spending are on opposite sides of the same fiscal coin. Much of the criticism about Kansas is based on preconception and myth, rather than empirical data.
“Moreover, Kansas didn’t adopt the spending restraint that North Carolina did. Revenue shortfalls plus excessive spending equals fiscal crisis,” wrote John Hood, Chairman of the John Locke Foundation. Kansas serves as an example of why it is important to keep both spending and larger economic trends in consideration.
In order to lower tax rates, what do policymakers need take into consideration? The following factors are not to be taken as an exhaustive list, but perhaps the most important to take into consideration:
- Taxes and spending are the same side of the coin: Since states must balance their budgets, any tax reform, including revenue neutral, must take into consideration the impact regarding revenues. If lower rates are the objective, then policymakers need to be prepared to prioritize spending. Controlling spending is a vital part of tax reform. “Pro-growth tax relief can be trusted to make states more competitive, but it takes time to develop and must be offset with appropriate spending reforms,” stated Jonathan Williams. It is also important to remember that pro-growth tax reform will result in economic growth, which means more revenue, but the growth may not be immediate. This also depends on the structure of the tax reform.
- Revenue triggers can be an effective policy tool: Several states have utilized revenue triggers as a tool to help lower tax rates. Revenue triggers, if designed correctly, can help states lower tax rates, while providing protection for the state budget. North Carolina is an example of a state that utilized triggers effectively to lower tax rates. In 2018, Iowa utilized a revenue trigger in order to lower individual income tax rates, but one mistake was tying the triggers to a specific year and requiring a high four percent growth target, whereas North Carolina specified a revenue target, but not a specific year. States can also utilize a phasedown approach to rate reduction. Indiana and Missouri are examples of states that have slowly lowered both individual and corporate income taxes by a certain percentage each year or when specific revenue targets are met.
- Evaluate tax credits, incentives, exemptions, and deductions: Any tax reform, especially a pro-growth rate reduction reform, requires “paying for” those reductions. This means that policymakers should consider reforming tax credits, incentives, exemptions, and deductions. North Carolina’s historic tax reform made numerous changes in an effort to lower rates and broaden the tax base. Arkansas repealed the InvestArk tax credit program as a result of their effort to lower tax rates. Tax exemptions also create distortions in the tax code. One way to combat this is to broaden the tax base., Broadening the sales tax base can create additional revenues that could then be used to lower tax rates or replace lost revenues due to income tax rate reductions. If Iowa broadened the sales tax base and removed some of the largest tax exemptions, it could raise an additional $1.4 billion in revenue.
Reviewing tax expenditures is always a good policy but repealing some deductions and exemptions may result in a tax increase for taxpayers. One again North Carolina’s tax reform is an excellent example of tax reform that was carefully evaluated in order to lower rates and broaden the base that benefits all taxpayers. States are also making improvements to how they evaluate tax credits. Both Indiana and Arkansas as part of their tax reform efforts made improvements to tax credit evaluation.
Some states may also consider that their ultimate tax policy goal is the elimination of the income tax. This is an admirable policy goal. Income taxes are considered the most harmful tax because it punishes work, investment, productivity, and growth. States with no income taxes are seeing both economic and population growth, especially in comparison to high tax states. However, repealing a state income tax is not easy, especially if that state relies on the income tax as a major source of funding. Iowa is a perfect example of this as it relies heavily on the income tax and it encompasses close to 53 percent of state revenues.
For Iowa to repeal the income tax, it would require substantial reform to the tax code. This would include either broadening the sales tax base, increasing the sales tax rate, or designing an income tax rate reduction system that would protect the budget. The Arizona legislature is currently considering a bill to phase out their state income tax. The proposed legislation would ratchet down income tax rates after specific revenue triggers are met.
It should be noted that the goal does not necessarily have to be the repeal of the income tax. Utah, North Carolina, and Indiana are examples of states that have both broadened their tax base and lowered income tax rates. All three have enacted pro-growth tax reforms that are benefiting taxpayers and the economy.
Tax reform, with the goal of lowering rates and providing tax relief is a worthy policy goal. Policymakers can look to several states that have initiated tax reform which benefited both taxpayers and the overall economy. It is possible to lower tax rates, prioritize spending, and in the process create a better economy, while allowing taxpayers to keep more of their income.