How states can effectively end the federal income tax --and why they should.

Murphy, Ryan H.

Proponents of a more rational tax code may be feeling optimistic because of the Marco Rubio-Mike Lee proposal for tax reform. The senators' proposal would move the tax code closer to a tax on consumption, a policy that many economists have long argued would be conducive to economic growth. But the Rubio-Lee plan is a very watered down version of such a transition and likely would have to be watered down further in order to be enacted.

One alternative for achieving a genuine transition away from federal income taxation would be for state governments to de facto change the way federal taxes are collected. Such a change would profoundly improve the prospects for economic growth, even from the perspective of very orthodox economists. All that's needed is a state legislature daring enough to try it--a legislature like, say, Texas.

Lone Star pluck / In Texas, taxes on income are against the state constitution. However, Texans still pay the federal income tax.

In principle, the state could effectively end the federal income tax by using two surprisingly simple and straightforward legislative maneuvers--neither of which involves secession. Texas could choose to send its federal taxpayers a check in the form of a state tax credit equal to their federal income tax liability. It could then pay for the credit by increasing the state sales tax in a revenue-neutral way. Effectively, that would mean the end of all income taxes in the state while significantly raising sales taxes. This isn't about cutting taxes per se; rather, this is the tax swap to end all tax swaps.

Texas may be well-positioned to make such an extreme change because its population centers are distant from its borders with other states, which means most Texans would have difficulty arbitraging away from a higher sales tax. (Some other states may find that their citizens will cross borders to avoid paying significant sales taxes, but those states could pay for the income tax credit by raising the next least worst type of tax--perhaps the property tax. The arbitrage problem shouldn't be insurmountable for any state.)

The resulting inflow of investment from other states--and other countries--into Texas would be unprecedented. It could dwarf the recent "fracking" boom by an order of magnitude. Every firm in the world would eagerly seek to make a city in Texas home to its world headquarters.

Why do it? / This would constitute a drastic policy shift, but why not do it? The superiority of consumption taxes to income taxes has long been argued by many neoclassical economists.

The real difference between a consumption tax and an income tax is that a consumption tax encourages saving and thrift. We have good reason to believe that (relatively speaking) discouraging saving--and therefore investment--has significant negative effects on growth. There's no good reason to structure the tax code in such a way that it encourages using income on immediate consumption. If anything, we should raise revenues in such a way that discourages activities we think are harmful, not ones that are socially beneficial like saving.

The positive effects have been convincingly shown most recently by Jens Arnold, an economist with the Organization for Economic Cooperation and Development, who studied the effects of different tax policies on economic growth across OECD countries. Arnold's work indicates that consumption taxes and property taxes are distinctly superior to income taxes, especially to an income tax with high progressivity. William McBride of the Tax Foundation summarizes this in a 2012 study, "What Is the Evidence on Taxes and Growth?" What is clear is that a U.S. state that is willing to move its tax environment strongly in this direction would attract investment, entrepreneurs, and workers from the other 49 states.

This tax shift would implicitly allow states to unilaterally end one of the most pernicious parts of the federal tax code: the home mortgage interest deduction. While the economic effects of the deduction would cease to exist, the statute would still be on the books. A tax deduction that economists left and right agree is economically terrible would be erased, even though right now it is politically impossible to do so.

Other features of the federal tax code could be preserved, if a state wishes to do so explicitly. The information needed for charitable-giving subsidies or wage subsidies would still be contained in a filer's federal tax return. While we may or may not want to publicly subsidize such activities, we can agree it is more efficient to do so directly than to awkwardly build them into a progressive income taxation scheme.

Clearly, sales taxes are regressive, especially in comparison to progressive income taxes. But combating income inequality--or, far more importantly, poverty--should not impede this tax shift. Again, orthodox neoclassical welfare economics tells us to raise revenue in the most efficient way and to address distributional concerns in the most efficient way. That means consumption taxes followed by either wage subsidies or guaranteed minimum incomes for the poor.

Conclusion / Governments in "red" states face few impediments to enact policies conservatives want. From Georgia's so-called "Guns Everywhere" law to Right-to-Work becoming a reality in Michigan of all places, states have shifted policy significantly since the rise of the Tea Party. In contrast, even the most free-market states have tax policies to the left of the median economist--that is, if this tax-shift policy option is on the table.

Perhaps progressive jurists may challenge the legality of states effectively circumventing the desires of the federal government. I am not qualified to judge whether such a challenge would be successful. But beyond that, the only real obstacle to this policy change is the tyranny of the status quo. If states want to unilaterally end inefficient federal taxation from taking place within their borders, they can do it.

READINGS

* "Do Tax Structures Affect Aggregate Economic Growth? Empirical Evidence from a Panel of OECD Countries," Working Paper No. 656, by Jens Arnold. OECD Economics Department Working Papers, 2008.

* "What Is the Evidence on Taxes and Growth," Report No. 207, by William McBride. Tax Foundation, Dec. 18, 2012.

RYAN H. MURPHY is a research associate in the O'Neil Center for Global Markets and Freedom at Southern Methodist University.