Federal Taxes and Cost of Living

 

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Unfortunately, cost of living differences between regions has been overlooked in public policy leading to disastrous economic consequences. Perhaps the biggest is the interplay between the progressive federal individual income tax and cost of living leading to different tax liabilities between taxpayers with the same standard of living.


The problem stems from the fact that nearly all provisions within the federal individual income tax are based on preset amounts. For instance, in 2013, the federal standard deduction is worth $12,200 for a married couple. In real purchasing power, this is worth a lot more in Mobile, Alabama than it is in New York City.


Other important preset amounts include the exemptions, federal income tax brackets, the child tax credits and other credits, and the list goes on and on. The end result is that high cost of living areas are penalized by the federal individual income tax while low cost of living areas are given a bonus.


Naturally, people react to these incentive which helps to fuel other economic distortions such as, for example, the flight of people from high cost inner cities to low cost suburbs. Ironically, the much maligned mortgage interest deduction helps mitigate cost of living differences due to housing since it is worth more to taxpayers living in areas with high home prices.


Differences in Federal Individual Income Taxes


Table 1 shows how cost of living differences results in winners and loser in regards to the federal individual income tax for the top 10 and bottom 10 cities. The most negatively impacted city is New York City which has three boroughs represented in the top 5--Manhattan, Brooklyn, and Queens.


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Table 1 Cost of Living Differences Results in Winners and Losers in Regards to the Federal Individual Income Tax Top 10 and Bottom 10 Cities 2013.jpg

A married couple with two children living in Manhattan would have to earn $220,449 to buy the same standard of living as $100,000 would buy at the national average. Consequently, this family would pay the highest individual income tax liability of $41,407, or 18.8 percent of income. An average income of $500,000 would require an equivalent Manhattan income of $1,102,247 with a tax liability of $379,305, or 34.4 percent.


On the other hand, if this same couple lived in the Brownsville-Harlingen, Texas metro area, they would only have to earn $81,581 to buy the same standard of living. Consequently, this family would pay the lowest individual income tax liability of $5,175, or 6.3 percent of income. An average income of $500,000 would require an equivalent income of $407,904 with a tax liability of $106,282, or 26.1 percent.



The key fact to keep in mind is that the basket of goods the this couple can buy is identical in each location, i.e., the same standard of living. However, because the federal individual income tax does not recognize these geographic difference in costs, living in Manhattan imposes  a higher tax burden (18.8 percent of income) where as living in Brownsville, Texas yields a lower tax burden (6.3 percent of income).


Similarly, Table 2 shows how cost of living differences results in winners and loser in regards to the federal individual income tax but for the top 50 and bottom 50 counties.


[Click Here to View Federal Taxes and Cost of Living Data by State and County]

 

Table 2 Cost of Living Differences Results in Winners and Losers in Regards to the Federal Individual Income Tax Top 50 and Bottom 50 Counties 2013.jpg

 

A married couple with two children living in Kings County, New York would have to earn $188,284 to buy the same standard of living as $100,000 would buy at the national average. Consequently, this family would pay the highest individual income tax liability of $32,401, or 17.2 percent of income. An average income of $500,000 would require an equivalent Manhattan income of $941,419 with a tax liability of $315,617, or 33.5 percent.


On the other hand, if this same couple lived in the Elliott County, Kentucky, they would only have to earn $77,464 to buy the same standard of living. Consequently, this family would pay the lowest individual income tax liability of $4,557, or 5.9 percent of income. An average income of $500,000 would require an equivalent income of $387,320 with a tax liability of $98,624, or 25.5 percent.


Again, the key fact to keep in mind is that the basket of goods the this couple can buy is identical in each location, i.e., the same standard of living. However, because the federal individual income tax does not recognize these geographic difference in costs, living in Kings County, New York imposes  a higher tax burden (17.2 percent of income) where as living in Elliott County, Kentucky yields a lower tax burden (5.9 percent of income).


 

 

Conclusion: Time for a Flat Tax


Overall, the fundamental issue is that the value of the dollar is not constant. We all know that the dollar loses value over time and we call that inflation. Economists have long agreed that it is bad tax policy to have a built-in "inflation tax" in the tax code. That's why the Economic Recovery Tax Act of 1981 finally indexed the income tax code for inflation such as tax brackets, standard deductions, and exemptions.


However, as we've pointed out here, the value of the dollar is also very different by geographic location. One way to fix this issue would be to index the tax code to a cost of living index like the one used here. Better still would be to simply move to a "Flat Tax" like the one suggested by economist Robert Hall and Alvin Rabushka. Although the Flat Tax does contain fixed dollar exemptions that would have to be changed to percentages or eliminated.


This analysis shows an important, yet overlooked, reason for national tax reform . . . do share so that one day we can all enjoy fundamental tax reform!


For more information, see: Moody, J. Scott and Hoffman, David, "Federal Income Taxes and the Cost of Living (pdf)," The Tax Foundation, Special Report No. 125, November, 2003.


 

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