We all know that taxpayers respond to tax incentives and disincentives. For example, they may buy a larger house than they may "need" because they can deduct the mortgage interest from their income taxes. Since the behavior is tax-induced, it harms the economy. Rather than buying a larger house, the taxpayer could have invested in Google instead.
"Deadweight loss" is a term used by economists to describe the economic inefficiencies created by taxation such as when taxpayers reduce work and/or consumption or shifts income to avoid taxation. In other words, the very process of transferring resources from the private to the government sector results in a permanent loss of potential economic output.
Chart 1 graphically shows how economists are able to estimate deadweight losses where Quantity (Qe) and Price (Pe) show the market equilibrium. The addition of a tax has the same effect as an artificial price increase. The new price point of intersection with the Demand (P+Td) and Supply (P+Ts) curves is at Quantity (Qt). The rectangle formed by the new intersection is the revenue gained by the tax. However, the triangle represents the value of trade that would have occurred without the tax, but are now precluded by the tax. Deadweight loss can be estimated by calculating the area of the triangle.
However, estimating the deadweight loss is subject to the degree in which taxpayers change their behavior. If, in fact, taxpayers buy larger houses because the mortgage interest is deductible; then the deadweight loss is large and vice-versa. Economists refer to this as the "tax elasticity” (TE). The example given above is an example of "high tax elasticity." Graphically, in Chart 1, TE is shown by the steepness and curvature of the supply and demand curves.
Based on this standard economic methodology, Dr. Martin Feldstein, President and CEO of the National Bureau of Economic Research, pioneered the empirical estimations of deadweight loss. In one of Dr. Feldstein’s famous studies, co-authored with Dr. Daniel Feenberg, they estimated that the TE during the 1993 Federal income tax increase was 0.75. This means that for every 1 percent reduction in after-tax income, taxable income decreased by 0.75 percent.
In dollar terms, suppose a taxpayer with $100,000 in after-tax income experiences a statutory tax increase of $1,000 to $99,000. In response, the taxpayer reduces his taxable income—perhaps by buying tax-free municipal bonds—by $750. As a result, the government collects lower tax revenues (the $750 is tax-free) and the economy suffers significant deadweight losses (he could have went on vacation instead).
According to static federal revenue projections, the 1993 tax increase (both marginal income tax rates and the payroll tax) was estimated to raise $19.3 billion in additional revenue. However, based on behavior response, the actual additional revenue raised was estimated at a much lower level of $8.4 billion—a decline of 57 percent.
In addition, the deadweight loss was estimated at 15.9 billion, or nearly twice the behavior adjusted revenue of $8.4 billion. Thus, federal taxpayers incurred a cost of nearly three dollars due to this tax increase—the dollar transferred to the federal government plus the deadweight loss of nearly two dollars.
More recently, new evidence has come to light that strongly supports the TI estimate used in their study. The study by Dr. Adam Looney and Dr. Monica Singhal (pdf), published by the John F. Kennedy School of Government at Harvard University, used two different data-sets. Both datasets produced virtually identical TE estimates of 0.75. To summarize their conclusions:
"We focus primarily on tax rate changes arising from the loss of a dependent exemption. Using the SIPP, we estimate a significant elasticity of family labor income of 0.75 for families with base year earnings between $35,000 and $85,000. Our estimates using the tax panel data are almost identical. These estimates are at the high end of the range found in previous work . . . In theory, however, our estimates of labor income elasticities from the SIPP data should be lower bounds on the true elasticities of taxable income. The high-end estimates then imply substantial behavioral responses to taxation and sizable efficiency costs of taxation." (emphasis added)
And deadweight loss is not just an academic issue because in the real world it means a smaller economy and lower standard of living for everyone. For example, a recently released study by the National Bureau of Economic Research by Dr. David Romer and Dr. Christina Romer (pdf), highly reputable economic professors at the University of California, Berkeley, that studied federal tax law changes over the last 50 years conclude:
“This paper investigates the impact of changes in the level of taxation on economic activity . . . the resulting estimates indicate that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes. The large effect stems in considerable part from a powerful negative effect of tax increases on investment.” (emphasis added)
At the state-level, Dr. Besci (pdf) comes to same conclusion:
“The study finds that relative marginal tax rates have a statistically significant negative relationship with relative state growth averaged for the period from 1961 to 1992. These results are economically significant because controlling for progressivity with greater accuracy than other specifications uncovers the effects of taxes.”
Despite this economic evidence against taxation, some pro-government ideologues insist that "government spending" is really "government investment." Naturally, this implies that government spending has a surplus benefit above and beyond the taxes raised and resulting economic carnage. To test this hypothesis, Dr. Stephen Brown, Dr. Kathy Hayes and Dr. Lori Taylor (pdf) released a recent study at the state-level that sheds new light on the “investment” versus “tax” debate. They find that:
"If anything, most public services do not appear to justify the taxes needed to finance them. Any tax savings financed by slower growth in environmental services, health and hospitals, or elementary and secondary education is positively associated with growth in private capital. Similarly, any tax savings financed by slower growth in public safety or education spending is positively associated with growth in private employment . . . this finding would seem to imply that other state and local public capital has been increased to the point of negative returns, perhaps because a growing stock of other public capital is indicative of an increasingly intrusive government."
But you do not even need complex statistical studies to see the obvious negative impact of excessive taxation. To witness this effect in the real world, let’s look at three important measures of economic prosperity among the ten states with the highest and the ten states with the lowest level of taxation between state Fiscal Years 2001 and 2011. These measures include: population growth, personal income growth and employment growth.
Table 1 illustrates the difference in taxation and economic performance of the ten lowest taxed states and the ten highest taxed states. The ten lowest taxed states had an average tax bite of 8.5 percent of personal income versus 12 percent for the ten highest taxed states. As such, the tax bite of the lowest taxed states was 28.9 percent lower than the highest taxed states. Not surprisingly, the lowest taxed states enjoyed population growth that was 205 percent higher, personal income growth that was 15.6 percent higher, and private employment growth that was 56.7 percent higher.
On a more local scale, it is well-known that Maine and New Hampshire are polar opposites when it comes to tax policy. Maine has one of the highest tax burdens in the country at 11.7 percent of personal income (7th highest) in FY 2013 while New Hampshire has one of the lowest tax burdens at 8.3 percent of personal income (47th highest). These 3.5 percentage points represent one of, if not the, largest tax differentials between any two states in the country and is the basis for “The Great Tax Divide.” (pdf)
The close geographic proximity of the two states leads to numerous arbitrage opportunities for Mainers to escape their significantly higher tax burden. The most obvious way is through direct cross-border shopping which is occurring up and down the Maine-New Hampshire border. By utilizing comprehensive retail data from the U.S. Census Bureau over the last 60 years we can see the full extent of cross-border shopping.
More specifically, Mainers are engaging in cross-border shopping in New Hampshire in response to Maine’s higher sales tax, cigarette tax, gasoline tax, bottle tax and alcohol taxes (beer, wine and liquor). Additionally, retailing in New Hampshire was given a significant boost in the early 1990’s when they reformed their tax code instituting the Business Enterprise Tax in place of other job-killing taxes.
Overall, Chart 2 shows that per capita retail sales in the adjacent bordering counties in Maine (Oxford and York) and New Hampshire (Coos, Carroll, Strafford and Rockingham) have been diverging ever since Maine adopted the sales tax in 1951. By 2007, the retail gap was $8,660 per person ($19,976 versus $11,316). If Maine had the same level of retail activity as New Hampshire, retail sales would have been up to $2.2 billion higher—from $2.9 billion to $5.1 billion—and created thousands of retail jobs.
In short, taxes matter!
In order to compare the burden of tax systems across states, there must be a common yardstick. The best yardstick is to measure ax collections against the size of the private sector economy as defined by total personal income minus government compensation and personal current transfer receipts (Social Security, Medicare, and Medicaid).
As shown in Chart 3, the national state and local tax burden, as a percent of private sector personal income, in FY 2016 was 14.3 percent. Of course, tax burdens can vary a great deal among the 50 states.
The top tax burden states in FY 2016 are:
The bottom tax burden states in FY 2016 are:
Additionally, the composition of tax burdens can vary greatly by state. Some states have the full slate of taxes such as California with the individual income tax, corporate income tax and sales tax. Other states do without most of the major taxes such as New Hampshire which does not have a individual income tax or sales tax.
All states do, however, have property taxes. As shown in Chart 4, the national state and local property tax burden, as a percent of private sector personal income, in FY 2016 was 4.5 percent of personal income.
The top ten states with the largest property tax burden in FY 2016 are 1. Vermont (8 percent), 2. New Hampshire (7.5 percent), 3. Maine (7.5 percent), 4. Rhode Island (7.0 percent), 5. New Jersey (6.8 percent), 6. New York (6.8 percent), 7. Wyoming (6.1 percent), 8. Alaska (5.8 percent), 9. Illinois (5.6 percent), and 10. Connecticut (5.4 percent).
The bottom ten property tax burden states in FY 2016 are 1. Alabama (2.2 percent), 2. Oklahoma (2.4 percent), 3. Delaware (2.8 percent), 4. Arkansas (2.8 percent), 5. Tennessee (3.0 percent), 6. Nevada (3.0 percent), 7. North Dakota (3.1 percent), 8. Louisiana (3.1 percent), 9. Indiana (3.2 percent), and 10. Utah (3.3 percent).
As shown in Chart 5, the national state and local individual income tax burden, as a percent of private sector personal income, in FY 2016 was 3.4 percent of personal income.
The top ten states with the largest individual income tax burden in FY 2016 are 1. New York(7.2 percent), 2. Oregon (6.2 percent), 3. Maryland (5.7 percent), 4. Kentucky (5.3 percent), 5. California (5.1 percent), 6. Minnesota (5.1 percent), 7. Hawaii (4.8 percent), 8. West Virginia (4.8 percent), 9. Massachusetts (4.8 percent), and 10. North Carolina (4.3 percent).
The bottom ten individual income tax burden states in FY 2016 are (note the first 7 do not have an individual income tax and are ranked alphabetically) 1. Alaska (0.0 percent), 2. Florida (0.0 percent), 3. Nevada (0.0 percent), 4. South Dakota (0.0 percent), 5. Texas (0.0 percent), 6. Washington (0.0 percent), 7. Wyoming (0.0 percent), 8. New Hampshire (0.2 percent), 9. Tennessee (0.2 percent), and 10. North Dakota (1.1 percent).
Note that New Hampshire and Tennessee do not have a broad-based individual income tax though they do tax interest and dividends (Tennessee has since repealed their "Hall Tax" on interest and dividends).
As shown in Chart 6, the national state and local corporate income tax burden, as a percent of private sector personal income, in FY 2016 was 0.5 percent.
The top ten states with the largest corporate income tax burden in FY 2016 are 1. New York (1.4 percent), 2. New Hampshire (1.2 percent), 3. Delaware (1.1 percent), 4. Alaska (0.8 percent), 5. Tennessee (0.8 percent), 6. Mississippi (0.7 percent), 7. Kentucky (0.7 percent), 8. Minnesota (0.7 percent), 9. Massachusetts (0.7 percent), and 10. Illinois (0.7 percent).
The bottom ten corporate income tax burden states in FY 2016 are (note first 4 states do not have a corporate income tax and are ranked alphabetically) 1. Nevada (0.0 percent), 2. Texas (0.0 percent), 3. Washington (0.0 percent), 4. Wyoming (0.0 percent), 5. Ohio (0.1 percent), 6. South Dakota (0.1 percent), 7. Louisiana (0.1 percent), 8. Missouri (0.2 percent), 9. Hawaii (0.2 percent), and 10. Virginia (0.2 percent).
As shown in Chart 7, the national state and local sales tax burden, as a percent of private sector personal income, in FY 2016 was 3.4 percent.
The top ten states with the largest sales tax burden in FY 2016 are 1. Hawaii (7.8 percent), New Mexico (6.7 percent), 3. Washington (6.0 percent), 4. Arkansas (5.8 percent), 5. Louisiana (5.6 percent), 6. Nevada (5.5 percent), 7. Mississippi (5.3 percent), 8. Arizona (5.1 percent), 9. Tennessee (4.7 percent), and 10. South Dakota (4.5 percent).
The bottom ten sales tax burden states in FY 2016 are (note the bottom four are tied since they do not have the sales tax and are ranked alphabetically while Alaska does not have a state sales tax, they do allow for sales taxes at the local level): 1. Delaware (0.0 percent), 2. Montana (0.0 percent), 3. New Hampshire (0.0 percent), 4. Oregon (0.0 percent), 5. Alaska (0.8 percent), 6. Virginia (1.7 percent), 7. Massachusetts (1.9 percent), 8. Vermont (1.9 percent), 9. Maryland (1.9 percent), and 10. Connecticut (2.0 percent).
As shown in Chart 8, the national state and local all other tax burden, as a percent of private sector personal income, in FY 2016 was 2.1 percent. All other taxes is a catch-all for a multitude of taxes--such as the severance tax, various licenses, and the estate tax among others.
The top ten states with the largest all other tax burden in FY 2016 are 1. North Dakota (7.2 percent), 2. Delaware (6.2 percent), 3. West Virginia (5.3 percent), 4. Nevada (5.2 percent), 5. Wyoming (4.5 percent), 6. Hawaii (4.2 percent), 7. New Mexico (3.9 percent), 8. Vermont (3.7 percent), 9. Washington (3.2 percent), and 10. Montana (3.2 percent).
The bottom ten all other tax burden states in FY 2016 are 1. Alaska (-3.3 percent), 2. Massachusetts (0.9 percent), 3. New Jersey (1.2 percent), 4. Connecticut (1.4 percent), 5. New Hampshire (1.4 percent), 6. Arizona (1.4 percent), 7. Georgia (1.4 percent), 8. Nebraska (1.8 percent), 9. Colorado (1.5 percent), and 10. Kansas (1.6 percent).
Finally, another aspect of measuring tax burdens is to adjust for the collection of taxes from businesses or people who do not live within the state. This is called tax incidence analysis. A common example are the taxes to a state from tourists. A proper economic accounting of taxes paid by tourists would transfer the tax burden to the tourist's state of residence.
However, such an analysis is currently beyond the scope of the presentation here. The best source for tax burdens, adjusted for tax incidence, is published by the Tax Foundation in their annual State and Local Tax Burdens publication (pdf).
As of Fiscal Year 2012, their study finds that the top three highest tax burden states are New York (12.7 percent), Connecticut (12.6 percent), and New Jersey (12.2 percent); whereas the top three lowest tax burden states are Alaska (6.5 percent), South Dakota (7.1 percent), and Wyoming (7.1 percent).
Of course, the tax burdens for local government can vary just as much as they do among the 50 states. As such, we have also calculated the local government tax burden for every county in United States—this includes every taxing jurisdiction within the geographic county borders whether it is a city, a special district, or county government itself.
The 25 counties with the highest local government tax burden include:
The 25 counties with the lowest local government tax burden include:
Note: Alaska's Permanent Fund distributions are treated as a tax reduction at the state level. Also, Alaska's counties are excluded from the local tax burden analysis.
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