Consequences of eliminating Michigan’s individual income tax

An analysis of the possible impact of repealing the income tax and what we can learn from Kansas

Consequences of eliminating Michigan’s individual income tax

Two measures to eliminate the individual income tax have been introduced in the Michigan Legislature. Rep. Lee Chatfield (R-District 107) has introduced a bill, HB 4001, to reduce the income tax rate to 3.9 percent, beginning Jan. 1, 2018, and to reduce the rate 0.1 percent each year thereafter until the rate is zero. The second proposal, SB 4, would reduce the rate to 4.25 percent beginning  Jan. 1, 2018, and reduce the rate 1 percent each year until the rate is zero.

Impact on State Revenues

The income tax amounted to $9.4 billion in FY 2016 and accounted for about 67 percent of general fund revenue and 22 percent of school aid revenue.

FY 2016 General Fund (GF) revenue was 6.4 percent below the FY 2000 level, an inflation-adjusted decline of about 28 percent. FY 2016 School Aid Fund (SAF) revenue was up 22 percent from FY 2000 but down 4.2 percent when adjusted for inflation.

The consensus revenue estimate for GF revenue is for a 2.5 percent annual increase from 2016 to 2018. A 0.1 percent cut in the income tax would reduce revenue by about $250 million, or about 2.5 percent of total revenue. If this were the long-term growth in revenue, it would mean that there would be zero growth over the next 40 years—the period for the complete phase-out of the income tax. Assuming an inflation rate of 2.5 percent annually, the general fund in today’s dollars would about $4 billion. Phasing out the tax over 5 years would reduce revenues by about $2.1 billion each year.

Reducing the income tax immediately would leave $3.3 billion in the general fund. The reduction in SAF revenue would require a cut of over $1,800 per pupil.

Other States’ Experiences

As shown in Exhibit 1, nine states do not have a comprehensive individual income tax (Tennessee and New Hampshire tax only dividends and interest). There are three main reasons why these nine states do not have to levy an income tax. First, almost all these states raise most of their money from the general sales tax or selected sales taxes on specific items. Michigan raises 33.8 percent of its tax revenue from the general sales tax and 14.5 percent from selective sales taxes. As shown in the table below, all these states except Alaska, New Hampshire and Wyoming raise much more money from sales taxes. Second, Alaska, South Dakota and Wyoming have small populations and large natural resources. These states raise substantial revenues from taxes on oil, gas and minerals. For example, Wyoming raises 37.5 percent of its tax revenue from a severance tax (taxes on the extraction of natural resources). Third, all these states except Alaska have significantly higher business taxes. Michigan business taxes amount to 3.5 percent of private Gross State Product (the same as Alaska). (Council on State Taxation, Total state and local business taxes [FY 2015], December 2016). The average in the other eight states is 5.2 percent of Gross State Product (GSP). If Michigan’s tax rate on business were 5.2 percent, the state would raise $7.1 billion, enough to replace most of the income tax. How many votes would there be to sharply increase business taxes to replace the personal income tax?

Two other states sharply reduced their income tax in recent years. Kansas reduced the income tax in 2013 in hopes of improving the economy. The result has been serious budget problems and an employment growth rate among the slowest in the nation.  Since December 2012, employment has grown 2.4 percent, compared with 6.9 percent nationally.

Wisconsin also cut corporate and personal income taxes significantly in the past few years.  A recent paper delivered at the North American Regional Science Conference compared Kansas and Wisconsin with neighboring states (Nebraska and Minnesota, respectively) and found that those states had a better economic performance  (Two Tales of two States: Storytelling with Regional Science, Dan Rickman, Oklahoma State University, November 10, 2016).

The paper concluded that the Kansas and Wisconsin tax cuts led to reductions in tax revenues at current rates, leading to spending cuts—i.e., there were insufficient supply-side effects to maintain tax revenue collections and likely negative short-term demand effects.   The Kansas and Wisconsin experiments do not appear to be working in the short run.  These tax changes could be potentially harmful to growth and prosperity in the long run if spending drops below optimal levels. One should also look at the border states of Washington and Oregon. Washington has no income tax, and Oregon has no sales tax. Business taxes are much higher in Washington than in Oregon—5.5 percent of GSP compared with 3.6 percent of GSP in Oregon. Overall, state and local taxes are higher in Oregon. Since 2010, employment has increased at exactly the same rate in the two states.

Other Issues

The Michigan income tax rate of 4.25 percent is the fifth lowest top rate in the nation. Of the 41 states that levy an income tax, Michigan is one of eight states that levy a flat rate. Michigan also has the lowest state and local taxes in the Great Lakes region—9.7 percent of personal income compared with an average of 10.9 percent for the other six states (excluding New York, which is an outlier). The national average is 10.5 percent. If Michigan’s tax burden were the average of the other states in the region, state and local government would raise $4.8 billion more in state and local revenue.

Income taxes grow faster than sales taxes. It is hard to make comparisons because there have been so many changes in the income tax. However, Michigan personal income increased 41 percent from 2000 to 2015, and without changes in the base or rate, the income tax would have grown somewhat faster. The sales tax grew about 22 percent over the same period. Sales tax revenue has grown much slower than personal income in recent years because Michigan taxes few services, which are growing faster than taxable items, and because of the growth in Internet sales. Switching to a sales tax would put more strain on the budget in future years if legislation is not passed to expand the tax base to include services and Internet sales.

There is general agreement among tax policy experts and economists that the sales tax is regressive, in that it falls heavier on low-income taxpayers than high-income taxpayers, and that the income tax is fairer because it is based on ability to pay.

A recent study by the Institute on Taxation and Policy indicated that five of the states without an income tax—Washington, Florida, Texas, South Dakota and Tennessee—are among the 10 states with the most regressive tax structures. This is largely because they are heavily reliant on sales taxes (Who Pays? A Distributional Analysis of the Tax Systems in all 50 States, December 2015).

Revenue Replacement

There are only four viable options for replacing the income tax: raising the sales tax, which requires a vote of the people; expanding the sales tax to services; increasing business taxes and; and eliminating a large number of tax expenditures.

A 1 percent increase in the sales tax would raise about $1.6 billion. To replace the income tax with an increase in the sales tax would require an increase in the rate from 6 percent to about 12 percent (the highest rate in the nation), and would have to be approved by the voters. A rate this high could encourage Michigan residents to shop across the border and could have a negative impact on tourism. It would also likely negatively affect the sales of big-ticket items such as motor vehicles.

The State Tax Expenditure Report estimates state tax expenditures at about $36 billion. However, many of these expenditures have a legitimate purpose and would be difficult to eliminate. Examples include the personal income tax exemption, exemption of food and drugs from the sales tax, and the industrial processing exemption from the sales tax. If all services—including profit and nonprofit, business services, and health and social services—were taxed at the 6 percent rate, $12.5 billion in revenue could be raised. However, it is highly unlikely that there would be political or public support to tax many of these services. Realistically, it might be possible to raise about $1 billion with a tax on services. The elimination of the exemption for food and drugs would raise about $2 billion, but again there would likely be little support for this.

 As pointed out below, the states that do not have an income tax, with one exception, have much higher business taxes than Michigan (see Exhibit 1). The Michigan corporate income tax rate is 6 percent on Federal taxable income. Each 1 percent increase in the rate would raise about $170 million. Additional revenue could be raised by extending the tax to all businesses. Before the enactment of the corporate income tax, the Michigan Business Tax and the Single Business Tax covered all businesses above a certain size, not just corporations. It is unlikely there would be political support to raise anywhere close to the revenue raised by the income tax.

Impact on State Services

The elimination of the income tax would clearly have a significant impact on state services. How severe the impact would be would depend on how much of the revenue was replaced. As noted above, it would be difficult to replace a significant portion of the revenue. As shown in Exhibit 2, there has been little growth in general fund spending since 2000. From FY 2000 to FY 2017 (proposed budget), GF spending increased 2.4 percent. Adjusted for inflation, spending declined about 23 percent. There is plenty of evidence that Michigan state government is spending too little, including the deteriorating quality of our roads (we rank 50th in per capita spending), high college tuition (we rank sixth) and the financial problems of our cities (we have more cities under fiscal stress than any other state). In addition, there are a number of factors that will reduce revenues and/or increase expenditures in the future. These include the transfer, beginning in 2018, of $600 million from the GF for transportation purposes; the reimbursement of local governments for the phased elimination of the personal property tax which will reduce use tax revenue by about $450-$500 million annually; elimination of the Medicaid Managed Care use tax, which provided about $400 million to the GF and $200 million to the SAF in FY 2016; ongoing spending for the Flint water crisis; and potential increased budget costs due to the possible repeal of the Affordable Care Act. (See Exhibit 3 for a breakdown of GF spending.)

Impact on the Economy

Most studies have concluded that state taxes have little impact on economic growth (See The Relationship between Taxes and Growth at the State Level: New Evidence, Tax Policy Center, December 2015). I ran a simple regression analysis for the 50 states with employment growth since 2010 as the dependent variable and business taxes as a percentage of private gross domestic product and a dummy variable for states without an income tax as the independent variables. The two variables explained only 11 percent of the change in the employment growth rate (R squared), and neither variable was significant (T-value of less than 2.0). I do not view this as conclusive evidence, but it does not disprove my hypothesis that state taxes have little impact on economic growth.

Even if one assumes that the elimination or reduction of the income tax would have a positive impact on economic growth, it is likely that these positive effects would be offset by the potential reduction in the quality of public services.

Conclusion

The evidence is clear that the elimination of the individual income tax in five years or 40 years could have serious negative consequences on public services in Michigan, and it may not provide the economic benefits its proponents expect. Given economic and budget uncertainties, we should be cautious in making changes to our major revenue sources.

Exhibits

Exhibit 1
State Population

Total Taxes
(1,000)

Individual
Income Tax

% of Total
Taxes

Per Capita

 

General
Sales

% of Total
Taxes

Selected
Sales

% of Total
Taxes

Corporate
Income + Bus. Lic

% of Total
Taxes

Severance
Taxes

% of Total
Taxes

License
Taxes

% of Total
Taxes

Business Tax
% GSP

Michigan 9,928,846 $26,957,337 $8,825,375 32.7% $889 $9,121,783 33.8% $3,912,678 14.5% $1,185,568 4.4% minor 0 $1,563,500 5.8% 3.5%
Alaska 739,818 $863,723 0 0 $0 $0 0 $255,921 29.6% $227,852 26.4% $105,233 12.2% minor 0 3.5%
Florida 20,636,975 $37,217,259 0 0 $0 $21,800,895 58.6% $8,535,420 22.9% $2,237,500 6.0% $0 0 $2,138,233 5.7% 4.9%
Nevada 2,943,573 $7,532,989 0 0 $0 $4,080,507 54.2% $1,958,261 26.0% $0 0.0% $0 0.0% $649,333 8.6% 5.4%
New Hampshire 1,333,220 $2,482,737 minor 0 $0 $0 0.0% $970,102 39.1% $576,679 23.2% $0   $322,687 13.0% 4.2%
South Dakota 863,634 $1,674,108 $0 0 $0 $970,784 58.0% $401,898 24.0% $141,048 8.4% minor 0.0% $288,796 17.3% 4.7%
Tennessee 6,652,819 $12,697,655 $302,196 2.4% $45 $6,547,191 51.6% $2,648,649 20.9% $312,495 2.5% $0 0.0% $1,396,989 11.0% 4.3%
Texas 27,959,150 $55,086,348 $0 0 $0 $33,664,187 61.1% $13,989,995 25.4% $687,419 1.2% $4,005,371 7.3% $3,426,805 6.2% 4.8%
Washington 7,277,536 $20,644,454 $0 0 $0 $12,517,831 60.6% $3,723,403 18.0% $317,495 1.5% $0   $1,396,989 6.8% 5.5%
Wyoming 587,910 $2,356,323 $0 0 $0 $811,105 34.4% $183,745 7.8% $0 0.0% $883,913 37.5% $153,768 6.5% 8.1%

Exhibit 2

General Fund/ General Purpose Appropriation History (millions of dollars)   
Fiscal Year Appropriations Dollar Change Percent Change
2000-01 $9,744.4 $136.7 1.4%
2001-02 9,189.3 (555.1) (5.7)
2002-03 8,830.9 (358.4) (3.9)
2003-04 8,770.1 (60.8) (0.7)
2004-05 8,702.8 (67.3) (0.8)
2005-06 9,106.3 403.5 4.6
2006-07 9,118.7 12.4 0.1
2007-08 9,980.7 862.0 9.5
2008-09 8,568.7 (1,412.0) (14.1)
2009-10 7,787.4 (781.2) (9.1)
2010-11 8,424.6 637.2 8.2
2011-12 8,341.1 (83.6) (1.0)
2012-13 9,024.2 683.2 8.2
2013-14 9,571.3 547.1 6.1
2014-15 9,691.1 119.8 1.3
2015-16 10,149.6 458.6 4.7
2016-17 (initial) 9,975.3 (174.3) (1.7)
       
Change FY 2006-07 to FY 2016-17   $856.6 9.4%
Detroit CPI 10-Year Percent Change     12.6%

Note: Does not include Budget Stabilization Fund appropriations of $362.7 million, $140.0 million, $75.0 million, $94.0 million, and $95.0 million for Fys 2011-12, 2012-13, 2013-14, 2014-15, and 2015-16, respectively; does not include $230.0 million FY 2013-14 appropriation for the Roads and Risks Reserve Fund.

Source: State Budget Overview. Ellen Jeffries, director, Senate Fiscal Agency. October 1, 2016. Retrieved 1/18/17: http://www.senate.michigan.gov/sfa/Publications/BudUpdates/StateBudgetOverview_MostRecent.pdf.

Exhibit 3
Initial GF/GP Appropriations FY 2016-17 
Department/Budget Area  
Health and Human Services $4,374,548,300
Corrections 1,951,957,900
Higher Education 1,243,904,500
Technology, Management and Budget 485,518,600
State Police 402,662,800
School Aid 218,900,000
Judiciary 189,157,400
Talent and Economic Development 179,388,900
Legislature 137,227,800
Treasury-Debt Service 137,037,000
Community Colleges 135,510,800
Treasury-Operations 98,408,800
Education 76,181,200
Military and Veterans Affairs 55,243,600
Agriculture and Rural Development 49,926,900
Environmental Quality 47,736,400
Licensing and Regulatory Affairs 43,721,100
Attorney General 42,840,500
Natural Resources 39,910,000
State Police 22,109,600
Legislative Auditor General 16,123,900
Civil Rights 13,021,300
Transportation 8,500,000
Executive 5,636,300
Insurance and Financial Services 150,000
Treasury-Revenue Sharing 0
Total GF/GP Appropriations $9,975,323,600

Source: State Budget Overview. Ellen Jeffries, director, Senate Fiscal Agency. October 1, 2016. Retrieved 1/18/17: http://www.senate.michigan.gov/sfa/Publications/BudUpdates/StateBudgetOverview_MostRecent.pdf

 

Related Events

Related Articles

Related Resources