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Cutting State Income Taxes Has a Major Payoff: Job Creation

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Unless you live in one of the seven states that raises revenue without taxing citizens’ income—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—you’ve probably thought about how nice it would be not to pay state income taxes on top of federal income taxes.

After all, getting rid of this pesky paycheck deduction would increase your cash flow immediately. But do you know about the other, more long-term benefit that states, themselves, enjoy when they don’t charge income tax?

It’s an increase in job creation.

States With High Income Taxes Lose Jobs

Let’s first look at what happens in states with high income taxes. A state’s economic performance has several moving parts: population, labor force, employment, and output. Raising state income taxes leads not only to fewer jobs created, but also to less state revenue collected because of a combination of factors that involve the pieces above, according to “Wealth of States” (p. 24).

People vote with their feet. If they don’t like their tax rate, they move to another state with more appealing tax policies. What the authors of “Wealth of States” have proven is that each of the 11 states that adopted a state income tax after 1960 (Maine, Rhode Island, Connecticut, New Jersey, Pennsylvania, West Virginia, Ohio, Indiana, Illinois, Michigan, and Nebraska) ranked in the bottom half of population growth between 2002 and 2012 when compared with all 50 states (p. 30–32). Some examples include a population decrease of 50 percent for West Virginia between 1956 (five years before the state income tax) and 2012, a 38 percent decrease for Pennsylvania, a 37 percent decrease for Ohio, a 35 percent decrease for Michigan, and a 34 percent decrease for Illinois (p. 3–5).

As people migrate from states with high income tax rates to states with low or zero income tax rates, overall state output from businesses and entrepreneurial efforts goes with them. Subsequently, there’s been a decrease in these 11 states’ gross state product share compared to the remaining 39 states (p. 15). What does less output mean? That’s right: fewer jobs.

States Without Income Tax Fuel Job Creation

On the other end of the spectrum, “Wealth of States” notes that “eight of the nine zero-personal-income-tax (PIT) states were in the top half of decadal population growth” between 2002 and 2012 (p. 30). Over the past decade, “the average equal-weighted nonfarm employment growth for the nine zero-earned-income-tax states was 7.2 percentage points higher than the average of the nine highest earned income tax rate states, or 8.9 percent and 1.7 percent, respectively” (p. 59).

It’s no secret that states need money to run their governments, but collecting income tax is not the only revenue tool available; it’s not necessarily the best one. In “Wealth of States,” the authors explain that “the ideal spending and tax code for a state would be one where the damage done by the last dollar of tax collected is just a smidgen less than the benefit provided by the last dollar spent” (p. xxiii).

What are some better taxes states can impose? Research has shown that the sales or consumption tax is one of the least damaging taxes (p. 82–87). Moving to this sort of tax system—and there’s been increasing state interest in doing just that—can lead to a boost in job creation. And that is what we call good news for the average American.

Amanda L. Grossman is the creator and owner of FrugalConfessions.com -- live a VIP life on an average paycheck -- where she shows hard-working people how to end anemic savings account syndrome and pay off debt years earlier than your creditors want you to without getting a second job or eating ramen noodle dinners. Amanda's area of expertise is in personal finance, and she has authored several personal finance articles for the Houston Chronicle, is a featured blogger at the Houston Chronicle, and has staff written for ReadyforZero.com Blog and RelayRides.com Blog (several of which have been syndicated to LifeHacker, Business Insider, and Yahoo Finance). She has a knack for taking seemingly complex, and irrelevant financial topics and making them accessible and meaningful to the average person. She, her husband, and their two cats (Lyla Bear and Danny Boy) live in a fixer-upper in Houston TX.