Eliminating the State Income Tax: A Look at Indiana and Illinois

By  | 

Several states that traditionally have some of the highest personal income tax rates in the nation have also lost the most revenue in recent years, as revealed by IRS data on tax migration. These states include California, Illinois, Massachusetts, Michigan, New Jersey, New York, and Ohio. A common factor among many of the states that gained revenue during this time was that they have no personal state income tax.

Currently, seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—do not tax any form of personal income. Two more states, New Hampshire and Tennessee, require no taxes on noninvestment income. As a growing number of states consider either withdrawing or reducing their personal income taxes, does the freedom that comes from not having to file a state tax return yield a positive economic return for a state?

A Tale of Two States

To understand the logic behind eliminating a state’s income tax, let’s take a look at Illinois and Indiana, two neighboring states that couldn’t be more different. According to WalletHub, Illinois has the worst personal tax obligation in the nation, with the average resident paying $7,719 in state and local taxes, or 37 percent more than the national average. This is partly due to a temporary 67 percent tax hike passed in 2011 that was designed to help close a growing state budget gap. In January of 2015, however, income taxes were rolled back by 25 percent across the board. With income tax revenues suffering due to a growing reliance on market-volatile wealthy taxpayers, Illinois may require a major tax reform to gain financial stability.

The tax situation in Illinois has resulted in over $31 billion lost in adjusted gross income (AGI) since 1992 to states such as Florida ($7.2 billion gained) and Texas ($2.4 billion gained).

Meanwhile next door, Indiana ranks at number 35 on WalletHub’s list. The state imposes a flat 3.3 percent tax rate on all personal income, with tax deductions available for rent, out-of-state income, and elderly and handicapped living support. With the average resident paying $6,245 in state and local taxes, Indiana state residents pay a 7 percent state sales tax and a property tax capped at 1 percent of a property’s value. This has led to projections of actual revenue growth through fiscal year 2017.

Though the two states match closely in flat income tax rates now, Indiana has only lost slightly over $3 billion in AGI since 1992. With the newly lowered tax rate in Illinois, the state is hoping to keep their revenue where it belongs.

Sales Tax vs. Income Tax

In theory, a no-income-tax state revenue system would rely on sales and excise taxes to fund the government. Advocates argue that this would promote growth, because savings and investments would no longer be taxed. If more income is free from taxation, more money would be available for capital assets, reinvestment, and local infrastructure. While a sales tax-dependent model would require a larger sales tax rate and perhaps broader array of taxable goods, it would still represent tax savings for most.

Like most issues surrounding taxes, the income tax debate is complicated. While elimination of the tax may be a popular solution, it needs to be weighed against the funding philosophy of the state.