A lot of state governments are in trouble, afflicted as they are with high expenses and weak revenues. They need to be thinking clearly if they are to have any hope of solving their problems. Unfortunately, lots of fuzzy thinking occurs when it comes to taxes. The biggest problem is that many people think that average taxes matter. They don’t.
California governor-elect Jerry Brown’s slide show supporting his “Budget Discussion” is an example. On slide 15 he shows state revenues per $100 of personal income with the headline “California Ranks 15th in Taxes and Fees Compared to Other States.” The implication is that California is a relatively tax-friendly state. It’s not.
Similarly, many Oregonians were encouraged when this report came out. Figure 2 ranks states by the ratio of business taxes to government expenditures, implying that Oregon is a tax-friendly state. It’s not.
With one caveat, average taxes don’t matter, whether expressed as a ratio to income, a ratio to spending, or in any of the myriad ways we see it. Businesses make decisions based on marginal tax rates, not average taxes. Averages are only useful in comparison to marginal rates, because a big difference between the two is an indication of a poorly designed tax system. In particular, high marginal tax rates and low average revenues are signs that the state is both sacrificing revenue and hurting its economy.
Oregon has, along with Hawaii, the nation’s highest personal marginal tax rate, but it ranks low on average taxes. It is clear that the state’s tax structure is flawed. Oregon’s major problem is that it has no retail sales tax. It could increase state revenue and economic activity if it implemented a retail sales tax while cutting its top marginal tax rates.
California has a different problem. It has among the nation’s highest retail sales taxes, and it has a very progressive personal income tax with high top marginal tax rates. California could increase state revenue and economic activity by lowering retail sales taxes and top marginal rates, while increasing property taxes and broadening its income-tax base by decreasing the progressiveness of its tax rates.
For states with inefficient tax structures, changing the tax structure can result in the equivalent of free lunch. A well-designed tax structure will increase revenues, decrease revenue volatility, and increase business activity. What’s not to like?