Restructuring: Why does the federal government impose income tax rates on States?

With the current buzz around Restructuring, one critical part has to be devolution of power from the center to the states. Most times, the discussion is invariably reduced to why the FG needs to have a smaller share of revenue than it currently does. And that is how the discussion usually dies — no one wants to give up something s/he currently enjoys.

But that is only true if we narrow these discussions around sharing of revenue. We need to start looking at areas the FG can devolve more powers to the states without losing anything. One of such is the power to set income tax brackets and rates.

I’ve always wondered who thought it wise to give the FG power to set income tax rates, given that unless you live in the federal capital or you are a member of the Army, you pay your tax to the states. So why not allow the state determine what to charge its taxpayers? It is just another of the many incursions by the center into what should be left to the states in a true federation.

I’ve given this much thought and it is difficult to see any downside to letting states set their own income tax rates. But there are many advantages.

For one, allowing states to determine tax rates could start a much-needed competition among them. One example that immediately jumps at me is the ongoing duel between Ogun and Lagos. Between 2011 and 2016, Ogun state IGR increased from N7 billion annually to N34 billion and this is largely due to the campaign by Governor Amosun to get Ogun residents who work in Lagos to pay their tax to Ogun, as statutorily required (interestingly, the Commissioner of Finance in Ogun State during this drive was Kemi Adeosun, the current Minister of Finance). Yet the Governor insists there a tens of thousands of residents who still remit their tax to other states. Lowering income tax rates by 3 basis points below those of Lagos (for example) could encourage more Ogun residents working in Lagos to ask their HR departments to compute and remit their tax in Ogun.

Also, reducing the tax rates becomes more enticing for anyone who is thinking of either developing his/piece of land in an area of Ogun close to Lagos or renting an apartment in Lagos. To be clear, tax rate in itself might not be enough to entice people to relocate away from a state (since that assumes a lot of people pay tax, which is not entirely true) but when combined with other incentives like good access roads and decent power, it becomes very enticing. This may seem far-fetched, but I don’t see how it’s worse than the system we currently have. When I moved to the US, my friends (most of whom live in Texas) wanted me to move to Texas and enjoy paying zero state income tax (Texas is one of seven states what do not impose state income tax — residents only pay the federal tax). Who knows, Ogun state can entice companies to move their factories to the state if it promises to slash employee taxes. In fact, states with very low or zero income tax attract a lot of small businesses because they are classified as “pass-through” entities (I’ll blog on this next).

They may exist, but I cannot think of many countries that imposes tax rates on states. I thought of South Africa but they determine income tax rates centrally because income tax is collected centrally. As I said before, I do not see any downside to allowing states set their own income tax rates. Of course there is always the risk that a state like Lagos that is aggressive with tax revenue generation but is chronically opaque in accounting for how they use tax can raise tax rates astronomically. But it’s a little risk in the face of what should be a bigger discussion around giving more powers to the states. One thing is sure, this is one area where the federal government loses nothing if they get out of the business of telling states how much tax to charge their residents.

As they should do in many other areas.

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