Do State Taxes REALLY Impact Inequality?
Explaining a Complex Argument
Yesterday, my previous piece outlining the impact of state taxes on income inequality and migration got some discussion on Twitter. It was interjected into a discussion of Missouri tax policy, and a Show-Me State resident offered some criticisms of my work. Polemics aside, some of the questions raised may be worth clarifying. You can find John Davidson’s critique of my work here. I’m going to run through it piece by piece and offer some elaborations on my previous research, that I hope will be useful for policymakers in Missouri who find themselves in what I can only assume to be a particularly acrimonious debate. As I’ll show, the research demonstrating the connections between migration, taxation, and inequality is pretty much exactly as I’ve previously characterized it.
John characterizes my argument (that state income taxes in a federalized system with migration will tend to boost pre-tax inequality) as “ the most extreme argument for no state taxation I have read.” I think that’s an unfair way of describing my position.
First of all, I have never argued, and would never argue, for “no state taxation.” I suspect Missouri policymakers aren’t considering abolishing all taxes either. But beyond that, my model is not even necessarily an argument for less state taxation. There are many people who may prefer higher pre-tax inequality if it creates a post-tax society that they like more. As I explained in my previous piece, “Comparing inequality in a hypothetical flat-tax economy versus the same economy with a progressive tax, pre-tax inequality is probably higher in the progressive tax case, but after-tax inequality may be slightly lower.” If what you care about is after-tax inequality, then more progressive taxes may help you reach that goal. But they will also create higher pre-tax inequality.
This isn’t a new or radical argument, by the way. It was most famously explained by Martin Feldstein, who was, at the time, the President of the National Bureau of Economic Research. In his paper “Can State Taxes Redistribute Income?” he argues that the answer is, basically, no, not at all. Migration prevents all state-level redistribution. Follow up work by Andrew Leigh finds that, actually, this effect is probably not as extreme as Feldstein argues: pre-tax wages do not fully adjust to state taxes. Leigh’s method, however, precludes him from exploring the degree to which any incomplete adjustment may occur. I adopt the position best supported by these and other papers I reviewed: given the possibility of migration between states, any progressive impact of state taxation will be partially offset by wage negotiations for skilled workers. That’s all. It’s a partial offset.
If you want to ensure that the marketplace offers people more equal salaries, progressive taxation is counterproductive. But if your goal is just to make sure people have more equal incomes, regardless of the source, then progressive taxation may work, but not quite as well as you might expect. This doesn’t mean there’s no reason to pursue progressive taxation: as I said, plenty of people will rationally choose a world with higher pre-tax inequality and lower post-tax inequality. But it is a real offset that should be considered when policymakers weigh their options. If they ignore the role of state income taxes in setting the level of inequality, policymakers will ultimately go the way of New York and California, turning their states into zones of zero opportunity for those not already rich or extraordinarily talented.
The next argument John makes is that I’ve mischaracterized the incidence of taxation. For those who don’t know the terms, the incidence of taxation means who “really” pays the tax. Just because you pay the bill doesn’t mean you bore the full burden: maybe prices or wages adjusted to have other people bear some of the burden.
But here, John says there’s no evidence high-earners negotiate for higher wages. Except, there is. Research on wage negotiation is wildly abundant, and mostly focuses on high-earners (or collective bargaining for lower- and middle-income workers). I’m assuming John doesn’t mean what he seems to mean here, because it’s hard to imagine a world where high-earners don’t negotiate their wages. Here’s explicit published research proving that at least some high earners negotiate wages and locations based on tax rates.
I’m not arguing here that floods of rich people cascade in and out of areas based on small tax differences. I’m just saying that, yes, high income people, who usually have specialized skills, do arbitrage their tax burdens. Sometimes through migration but usually through wage negotiation. They push for higher wages to offset taxes.
John links an interesting article by Noah Smith on tax incidence, but he doesn’t properly translate the analogy involved. Noah is talking about a hypothetical massive tax cut: if taxes fell, who would get the extra dough? He argues high-skill people would get more money. Maybe, maybe not; I suspect firms would hang onto a lot of it, and maybe hire some more workers. But the example of a sudden tax cut is not analogous to the case of given tax policies that vary across regions. I’m not confident Noah’s analogy is very good even for the case he describes, but it certainly doesn’t apply here. I rather suspect if asked, he would agree that high-skilled people have more bargaining power and are therefore more likely to seek to offset their tax burdens through negotiation.
And John’s apparent claim that the incidence of taxation falls on employers for low-wage workers is difficult to understand. When taxes rise, the wages of low wage workers are not likely to rise, but the wages of high-wage workers are relatively more likely to rise. To argue otherwise is strange: does anyone actually think that hiking income taxes will directly cause wage increases for low-earners?
John’s next concern with my work is that I characterize returns to high-earners as “excessive.” I’ll grant that the word is a value judgment that others may dispute. But let’s think about what’s going on here.
Imagine a doctor who makes $300,000 a year and pays a flat tax of 20%, so $60,000. The doctor is willing to work for these wages. She has high income because, as John notes, she invested in her human capital. Well done Ms. Doctor. Imagine that she has a son who is in high school, and he works for $9/hr part-time, say he makes $10,000 a year. We have a flat tax, so he pays 20% too, or $2,000.
Now imagine we shift to a progressive income tax. The low-earner rate falls to 10%, the high-earner rate rises to 30%. Now Ms. Doctor pays $90,000 in taxes. But she’s skilled and is a prized worker at the local hospital, so she negotiates with her employer and gets a $30,000 pay raise. Now her pre-tax pay is $330,000, her taxes will be $100,000, and she has just slightly lower after-tax income than she had before.
That extra $30,000 in salaries is essentially a shift of the tax burden from Ms. Doctor to her employer. It leads to her receiving “excessive” wages because her wages have risen without regard to any change in productivity or other market forces. They went up purely for arbitrage and a kind of monopolistic economic profit. Now, her after-tax wages were the same, but the point of a tax increase on the rich is that the rich people will pay those taxes, not their employers (and therefore ultimately customers). So in the long run, much of the incidence of this higher income tax falls on customers, shareholders, and other employees.
Some people will rationally choose to favor progressive taxes even given such excessive returns: because they believe the price is worth it. And there’s a good argument for that! The higher taxes may pay for valuable services, and of course Ms. Doctor’s son’s taxes fell by $1,000, so low-income people benefited. After-tax inequality in our two-person economy is meaningfully lower. But pre-tax inequality is substantially higher.
John discusses some issues related to growth economics and high-skilled labor, which I don’t think directly relate to the question at hand, but then, he gets to an interesting question: case studies of specific states. He believes that Minnesota is the luminary example of the success of progressive governance, while Missouri is a good example of the opposite.
Let’s start by looking at inequality. Using data from the American Community Survey for household inequality, and historical data from the Census Bureau, we can get state-by-state breakdowns for inequality. The states that have had the least increase in inequality since 1979 are Alaska, South Dakota, Mississippi, Arkansas, Oklahoma, Wyoming, Idaho, Alabama, Nebraska, and Hawaii. I count 9 red, 1 blue.
The states with the most increase in income inequality are Connecticut, New York, New Jersey, Illinois, Massachusetts, California, DC, Ohio, Rhode Island, and Pennsylvania. I count 8 blue and 2 purple.
Now, it’s true Minnesota’s increase has been slower than the nation on the whole: well done! But it’s actually seen faster rising inequality than Missouri. Indiana and Michigan have both seen even faster rising inequality than either Minnesota or Missouri, but then again still slower than the cluster of blue states that are remarkable for their rapidly-rising inequality. In other words, for all Minnesota’s alleged good governance, inequality rose faster than many red states, and faster than Missouri, the state John wanted to compare.
Beyond that, as regular readers know, Minnesota’s record is not nearly as good as its advocates claim. It should not be held up as the example for everyone to follow, because its example is not that spectacular, and what good things it does have going for it often have little to do with local policies. Frankly, the same can often be said for Texas, where conservatives tend to overstate the case.
But as John noted, we can also compare states that may be more apples-to-apples. In my previous work at the Tax Foundation, I did this quite regularly. Here’s a discussion comparing Michigan and Minnesota: again, Minnesota’s record just is not that special. Here’s one comparing Illinois and Indiana, and here’s one looking at Indiana versus Ohio and Wyoming versus Colorado. Here’s a summary of inequality in the states and its relationship to taxes.
To make a long story short, my original argument holds: more progressive taxes tend to increase pre-tax inequality. With so many policymakers concerned about inequality, this is a very real trade-off that must be considered. Concerns about inequality alone are not sufficient to torpedo a given tax plan. There are plenty of other tradeoffs that may make the higher pre-tax inequality worth it for many people. But at that point, we’re really talking about political preferences, not economic questions. At the end of the day, economics can’t tell you how progressive your taxes “should” be. But we can point out costs and benefits associated with a given policy, and a higher base level of pre-tax inequality is one cost associated with higher and more progressive income taxes.
See my post reviewing the literature on taxes and migration.
See my last post, about migration and economic mobility.
Start the series from the beginning!
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I’m a graduate of the George Washington University’s Elliott School with an MA in International Trade and Investment Policy, and an economist at USDA’s Foreign Agricultural Service. I like to learn about migration, the cotton industry, airplanes, trade policy, space, Africa, and faith.
My posts are not endorsed by and do not in any way represent the opinions of the George Washington University nor the United States government or any branch, department, agency, or division of it. My writing represents exclusively my own opinions. I do not receive any financial support or remuneration from any party for this research.
