Tax the Rich? How's That Working?

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When David Paterson became governor of New York after Eliot Spitzer's hooker escapades, the former state senator from Harlem shocked New Yorkers by declaring that taxes were too high and that he had many friends who had left the state because there were better opportunities elsewhere. New York had to grab control of its spending rather than continue raising taxes, said the former state senator with a long tax-and-spend track record, in what amounted to the equivalent of ideological heresy.

Still, as a political lightweight and accidental governor, Paterson quickly got rolled by the big-government wing of his own party, who passed a budget for this year with $6.1 billion in projected new taxes and fees, led by sharply higher rates starting for those earning more than $200,000 a year. Asked if the budget made sense in the recession an outgunned Paterson said, "None of this makes sense."

I suppose it is cold comfort to New Yorkers that Paterson is now giving his political enemies the "I told you so" treatment. Speaking to reporters recently in Albany, Paterson noted that revenue from tax increases was running 20 percent below projections and that, in particular, the wealthy were not paying up. So far, the state had only collected about half of an expected $1 billion in income tax revenues from the state's wealthiest residents. "You heard the mantra, 'Tax the rich, tax the rich,"' Paterson said. "We've done that. We've probably lost jobs and driven people out of the state."

In a story about New York's tax woes, the Associated Press noted that other states that had enacted so-called millionaires' taxes (most of which, like New York's, start well under $1 million in annual income) were squirming upon hearing the New York's numbers. Actually, some of these states have been squirming for a while.

New Jersey enacted its half millionaire millionaires' tax in 2004. Pitched by the state's unions as the cure for Jersey's budget woes, the state collected $9.5 billion in personal income taxes in fiscal 2005. Last year, four budget cycles later, the state collected only $10.3 billion and this year it's estimating just $9.4 billion from the same tax. Revenues have fallen so far below projections that Jersey has actually had to cut its spending (not just its rate of spending, like most states) by more than $3 billion this year despite $2 billion in federal stimulus aid for the state budget. And even so, Jersey had to skip payments to its pension system. If it were a business Jersey would be insolvent, a remarkable achievement in a place whose residents boast the highest personal income in the nation.

Maryland enacted its millionaires' tax in the fall of 2007. Earlier this year the state scrambled to enact mid-year budget cuts because of a sharp shortfall in revenues. Year-to-date personal income tax collections are off by about $650 million, and the Maryland comptroller has said, "It seems reasonable to assume...that there will be a significant decline in the number of returns with taxable income over $1 million and a substantial decline in the income reported on those returns."

In each of these states there has been a debate about whether high taxes have driven the rich to relocate. Shortly after the New York State budget passed, Tom Golisano, a former Independent Party candidate and the owner of the Buffalo Sabers hockey team, said he was moving to Florida to escape the Empire State's high taxes, which amounted to $13,000 a day in his case. The head of the Working Families Party, the New York party founded by the state's unions and Acorn that had lobbied for the tax increases, said good riddance to Golisano. The New York Times, meanwhile, observed that people don't relocate because of high taxes, although at $13,000 a day the motivation for leaving seems pretty high.

But the issue goes beyond very rich guys like Golisano with a big nest egg and lots of personal mobility. Many small and mid-sized businesses that organize as sole proprietorships, partnerships and s-corporations report their earnings through the personal income taxes of the partners or owners, and hence they pay taxes at individual income tax rates. In fact, small business owners and partners are the main target of tax increases at the top rates. A 2003 study by the Tax Foundation found that two-thirds of taxpayers in the highest tax bracket report income from businesses on their tax forms. So it's not surprising that high individual tax rates discourage entrepreneurship, reduce investment and slow hiring at small firms. You don't have to scour a state to find rich people mad enough to leave in order to understand the impact of high income tax rates on a local economy.

Still there's more bad news for the states with the highest rates, which include California and Ohio. At the very least we are about to see the top two federal brackets boosted to 36 percent and 39.6 percent, and who knows what other federal tax increases are on the way. Those rises will almost certainly depress adjusted gross income among high-earners who either seek to shelter more of their income or simply work less because their next dollar earned is being taxed at a significantly higher rate. That will make it even harder for states with high tax brackets to hit future income tax projections.

In most states with double-digit (or near double-digit) top tax brackets, the combined federal and state tax bite will thus soon reach 50 percent of income, especially when you consider that the federal alternative minimum tax excludes many deductions by higher income households (including big, fat deductions for hefty state and local taxes). Add to that the fact that some states have further raised taxes by excluding some traditional deductions (New Jersey, for instance, has eliminated the property tax deduction for most households, a cruel irony in a state with the highest property taxes in the nation), and the result is a whole new definition of what even constitutes taxable income.

The pain might not be so intense if residents of these states were getting something for all of this extra taxation. But in fact the state motto in some of these places could be "High taxes, lousy government." Jersey, with the highest state and local taxes, has one of the worst performing governments in the country, according to Governing Magazine, and it invests so little in its infrastructure its roads have been rated the worst in the nation. New York, which spends much of its state budget on a Medicaid program that is twice as large as any other, doesn't have a healthier, better-cared for low-income population. California, which spent billions of dollars to lower public school class-sizes, has seen no payoff in higher test scores or graduation results.

The really bad news, however, is that there is no easy way out of this for many of these states. Their budget problems are structural and long-term and can't be fixed merely by trimming a little waste and pork here and there. Most of these states have wracked up huge debts, for instance, so that bond payments are now weighing down their balance sheets. Their bondholders must be fed or chaos will ensue.

These states also suffer from huge public employee pension and benefits obligations that are often guaranteed by law. In fact, the pension funds of these states are so underfunded they make the Social Security Trust Fund look solvent by comparison.

These long-term structure problems are one reason why prospects for local tax revolts of the type we saw in the late 1970s and early 1990s have been slow to materialize. Any reformer who looks closely at these budgets understands that the only way out are service cuts that will be felt by virtually everyone in the state.

Faced with unpalatable choices, these states sit and hope that the answer comes in the former of even more stimulus money from the Obama administration given directly to states to spend on government operations. But rising anger from politicians and citizens in states that have been fiscally responsible will make that harder.

In the next few years, it seems, we will truly test the notion of whether people will get up and move simply because of high taxes. Oh, and bad government.


Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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