Millionaire's Taxes Hit a Reality Roadblock

This month, Governor Tim Pawlenty successfully resisted an attempt to institute a "Millionaire's Tax" on high-income people in Minnesota. In New Jersey, Governor Chris Christie is standing firm in his insistence that a temporary high-income tax surcharge won't be extended this year. By taking these stances, Pawlenty and Christie are bucking a trend that took (mostly blue) states by storm last year, for the long-term benefit of their states' budgets and economies.

Minnesota's budget scramble arose when the state Supreme Court invalidated $3 billion in budget cuts that Pawlenty had imposed unilaterally. The legislature responded by sending a budget-closing bill to Pawlenty, which would have raised the top income tax rate from 7.85% to 9.1% for single taxpayers making over $113,110 per year (or married couples over $200,000). As such the tax would kick in at a lower income than other states' taxes on the well-off - but not by much, as Oregon has a Millionaire's Tax threshold of $125,000, followed by Hawaii and Maryland at $150,000.

In any case, Minnesota will not test the question of whether a taxpayer who just barely passes the Social Security tax cap can really be liable for "Millionaire's Tax", or at least not this year. Pawlenty promptly vetoed the bill, and won the ensuing showdown. This weekend, in an overnight session, the legislature passed a budget closing the gap solely with spending cuts - largely legislating what the Governor had tried, and failed, to do by fiat.

Meanwhile in New Jersey, the Democratic-controlled legislature wants to extend 2009's temporary income tax increase to apply in 2010, but Christie has repeatedly said that he will veto any tax increase bill. Lately, Christie's insistence that he won't raise taxes has taken on a General Sherman-meets-Green Eggs and Ham vibe.

"Let me be real clear on [the tax increase]," Christie said earlier this month. "They can call it whatever they want to call it. They can package it however they want to package it. They can send it to me with a bow on it. They can send it to me in a nice box, gift-wrapped. They can throw it over the transom and leave it there and hope nobody smells it. No matter how they send it to me, it is going back. It is going back with a veto on it. We are not raising taxes in the state of New Jersey this year."

Pawlenty's and Christie's actions go against a national trend. Since 2008, eight states have imposed income tax increases that apply only to high-income people: Connecticut, Hawaii, Maryland, New Jersey, New York, North Carolina, Oregon, and Wisconsin. Meanwhile, only three states raised the income tax in a broad-based manner: California raised rates on all tax brackets, Delaware raised income tax for people making more than $60,000, and Ohio cancelled a scheduled income tax cut.

These tax increases have been saleable to voters as a tax on somebody else; Oregon's Millionaire's tax (and associated business tax increases) were even approved by voter referendum. Californians, on the other hand, were asked to approve a broad-based tax increase and rejected it.

It's not surprising that Millionaire's Taxes are tempting for legislators. But states increase their reliance on high-income taxpayers at their peril, for two reasons.

One is that wealthy people tend to have the most volatile incomes, especially because they often have significant capital gain income that goes away when stock markets crash. California, which has the most progressive income tax code of any state, has seen some of the country's wildest revenue swings in the recession, contributing to its worst-in-the-country fiscal situation.

High volatility is even being seen with brand-new Millionaire's Taxes. As economic projections were revised downward through 2009, states realized they would not get as much revenue as expected from new taxes. New York raised its top rate for taxpayers earning over $500,000 from 6.85% to 8.97%, expecting to raise an extra $4 billion in 2009 - and has already fallen at least 10% short, with the gap likely to widen due to weaker-than-expected revenues with 2009 tax filings in April of this year.

Even more importantly, increased tax progressivity appears to have negative effects on states' economic prospects. A recent paper by Prof. Barry Poulson of the University of Colorado looked at states' economic growth and tax progressivity over time. He found that higher marginal tax rates correlated with lower economic growth, and greater tax regressivity correlated with higher economic growth.

This result isn't surprising. Because barriers to mobility are so much lower between states than countries, states are less able to impose greater tax progressivity (i.e., higher rates on high income people) without driving taxpayers and/or capital to lower tax jurisdictions. Federal tax changes to come in 2011, which will reduce high-income taxpayers' ability to deduct the cost of paying state income taxes, will heighten the competitive advantage of low-tax states over high-tax ones.

This story should particularly hit home for New Jersey residents. The 2009 tax surcharge was an increase to the state's already-existing Millionaire's Tax, enacted in 2004. A recent Boston College study found that, while New Jersey experienced a net wealth inflow of $98 billion from 1999 to 2003, this changed to an outflow of $70 billion from 2004 to 2008, as wealthy people chose to settle elsewhere. Extending an even-higher Millionaire's Tax could be expected to exacerbate the wealth flight.

Of course, revenue volatility and effects on economic growth are most important if these taxes become a permanent feature of state tax codes. Will they? Like many of the Millionaire's Taxes enacted or increased in the last two years, the proposals in Minnesota and New Jersey were for temporary increases: Minnesota's would have expired in 2013, and New Jersey's was to apply for 2010 only. But taxpayers reasonably fear that these increases could be made permanent.

Milton Friedman's observation that "There is no thing so permanent as a temporary government program" is often applied also to tax increases. In fact, the record is more mixed, and temporary tax increases sometimes do sunset: notably, New York raised income taxes temporarily in 2002, and California in the early 1990s, with both states allowing the increases to sunset after several years.

But tax increases in the current budget cycle are far more likely to be permanent. A temporary tax increase can be expected to sunset if it is used to close a cyclical deficit; when the economy improves and the state's finances return to normal, previous tax levels should be sufficient to cover government spending. California's tech bubble of the 1990s and New York's finance bubble of the 2000s helped matters by inflating tax revenues as the states climbed out of recession.

Today, most states face significant structural deficits in addition to cyclical deficits, and these can only be closed with permanent spending cuts or tax increases. In the absence of permanent reforms to spending programs, taxpayers can expect that "temporary" tax increases will be here to stay - and that states enacting Millionaire's Taxes will suffer competitive disadvantages on a permanent basis.

In this context, Governors like Christie and Pawlenty are wise to draw a line in the sand against tax changes that would make their states' tax codes less efficient and less competitive. Their alternative solution - spending reforms that will bring their states' budgets toward sustainability at current tax levels - bodes better for their states' economic prospects.