The state tax-cutting momentum that began unexpectedly during the pandemic has accelerated as 2023 dawns. This year, residents of 11 mostly Republican-leaning states are set to enjoy cuts to their individual income taxes, according to the Tax Foundation. That’s on top of an equal number of states that trimmed their income-tax rates in 2022. A handful of states have also sliced business taxes and reduced or suspended levies on gasoline and groceries, amid rising inflation.
Behind these reductions lie the faster-than-average recovery of tax collections from lockdowns and the flush budgets enhanced by $500 billion in stimulus funds that the Biden administration sent to states, cities, and school districts via the American Rescue Plan Act. Though some local governments have chosen to spend most of their money, others have used the budgetary cushion to bolster their economic competitiveness by lowering tax bills.
All this seemed unlikely when the pandemic first struck. Not only did Covid’s effect on hospitals and the larger health-care system strain state budgets, but lockdowns also shuttered large sections of the economy, leaving experts predicting as much as $200 billion in tax-revenue shortfalls for the states in fiscal 2020 and 2021. Instead, the rise of remote work and an unlikely bull market in 2021 boosted tax collections, even as the federal government passed several packages offering trillions of dollars in aid and stimulus to local governments, out-of-work individuals, struggling firms, and overburdened health-care facilities. Thanks to these actions, by May 2022, one study found, states had amassed more than $200 billion in surplus funds.
Ten of the states cutting individual taxes this year are Republican-led or -leaning. Indiana, for instance, has reduced its flat income-tax rate to 3.15 percent from 3.23 percent for the next two years, with the potential for the rate to fall further to 2.9 percent if revenues keep growing. Iowa, which cut taxes in the last two legislative years, is reducing the number of income-tax brackets from nine to four, lowering its top rate from 8.53 percent to 6 percent, and bringing down its highest corporate tax rate. New Hampshire is phasing out its taxation of dividends and interest on individual income taxes and reducing the top rate of its business-profits tax.
New York is the only solidly blue state that has joined the income tax-cutting party. The state is speeding up tax cuts originally passed in 2016 but delayed by legislation until 2025. Middle- and upper-middle-class taxpayers will see their rate fall this year to 5.55 percent from 5.85 percent. However, that cut comes on the heels of big tax hikes on the wealthy enacted by New York in 2020. Another strongly Democratic state, Massachusetts, is the only jurisdiction raising income taxes this year. Though media accounts described the state’s budget as “awash in cash,” Bay State voters passed a teachers’-union-backed ballot initiative in November that boosts income taxes on the wealthy by $1 billion.
One movement gaining momentum is a return to the flat-tax model: a single rate for all payers. This year, Mississippi has eliminated income taxes on those earning less than $10,0000 annually, and the state will begin cutting its top rate starting in 2024, with the goal of a single 4 percent tax rate by 2026. Iowa’s tax reductions this year are part of a plan to convert to a flat-tax rate of just 3.9 percent by 2026. Robust tax collections in Arizona triggered a move this year away from two tax brackets to a single 2.5 percent rate. These states join nine others that already have a flat tax.
These changes take effect as the latest reports on migration among the states confirm a growing flight out of high-tax East and West Coast states. The states receiving the most residents in 2022, according to the U-Haul Growth Index, were Texas and Florida, neither of which levies an individual income tax, and the Carolinas. Other low-tax states, like Tennessee, also stood among the top ten. By contrast, the biggest losers included California, which has the highest income-tax rate in the country, and such other high-tax states as New York, New Jersey, and Massachusetts. These migratory patterns, the U-Haul report noted, were part of a trend that the pandemic spurred on in 2021—a record-breaking year for moves by residents among the states.
Perhaps those big gains in residents and businesses by red states will encourage even more reductions. Budget season is just beginning; already, a number of governors have proposed slicing taxes, including Republicans Jim Justice of West Virginia and Glenn Youngkin of Virginia. Democrat Ned Lamont, the Connecticut governor, also potentially joined the party, saying that he will propose a “middle-class” tax cut.
The tax cuts come amid efforts by the Federal Reserve to raise interest rates, cool off the economy, and tame inflation. Fortunately, the bounty of the last few years has left many states in strong condition to weather any economic slowdown. The $200 billion plus in surplus funds that states are sitting on represents a record fiscal cushion. States with flatter taxes are also likely to see the least disruption from a downturn because their tax collections tend to be less volatile.
By contrast, sharply progressive tax regimes that rely on steep levies on the rich will face a more unpredictable forecast. California budget watchdogs, for instance, are already predicting a possible $25 billion deficit for the state, after it enjoyed a $75 billion surplus last year. The swing in California’s revenues in a recession could be greater than the total budget of most states. In other words, the higher the taxes, the bumpier the ride. Buckle up.
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