Tax Flight: Behavioral Responses to State Income Taxation

From widespread unemployment to steep declines in wages and profits, the 2020 pandemic has had devastating economic consequences for many Americans.

Theses economic harms aren’t limited to families and business, they have also strained state budgets. Government revenues have fallen while spending on unemployment insurance and assistance programs have risen considerably. The shock has exposed inherent weaknesses in many state budgets. For decades, state policymakers have looked the other way as rising pension obligations and out-of-control Medicaid spending have consumed a growing share of state revenues.

States now face large budget shortfalls that will require difficult budget decisions. For many policymakers, the answer seems obvious: they want to raise state income taxes on high earners. They think they can fill budget holes without increasing taxes on middle class families or reducing government services and programs. Despite their political popularity, history suggests these tax hikes won’t solve the budget challenges that states are facing.

In 2012, California voters approved Proposition 30. The ballot measure was backed by many state lawmakers including then-Governor Jerry Brown. It promised to raise billions of dollars for statewide education spending by raising taxes on high-income taxpayers. Income taxes rose by as much as 3 percentage points on single tax filers with incomes over $500,000 and married filers with incomes over $1 million. The state’s top rate rose to 13.3 percent. 

While a booming national economy helped grow the state’s revenue, ultimately only 40 cents of every dollar the state would have hoped to take in from this tax increase actually materialized. What happened?

First, tax hikes encouraged many wealthy Californians’ to flee to low-tax states like Texas or Nevada. An abnormally large number of high-income earners exited the state right after the new taxes were enacted. And, as you would expect, the higher the taxpayer’s income, the more likely they were to leave. 

But even taxpayers who stayed found ways to reduce their taxable income. If we compare high-income filers in California to other states with similar tax policies, we find a relative decline in taxable income. Some of these filers reduced how much they worked. Others likely had their accountants work overtime to find more ways to avoid paying the taxes. 

It could have been even worse. The tax hikes were partially offset by federal tax provisions that allowed filers to deduct their state and local taxes. Since 2018, these provisions have been limited, giving California taxpayers even more incentive to move or reduce the California taxable income. 

The state’s high taxes do more than just lead to tax avoidance; they weaken the state’s economy. My research has found that for every percentage point increase in income tax rates, the state loses 0.4 percent of non-corporate jobs, adding up to hundreds of thousands of jobs at risk. 

Despite not raising anywhere near the promised revenue and the harmful effect they had on the economy, the 2012 tax increases were extended until 2030. And now California policymakers are looking to further to increase top rates to address budget shortfalls. 

It couldn’t come at a worse time. These higher tax rates will further weaken the state’s economy and are unlikely to raise the revenue needed to meet state’s budget woes.  

Across the nation, state policymakers must face difficult budget decisions. But as California’s ineffective tax policies illustrate, tax hikes on the high-income earners won’t close large budget deficits.