Op-eds and Articles

Uncluttering State Tax Systems

By and / 4.15.2014

Over the last week, as you’ve raced to file your taxes by the deadline today, you’ve no doubt been bombarded on talk radio, cable TV, and the opinion pages about how complex and anti-growth the federal income tax system has become. Tax reform is indeed long overdue, but it’s not just the federal code that needs fixing: Many state tax systems are regressive, economically distorting, and mind-numbingly complex.

This month, the Progressive Policy Institute unveiled a unique study ranking the tax systems of all 50 states plus the District of Columbia — the State Tax Complexity Index. The index measures complexity in terms of the number of loopholes lurking in the code. What we discovered surprised us.

First, it doesn’t matter whether states rely on income or sales taxes, or whether they have a single rate or multiple rates — all of these systems can be honeycombed with complicated tax breaks, despite what you may have heard from advocates of a national sales tax or “flat tax.” For example, Hawaii and California, two states with very progressive income-tax systems (Hawaii has more marginal rates than the federal code) ranked among the least complex tax systems in terms of special tax preferences. Meanwhile, states with no individual income tax ranged all over the spectrum; for example, Washington ranked near the top of our complexity scale, Texas finished in the middle, and Alaska was toward the bottom. And states that have a flat tax clustered in the middle of our survey, with the exception of Utah, which tied for 37th.

Second, reducing complexity by eliminating tax breaks can finance lower tax rates and also increase progressivity, because such preferences mostly benefit higher-income individuals and businesses.

Choosing how to measure tax complexity across all types of tax systems was a challenge. The only feature that all systems shared was tax expenditures — tax provisions that provide a targeted benefit to specific individuals and groups, and thereby reduce government revenue. Common tax expenditures include deductions, credits, exclusions, deferrals, and rebates.

Some progressive analysts view tax expenditures as an indirect and more politically palatable form of government spending that obviates the need for new programs and administrative bureaucracies. Conservatives usually see them as a way of chipping away at tax burdens on affluent families and businesses. Either way, the growth of tax expenditures greatly increases tax complexity, because they spawn a special set of regulations that multiply over time and often lead to growing inconsistencies and inequities.

How do we know tax expenditures add to complexity? According to the IRS, the average person filing a 1040 form (which includes those taxpayers who chose to itemize their deductions) devotes 16 hours, the equivalent of two full work days, to the task. The 1040EZ form (which limits the number of deductions, credits, and other tax expenditures), by contrast, takes just four hours.

Tax expenditures don’t just clutter up the tax code; they also leak revenues and usually bestow their benefits upon the least needy among us. Federal tax expenditures cost the government over $1 trillion a year. Because you have to itemize to take advantage of deductions and credits, and because the value of deductions is tied to one’s tax bracket, upscale taxpayers reap the lion’s share of the benefits, whether we’re talking about deductions for charity, for home mortgages, or for health care. One big exception to this general rule is the Earned Income Tax Credit, which is specifically targeted to minimum- and low-wage workers as an incentive and reward for work.

Whether at the state or federal level, the lesson is clear: If simplicity is your goal, you have to reduce the number of tax breaks. Switching to a flat or sales tax isn’t the answer. Closing loopholes will also help governments pay their bills the old-fashioned way, by raising revenue instead of piling up public debt. Plugging revenue leaks will ease pressure for raising tax rates, which should be kept as low as possible. And eliminating tax breaks will reduce economic distortions and help channel capital investment to its most productive uses, rather than those favored by politicians.

That’s just as true on the state level as it is in Washington, D.C. So if federal lawmakers ever do get around to serious tax reform, they should invite the nation’s governors to the table, too.

This op-ed was originally published by Real Clear Politics, read it on their website here.