Honey, it’s Time to Move; The State Increased its Tax Rate Again

Boy in Box

How sensitive are people to income taxes?  Economists have debated this question for decades.  Finding the answer is not merely an academic matter.  In his surprise bestseller Capital in the 21st Century, Thomas Piketty argued that a global tax on wealth may hold the key to reducing inequality.1 Taxes are the most direct way for a government to redistribute wealth, so if the distribution of wealth in a society is unequal the government simply needs to increase taxes.  In other words, the solution to inequality is to take from the rich and give to the poor.

But what if rich people decide to move away?

Old Millionaire

We’ve seen it happen with a number of U.S. corporations.  The U.S. currently has one of highest corporate income tax rates in the world, taxes profits twice,and taxes companies on profits earned outside U.S. borders.3  These facts have prompted a number of firms to re-locate their operations overseas.  One way to do this is through a corporate inversion:  Company U (a U.S. firm) acquires Company I (a firm located outside the U.S.) and shifts its domicile to the country of Company I.  In most cases this is simply a way to reduce taxes, as the key employees continue to work in the same offices they did prior to the inversion.  The corporation has changed its location on paper but not in fact.  Thus, it is clear that corporations will change their location to save money on taxes. 

But what about people? 

People, unlike corporations, have friends.

Happy Celebrities

People live in communities, swap stories with neighbors, and get to know the teachers at their child’s school.  The goal of a person is not to maximize shareholder value and increase profit—people are different from corporations. 

Aren’t they? 

For years researchers focused on the relationship between personal income taxes and the labor supply.4  In short, they wanted to know if people respond to increased taxes by working less.  The answer is yes, although it’s a bit more complicated.  But a number of researchers have decided to ask a different question, one that is related to the driving force behind corporate inversions:  if a state raises its income tax, will wealthy people actually move away?

Angry Chef

Two researchers tried to answer this question by examining what happened after a tax increase in New Jersey.  In 2004, New Jersey increased its marginal income tax rate from 6.37% to 8.97% for people who earned more than $500,000.  They found that these “millionaire taxes” did not result in a significant number of people leaving New Jersey.5  This finding was then used to argue for more tax increases; if rich people aren’t going to leave New Jersey, what’s the harm in taxing them a couple of percentage points more?  The increased tax revenue could be used to improve public schools, re-build the state’s infrastructure, or give state troopers a raise. 

There’s just one catch:  that research finding might not be so solid.

Robust Findings

A group of researchers discovered that the findings of the New Jersey study were sensitive to the way in which migration was modelled.6  If out-migration (the number of people leaving New Jersey) and in-migration (the number of people entering New Jersey) were modelled at the same time, there did not appear to be a relationship between the tax increase and people deciding to move.  But when the model focused strictly on the out-migration that was at issue, the relationship was statistically significant.7  More people moved away after the tax increase.

            States certainly believe that people are sensitive to income tax rates.  They invest advertising dollars to entice people to move to their state, often touting a friendlier environment toward business and lower taxes.  But with the results of the New Jersey study called into question, the relationship between taxation and migration remains unsettled. 

Researchers haven’t given up.

Science moving forward

Recent studies have examined the effect of taxes on soccer players,8 inventors,9 and scientists.10  The latter study tested whether star scientists11 are more likely to move following an increase in their state’s income tax rate, and that they had an elasticity of 1.8.12  To illustrate what this elasticity means, assume that the after-tax income of high earners in Missouri decreases by 1% relative to Kansas.  According to the study’s findings, Kansas would expect a 1.8% increase in its net inflow of star scientists.  The researchers performed a number of additional tests to assess the strength of their findings:  they looked at star scientists’ responses to changes in corporate income tax rates and tax credits, and the researchers also showed that star scientists working for companies with locations in multiple states were more likely to move to a lower-tax state after a tax increase.13  These results imply that cutting taxes may be a good strategy to attract star scientists, whose intellectual breakthroughs have the ability to create jobs.  If you want your state to be a hub for technological breakthroughs and economic growth, you just need to dramatically slash the state’s income tax rate… right? 

Actually, Kansas did exactly that.

Exciting Kansas

In 2012, Kansas reduced its top personal income tax rate from 6.45% to 4.9% and completely eliminated the income tax for small businesses.14  The goal was to attract people and businesses to Kansas, and Governor Sam Brownback praised the tax cut as, “a shot of adrenaline into the heart of the Kansas economy.”15

This shot of adrenaline nearly killed the patient.

Surprised Monkey due to Tax Cuts

Kansas’ economic growth did not materialize:  people and businesses from across the U.S. didn’t flock to Kansas (shocking, I know), and the people already living in Kansas didn’t create large numbers of new jobs.16  The tax cuts, which were supposed to pay for themselves with increased economic growth,17 led to a budget shortfall of nearly nine-hundred million dollars.18  The state government had to cut spending on education, infrastructure, and public assistance.19  The state legislature eventually gave up on the experiment, voting to raise taxes against the governor’s veto.20 

So what does this all mean? 

Is tax-cutting a recipe for disaster, or a good way to attract talent? 

The answer probably lies somewhere in the middle.  A modest tax cut may indeed attract some high-income earners to your state.  But as the size of the tax cut grows larger, the government jeopardizes its ability to provide citizens with basic services.  And in the long run, a solid infrastructure and an educated workforce may be more important to a state than a few scientists.

Kermit the Frog Contemplating Existence

1. Piketty, T. (2013). Capital in the twenty-first century. Cambridge, MA: Belknap Press of Harvard University Press.

2. Once at the corporate level (when the profits are earned) and once at the shareholder level (when the profits are distributed to shareholders).

3. Companies such as Apple can avoid paying U.S. tax on foreign profits if the profits remain overseas and are not repatriated to the U.S.

4. Moretti, E., & Wilson, D. J. (2017). The effect of state taxes on the geographical location of top earners: Evidence from Star Scientists. American Economic Review, 107(7), 1858-1903.

5. Young, C., & Varner, C. (2011). Millionaire migration and state taxation of top incomes: Evidence from a natural experiment. National Tax Journal, 64(2, Part 1), 255-284.

6. Cohen, R. S., Lai, A. E., & Steindel, C. (2015). A replication of “Millionaire Migration and State Taxation of Top Incomes: Evidence from a Natural Experiment” (National Tax Journal, 2011). Public Finance Review, 43(2), 206-225.

7. Ibid.

8. Kleven, H. J., Landais, C., & Saez, E. (2013). Taxation and international migration of superstars: Evidence from the European football market. American Economic Review, 103(5), 1892-1924.

9. Akcigit, U., Baslandze, S., & Stantcheva, S. (2016). Taxation and the international mobility of inventors. American Economic Review, 106(10), 2930-2981.

10. Moretti, E., & Wilson, D. J. (2017). The effect of state taxes on the geographical location of top earners: Evidence from Star Scientists. American Economic Review, 107(7), 1858-1903.

11. A scientist is a “star” if he or she holds more patents than 95% of other scientists. 

12. Moretti, E., & Wilson, D. J. (2017). The effect of state taxes on the geographical location of top earners: Evidence from Star Scientists. American Economic Review, 107(7), 1858-1903.

13. Ibid.

14. Gale, W. G. (2017, June 14). What the Kansas tax cut about-face means. Tax Policy Center. Retrieved from: http://www.taxpolicycenter.org/taxvox/what-kansas-tax-cut-about-face-means

15. Ibid.

16. Turner, T. M., & Blagg, B. (2017). The short-term effects of the Kansas income tax cuts on employment growth. Public Finance Review, 1-20.

17. The Economist. (2017, June 10). A Republication revolt in Kansas. http://www.economist.com/news/united-states/21723145-has-kansas-experiment-tax-cutting-failed-republican-revolt-kansas

18. Henchman, J. (2017, June 6). Kansas Pass-through carveout repealed after legislature overrides Gov. Brownback’s veto. Tax Foundation. https://taxfoundation.org/brownback-pledges-veto-kansas-tax-bill/

19. Gale, W. G. (2017, June 14). What the Kansas tax cut about-face means. Tax Policy Center. Retrieved from: http://www.taxpolicycenter.org/taxvox/what-kansas-tax-cut-about-face-means

20. Henchman, J. (2017, June 6). Kansas Pass-through carveout repealed after legislature overrides Gov. Brownback’s veto. Tax Foundation. https://taxfoundation.org/brownback-pledges-veto-kansas-tax-bill/

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