Previous posts (here, here and here) on this blog have discussed the fiscal debacle also known as "California." Despite some of the highest income tax rates in the nation, the state runs perpetual budget deficits and is piling up more debt each year. As a result, the state's bond rating of "A" is second to last among American states and equal to that of nations such as Malaysia and Slovenia. Moreover, this rating is far lower than that of numerous corporations who, unlike California, do not possess the power of coercive taxation. By contrast, states such as Virginia, Indiana and Utah all maintain AAA ratings, higher even than the ratings of the United States and France, for instance.
To be sure, some attribute California's fiscal woes to Proposition 13, which placed limits on state property taxes, a major source of revenue for localities. However, as previously explained on this blog, despite Proposition 13, California still raises significantly more tax revenue per resident than Virginia, Utah and Indiana, for instance. Indeed, the per resident tax gap between California and these other states is likely higher now, given California's most recent tax increase, advocated by Governor Jerry Brown (pictured above) and adopted by a referendum known as "Proposition 30," which will raise an additional $6 billion annually.
In a nation based upon competitive federalism, states are free to adopt their own fiscal policies, increasing or decreasing taxes and/or spending as they wish. Such policies are part of the package of background rules that different states, in competition with one another, offer citizens and businesses. For instance, a state might adopt a high tax/high spending strategy as a means of investing in infrastructure that attracts private enterprise and thus employment, hoping that industry (and employees), will view the extra infrastructure as sufficiently valuable to justify such tax rates. Other states might adopt a low tax/modest infrastructure approach, hoping that potential firms and workers will overlook infrastructure shortcomings because they can retain a larger share of their earnings and paychecks. Of course, taxes and spending are just one element of the regulatory package that states offer potential citizens and private enterprise. As previously argued on this blog, so-called right to work laws and the absence of minimum wage laws can also make a state more attractive to private investment, though of course some continue to claim that, say, compelled unionization actually enhances economic welfare. Competitive federalism allows each state polity to set its own course on these matters, with competition for citizens and investment rewarding those states that adopt the optimal mix of such policies, so long as such policies relate to matters with no external effects.
At the same time, competitive federalism does not exist in a vacuum, but itself depends upon a set a background rules that channel such competition toward efficient results. To take but one example, longstanding Supreme Court precedent protects the right of citizens to travel between states. See Crandall v. Nevada, 73 U.S. 35 (1868). As a result, citizens who are not satisfied with their home state's policies can exit and move to states that offer more friendly environments. Indeed, as previously explained on this blog, Americans have been fleeing states with high taxes and onerous regulatory environments over the past several years, moving to states like Texas, Florida, Utah, South Carolina, Nevada and Georgia, all of which have relatively low taxes and business-friendly regulatory environments. These states impose a competitive constraint upon states that, like California, regularly increase taxes, spending and various regulatory burdens.
Against this background, a December Op-ed in the Los Angeles Times argued for the retention of a tax loophole that distorts competition between the states. In particular, the Op-Ed defended the ability of wealthy individuals to deduct state taxes from their income subject to federal taxation. According to the Op-Ed, removal of the loophole would threaten the finances of states, like California, that choose high tax and high spending models of governance. As a result, the essay concludes that Congress should reject proposals to limit the amount of state taxes that individuals can deduct.
Hopefully Congress will, in fact, threaten California's finances in this manner. After all, as my colleague Nate Oman recently explained, the ability to deduct state taxes from one's federal taxable income allows states to externalize a portion of their costs to the rest of the nation. Assuming a federal tax rate of 35 percent (the top rate on most Americans), increasing state taxes by $1 Billion per year will reduce federal tax receipts by $350,000,000 thereby imposing a net tax increase on individuals of only $650,000,000. If the national government wishes to maintain the same level of spending, it must make up the difference somehow, either by increasing federal taxes by $350,000,000 on all Americans and/or borrowing and incurring even more debt. Citizens of the tax-raising state in question will pay only a fraction of the cost of such new federal taxes or borrowing.
The deductibility of state taxes does more than allow for the sort of externalization just described. It also weakens the competitive constraint imposed by the ability of citizens to exit jurisdictions that adopt unjustified taxes and onerous regulatory policies. Given Crandall v. Nevada, citizens will remain within their respective states so long as they receive private benefits from the state that exceed the private costs the state imposes upon them. However, the deductibility of state income taxes will cause private costs to diverge downward from actual costs, with the result that citizens will sometimes remain in a state that adopts a suboptimal mix of taxes and spending. Such citizens may even choose affirmatively to export costs to other states, as Californians did when they voted for proposition 30. Indeed, these distorted incentives may help explain why competitive federalism has resulted in a ten-fold increase in state spending since 1950, double the rate of increase in private spending during the same period. Like markets, governments too fail when the people who direct them face distorted incentives.