Ohio's economy is anemic, ranking near the bottom of most lists on job creation, new investment and business climate. The state, not surprisingly, is also ranked among the most heavily taxed. It's time for Ohio policymakers to consider dramatic steps to reverse its long-term decline by creating an investment friendly business climate. Abolishing the state income tax, while politically bold, should be near the top of their agenda.

The Economic Implications of the State Income Tax

Ohio's economic decline may not seem obvious to many. The state's economy has not fallen in absolute levels. Ohio's gross state product per capita, a common measure of economic output, was $25,345 in 1990 and managed to increase to 34,450 by 2005 (after adjusting for inflation). Rather, the state has failed to keep pace with the rest of the nation and increasingly the world. In 1990, Ohio ranked 25th nationally in terms of gross state product per capita. By 2005, our position had  slipped to 28th. Other states - Texas, Oregon, Nevada, Tennessee and others - were gaining while Ohio workers and businesses remained stuck in neutral. Meanwhile, Ohio has lost three Congressional seats since 1980 and may be in danger of losing another one as its population continues to lag more prosperous and growing states. Ohio is losing both its relative prosperity and its demographic share.

Many critiques of the Ohio economy correctly note non-tax factors are important drags on the state economy, including a legacy in traditional manufacturing, low education rates, and high wages for unskilled labor. But these factors do not offset other elements directly influenced by public policy, such as tax policy. A statistical analysis of population and income tax rates found that eliminating the state income tax would have vaulted Ohio population growth from the 44th fastest growing state to the 24th fastest between 1990 and 2000, boosting the state's growth rate to just below Maryland. More directly, the state income tax may well have cost the buckeye state a Congressional seat during that decade.

Population growth, however, is just one measure of the state's health. A more important one is its ability to generate wealth and economic value. Here again, Ohio's high and complicated income tax system puts it at a disadvantage, and the evidence is in the numbers. Eliminating the state income tax would increase Ohio's long-run annual rate of per capita economic growth from around 2.1 percent to near 2.5 percent. This increase, while seemingly small, makes the difference between Ohio continuing to lose ground to other states and holding its own in an increasingly dynamic, globally competitive American economy. Abolishing the income tax would allow us to double our standard of living in 28 years, five years sooner than under current trends.

Abolishing the income tax will not necessarily threaten the fiscal health of the state, either. Several states have no state income tax at all, including Alaska, Florida, Nevada, Texas, South Dakota, and Washington. My analysis found that abolishing the income tax would raise the rate of growth of all other state and local taxes because of higher economic growth. Cutting the state income tax doubles revenues from all other state taxes in five or fewer years.

Fiscal Impacts of Abolishing the Income Tax

Clearly, abolishing the income tax presents a few challenges, particularly finding a way to compensate for the net loss of $6.5 billion in annual revenues generated from the current tax system. Any responsible proposal to eliminate the state income tax must recognize that either state spending will be curtailed dramatically or some other source of funding must be found.

The General Assembly may have unintentionally laid important ground work for developing this alternative when it created the Commercial Activity Tax (CAT) in 2007. This is a broad based tax that is calculated as a fraction of business revenues for each transaction. Indeed, a CAT rate of about 1.1 percent, while higher than the current planned rate of 0.26 percent, would be enough to offset any lost revenues from phasing out the state income tax.

My conservative forecast for the state economy estimates economic growth of about 3.1 percent per year after we have eliminated the state income tax (higher than the current average growth rate of 2.1 percent). Phasing out the income tax will accelerate per capita output growth by 0.35 percent and increase annual population growth by 0.6 percent. It would take around 16 years for the increased revenue from the CAT and the sales tax to cover the revenue necessary to fully eliminate the state income tax (hence requiring a phase out of the income tax rather than immediate termination). Nearly three quarters of the income revenue foregone would be compensated for by increased economic growth because Ohio's economy is more competitive and more attractive to wealth generators.

These revenue targets assume that the Ohio General Assembly will continue its recent history and hold the line on spending increases to only 2.4 percent per annum. In fact Ohio's recent law requiring Tax and Expenditure Limits restrains increased expenditures by the Assembly to 3.5 percent or the sum of the rates of inflation and population growth, whichever is greater. If Ohio holds the line on spending and completely phases out the income tax, I actually project large budget surpluses in the years after the income tax starts to be phased out because revenues from the CAT will be much higher than Ohio's Office of Budget and Management has forecast.

Two plausible assumptions allow projections to generate surpluses during the entire decade when the income tax is phased out. If the rate of growth of State-Only spending is limited to 2.5 percent per annum, or if the long-run boost to per capita economic growth from eliminating the income tax is 2 percent per annum, then budget surpluses may well occur during the entire decade that it takes to eliminate the income tax.

The projection of sustained surpluses while phasing out the income tax between 2007 and 2017, however, may be optimistic, especially if the state legislature seems unwilling to control its spending. But a little fiscal discipline and a plausible boost to state-wide economic growth may make it possible to eliminate the income tax while respecting the spirit of a balanced budget.

Conclusion

Ohio could significantly boost its economy by phasing out its income tax. House Bill 66, which established the CAT, may well be an important step in the right direction, but it has not gone far enough. The intent of that reform was to lower income tax rates by about one-fifth during the next five fiscal years. This reform will provide a very good trial run for the important work that lies ahead. Ohio must continue to adopt serious fiscal reforms or face the long-run prospect of becoming an increasingly marginalized state on the national economic and political scene.

A politically realistic way of eliminating the Ohio income tax by 2020 can move forward in steps. The first step continues to phase in the reduction of income tax rates by one-fifth over the next five years, as planned under the current law. If these revenue and state growth forecasts prove accurate, then policy makers should accelerate the phasing out of the remaining four-fifths of the income tax between 2013 and 2020.

Ohio's economic cup may not be overflowing, but the glass is half full. Indeed, the same historical conditions that allowed Ohio to become a predominant state in the nineteenth century still exist today. Its central location is as much an advantage today - in an increasingly integrated world economy - as it was in 1825, when the Erie Canal opened. Ohio also has the economic infrastructure and the human capital necessary to become real sources of economic prosperity. The key is to find a way to unleash the forces of the market so that all the residents of the Buckeye State may benefit from her full economic potential.

Phasing out the state income tax provides a longrun vision for how the Buckeye State might regain its important stature in the economic history of our nation. Continuing the status quo is a sure recipe for the steady decline of Ohio in the economic and political life of our country.