Phasing Out Ohio's Income Tax
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Policy Summary
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.
Eric N. Fisher is a Buckeye Institute adjunct scholar and academic advisor. He is a professor of economics at California Polytechnic State University specializing in macroeconomics, international economics and trade, and money and banking. Prior to joining Cal Polytech, Dr. Fisher was a
professor of economics at The Ohio State University.