States without an income tax - good idea?

California's largest tax revenue source by far is its personal income tax. This tax generated 67% of total tax revenues for FY 2012-2013's General Fund. As shown in the pie chart from the California State Controller's Office, the corporate income tax only provided 8% of state tax revenues.


Source: California State Controller

Seven states do not impose an income tax and two states impose it on only a portion of one's income. How can they do that? A recent article in Cleveland.com answers that question. See "No-income-tax states use other taxes to pay the bills: Axing Ohio's Income Tax," by Robert Higgs, 10/2/14.

The seven states without an income tax are:

• Alaska (relies on significant oil taxes)
• Florida
• Nevada
• South Dakota
• Texas
• Washington
• Wyoming (also relies on significant oil severance tax)

See the article for details on how the other states manage.

Is it good to not have a state income tax? I say no regarding the personal income tax and maybe regarding the corporate income tax. For states that don't have few people and lots of oil, lack of a personal income tax means greater reliance on the state sales tax, which is a regressive tax. While Nevada and Florida are able to get tourists to pay a good amount of the sales tax, that is not true in all states and Florida have a greater population than Nevada (for 2013, 19.5 million for Florida and 2.78 million for Nevada, per US Census Bureau).

The problem with the sales tax is that it results in lower income individuals using a larger portion of their income to pay it relative to higher income individual (making it regressive). In contrast, the income tax is progressive and even more progressive if tax rates increase with income. High income individuals get a significant tax break if their income is all earned in a state without an income tax. They likely only spend a small portion of their income, so do not pay much in sales tax (again, relative to their income).

Another benefit of having an income tax is that a balance of taxes can help improve revenue stability. For example, an economic downturn might hurt income tax revenues quickly, but not so quickly with respect to sales and property taxes.

So far as the corporate income tax, I think states should consider eliminating it. Already, most states have significant tax benefits to lower corporate taxes and entice corporations to do business in their state. The state will still make revenues from the spending and the wages paid to employees. The tax incentives include single sales factor apportionment (so state income taxes don't go up when you put more property and employees in the state), film credits, R&D credits and various energy and equipment purchase credits. These special rules also add more complexity to the law.

But, elimination of the corporate income tax is not as easy as it might sound. Many businesses operate as LLCs, partnerships or S corporations. The taxes paid by these entities mostly shows up in the personal income tax piece of the revenue pie. It doesn't seem fair to continue to tax these businesses, but not ones that operate in the corporate form. What happens if these businesses convert to the corporate form?  They still have federal income taxes. It could turn into a tax shelter as well if people place investment assets in corporations. Then you need rules to prevent that. So, we end up with a complex corporate income tax that produces a small amount of revenues. Oh well.

What do you think? (about a state having no income tax and elimination of the corporate income tax)