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States with High Tax Rates Enjoy Higher Average Incomes

Low tax states can’t post strong incomes without energy or tourism.

In the ongoing debate over tax cuts, both sides make arguments that sound plausible. Progressives and liberals claim that a state with low taxes can't invest in schools, roads, and other improvements that boost productivity. Conservatives claim that high taxes discourage entrepreneurs and push businesses to flee the state. Both arguments are logical—but both cannot be true.

This argument reminds of a sign I once saw a sign in a client's office which read, "In God we Trust. All Others Must Bring Data." What does the data tell us about taxes and incomes?

How higher taxes affect personal income

The Tax Foundation, a respected conservative-leaning group, has analyzed tax issues since 1937. They publish reports showing the average income and average tax load for all 50 states. Their analysis includes all state and local taxes.

I've charted this data (below) and added a green line to separate the states with high incomes from the rest. Aside from a few outliers, the trend is obvious: All but one of the states that enjoy higher incomes (greater than $50,000 per person) also impose higher total taxes (above 9 percent). At the same time, all but one of the states that keep taxes low (less than 9 percent) have lower incomes.

State Tax Rate vs. Average Income, source: Tax Foundation as reported by CNN

There is no evidence in this chart to confirm that low taxes lead to prosperity. In contrast, higher taxes accompany higher incomes, not the other way around.

Higher incomes or higher taxes: Which come first?

Although the chart shows high incomes and high taxes go hand in hand, it raises the question of which comes first: Do higher taxes enable higher incomes, or do higher incomes simply make high taxes acceptable? Frankly the evidence here is mixed.

One important state on the high-income side of the chart is Massachusetts, which owes its prosperity to great universities and to the successful technology companies spawned by their alumni. Massachusetts shows that taxes, when invested in leading educational institutions, can create prosperity even without other economic advantages. Northern California, if it were a separate state, would illustrate this point as well. Stanford University provides essential support for Silicon Valley. The leading private universities do not take direct support from state or local taxes, but they take a great deal of indirect state taxpayer support, since they are exempt from taxes on their property and income.

The other high-income states fall into two distinct clusters: the financial services cluster of New York, New Jersey, and Connecticut (fueled by Wall Street), and the government cluster of District of Columbia, Maryland, and to a lesser extent Virginia (fueled by the U.S. capital and its lobbyists and government contractors). Wall Street and the nation's capital exert such strong magnetism on talent that these states may not need top quality education and infrastructure to maintain their prosperity. People who live there pay higher taxes because they value the things that higher taxes provide (better roads, schools, parks, transit, cultural amenities and more.)  In turn, these services and amenities attract tourists who bring even money to these already-prosperous areas.

How some states with low taxes generate healthy incomes for residents

A few states—Alaska, Nevada, Florida, Wyoming, and New Hampshire—impose very low tax rates yet their residents enjoy solid mid-range incomes. Do these states blaze a trail that other states can follow?

Unfortunately these states' success is tough to copy. Both Alaska and Wyoming have abundant and valuable natural resources (energy and minerals) coupled with small populations and little need for public services. Nevada, Florida, and Wyoming benefit greatly from tourism as well. And New Hampshire gets a free ride from Massachusetts-based high tech companies without paying the corresponding taxes.

How do low taxes really affect growth in income?

A new study by the Institute on Taxation and Economy Policy provides additional perspective. Researchers at this respected, progressive-leaning group looked at the net change in income from 2001 to 2010. They compared the nine states with the highest income tax against the nine states with the lowest income tax. The results, in the chart below, show that the states with the highest taxes actually had the strongest economies throughout a difficult decade.

Net Change in Income Given Tax Rates, by Institute on Taxation and Economy Policy

There are no guarantees when it comes to taxes and economic development. But without abundant natural resources or heavy tourism or the generosity of a neighbor, no state in the United States has been able to sustain high prosperity without a robust tax base. The data speaks clearly on this point. Let's trust it.

May 11, 2012

(A version of this was posted earlier at www.usnews.com)