The new war between the states: Are income taxes to blame?

FORTUNE — The widening gap in policies and prosperity among the states has been a source of increasing controversy. The migration of people and businesses from high-tax states such as California and Illinois to fast-rising rivals Texas, Nevada, and Florida is creating a divide that, to some observers. mirrors the battle between emerging markets and aging economies in decline.

An important new book identifies a major factor that, the authors claim, separates the winners from the laggards: state income taxes. An Inquiry Into the Nature and Causes of the Wealth of States has four co-authors, all prominent supply-side thinkers. Economist Arthur Laffer has spent a career studying the policies that lead states to success and failure. Travis Brown, CEO of Missouri issue-advocacy firm Pelopidas, contributes research from his recent book How Money Walks, which uses U.S. tax records records to show precisely how many people moved from one state to another and how much tax revenue they brought to their new homes. Stephen Moore is chief economist at the conservative Heritage Foundation, and Rex Sinquefield is co-founder of Dimensional Fund Advisors, a pioneer in the index fund industry that now manages $356 billion.

Given the authors’ pedigree, the conclusions are predictable: Imposing income taxes inevitably leads to economic decline and enriches the competing states that don’t have them. What gives their arguments credence is the staggering wealth of data summoned to support their claims.

The book makes its case by comparing the performance of states after they adopt income taxes to the nation as a whole. As An Inquiry details, state income taxes were far less widespread in 1960 than they are today. Back then 31 states imposed levies on salaries, tips, and bonuses, and 19 left income untaxed. Since then, 11 of those 19 states have enacted an income tax. Those states are concentrated in the Northeast (Connecticut, New Jersey, Rhode Island, Pennsylvania, and Maine), and in the Midwest (Illinois, Nebraska, Michigan, and Indiana). (The 11th is West Virginia.) No states in the South or Far West adopted income taxes; those regions are home to all but one of the nine no-tax states (Florida, Tennessee, Texas, Nevada, Wyoming, South Dakota, Washington, and Alaska). The only non-tax state in the Northeast is New Hampshire.

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An Inquiry compares the performance of what we’ll call the 11 Adopters in the five years before they enacted an income tax to their status in 2012. The measure is their position vs. the other 39 states. The book argues that income taxes are a cause of decline in these states, but far from the only cause. Restrictive labor laws, and a heavy burden of sales and other taxes also play a role, An Inquiry claims.

Most readers will quickly identify other reasons that these states underperformed that are unrelated to income taxes. For example, the decline of the auto industry punished Michigan’s economy, and low-cost competition from Asia battered Midwestern manufacturing. Nor is the appeal of the non-income tax states simply a matter of income taxes. Texas offers far lower housing costs than, say, New Jersey, a major lure for companies and families alike. In fact, while it’s obvious that rich people leave high-tax states all the time for a Florida or Texas, it’s uncertain how many people specifically left the Adopters because state income taxes rose.

But the book’s data are convincing. It appears that the likes of Illinois, New Jersey, and other big income-tax states are also the ones that, according to the authors, are far less hospitable to business, combining higher taxes with restrictive zoning that raises housing costs, expensive mandates on such issues as overtime pay, and laws that favor unionization. Only one of the Adopters — surprisingly, it’s Michigan — is a right to work state. By contrast, six of the eight states with no income tax have right to work laws that discourage unionization.

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So it’s a whole package of drawbacks that the authors claim is pummeling the 11 Adopters. But they also make it clear that in their view, high income taxes head the list.

While it’s impossible to prove that high taxes are the major force, it is startling that the 11 Adopters have lost ground on virtually every measure. Let’s start with population. Every one shrank as a share of the total population of the other 39 states. The declines ranged from 4% from Connecticut to 46% for Michigan, with Ohio down 27% and Illinois shrinking 24%. In absolute numbers, all of the 11 Adopters fell into the bottom half of all states in growth from 2002 to 2012, with Ohio, Michigan, and Rhode Island occupying the last three places.

Nor did the new taxes spur growth. The Gross State Product of every one of the 11 Adopters fell in double digits relative to the GSP of the rest of the nation. Pennsylvania went from an 8.5% share of the nation excluding the Adopters to 5%, and Illinois dropped from 9.8% to 5.8%.

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All of the 11 Adopters raised less revenue relative to the other states once they put their new levies in place. Prior to enacting the tax in 1972, Ohio collected total revenues amounting to 6.1% of the number for the other 39 states; by 2012, the figure had fallen to 4.5%. The fall in tax receipts was obviously worsened by the shrinkage in population relative to the rest of the country. The authors would argue that the high tax rates never raise the projected revenues precisely because they cause people to leave, and the extra revenue spent on the folks who remained didn’t improve the quality of their lives as promised.

It’s also notable that state tax rates almost always start small, and always grow, despite the obvious challenge in actually booking more revenue. Connecticut — a late adopter in 1991 — has lifted its levy from 1.5% to 6.7%. In the early 1960s, New Jersey had neither an income nor a sales tax, and ranked as one of the fastest-growing locales in the nation in population and output. New Jersey started at 2.5% in 1976, and now imposes a maximum rate of 9%. The exodus of the over-taxed, and its chronic budget woes, provide strong evidence that bigger taxes don’t work.

By mining federal tax data, An Inquiry identifies precisely how much taxable income has entered and left these states. The net outflow of taxable income explains how these states can impose an income tax, keep raising the rates, and yet fail to collect anything resembling the promised revenues. New Jersey’s income tax base in 2009 to 2010 was $250 billion; but people leaving the Garden State over the previous 18 years removed $24 billion more in income than the folks moving in replaced. The huge out-migration, spurred by high taxes, substantially lowered the potential pool of taxable income — so that hiking rates failed to stanch a near-budget crisis.

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It’s also remarkable that people moving out of the 11 Adopters almost always earn more than the people moving in. In California, the out-migrants made 3.3% more than the new arrivals, and there were a lot more of them. For the non-tax states, it’s just the opposite. Florida’s new arrivals earned $12,000, or 33%, more than those who left.

Adopting income taxes might prove beneficial if it improved social services. Indeed, state-tax supporters invariably claim that since it funds branches of government closest to the people, it will make the best use of more resources. The evidence isn’t as universally negative as on population, growth, and revenue issues, but it strongly suggests that income taxes do little or nothing to improve quality of life for the people who stay on. On education, the book cites U.S. Department of Education test scores to show the improvement or decline in the 11 Adopters.

In fourth-grade reading, for example, seven out of the ten for which data is available posted 2013 scores lower than the ones from 1992, relative to the entire nation. And the numbers aren’t much better for 4th- and 8th-grade math. How about health and hospital services? As a benchmark, the authors use the ratio of health care professionals per citizen, compared to the rest of the nation. By that measure, seven of the 11 states experienced a decline since they introduced the tax.

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In the interests of disclosure, co-author Rex Sinquefield is a close friend of this writer. We met in a dorm at the University of Chicago business school, now renamed The Booth School of Business for Sinquefield’s partner at DFA, and its benefactor, David Booth. I called Rex to discuss the book, and he reiterated its crucial point: “People are the most mobile resource,” he explains. “The state income tax taxes their work and effort, and they can easily escape it, and they do by moving to no-tax states.” A weakness of the state income tax, he notes, is that it often sharply raises the amount people pay on an extra dollar of income, compared to the no-tax states. So it discourages people from working extra hours, or taking on a second job.

What about taxes — other than on income — that states impose? Are some nominally no-tax locations dinging their residents at higher rates on, say, property taxes to compensate for the lack of sales tax? That, it turns out, is not the case. The 11 Adopters, and high-income tax states in general, impose the highest overall tax burden on their residents and businesses. Of the states that collect the biggest overall share of personal income in taxes each year, five are in the Adopter group, including Maine (10.3% of taxpayers’ income), California (11.2%), and New Jersey (12.4%). The other three, New York, Wisconsin, and Minnesota, are among the highest income tax states in the nation. Of the eight states with the lowest overall tax burdens — income, property, and everything else — six are states that run their state governments without an income tax.

It’s important not to adopt a narrowly numbers-based view of why people want to live and work in certain places. New York City and Silicon Valley have high taxes, yet they boast plenty of economic vitality. The rub is that politicians often wrongly assume their allure is untouchable. New York City’s zigzagging fortunes prove that is not the case.

The climate of heated tax rivalry is healthy. One of the best arguments against a value-added tax, the main source of revenue in Europe, is that it would apply to the entire country, so that changing states would no longer provide relief. A major factor pressuring governors in high-tax states to push for fiscal restraint is that those states can’t allow their tax bases to shrink forever. For the laggards, the pressure is on. It will only get more intense.








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