State lawmakers have been driving down income-tax rates across the map for two consecutive fiscal years, and they show no sign of relenting in 2023. The extraordinary wave of state income-tax cuts that began in 2021 is set to continue as states such as West Virginia, North Dakota, and Kentucky are moving quickly to cut rates this year.
Strong state revenue made the recent wave of tax cuts possible. Changes in federal tax law enacted in 2017, and the rise of remote work following the pandemic — that allows workers to move to better-managed, lower-tax states — gave lawmakers the further incentive to act, resulting in unprecedented interstate tax competition.
In just the last week, West Virginia lawmakers sent Governor Jim Justice a bill to cut the top income-tax rate from 6.5 percent to 5.12 percent. North Dakota’s house passed a series of bills that would scrap the state’s progressive tax structure, with its 2.9 percent top rate, and replace it with a flat income tax of 1.5 percent.
Kentucky already enacted an income-tax-rate cut from 4.5 percent to 4.0 percent in February, effective next year. Still more states such as Ohio, Wisconsin, Nebraska, and Kansas are teeing up major income-tax overhauls, each targeting a low, flat (or near-flat) income-tax structure.
Strong state revenue combined with extraordinary federal pandemic aid created the opportunity for a wave of state tax reforms. The National Association of State Budget Officers estimates that state general revenue grew by 16.6 percent in fiscal 2021 and 14.5 percent in fiscal 2022, which explains why so many states have been able to cut rates in concert.
In addition, two structural changes have enhanced state tax competition. First, the 2017 Tax Cuts and Jobs Act capped the federal deduction for state and local taxes paid at $10,000, thus increasing the “felt cost” of state taxation, particularly for higher earners. A high-paid Silicon Valley engineer who could previously deduct $70,000 in California income taxes on his federal tax return can now only deduct $10,000. In short, the burden of his state-government tax policy went up, incentivizing him to find a better-managed state.
Second, the pandemic untethered a multitude of high-paid workers from a geographic location, creating the opportunity for taxpayers to move, and giving states an incentive to compete for their relocations. A 2022 McKinsey report found that 35 percent of workers were eligible for full-time remote work, including 46 percent of workers earning over $150,000. The Silicon Valley engineer who lost federal deductibility for his California income taxes in 2018 became eligible for remote work in 2021. His move to Austin, Texas, eliminated his entire state income-tax liability.
But will he be smart enough to support the policies that attracted him?