Illinois is facing a constitutional amendment to change the way its citizens are charged taxes. Historically, Illinois has had a flat tax system where everyone pays the same rate. This does not imply that everyone pays the same taxes. A 4% flat tax equates to $40,000 on earned income of $1 million, but only $2,000 on earned income of $50,000.
But Illinois is in bad fiscal condition right now, and our Governor, apparently having forgotten his Econ101, thinks that a change to Illinois’ tax program which allows him to increase the rate of high earners is the ticket he needs to buy the state out of trouble.
Economists across the state and country know this is a bad idea. A flat tax which we have currently is the most efficient form of tax because it creates the smallest amount of social waste. Social waste is an economic term for the inefficiency caused by behavior changes that reduce productivity in an effort to maximize how much income folks get to keep.
All taxes create an incentive for people to change their behavior so that they keep more money. But flat taxes, create the smallest incentives. They are the most efficient.
Understand, I am not referring to fraud, hiding assets, or anything illegal. I am talking about the calculated decision to reduce professional productivity or to position assets in less productive places to offset the higher tax burden.
A common example of reducing productivity to maximize kept income comes about when a worker turns down a promotion that puts him or her in a higher tax bracket. A 5% increase in salary corresponding to relocation in the higher tax bracket, would nearly wipe out the monetary raise without affecting the greater work and pressure of the promotion. We will see wealthy Illinoisans repositioning assets into nontaxable and retirement accounts and deferring compensation through stock sharing and vested option.
Another concern is the flight of taxpayers to lower tax states. New York and New Jersey have been suffering at the hands of Florida for years, while Illinois has been largely immune, but this could all change now.
These behavior changes involve personal sacrifice and put downward pressure on collected tax revenue. Downward pressure is another economic term that means kind of what it sounds like. These changes will work toward reducing overall tax efficiency in the long run even if the amendment causes an uptick immediately.
The best way to increase tax revenue is with a low tax rate that taxpayers feel is fair – one for which they do not feel a need to change behavior and do have enough to invest and spend which expands the tax base.
You might ask what history has to say about this. Well, Reagan cut taxes in the 80s and tax revenue doubled in five years. Not a fan of Reagan? How about JFK? He dropped the tax rate from over 90% to 50%. The tax base soared, unemployment fell, and the economy took off.
Flat taxes work because everyone pays the same rate. It is understood, there are no (or very few) exemptions or loopholes. People continue to maximize their income, and the government maximizes tax revenue.
Graduated tax rates, like our Governor is requesting, incent those at the top – the biggest payers – to change their behavior. They might write big checks next year, but in time they will change their behavior to keep the largest amount of earned income even if that means making personal sacrifices. In the long run, a graduated tax system in Illinois will not increase the state’s ability to pay off its debt, but will reduce the State’s ability to collect tax revenue.
So why do it? Tune in tomorrow.