Fiscal Fact No. 21
As Indiana state lawmakers consider changes to their taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system in 2005, they should pursue those changes that will make their state more attractive to business investment, and eschew those changes that will drive labor and capital to other states and countries. The Tax Foundation developed its State Business Tax Climate Index (hereafter, the Index) to rank the features of a state’s tax system that are most helpful in seeking and attracting new investment in the competitive international economy. A rational, competitive tax climate is essential to a state’s fiscal health and is therefore a crucial component of a state’s overall business climate.
This study analyzes how Governor Mitch Daniels’ proposal to increase income taxes would impact Indiana’s ranking in the Index. The Governor’s proposal would create a temporary income tax bracket of 4.4 percent for taxpayers with more than $100,000 in income. According to the Index, this tax increase would make Indiana’s business tax climate more hostile to business investment, less competitive in attracting more jobs, and harm Indiana’s ability to keep the jobs currently located there. If the proposed tax increase had been in effect when the last Index rankings were calculated, Indiana, which ranks 12th best in the Index, would have dropped to 19th.
Index Analysis In his first State of the State address, Indiana Governor Mitch Daniels asked Indiana lawmakers to enact an income tax surcharge. The governor wants a “temporary” 4.4 percent income tax bracket for Indiana taxpayers with incomes (either single or joint) in excess of $100,000 per year. Principally, he intends the new money to shore up the state’s rainy day fund. The Department of Revenue estimated that the new tax would raise approximately $290 million each year.
Indiana’s current rate of 3.4 percent is higher than Illinois’ rate but lower than in the other three neighboring states: Michigan, Ohio and Kentucky. If Governor Daniels’ proposal becomes law, Indiana will lose its tax advantage over Michigan where the top rate is 3.9 percent, falling to the middling third in the region (see Table 1).
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Table 1: The Impact of Governor Daniels’ Income Tax Proposal on Indiana’s Top Tax Rate, Compared with Neighboring States |
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State |
Top IndividualIncome Tax Rate |
Ranking in Tax Foundation’sState Business Tax Climate Index |
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Indiana(with new rate) |
4.4%(up from 3.4%) |
19(down from 12th) |
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Illinois |
3.0% |
23 |
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Michigan |
3.9% |
36 |
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Ohio |
7.5% |
29 |
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Kentucky |
6.0% |
44 |
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Source: Tax Foundation |
The State Business Tax Climate Index ranks five key features of a state’s tax climate: the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. ; the personal income tax; the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. ; the unemployment insurance tax; and the state’s overall fiscal balance. These five sub-measures tier up to a national ranking.
Gov. Daniels new tax plan only concerns the personal income tax, so Indiana’s ranking on the other four measures are unaffected: 23rd on the corporate income tax, 10th on the sales tax, 5th on the unemployment insurance tax, and 28th on fiscal balance.
Indiana’s personal income tax system is currently quite competitive: 10th overall, and best among states that levy a broad-based tax on all types of personal income. One of the features of Indiana’s income tax that is most conducive to economic growth is its single-rate that applies to all income. It is one of only five states with this advantage. The changes proposed by Governor Daniels would create a two-tiered rate structure and drop Indiana’s personal income tax ranking from 10th to 16th best.
Overall, the tax changes promoted by Governor Daniels would damage Indiana’s standing in the Index relative to other states. Indiana’s final Index ranking would fall seven spots from 12th to 19th (see Table 2).
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Table 2 : Indiana’s Ranking in the State Business Tax Climate Index |
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Rank of Indiana’sIndividual Income Tax |
Rank of Indiana’s Entire Tax System |
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Original Rank |
10 |
12 |
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Final Rank |
16 |
19 |
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Rank Change |
-6 |
-7 |
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Note: No changes to Corporate, Sales, UIT or Fiscal Indexes. Source: Tax Foundation’s State Business Tax Climate Index |
Temporary Taxes Gov. Daniels is undoubtedly sincere in his intent to let this new tax expire after one year. But savvy taxpayers know that many a “temporary” tax hike has settled in, gotten comfortable, and made itself indispensable (or so people will say).
A typical case is the brawl next door in Ohio, where a sales tax hike from 5 percent to 6 percent was passed in 2003, supposedly for just 2 years. Despite a loud campaign for repeal by Ohio Secretary of State Kenneth Blackwell, the Taft Administration made no promises, and it has just now officially reneged on total repeal, calling for a permanent 5.5 percent rate. Ironically, the 5-percent rate itself was a “temporary” rate increase passed in 1981, made permanent less than a year later.
Another temporary tax hike passed recently in New York, one which closely resembles Gov. Daniels’ proposal. In 2003, New York enacted a 3-year “temporary” income tax rate of 7.7 percent on high-income taxpayers. Who believes it will actually expire at the end of 2005? Even with a lantern in the daytime, you would have a hard time finding a New Yorker who would bet on the timely expiration of that rate.
Conclusion Governor Daniels should withdrawal his proposed income tax surcharge. Daniels himself vowed, as a candidate for Governor, to do a better job competing with neighboring states for jobs and investment. This makes his proposal all the more surprising considering that it would make Indiana less competitive. In the end, Daniels may have left himself an escape route, however. Having promised to put the new tax revenue in the state’s rainy day fund, creating no new spending obligations, he will have an easier time backing away from his controversial proposal.
State lawmakers will always face higher spending demands. Raising taxes, particularly in an era of mobile labor and capital, is not the right way to meet those demands. A healthy Indiana economy is the surest source of stable revenue to support necessary public infrastructure.
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