The inflation rate has slowed markedly in recent months, even falling slightly in December, but at the end of the year, prices were still 14.6 percent higher than two years earlier. That’s the fastest inflation rate for two calendar years since the stagflation era of the late 1970s. State policymakers are understandably keen to throw in whatever tools at their disposal to tackle the problem. And many of them are looking for fiscal policy solutions.
Are tax refunds and tax holidays the answer?
Most states are still flush with cash, while taxpayers continue to face high prices for everyday goods. No wonder 19 states have adopted some form of temporary tax refund program since 2021, with another wave of checks likely to be written this year. But as we’ve explained before, good intentions don’t always make good policy:
Consumers not only pay more, they buy more. Despite supply chain failures, and indeed contributing to them, container traffic at major US ports broke records in 2021. Prices are high, in part, because supply is struggling to meet demand, especially for physical goods. Additional one-time transfers put even more pressure on the system. Even if taxpayers put only a fraction of the money into additional consumption, the result is more pressure on the demand side when there is already a shortage of supply.
Long-term tax relief also puts more money in taxpayers’ pockets, of course, but with a very different incentive structure. Permanent rate reductions or structural reforms create a higher return on labor and investment and thus promote economic growth. Conversely, while a single payment induces some economic changes, it by definition does not change long-term planning. More money withheld from taxpayers under long-term reforms will be accompanied by changes in labor supply, productivity, and capital investment, increasing supply and demand.
Even if one-time tax rebates aren’t particularly economically efficient, it’s not unreasonable for lawmakers to prefer them over unnecessary one-time government spending or, worse, use one-time revenue gains for long-term spending increases. . Such policies may have their place. But its ordinary inefficiencies are magnified in a high-inflation environment.
Income taxes that adjust for inflation are always a good policy, but they are particularly important in today’s high-inflation environment. Indexing for inflation helps prevent taxpayers from moving into higher tax brackets due to inflation-induced wage increases that have not increased their purchasing power, a process known as bracketing. Here is an example taken from our previous analysis:
Let’s say you bought $10,000 worth of stock in 2001 and sold it for $20,000 in early 2021. Both the federal and state governments would treat this as capital gains income of $10,000. The federal government offers a prime rate on long-term capital gains, while most states do not. However, in real terms, the profit is much less than $10,000 because cumulative inflation during that period was almost 55 percent, making the real profit $4,502. Note that indexing tax codes for inflation alone cannot solve the capital gains income surtax problem, but it is at least illustrative of the larger problem.
When states do not index brackets, deductions, and exemptions for inflation, they allow one unlegislated tax increase to take place each year. The federal government created much of the inflation taxpayers suffer today; States should not add insult to injury by using inflation as an excuse to increase effective income tax rates.
Property values have risen dramatically since the start of the pandemic, and that means the property tax burden has risen as well. It makes sense for property value to be the base of a homeowner’s tax bill, but it doesn’t make sense to allow tax collections to skyrocket just because property values are increasing. In many states, assessed values have increased by 25 to 40 percent in the past two years. The cost of local government hasn’t increased by that much, and residents don’t get 25 to 40 percent more or better government services for their money.
This is where property tax limitations can come in. These limitations come in three forms: lien (income) limits, rate limits, and assessment limits. States often set assessment limits by default, following the path blazed by California’s Proposition 13, but as we recently explained, that’s a mistake:
Proposition 13 and other property tax assessment caps have done their job, keeping property owner taxes in check. But they have come with hidden costs. They discourage homeowners from renovating or adding to their homes, for fear of incurring a drastic increase in taxes. They make it less attractive for growing families to move beyond their initial homes or for empty nesters to downsize. They interfere with efforts to change the use of a property. And, over time, they pass the costs on to newer, younger homeowners – the rising generation that [state] lawmakers want to keep in state.
As we have discussed in the past, legislators would be better served by adopting tax caps, which allow property tax burdens to change. in relative terms based on changes in the assessed value of a given property, but avoid allowing general property taxes to rise too much, too fast.
Should groceries be exempt from sales tax?
Spend a few minutes pushing a shopping cart these days and you might be crying out for some savings on groceries. Not surprisingly, there has been a renewed push to exempt groceries from the sales tax base. Unfortunately, the exemption erodes a relatively growth-friendly tax, leaving states to generate more of their revenue from less economically efficient sources, and it doesn’t do what it sets out to do. As our research has revealed:
It is commonly assumed that the grocery exemption from the state sales tax bases has a progressive effect, with a distribution of benefits that favors low- and middle-income taxpayers. It is primarily on this basis that legislators in most states have removed groceries from the sales tax base. The assumption is simple and, on the surface, reasonable, and it is wrong. As counterintuitive as it may seem, the lowest decile of households experience 9 percent more sales tax liability under a sales tax with a grocery exemption than one with groceries in the base, assuming rates adjust to generate the same amount of revenue from each tax. base.
Our report details the reasons for this surprising result, including the existing exemption for SNAP purchases (increasing the relative importance of income tax). not-food for lower-income households), how groceries are defined for tax purposes, and the distribution of grocery costs. The bottom line is that states would not only make their tax codes more efficient, but their lowest-income households would also do better if they took whatever income they were willing to give up to take groceries out of the income tax base. sales and instead steer it towards a general rate cut.
Can states implement fiscal policies to Combat Inflation?
States can respond to inflationary pressures on taxpayers, but because inflation is essentially a monetary phenomenon, there is relatively little any state can do to curb inflation itself rather than cushion its effects on its residents. However, states have a valuable tool available that not only promotes economic growth in the state, but also helps lower prices.
Our economy has changed since the beginning of the pandemic. We are consuming differently and companies are forced to adapt to these changes in demand. Remodeling takes time and investment. Unfortunately, a recent change in the federal tax code means that inflation increases the cost of the very business investments that can increase supply, address supply chain bottlenecks, and begin to flatten the cost curve. Here is the problem:
When a business pays tax, it deducts ordinary business expenses from income to determine taxable income and its tax liability. Ordinary business expenses include labor costs (wages and salaries) as well as operating costs. However, when a company makes a capital investment (in land, facilities, machinery or equipment), under traditional rules, the deduction is spread over several years, sometimes decades. (There are different depreciation schedules for different kinds of capital investment.) By denying a full deduction for capital investment costs, the tax code creates taxable income that exceeds actual income on a cash flow basis.
This increases the cost of the investment even though the company will ultimately take the full deduction, as the value of future tax savings is reduced by both inflation and the time value of money. On margin, some investments are no longer profitable and will not be carried out.
States can’t force the federal government to make full spending permanent, but they can use their 2023 legislative sessions to ensure pro-investment tax policy doesn’t disappear at the state level just when it’s most needed.
