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Adapting Income Taxes to the Changing Nature of Work

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Ian Hutcheson
April 23, 2021

One of the enduring impacts of the COVID-19 pandemic will be the re-evaluation it has forced over how people work. As working from home became widespread, the bond between jobs and geography was eroded. This shift has critical consequences for those state and local governments which depend on income tax revenue to fund their operations.

Tensions between neighboring governments over income tax policy became more acute with the October 2020 lawsuit filed by the State of New Hampshire against the Commonwealth of Massachusetts over differences between the two states’ approaches to income tax. Such confrontations are inevitable in federal systems when socio-economic realities and the tax codes that build off them begin to shift. To adapt to the changing nature of work, state and local governments that rely on income taxes should explore opportunities for reducing uncertainty for taxpayers and promoting partnership between governments.

Tax Checks

Most Americans pay income taxes to both the federal government and at least one other governmental entity. An individual income tax is levied by 42 states and nearly 5,000 local governments. While governments and their tax systems are geographical and static in nature, people’s lives are fluid and move easily across boundaries. A common example of this disconnect are the many Americans who reside in one state while working in another.

Given the prevalence of interstate employment, 17 states share income tax reciprocity with other states,  which is a bilateral arrangement through which the states commit to only levy income tax their own residents. Neither New Hampshire nor Massachusetts have any reciprocal agreements, and the Granite State only taxes the dividend and interest earnings of its residents. At stake in New Hampshire v. Massachusetts is whether the Commonwealth is able to tax the (otherwise exempt) earnings of New Hampshire residents working remotely since the pandemic for their Massachusetts-based employers.

Functions and Arrangements

Taxation in the United States can be explained using the theory of fiscal federalism which describes the financial interactions between different levels of government and presupposes that the federal government is suited to providing overall stability, while state and local governments are more proficient in fostering innovation. As with other public policies that are left to the discretion of lower governments, the patchwork system of state and local income taxes lacks predictability, but also provides space for experimentation.

Existing somewhere between institutional levels in this framework are cooperative agreements between co-equal governments which can provide stability in moments of societal change, such as the Streamlined Sales and Use Tax Agreement (SST) which has helped states adapt to a changing retail sector with the growth of e-commerce. Income tax reciprocity and other innovations which provide broader stability may prove similarly helpful to state and local governments seeking to stabilize revenues as attitudes towards work change within society.

Limited Flows

In contrast to the broader multilateralism embodied by the SST, reciprocity agreements are bilateral and more limited. Some states do take a more expansive approach to their agreements—both Kentucky and Pennsylvania have reciprocity with seven states, including some they do not share borders with. Although their limitations limit the utility of reciprocal agreements nationally, they can have meaningful impacts for cities and regions.

Research suggests that reciprocity may help stabilize the influx and efflux of residents between neighboring states. In their 2008 article, “Income Taxes and the Destination of Movers to Multistate MSAs,” for the Journal of Urban Economics, Paul Coomes and William Hoyt discover that within multi-state metro areas, shifts in population between states with different income tax rates were less severe when reciprocity was present. If the trend towards more telecommuting continues, such agreements between states may help to allay fears that states with higher tax rates will begin to lose residents.

Mutual Assurances

The argument that broadening the tax base is potentially more important to revenue growth than the actual tax rate is a common refrain from advocates of lower taxes. From this perspective, reciprocity would seem ill-advised, since it precludes growth in a state’s tax base from in-state employers attracting out-of-state workers.

In states with higher income taxes, reciprocity may help spur entrepreneurial activity, as argued by Don Bruce, Jon Rork and Gary Wagner in their 2014 article for the Journal of Entrepreneurship and Public Policy, “State Income Tax Reciprocity Agreements and Small Businesses.” The authors find that reciprocity helps encourage small business growth in higher income tax states by softening the impact of those rates on inhibiting growth in the sector. Cooperation between neighboring states over tax rates may help create the fiscal predictability that will ultimately appeal to both businesses and residents looking to relocate.

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Among the many trends in society that the COVID-19 pandemic has accelerated is the increasing mobility of the workforce, and the tax revenue associated with it. Along with their economies, state and local governments will need to stabilize their income tax revenues. Collaborative reforms like reciprocity that reduce uncertainty for residents and businesses will aid them in creating tax codes that are adaptable to changes in society.

Author: Ian Hutcheson, MPA is a Management & Budget Specialist for the City of Oklahoma City and the President of the ASPA Oklahoma Chapter. He is a 2018 graduate of the Master of Public Administration program at the University of Kansas. Ian’s professional areas of interest include city management, finance and budget, economics, and organizational change. Contact: [email protected]. Twitter: @ihutch01

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