A Better Reason for a Flat Tax
Newly-released data from the Bureau of Economic Analysis (BEA) show that in states such as Arkansas and Mississippi, $100 can buy $115 worth of goods, while in New York and Hawaii, the same dollar value will only get you $86 worth. The Tax Foundation used the data to create a map showing large overall disparities in regional price differentials. This provides yet another argument for a flat tax.
Tax Foundation economists Alan Cole and Scott Drenkard correctly note that areas with higher prices also tend to have higher incomes, because employers must compensate for their employees’ reduced purchasing power. Therefore, people earning $44,000 in West Virginia can afford the same standard of living as someone earning $58,000 in Hawaii, despite the gap in nominal income.
But the federal government does not account for these regional price disparities when setting tax policy. The progressive federal income tax means that those who earn a higher income in nominal terms will pay a higher tax rate. However, the varying cost of living across the United States means that those who earn a higher nominal income may not actually be any richer, yet will still have to pay the taxes for it.
This violates an important goal of tax policy known as horizontal equity: people with the same income ought to pay the same amount in taxes. As long as regional price disparities exist and the U.S. maintains a progressive federal tax system, the principle of horizontal equity will be violated.
To illustrate, I calculated what a person would have to earn in each state in order to afford the same standard of living as someone earning $45,000 with U.S. average prices. The results ranged from $39,060 in Mississippi to $52,965 in the District of Columbia—a gap of nearly $14,000. Then, I ran each income through the Tax Foundation’s federal income tax calculator to determine what each individual would end up paying to Uncle Sam on April 15.
The results were striking. Despite earning the same amount in real, price-adjusted terms, someone in Mississippi would pay an effective tax rate of only 17.6 percent, while someone in D.C. would pay over 20 percent. This effectively acts as an income-redistribution program from people in high-price states to those in low-price states. The following charts show the additional tax liability or subsidy a person earning the equivalent of $45,000 in each state receives due to price disparities.
People in high-price, mostly coastal states are paying hundreds of dollars more than their fair share of tax liabilities, while people in the lower-price, mostly central states underpay. Regional differences in prices are a nightmare for horizontal equity.
A potential solution is to adjust federal tax brackets in different states for differences in purchasing power. But price disparities do not end at the state level: prices also differ by metropolitan area. People in New York City pay higher prices than people in Buffalo. This phenomenon exists even within cities, as anyone who has compared apartment prices in Manhattan and Queens can attest. There are far too many jurisdictions to effectively adjust tax brackets for cost-of-living differences.
A better remedy is to apply a flat income tax at the federal level. Under such a tax everyone would pay the same proportion of their income to the federal government, eliminating the interregional redistribution that comes with progressive taxation. Additionally, as Economics21 contributor Joseph Mitrani has argued, flat taxes have the added benefit of boosting economic growth.
Little can be done about price differentials across states. The federal government should recognize this natural economic phenomenon and update tax policy to reflect it.
Preston Cooper is a Policy Analyst at Economics21. You can follow him on Twitter here.
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