Polls show that a majority of Americans believe that inequality is increasing, and that taxes should be raised on the very wealthy. But income tax rates on high earners remain historically low, and estate planning techniques that minimize the reach of federal transfer taxes proliferate. What about state-level taxation? Conventional wisdom holds that progressive state tax regimes backfire by triggering wealth flight to low-tax jurisdictions, leading many states to stick with regressive sales and property taxes. But the consequences of progressive state tax policy are misunderstood, and states have many options, write Brian Galle, David Gamage and Darien Shanske, in their comprehensive, informative and practical article, Money Moves: Taxing the Wealthy at the State Level.
The tax theory of “fiscal federalism” holds that only the federal government should impose progressive taxes to fund government benefits. Fiscal federalists argue that if individual states undertook to create progressive tax regimes, the wealthy would just relocate to other states, creating “horizontal externalities.” Therefore, the federal government has put in place its more progressive income tax, which enables it to return tax revenues to the states in the form of grants or other types of revenue sharing.
But according to Galle, et al., there is no empirical support for the view that progressive state-level taxation triggers migration to tax-friendly states. In fact, they write, it’s money that usually moves while taxpayers largely stay put. And anyway, fiscal systems should be “federalism neutral.” This occurs when “voters and businesses are indifferent to whether policies are funded at the national level or instead by state or local governments. That is, political players have no reason to think that they will pay more or pay less based on which government is imposing the tax.” But since the federal tax system is generally more progressive than that of the states, the wealthy favor tax policy devolving to states. It need not be this way.
What challenges do state lawmakers face when implementing progressive tax policy? The authors helpfully borrow the descriptive term “exploitive mobility” from Julie Roin. It refers to the jurisdictional flight of taxpayers or their money that allows them to “extract benefits from one jurisdiction while escaping the costs of providing those benefits.” Exploitive mobility violates the normative principle that “the jurisdiction in which wealth or income is accrued should have the priority claim of taxing that wealth or income.” The authors further break down exploitive mobility into “exploitive migration” (physical relocation of the taxpayer) and “exploitive money moves” (relocation of “money”).
Exploitive migration takes advantage of the well-known “realization rule,” which taxes the appreciation in the value of property only when the property is sold, and never before this “realization event.” So, a resident of State X, which has an income tax, acquires property and allows it to appreciate while living in state X, and enjoying the state’s benefits. The resident then moves to State Y, which has no income tax, and sells the property there (or dies holding it), escaping the costs imposed by State X.
To combat this technique, the authors advocate taxing the owner on the property’s periodic appreciation. The recommended approach, called a “mark-to-market” tax, requires the property owner to pay a tax on the value of any appreciation in the property that occurred during the tax period. A common criticism of a mark-to-market tax is that it is difficult to measure the value of many types of property in the absence of an arm’s-length sale. Ever practical, the authors have a proposal to deal with this problem. The taxpayer can give the taxing authorities an IOU rather than a cash payment. The IOU comes due when the asset is sold (or, presumably, when the taxpayer dies), and interest on the tax debt is due at the asset’s appreciation rate. The debt is secured by “notional equity,” a proportional non-voting share in the asset. As an added feature, the taxpayer can be required to consent to the state having jurisdiction to collect the tax liability in the future.
The authors also suggest a state-level wealth tax. Here again, they pay heed to the normative principle of assigning taxing authority to the jurisdiction where wealth accumulated. They point out that since wealth taxes are “backward-looking” (wealth is built up over a period of time and taxed periodically), residency for purpose of the tax should be “phased both in and out, symmetrically, over a period of multiple years. So, their wealth tax proposal includes something called “phased residency rules.” For example, a bill in the California legislature uses a four-year phase-in and phase-out period. New residents only have one-fourth of their wealth taxed in the first year, then half in the second year, then three-fourths, and then all. A migrant out would be taxed on three-fourths of their wealth in the year after their move, then one-half, and then one-fourth, with nothing thereafter. The authors also suggest that the phasing rules could be a default fallback to “equitable apportionment” rules, that would give the taxpayer or the government room to argue for lesser or greater apportionment than the default rules provide.
When the tax base is value, volatility can be a problem. To deal with this, the authors propose that while all gains should be treated as realized in every year, a percentage of them should be unrecognized. This spreads out fluctuating gains over time. They also propose making partial non-recognition elective. Taxpayers choosing to defer recognition would be required “to agree that they would continue to report and make payments on the unrecognized balance,” regardless of whether they remain in the state or migrate out. States that implement both wealth and mark-to-market reforms could also make the wealth tax payments creditable and refundable against the mark-to-market reforms.
What about exploitive money moves? As mentioned, taxpayers can, through a number of techniques, take advantage of low tax jurisdictions without physically relocating to those jurisdictions. Instead, they can move their “money” to these jurisdictions, which is often just the movement of records and paper. Although this problem seems less tractable, the authors have a number of ideas to combat it, but here I will mention just a few.
Money can be moved to trusts. Trusts are problematic because, as the authors note, they “replicate all the estate planning strategies offered by gifts, but with greater flexibility, and the benefit of generous IRS rulings that often allow for even better estate and gift tax results.” The Supreme Court, in a 2019 case called Kaestner, held that a state’s attempt to tax a trust based only on the fact that a discretionary trust beneficiary resides in the state violated due process. According to Kaestner, the beneficiary must have “some degree of possession, control, or enjoyment of the trust property or a right to receive that property before the State can tax the asset.” This case confirmed the presence of a large loophole through which taxpayers can slip, avoiding state taxation of wealth that sustains a currently discretionary trust beneficiary who benefits from state services. The settlor need only ensure that the trustee resides in a low or zero-income tax jurisdiction. The beneficiary can even borrow against the trust assets while avoiding state income taxes in the state of residency.
The authors point out that Kaestner seemed to approve of California’s “throw-back tax.” This tax applies “when a beneficiary ‘vests,’ or becomes entitled to, the trust assets.” Importantly, the tax includes an assessment “for any prior years when the beneficiary lived in California.” A loophole to this tax, however, is that the trust beneficiary must live in the jurisdiction in the year when the trust interest vests. “If the trust beneficiary moves to Nevada, vests, then moves back to California, there is no throwback.” Of course, from that point forward it would seem that the beneficiary could be taxed in California on the income generated by the vested trust interest.
They also present ideas for taxing “’nonqualified’ deferred compensation plans” that are not subject to the contribution limitations and nondiscrimination rules of “qualified plans,” and grant highly compensated employees “unlimited” deferral of taxes. They maintain that states can subject taxpayers to wealth taxes on amounts set aside under these plans. The phased residency scheme discussed above should also work here.
In this review, I have attempted to highlight just some of the suggestions in the authors’ box of “anti-avoidance tools,” that would serve to increase the progressivity of state taxes. They have clearly been working on these ideas for some time, and have even helped design legislation, pending in some states, using some of the techniques highlighted here. Given that constituents are calling for a response to increasing inequality by way of more progressive tax policy, their ideas are timely and constructive, and recommended reading for tax scholars and policymakers alike.
