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Monday, January 04, 2010

The Foundation of the Blue State Blues

Some Blue States, like California (my home State), are really hurting. Not only do they face never ending fiscal crises, but people, especially people in their most productive years, are starting to leave these States in droves.

California was once a really great place to live. It had (and still has) great weather, beautiful terrain, and bountiful natural resources.

The typical conservative explanation is that all this wealth attracted leaching liberals who took over the government and taxed and regulated the State from prosperity into its current mess.

There may be a grain of truth to that, but the question is why did everybody else (besides the leaching liberals) let this happen. The answer, in my opinion, is that changes in Federal Tax law deserves a substantial part of the blame.

Let me explain.

From FDR's administration until after Reagan was elected, the top Federal Tax Rates were always above 70% and even exceeded 90% at points. But State Income tax was deductible. During that period, in those States with a preponderance of high income earners, both the earners and the rest of the State could benefit from instituting high State income tax rates for the high income earners and returning part of those taxes as services.

To illustrate, let's consider an example. Let's say your marginal Federal Tax rate is 90%. Then for each dollar the State taxes and receives from you (which you then deduct from your Federal taxable income), your total income tax bill (State plus Federal) rises only 10 cents. The State then provides 15 or 20 cents in services to you, a bit goes to help the poor in your State, and the rest is pocketed by the bureaucrats and lobbyists. Everybody wins! Well, everybody but the poor and middle class in all States who have to pay more to provide the revenue needed by the Federal government.

California leveraged that situation wonderfully well. They built great infrastructure (like the University of California), provided great services and funded fabulous levels of graft and corruption. Everybody assumed this gravy train would run forever.

However, two things happened that ended the free ride fairly abruptly. Federal income taxes were slashed by Reagan and the Alternate Minimum Tax (AMT) scheme was instituted which greatly reduced the ability to deduct State income tax. Suddenly paying State income taxes was a big net negative for the taxpayer. A dollar of revenue to the State was pretty much a dollar out of the pocket of the high income taxpayer.

Suddenly the services to the high income tax payers couldn't possibly make it worth it to pay the tax (that's why high income earners are leaving in droves), the programs for the poor couldn't be lavishly funded, infrastructure couldn't be maintained, and, worst of all, the fabulous levels of graft and corruption to which so many people had become so addicted could only be maintained by massive and unsustainable borrowing. Since graft and corruption are the lifeblood of politicians and lobbyists, the massive and unsustainable borrowing is a given.

This is simply a case of people responding to incentives created beyond their control. Unfortunately, bureaucracies can generally only expand, so it can't really be undone at this point until the Blue States go hopelessly bankrupt. It's a bit like a Roach Motel - or for my State, "Welcome to the Hotel California."


Susan's Husband said...

I think that's definitely a contributing factor, but I don't think it factors in public employee pensions which are just as large a part of the problem. That was permitted to happen because the benefits were gained by politicians past and the costs paid by taxpayers of today and tomorrow.

Bret said...

The public employee pensions are part of the graft and corruption. If the gravy train had continued forever, they wouldn't be as much of a problem.

Susan's Husband said...

I don't think the gravy train was enough to cover that. The pension overhang was growing much faster and didn't provide any services as part of the bargain you discuss.

Harry Eagar said...

Might be a factor, I don't know. But look to the west (Hawaii) and the east (New York), and it doesn't sound like THE factor.

Bret said...

I didn't say the pension overhang wouldn't be ANY problem, I said it wouldn't be as much of a problem.

Also, I believe the problems are much farther along now because of the advantage in the past of States like California having high income taxes and revenues because of state income tax deductions.

David said...

The problem is that it can't explain differences among the states because all states were faced with the same federal tax policies.

Why did California decide to ratchet up its taxes and build infrastructure while other states did not?

I suspect that losing control of public employee contracts is a much bigger explanation of variation among the states, which is to say, Democratic dominance.

Bret said...

Poor states, for example Mississippi, didn't have enough highly federally taxed, high income earners to make higher State taxation a viable strategy.

California did.

Mississippi was majority democrat as well, wasn't it?