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Last week, Tennessee Gov. Bill Haslam signed Senate Bill 47, affecting the state’s Hall Tax on dividend and interest income. But the unusual nature of the Hall Tax, and of this legislation, have created some lingering questions regarding this bill’s consequences.
Did Tennessee just eliminate its income tax? Yes and no. SB 47 reduces the tax rate from 6 percent to 5 percent in the first year, eliminates the tax entirely in 2022, and declares the legislature’s intent to gradually reduce the rate in the intervening years. In essence, lawmakers bought a ring and set a wedding date, but gave themselves six years to plan the wedding and find the money for it. That’s a big commitment, but not quite the same as tying the knot; people can change over the course of six years, and the Tennessee legislature will have new members and be operating in a different context six years from now.
So why the long engagement? While Tennessee had a modest budget surplus coming into this year, the Hall Tax brings in more than $300 million per year and Gov. Haslam and others expressed concerns about the state’s ability to afford full repeal of the tax. And because more than $100 million in Hall Tax revenues are distributed to Tennessee cities and counties each year, opposition to repeal from local officials was strong as well. By delaying repeal until well outside the current budget window (2022), current legislators can take credit for “eliminating” the Hall Tax without having to identify a way to deal with the associated revenue drop for another six years—if they are even still in office when that time comes.
Who will be harmed and who will benefit? As we have written about here, here, and here, the primary beneficiaries of this bill are a small number of the wealthiest Tennesseans. The highest-income 5 percent of households will receive 61 percent of the tax cut while only 14 percent of the benefit will flow to the 95 percent of Tennesseans who earn less than $173,000 per year. The remaining 25 percent actually ends up going to the federal government as Tennesseans will lose the ability to write off their Hall Tax payments on their federal tax returns and will pay more in federal taxes as a result.
The negative effects of Tennessee losing more than $300 million in revenue, meanwhile, are more likely to fall on everyday Tennesseans. Local officials have been vocal that they are “definitely not happy about” losing their share of the funding (three-eighths of total Hall Tax revenues) and will “have to either increase property tax or cut services or both.”
The state will ultimately face a similar decision, either having to cut funding for services like schools and public safety or raise other taxes to replace the lost Hall Tax funding. But finding potential cuts in Tennessee’s already lean budget will be difficult, as the state currently ranks 48th in education spending and 43rd in total state and local spending as a share of personal income.[1] Moreover, the fact that Tennessee is unusually reliant on its sales tax (2nd highest reliance on general sales taxes in the country) to fund government means that its budget situation is likely to grow increasingly difficult in the years ahead if Tennesseans’ consumption habits continue to shift away from (taxed) goods and toward (often untaxed) services and Internet purchases.
What is more, the Hall Tax was already one of the few progressive features of Tennessee’s tax structure, so any future tax increases to offset the revenue loss are likely to hit low- and middle-income Tennesseans the hardest. The Tennessee tax system is more regressive (meaning it captures a greater share of income from the lowest-income residents than the wealthiest) than in all but six other states, a situation that will only worsen under SB 47.
Is this an example other states can follow? Anti-tax advocates in other states might mistake this year’s action in Tennessee as an indication that their state may be able to eliminate its own income tax. In reality, however, Tennessee’s situation is unique enough that it’s unlikely to offer many lessons for would-be tax repealers elsewhere.
To be clear, Tennessee already lacks a broad-based income tax as the Hall Tax only applies to certain types of dividend and interest income. Moreover, the tax already includes generous exemptions that keep the vast majority of Tennesseans from paying anything at all. So while the Hall Tax is an important source of revenue for Tennessee’s state and local governments, it is also much more modest than the broad-based income taxes that advocates in other states sometimes seek to repeal.
The Hall Tax generates 1.3 percent of state and local tax revenue in Tennessee, the lowest share of any state outside of the seven states that have no personal income tax at all.[2] Other states that have recently considered eliminating their income taxes are many times more reliant on those taxes than is Tennessee. For example, personal income taxes are 15 percent of tax revenues in Arizona, 21.7 percent in Oklahoma, and 22.9 percent in Kansas.
And despite the Hall Tax’s comparatively small size, Tennessee lawmakers were only able to cut the rate by one-sixth this year—meaning that instead of losing 1.3 percent of public revenues, the short-term loss will be closer to 0.2 percent. In this light, income tax elimination in Oklahoma or Kansas would be about 100 times more damaging than what is occurring in Tennessee this year, and 17 times more damaging than what Tennessee is hoping to do over the next six years.
What’s the bottom line? Tennessee’s Senate Bill 47 has the potential to significantly reduce the adequacy and fairness of Tennessee’s tax system. But lawmakers’ desire to avoid making difficult budgetary tradeoffs led them to delay most of the bill’s impact until 2022, meaning that there is plenty of time for the law to be scaled back or repealed before it takes effect. Moreover, lawmakers and advocates in other states should be careful not to read too much into Tennessee’s experience—income tax repeal in a state like Tennessee means something very different than it does in a state deriving 15 to 20 percent, or more, of its revenue from taxes on income.
[1] Data in this paragraph are for Fiscal Year 2012-13 from U.S. Census Bureau Survey of State and Local Government Finances, the most recent data comparable across states; spending measure is direct general expenditures; Personal Income data from U.S. Bureau of Economic Analysis.
[2] Data in this paragraph also from U.S. Census Bureau Survey of State and Local Government Finance, Fiscal Year 2012-13.