Should the state ax its individual income tax?

A powerful Senate Republican plans to introduce legislation next year to create a commission to consider changes to Indiana’s tax structure, including phasing out the state income tax. Also up for discussion are making adjustments to the property tax structure and accelerating the timeline for paying down the remaining $8.8 billion owed to the state’s pension fund for teachers who retired before 1996.

Sen. Travis Holdman, a Republican from Markle who chairs the Senate Tax & Fiscal Policy Committee, said repealing the income tax by 2030 would help Indiana compete with states like Florida, Tennessee and Texas that don’t have a state income tax and have seen economic and population growth in recent years.

Repealing the tax would benefit both individuals and pass-through corporations, such as S Corporations and LLCs, that pay income taxes, he said.

“I think that’s somewhat aggressive, but I think we could get there,” Holdman said during a panel discussion on fiscal leadership at the 31st annual Dentons Legislative Conference downtown. “It’s going to mean there’s less revenue for us to spend at the state level, but at the same time, we attract businesses to the state of Indiana.”

He also said he would like to see changes to the property tax structure but cautioned that there is “not a quick fix” to the state’s complex formula.

“We have a complicated property tax structure with property tax caps, and if we start pulling that thread, we can see the whole blanket becomes unraveled,” he said.

Holdman’s remarks came as economists predict a mild recession in 2023 and lawmakers prepare to return to the Statehouse in January to craft a two-year budget and consider funding increases for education, public health funding, workforce development programs and tax incentives.

Indiana received almost $8.2 billion in revenue from individual income taxes in 2022, accounting for more than 35% of the state’s overall tax revenue, according to the Indiana Legislative Services Agency. The only higher tax-revenue generator is the 7% sales tax, which brought in $10.3 billion, or more than 44% of overall tax revenue.

Holdman said the loss of the income-tax revenue stream could potentially be offset by increasing the sales tax or imposing a sales tax on services.

Only four states—Hawaii, South Dakota, New Mexico and West Virginia—tax services by default, while some states tax only specific services. A recent study by the Legislative Services Agency found that a 7% sales tax on services in Indiana could generate $1.9 billion to $2.2 billion in fiscal 2023 and $4.9 billion to $5.5 billion in fiscal 2024.

Michael Hicks, an economist at Ball State University, said Indiana needs to improve its public services—not reduce taxes—if it wants to attract people and businesses.

“It doesn’t really matter that Indiana does great at capital investment—mostly that subsidizes the automation of jobs,” Hicks said. “If you want to be a place that has more people in it in a decade or two or three, you must have public services that are at the level that people want. I think we have places that do well and others where there is clearly a shortfall, and we need to close that gap.”

Some economists argue that there is a direct correlation between population growth and income taxes. Over the past decade, the nine states without an income tax—Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Wyoming, Washington and New Hampshire—have seen their populations grow at twice the national rate, according to the Washington, D.C.-based Tax Foundation.

From 2019 to 2020, all of those states, except Alaska, experienced a net gain in interstate migration, according to data from the Internal Revenue Service.

Indiana experienced 0.13% growth in that year, more than any other Midwestern state but below the top 10 statewide increases.

Florida’s population grew at more than six times that rate, while Tennessee experienced 0.66% growth, and Texas saw its population jump nearly half a percent.

While the income-tax-free status of those states might play a role in their booms, families consider a variety of factors when deciding to move, including the quality of schools, health care and weather patterns, said Bridget Stomberg, associate professor of accounting at the Indiana University Kelley School of Business.

“I think that we like to think that people do things for economic reasons all the time, but that’s not necessarily the case,” Stomberg said. “There’s no easy fix if population growth is what you’re looking for. There’s no silver bullet.”

More cuts coming?

During this year’s session, lawmakers passed House Bill 1002, a tax-cut package that will gradually reduce the income tax rate over the next seven years—with the stipulation that state tax revenue must have grown at least 2% in the previous budget year. It was the state’s first income tax cut since 2013, and it was Holdman who added language to the bill to tie any income tax decrease to overall revenue growth.

The current rate of 3.23% will dip to 3.15% on Jan. 1 and, assuming revenue growth exceeds the 2% threshold, fall again to 3.1% in 2025, 3% in 2027 and 2.9% by 2029.

House Speaker Todd Huston, R-Fishers, has indicated that he would like to see further reductions in income taxes.

“We should continue to reduce income taxes for Hoosiers, especially as record inflation continues to impact the cost of everything, from what we eat to the heat in our homes,” Huston said during a speech on the House floor last month.

Senate President Pro Tem Rodric Bray, R-Martinsville, told IBJ he would like to see broader changes to the state’s tax structure.

“I’d like to do something a little more comprehensive than just make changes around the edges, and that’s why we’re putting together this blue ribbon commission—to take a look at the income tax as well as the property tax,” Bray said. “Given that, I would probably advocate for holding off on making any small changes so we can have the flexibility to make some changes that are pretty substantial for the state of Indiana.”

Bray said his caucus remains “very serious” about paying down the teachers’ retirement fund liability “as quickly as we can,” but some Democratic lawmakers aren’t as eager as Republicans and fear that allocating additional funds to the pension fund debt will take money away from efforts to improve public health, the state’s college-going rate, and pre-K and early childhood education.

“From my perspective, we need to pause on paying down the pre-’96 fund,” said Greg Porter, a Democrat from Indianapolis and the ranking minority member on the House Ways and Means Committee. “We need to focus more on human capital.”

Sen. Ryan Mishler, a Republican from Bremen and chair of the Senate Appropriations Committee, said paying down the pre-’96 fund early will open up an additional $1 billion in annual spending.

“Once you pay that down, you’ve got options to look at,” Mishler said.

Stephanie Wells, president of the Indiana Fiscal Policy Institute, said her organization does not have a position on Holdman’s proposal to eliminate the income tax but supports the creation of a panel to examine the state’s tax structure.

“I’m interested to hear more and have some data to look at the impact on Hoosiers and the fiscal health of the state,” Wells said. “The Fiscal Policy Institute would be pleased to engage in some of that research.”

A balancing act

States without an income tax must find other sources of revenue to balance their budgets. In Alaska, a state that repealed its income tax in 1980, a severance tax on the oil and natural gas industry keeps the government solvent, while Texas has higher-than-average property tax rates, and Florida brings in billions of dollars a year in tourism development taxes. Tennessee has the same state sales tax rate as Indiana at 7%, but local jurisdictions can enact their own sales tax, making the rate as high as 10% in some places.

Sen. Fady Qaddoura, an Indianapolis Democrat and the ranking minority member on the Senate Tax & Fiscal Policy Committee, said Indiana lacks the diverse revenue streams of some states and would likely have to raise sales taxes, which could place more of the tax burden on lower-income families that spend a larger share of their income on goods and services.

“Any idea that would eliminate state income tax must absolutely come up with a replacement mechanism that does not impose harm on Hoosiers, especially the most vulnerable across the state,” he said.

Qaddoura said he plans to introduce legislation to offer more tax deductions and credits for families making lower incomes.

Indiana isn’t the only state considering repealing its income tax. Kentucky, Mississippi and West Virginia are considering repealing or phasing out their individual income tax, and North Carolina recently enacted legislation to phase out its corporate income tax by 2030.

“This is a discussion that is happening in more states now than we’ve ever seen,” said Katherine Loughead, a senior policy analyst at the Tax Foundation. “And I think there are a few states, including Indiana, that have the ability to do that.”•