What happens to blue states if there is no federal income tax?
As I write, the news and financial markets are reeling over the effects of President Trump’s imposition of tariffs on goods imported from Mexico, Canada, and China. Mexico and the US have just agreed to a pause in those tariffs for a month as diplomats from both countries come up approaches designed to prevent the flow of fentanyl into the US from the south.
While Trump appears to be using these tariffs as a blunt diplomatic tool to address a particular problem on his mind, it has become increasingly clear that he would like to impose universal tariffs on all goods imported into the US. Meanwhile, there has also been more and louder conversations about not merely extending the tax cuts passed during the first Trump administration, but eliminating income taxes altogether.
There are certainly a number of complicated questions that would need to be addressed should the combination of universal tariffs and no federal income taxation arise. However, there is one question that I have yet to hear being addressed.
If this actually happened, what would happen to blue states?
It is generally understood that blue states have higher taxes and regulations than red states. While their differences in governance may be stark, the federal government’s larger scale of taxation and involvement in our lives has tended to mute those differences. After all, a wealthy California resident may have to pay the highest state marginal tax rate in the state of 13%) but also has to pay the highest federal marginal tax rate of 37%.
If that resident finds him- or herself no longer having to pay federal income tax (putting aside payroll taxes that would most likely continue), that 13% state income tax rate becomes a much more significant burden relative to the remaining taxes.
It would then become far more reasonable for that person to ask whether he or she has been receiving from the state in exchange for these taxes.
If we look over just the past five years, California’s government spending has been out of control. The state’s spending through its general fund (which is the state’s primary operating fund) has grown 20% a year over the past five years. However, the most recent wildfires in the Los Angeles area have shown that the state’s spending priorities have been geared more towards pet projects such as DEI and the Green New Deal over providing basic services to California residents.
At a certain level, investors financing California’s debt are aware of this. On the one hand, wealthy Californians can earn more after-tax income from investing in California municipal debt than if they were to purchase US Government bonds of a similar maturity. However, one reason they’re able to earn such a return is because of the increased risk arising from investing in California debt. California still may have a AA credit rating, but it is increasingly obvious that the state will face challenges meeting the increasing liabilities it is incurring.
What I am not sure about is whether either blue states like California and investors who purchase their municipal securities have thought through the implications of the US repealing the income tax. If that happens, municipalities will have to pay a much higher interest rate to compensate for investors no longer receiving federal income tax benefits from investing in their debt.
That’s not the only problem blue states may face. In this scenario, higher-income residents might find themselves asking increasingly challenging questions about whether blue states can maintain their services and debt financing. Not only would they become increasingly reluctant to invest in their debt (or at least demand a higher return to compensate for the higher risk), they may decide to leave blue states altogether.
Among the arguments blue states made to attract and keep businesses and wealthy taxpayers is that they have first world infrastructure and cultural activities, at least in relation to red states. However, the relative attraction of blue states has been rapidly fading, especially after the COVID lockdowns in 2020. Meanwhile, Florida, Nevada, Texas, and Washington are among the nine states that have no state income taxation. It has become increasingly difficult for blue states to demonstrate that they are attractive states in which to work and live. If the United States eliminates the federal income tax, red states become that much more attractive.
As poorly as blue states like California has performed recently, it would not be prepared in the slightest should Congress implement the universal tariff/no income taxation structure Trump has been pointing towards.
Whether this occurs remains to be seen.