Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / Why US States Keep Cutting Taxes and What It Costs
Transcript
- Lucas: There is a tax cut experiment happening right now in American states that barely gets national attention, but it is reshaping everything from school funding to small business formation. Luna: You mean the wave of income tax rate reductions we have seen since 2021? I think something like a dozen states have cut their top marginal rate in the last three years. Lucas: More than that. By my count, 19 states have enacted some form of individual income tax cut since the pandemic recovery started. And the pace accelerated in 2025. Georgia, Idaho, Mississippi, Missouri, Nebraska — all of them have brought their top rates down. Luna: And the argument is always the same: lower taxes will lure businesses and workers from high-tax states, boost economic growth, and eventually the tax base expands enough that revenues don't actually fall. Lucas: That is the Laffer Curve logic in its purest form. But the evidence is a lot messier than the politicians admit. And I want to drill into one specific case that I think is the most instructive failure of the last fifteen years — Kansas. Luna: Oh, the Brownback experiment. That is the cautionary tale that keeps getting cited, but does it actually apply to what states are doing today? Lucas: It absolutely does, because the mistakes Kansas made in 2012 are being repeated in slightly different packaging. Governor Sam Brownback signed massive income tax cuts — the top rate went from 6.45 percent all the way down to 3.9 percent, and they eliminated taxes entirely on pass-through business income. Luna: And the promise was that this would be a 'shot of adrenaline' to the Kansas economy. Lucas: Exactly. Brownback said it would create a 'red-state model' for growth. What actually happened was catastrophic for the state budget. By 2017, Kansas was facing a roughly $900 million budget shortfall — that is about 15 percent of the state's general fund. They had to slash education spending, delay infrastructure projects, and eventually the legislature overrode Brownback's veto to repeal most of the cuts. Luna: But critics say that Kansas was an outlier — they cut too fast, too deep, and with no trigger mechanisms if revenues fell short. The current wave of cuts is more gradual. Lucas: That is a fair point. States like North Carolina have taken a much slower approach. North Carolina has been reducing its income tax rate for over a decade, from a top rate of 7.75 percent in 2013 down to 4.5 percent now. They have gradually broadened the sales tax base to offset the losses. And their economy has grown reasonably well. Luna: So the question becomes: can the gradual approach actually sustain itself? Or are we just delaying the reckoning until the next recession? Lucas: That is the million-dollar question. And we actually have some new data that helps answer it. In early 2025, the Federal Reserve Bank of Philadelphia published a study looking at all state income tax changes between 1990 and 2020 — not just the big cuts, but every rate change. Luna: What did they find? Lucas: The headline result: a one-percentage-point cut in the top marginal income tax rate increased net business formation by about 0.3 percent. That is statistically significant but economically tiny. Meanwhile, the same cut reduced state education spending by about 6 percent over five years, because revenues simply did not rebound enough. Luna: So the trade-off is brutally clear. You get a very modest boost to business creation, but you pay for it with cuts to public services that are correlated with long-term growth — like education. Lucas: Right. And the study also found that the business formation effect was concentrated in a few industries — professional services, real estate — not broad-based across manufacturing or retail. So the supposed 'jobs boom' is really more of a reshuffling. Luna: I want to push back on one thing, though. The study looks at average effects, but what about states that are losing population? New York and California have seen net out-migration for years, and high taxes are often cited as a reason. Lucas: That is the classic 'race to the bottom' argument. And there is some truth to it. A 2024 study from the University of Michigan found that high-income households are indeed more likely to move from high-tax to low-tax states, especially at retirement age. But the overall impact on state GDP is surprisingly small — because the people moving are often older, wealthier, and less attached to the labor force. Luna: So you lose some tax base from retirees, but the working-age population is less mobile? Lucas: Exactly. Young professionals tend to move for jobs and housing costs, not primarily for state income tax rates. And California, despite its top rate of 13.3 percent, still has the fastest per-capita GDP growth among large states over the last decade. So the narrative that high taxes automatically kill growth is just not supported by the data. Luna: Before we go further, Lucas — I know this episode is getting into some dense fiscal territory, and I want to mention something. If this kind of analysis is useful to you, and you want to keep the show free and ad-free, there is a simple way to help. Lucas: Yeah, we don't run ads on The Fiscal Policy Podcast — that is a deliberate choice. And the support comes entirely from listeners who chip in. If today's episode was worth something to you, you can go to buy me a coffee dot com slash fexingo. That is buy me a coffee dot com slash fexingo. Luna: Even a couple of dollars a month means we can keep producing these deep dives without any sponsor pressure. So if that feels right, we appreciate it. Now back to the tax cuts — you were about to talk about what happens when the economy slows. Lucas: Right. So the real test for these tax cuts will come when the economy hits a rough patch. We have been in an expansion since 2020 — the longest on record, actually — and state revenues have been boosted by inflation and strong corporate profits. But the Congressional Budget Office projects a slowdown starting in late 2026. Luna: And that is when the structural deficits from permanent tax cuts become visible. Because if you cut rates during a boom, you are locking in lower revenue when the bust comes. Lucas: Exactly. Look at what happened in Kansas during the 2015–2016 downturn. Their revenues collapsed, and they had to cut spending on education by over $200 million in a single year. That had real consequences — teacher shortages, larger class sizes, lower test scores. Luna: And yet, other states seem not to have learned that lesson. I was looking at Oklahoma, which just passed a bill to reduce its top rate from 4.75 to 3.99 percent over the next three years. They did not include any revenue triggers. Lucas: No triggers, no sunset clauses. That is the pattern. The Tax Foundation — which is generally pro-growth — recommends that states at least include a 'circuit breaker' that automatically pauses cuts if revenue growth falls below a certain threshold. Very few states do that. Luna: So what is the alternative model? Are there states that have managed to stay competitive without slashing income taxes? Lucas: Yes, and I think Minnesota is the most interesting example. In 2023, Governor Tim Walz and the legislature actually increased the top marginal income tax rate to 10.85 percent — one of the highest in the country. They also created a new fourth bracket for income over $1 million. Luna: And the sky did not fall. Lucas: Not at all. Minnesota's GDP grew 2.7 percent in 2024, above the national average of 2.4 percent. Their unemployment rate is 2.9 percent, below the national average. And they used the additional revenue to fund universal free school meals, expand paid family leave, and invest in affordable housing. Luna: So the progressive tax and invest model is working in practice, not just in theory. Lucas: It is working for now. But the challenge for states like Minnesota is that they are increasingly outliers. As more states cut rates, the pressure on them to follow suit will grow — especially if businesses start voting with their feet more aggressively. Luna: And that is the real tension: individual states are acting rationally in their own self-interest, but collectively they may be creating a race to the bottom that undermines public investment across the country. Lucas: That is exactly the collective action problem. The federal government could theoretically set a floor on state income taxes — the way it does with the federal estate tax credit — but there is zero political appetite for that. Luna: Not in this Congress, no. Lucas: So we are left with a patchwork. And the stakes are about to get higher. The 2026 midterm elections will see 36 states elect governors, and tax policy is already a top issue in swing states like Pennsylvania, Michigan, and Arizona. Luna: What do you expect to happen? More cuts, or a pause to assess the damage? Lucas: I think we will see a split. States with Republican trifectas will probably push for more cuts, especially in states like Texas — which currently has no income tax but is considering a property tax swap. Democratic states will likely hold the line or raise rates on the wealthy. But the real wildcard is what happens in purple states where control of the legislature is up for grabs. Luna: And in the meantime, the fiscal capacity of states — their ability to respond to the next recession — is eroding. Lucas: That is the part that keeps me up at night. State rainy day funds are at record levels right now, about $130 billion nationally. But if the next recession hits in 2027 or 2028, and states have permanently lower income tax rates, those funds will be depleted much faster. Luna: And we saw in 2020 that states with deeper revenue cuts had slower recoveries. The CARES Act helped, but it was a one-time fix. Lucas: Right. So the question for voters in 2026 is not just 'do you want lower taxes?' but 'what services are you willing to give up to get them?' And that is a conversation that deserves a lot more nuance than campaign ads usually provide. Luna: I think that is the core of this episode. Thanks for walking through it, Lucas. Lucas: Glad to. And I hope listeners take away one specific question to ask their state candidates: what is your plan to fund education and infrastructure if you cut income taxes? Because the answer reveals everything.