States want to cut taxes on pensions, proving bad ideas never die

The siren song of retirement income free of state taxes continues to seduce politicians. No matter that there is little evidence that high taxes on pension income drive away seniors, or that few older people move from one state to another for any reason at all. No matter that tax-free retirement income benefits the rich at the expense of low- and moderate-income households. No matter that many states talking about doing this are facing serious budget shortfalls.

In sum, excluding retirement income from state tax gives money that states don’t have to people who don’t need it to discourage them from doing something that, by and large, they are not doing.

The idea of excluding pension income from state tax is hardly new. Nearly every state with an income tax has enacted some tax break for those over 65. But there seems to be a new wave of interest in expanding these subsidies proving, yet again, that bad ideas never die. Two examples: Rhode Island and Maryland.

In Rhode Island, Democratic leaders in the state legislature have introduced measures to exempt retirement income, including Social Security and private pension benefits, from state tax.

Some versions could cost the state as much as $60 million annually. This for a state that already faces a projected budget deficit of $190 million. And has an unfunded public pension liability of $8.9 billion (a still-unresolved deal between the state and its unions could cut that to merely $5 billion).

In Maryland, Republican Governor Larry Hogan has proposed phasing out the income tax on veterans' pensions over four years, and he calls it just the first step towards eliminating tax on everyone's retirement income.

Hogan argues that military pensions in Maryland average about $29,000, implying that these vets need the extra cash. Trouble is, Marylanders over 65 and those with disabilities can already exclude $29,000 from their Maryland taxable income, plus vets get to knock off an extra $5,000. Thus, the average military pension is already tax free.

So who benefits? Mostly vets under age 65—many of whom take early retirement and get another job.

But what about the argument that lowering taxes on pensions keeps retirees from fleeing to lower-tax climes or attracts new ones? In sum, it is a myth.

For years, economists Karen Smith Conway of the University of New Hampshire and Jonathan C. Rork of Reed College have been carefully studying this issue. Their conclusion, from a 2012 National Tax Journal paper: “Our results are overwhelming in their failure to reveal any consistent effect of state income tax breaks on elderly interstate migration.”

The first thing to know is that very few seniors move from one state to another at all. The five-year migration rate of older people is only about 4 percent, according to Conway and Rork and others.

Of course, some people do move. Is their choice driven by tax policy?

Over the past 40 years, many states have changed the way they tax retirement income, often by enacting full or partial exemptions for pension income.  And seniors know it. Most of those ubiquitous articles that rate the best places to retire are very explicit about taxes.

All this makes economists very happy because they can study how these tax changes drive retiree behavior.

Back in 2004, Jon Bakija and Joel Slemrod found that some very wealthy people did leave states with high estate and sales taxes, though high income taxes were less likely to drive their decision.

Conway and Rork, looking at much more extensive data, found little evidence of tax-driven migration. Even among high-income, relatively young (age 55-70), and healthy retirees, income taxes hardly matter.

One caveat: Conway and Rork’s data end in the year 2000. It is possible that something happened over the past 15 years to change the way seniors think about taxes and residence. But, if so, no one has found it.

My guess is that right now, Rhode Island is filled with seniors mulling a move south. Most of them are sadly contemplating the enormous piles of snow in their driveways, the ice dams on their roofs, and their busted shovels. Few of them are thinking about taxes.

The post States Want To Cut Taxes Even More on Pensions. Bad Ideas Never Die. appeared first on TaxVox.