How State Taxes Are Paid Matters

I have a lot of clients who escape New York in retirement, and I really can't blame them. It's difficult to tell what the most painful part about living in the Empire State is: the brutally cold winters, the aging & rotting infrastructure, or the painfully high income taxes.

The factor that my clients cite the most, though, are high income taxes (this is probably just due to the nature of my business). "These taxes are killing me!" they say, and I nod, because it's true: they're killing me as well.

Illustrating their point is this chart, showing the highest marginal (top) tax rate in each of the 51 states (including DC):

At 8.8%, New York is in the top decile of income taxes paid for higher-income clients. That's why many escape from New York and head south to Florida (no state income tax), Pennsylvania, or the Carolinas. Including local taxes, such as sales and property tax, New York ranks as the single worst state for the median (roughly $50,000) household income at about 12.6%.

The thing to keep in mind - and the point of this post - is that simply using the highest marginal tax rate can be misleading, since few of us are subject to the highest rates. A married couple making even $300,000 in New York is still paying "only" 6.9% of their marginal (top) in state income taxes - the 8.8% tax bracket doesn't kick in until annual income exceeds $2.06 million (this is a problem I want to have some day).

Furthermore, being a guy who thinks about taxes a lot, I have often wondered how no income tax states like Florida, Washington, Texas, and Nevada fund themselves. We can all celebrate living in a state without any income tax, but these states still have police officers, government workers, capitol buildings, roads, bridges, and other state-run services. It's not as if the government workers in these states do their jobs for free after all!

These states are funded by other taxes - property taxes, registration taxes and fees, sales taxes, ad valorem taxes, and the like. In fact, not having an income tax means that doing just about any other sort of business in Florida probably costs more than it does in New York!

The data bear this out. The Institute for Taxation and Economic Policy did a study earlier this year and found that "poor" folks (defined as those in the bottom 20% of annual income) pay a much HIGHER percentage of the total tax burden in states WITHOUT an income tax. This phenomena is particularly shocking in the State of Washington, where the poorest 20% of earners pay 16.8% in taxes (as a percent of their total income) while the wealthiest 1% pay only 2.5%. That is literally taxing the poor to cut taxes on the rich!

Washington is not alone - check out Flora and Texas on the list as well!

The ITEP's full report can be read here.

This finding should surprise you - it certainly surprised me! I would spend some time evaluating the total tax structure - not just income tax - for any state that you are considering moving to BEFORE committing to the move.

The key takeaway for me is that this is yet another instance of conventional wisdom being flat-out wrong. We are all told that New York and California and New Jersey are high income tax states, and while this is true, a taxpayer or retiree might be worse off in the aggregate by moving to a supposedly tax-friendly state.

I suppose the question should be: tax friendly for who?