Indiana Effort to Eliminate Income Tax Creates New Tax Puzzles

The Indiana legislature has annually looked for ways to improve Indiana’s tax climate during the past two decades to make it more attractive to businesses and to its residents.

Those changes have included reductions in income tax rates, the issuance of tax refunds, the elimination of the throwback rule, and more recently the adoption of a pass-through entity tax. This steadily progressing, finely tuned approach has had excellent results—the Tax Foundation ranks Indiana in its top 10 best business tax climates in the country.

Indiana is now exploring arguably its most ambitious initiative. The Senate earlier this year established a task force to review, among other goals, “[t]he individual income tax, including methods to reduce or eliminate the individual income tax.”

Is Indiana likely to eliminate its individual income tax? The challenges are as numerous as they are substantial.

The individual income tax accounts for roughly $8 billion of annual revenue. Finding government cost savings of that magnitude seems to be an insurmountable hill to climb. That leaves either considering alternative revenue sources or merely reducing as opposed to eliminating the tax, or both.

The state can’t just nickel-and-dime its way to finding $8 billion of alternative revenue—instead, there need to be “big buckets” of new revenue. A broadening of the sales tax base to include more services might generate big revenue, but at what cost?

Those big buckets theoretically could include sales tax on groceries, health care services, business-to-business services, educational services, and real estate, including rentals. Sales tax on groceries would disproportionately hurt lower-income individuals. The high cost of health care and education is already more than many can afford and is continually rising, so adding a sales tax to further increase those costs seems doubtful.

Sales tax on B2B services would result in tax pyramiding and higher costs of goods to consumers, so that also seems doubtful. Imposing sales tax on real estate would increase the cost of home ownership and rentals, adding a burden to an already ailing commercial real estate market. The negative political and economic impacts from those new taxes could far exceed any benefit of eliminating the income tax.

A local option sales tax has been mentioned, but that would create administrative and compliance complexities and burdens. It also would place more reliance on volatile and regressive taxes. Any proposal to eliminate the individual income tax that is to be funded with new taxes, higher rates or broadening of the base of other taxes, eliminations or reductions of deductions and credits, or the imposition of fees of various types, likely would be vigorously opposed.

Incentivizing businesses and individuals to move to, remain in, or expand in Indiana are primary purposes of eliminating the individual income tax. Indiana wants to attract and retain remote workers, college graduates, and businesses. But is there compelling evidence that state individual income taxes are a primary reason individuals and businesses locate in a particular state?

Income tax is one part of a tax system designed to balance the state’s need for multiple revenue sources, the need to provide an attractive business climate, and principles of fairness. Eliminating individual income taxes may disproportionately benefit the wealthy, thereby making Indiana’s tax structure more regressive. And if elimination is funded through reduced government services, the disproportionate adverse impact on the poor could be exacerbated.

No one likes to pay taxes, but everyone likes good roads and sidewalks, police and fire protection, good schools, broadband, and myriad other government services. Taxes are the price we pay to live in a civilized society, and they fund essential government services.

Of course, “essential” is a subject of great debate. Reducing tax burdens and allowing Hoosiers to keep more of what they earn is a noble goal, if not simply part of good governing. But the other part of good governing is providing the infrastructure and quality workforce that businesses need to thrive, as well as the services and programs that enhance the quality of life for all Hoosiers.

This is a bold initiative, and the legislature should be commended for thinking big. It’s healthy to reexamine Indiana’s tax structure to determine whether the state is already on the right path, if its path can be fine-tuned and improved, or if big changes are needed and the benefits outweigh the costs.

At the same time, Indiana should be proud of what it has accomplished. We have one of the best, if not the best, tax climates in the Midwest. As the task force continues its work, let’s remember the words often attributed to Bert Lance, adviser to former President Jimmy Carter: “If it ain’t broke, don’t fix it.”

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Mark J. Richards is a tax partner at Ice Miller, with over 38 years of experience in the area of state taxation.

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