Texas Shows Why Federal Aid Should Be Tied to State Tax Reform

Texas’ tax model is an instructive case study in a time of mounting federal debt and increasing concerns over economic inequity. The issue isn’t just a Texan problem—taxpayers across the nation subsidize a state fiscal approach that lets corporations and the wealthy off the hook. It may soon be necessary to condition federal aid on meaningful Texas tax reform.

The Lone Star State has rebranded itself as a business haven in recent years. Its permissive tax policies attract businesses and wealthy residents, offering higher take-home pay and lower overhead.

But this fiscal allure sits atop an inequitable system, as Texas relies heavily on taxes that disproportionately burden its lower- and middle- income residents. And a significant portion of the state’s revenue comes from federal coffers, which is funded by taxpayers nationwide.

Texas’ tax system is best defined by what it lacks: personal and corporate income tax. It isn’t alone on either front, but it does seem to uniquely benefit from its low-tax environment.

The absence of more progressive tax systems is attractive to wealthy individuals and businesses that would otherwise be taxed in higher brackets. It also means the state relies more heavily on regressive models of property and sales and use taxes to compensate.

Texas property taxes, which are the seventh-highest in the nation, are regressive and can penalize property owners that would seek to maintain or improve their property. Nationwide studies have indicated owners of inexpensive houses pay almost 50% higher effective rates than owners of more expensive ones. That’s because the effect of inaccurate assessments are more impactful on taxes owed for a lower-value home than a higher-value one.

At the same time, sales and use taxes, with Texas ranked 14th-highest in the nation, weigh most heavily on those who spend the largest share of their income on taxable goods and services.

Compounding this reliance on regressive policies is Texas’ dependence on federal aid, which tends to undercut any defense of these regressive policies that turns on the state having posted a surplus in 2023. Texas might be doing its own thing fiscally, but it’s doing so at least partially on the backs of federal taxpayers.

Texas’ reliance on regressive tax models and federal aid creates challenges. First, lower- and middle-income Texans bear a disproportionate share of the state’s tax burden.

The state has the seventh-most regressive taxes in the US, according to an Institute on Taxation and Economic Policy study this year. Property and sales taxes aren’t tied to income or wealth, so they consume a larger percentage of earnings from people lower on the economic spectrum.

The effect is a subsidization of corporations and high-income residents who benefit from state infrastructure, public services, and economic growth, but don’t proportionately contribute to the costs incurred by those benefits.

Texas’ reliance on federal aid places additional strain on national budgets and gives corporate and wealthy individual migration to the state an air of market distortion. With 38.2% of its revenue coming from federal coffers, and a large chunk of federal revenue coming from the federal income tax, there is some degree of cost-shifting inherent in each corporation’s tax-motivated move to Texas.

Using a simplified example, California gets 28.3% of its revenue from federal funds, which is fourth-lowest. When a wealthy individual moves from California to Texas to capitalize on lower state taxes, they effectively reduce their contributions to the combined state and federal tax base while benefiting from a state more heavily reliant on federal aid.

This creates a paradox: The tax savings that entice the wealthy and corporations to move to Texas are partially underwritten by taxpayers in states such as California, where personal and corporate income taxes fund a larger share of the combined state and federal tax revenue.

Such a dynamic distorts the competitive landscape among states and rewards those that avoid progressive taxation in the same way that tax shelters distort the international tax system. Unlike in the global context, however, the federal tax system has a framework to provide aid to all states regardless of their tax policies.

This means that states such as Texas can maintain low-tax environments, operate as quasi-domestic tax havens, and not bear the full economic consequences of their choices.

Meanwhile, states that prioritize higher taxation will likely continue to see their state tax base dwindle due to residents picking up stakes for greener tax pastures, even as the need for their contributions increases. Census and migration data suggests this trend is already underway, showing population declines in states such as New York and California, while lower tax states experience inbound migration.

As severe weather from climate change and the costs of maintaining an infrastructure for a growing population take their toll, Texas will likely keep straining its regressive tax models and federal aid. Federal policymakers may eventually be forced to address the inequities created by these state policy choices.

Conditioning federal funding on policy reform is one option. Federal infrastructure grants, disaster relief funding, and education assistance could be tied to required commitments to state-level policy reforms.

Any such reform conditions would have to be unambiguously presented and related directly to federal interests and the funds being provided. For example, if federal aid was for long-term disaster relief, any requirement placed on Texas regarding tax policy reforms would need to demonstrate a connection between state fiscal independence and national economic health.

Texas’ tax policies, while attractive to wealthy individuals and corporations, significantly rely on federal support. Since 2015, Texas has consistently ranked among the top state recipients of federal disaster aid, which reflects its vulnerability to hurricanes, floods, and other natural calamities.

As other states consider emulating the Texas model—and may follow in its policy footsteps in the coming years—equity and sustainability issues will grow. Long-term, federal policymakers may need to tie federal funds to meaningful policy reform. Such measures would promote fairness in fiscal responsibility and help ensure the state benefits of economic growth are distributed fairly, rather than at the cost of taxpayers elsewhere.

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social

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