When Donald Trump unveiled his proposal to make child care tax deductible, there was one line that went by almost unnoticed. It said the benefit would be capped “at the average cost of care for the state of residence.”
Whether or not this ever becomes law, the mention of it is remarkable. Today, virtually no federal taxes are adjusted by regional differences in the cost of living. If you earn $50,000 in an expensive city, you’re taxed just the same as someone earning that salary in a cheap place to live. Is that fair?
Kate and Mike Swelstad had been married for a couple of years when they started thinking about moving from their native Michigan to the San Francisco Bay Area, feeling the draw of nicer weather, mountains, and great camping.
At the time, Kate was working as a zookeeper at the Detroit Zoo. Mike worked at a Ford call center. She was cautious about such a big move, but Mike persisted.
“One day he said, ‘I’m just going to buy a ticket,” Kate told Business Insider. And shortly after he did.
Toward the end of 2003, as 23-year-olds, they packed their bags and headed west, settling near San Francisco.
As she’d done in Michigan, Kate worked at a zoo for a while. Mike ended up working as a receptionist at an insurance agency.
The jobs they did in California were at the same level as their jobs in Michigan. But costs out west for housing, food, and other expenses were much, much higher.
“It’s almost twice the price to go out to dinner in California versus Michigan,” Kate said.
Their salaries reflected this. They were higher than they would have been back in Michigan. But those higher wages meant they also paid more in tax to the federal government, with some of that ending up in a higher tax bracket than they would have been in back in Michigan.
- Michigan 2003 earnings: $48,944
- California 2005 earnings: $61,967 (earnings above 59,401 are subject to higher tax)
“It’s not really fair,” Kate said. “We’re making more money than we were in Michigan, but we’re not seeing the value of it.”
“City dwellers have every right to feel a little ripped off.” Listen to the BIQ Podcast:
A question of fairness
Kate and Mike had never really thought about tax brackets and regional differences, but after they moved, they were talking with their friend David Albouy about just how much more expensive everything is on the coast, and Albouy started thinking deeply about whether it’s fair that they also have to pay more tax.
“They were paying a lot in taxes and not receiving a whole lot in benefits,” Albouy said.
He happens to be an economist, today teaching at the University of Illinois, and the experience of Kate and Mike partially inspired his research, which looks at how the tax system treats people in different regions.
As he sees it, people like Kate and Mike pay more to the federal government, but they don’t use more services. If anything, they’re subsidizing those people who are earnings less because they live in cheaper cities.
“There was some real effect of living in the Bay Area on how much you earned, but they were clearly poorer in the long run,” Albouy said.
The Bay Area costs more than Michigan for a lot of reasons. There’s the natural beauty that draws people. There’s wine country, great restaurants, and a concentration of talented, productive workers who drive up prices. But there’s also a healthier labour market than where they came from.
“Kate and Mike ultimately did the right thing to come to San Francisco. The economy in Detroit was declining and it didn’t need more workers,” Albouy said. But as they moved, the US “didn’t make it easy for them because they paid more in taxes. They lost a lot of benefits.”
For Kate and Mike it was a choice, and they clearly understand the consequences. But not everyone living in a more expensive place has chosen to live there, and sometimes an expensive region needs to attract workers.
You have to have nurses
Albouy offers an example: Every city needs nurses. Let’s say New York City has a shortage and Cleveland has a surplus. There’d be a pretty good incentive for nurses to move east, and they’d likely get a big pay bump in the process.
If nurses made $50,000 in the Midwest, they might earn $80,000 for the same kind of job in New York. In theory, that wage premium accounts for the higher cost of rent and food and other necessities. But a nurse would also pay more tax.
“Why is she paying extra money?” Albouy said. “Is she costing the federal government more? Probably not.”
The question of fairness is even more stark at the low end of the income spectrum. Take a janitor, for instance.
In an inexpensive city like Kansas City, he might earn about $8 an hour. If he worked 40 hours a week every single week, he’d take home just $16,640 per year.
A similar janitor in New York may earn $15 an hour, bringing his pay to $31,200.
Presumably, the standard of living for the New Yorker will be the same — or perhaps even lower — than the Kansas City janitor because of the high cost of living. And we can assume that neither has much choice about where he lives, given financial means, and family ties.
But a few things happen here. For one, the Kansas City filer only pays 10% federal tax on his income. The New Yorker has to pay 15% tax on his income over about $18,500 (in this simplified example, assuming married, filing jointly.)
Further, the New Yorker will qualify for far less of the Earned Income Tax Credit, which is one of the more effective programs helping bring Americans out of poverty.
“That’s going to put them above the poverty line and they’re not going to qualify for most benefits, and they’re not going to qualify for medicaid, or barely,” Albouy said.
In New York, for instance, the worker’s family would likely lose access to food stamps or free student lunches, even though he’s not living a nicer life necessarily than the worker in the cheap city.
A better way?
Adjusting federal tax rates to account for regional differences in wages and costs almost never comes up in debates over tax reform.
Congressman Jerrold Nadler, a Democrat representing parts of Manhattan, has proposed changes along these lines, but they got little traction in the House of Representatives, in part because they were seen as benefiting the richest New Yorkers. His office did not reply to requests for comment.
Albouy’s ideas take that objection into account. He says there are a few ways we could change our tax code to be more fair but not give big breaks to the rich.
First, regional differences could be based on conservative salary measures. Second, it could go beyond cost-of-living variances and incorporate measures of quality of life. Really great places to live, like near a beautiful beach, might be taxed more.
It might also make sense to tax people based on where they work rather than where they live, to account for the higher wages in city centres. A lower-income worker might travel a long distance to get to work in an expensive city center.
What could go wrong?
Despite all the differences in pay and costs across the US, federal taxes do not take into account regional differences. Part of the reason why Albouy’s ideas have not caught on is that it would be complicated.
“It would add incredible complexity to the tax code,” said Matthew Gardner, senior fellow with the Institute on Taxation and Economic Policy.
There are many good reasons, he said, why things cost more in New York than they do in rural Nebraska. There’s more to offer in New York, and more people want to live there, which creates scarcity of housing and other goods. That means employers have to pay workers more there.
But the tax code doesn’t know any of that. “The income-tax laws are obviously blind to what’s driving your wages,” he said. “All your income tax laws know is that you’re earning more.”
So the question becomes where do you draw the line. Do you base tax rates on each state’s average wages? If so, you lose the stark differences between New York City pay and what workers upstate earn.
Or you could have two sets of tax brackets, one for those living in urban areas and another for those in the country. But that is a “blunt instrument,” Gardner said, and could create new inequalities. How do you distinguish between those who choose to live in an expensive city, and those who are stuck in one?
Just as city dwellers today might feel like they’re subsidizing the rest of the country, changing the tax code might create resentment in the opposite direction.
“It’s hard to think of a mechanism for alleviating geographic differences in cost of living that wouldn’t add as many inequities as it would solve,” he said.
And, Gardner said, wealthier residents of expensive cities already get tax breaks that make it easier to live there. The mortgage-interest tax deduction, for instance, incentivizes homeownership in places with astronomical home prices, like San Francisco. And state and local taxes are deductible from federal returns.
“There are people who argue and look at the itemized deductions for state/local taxes and mortgage interest, and view it as insane subsidy for people who live in high cost areas,” he said.
And, he said, there are only a few cities where cost of living is significantly higher than elsewhere, which raises the question of whether state and local governments should be responsible for reducing tax burdens.
But for Kate and Mike, who now have two kids, the strain of living in the Bay Area is taking a toll. Their incomes have risen in the past decade, now about $71,000 a year combined. They know that would be plenty to live a comfortable life in Michigan, but even in the outskirts of San Francisco, it’s hard.
“It seems like we were penalised for coming out here,” she said. “It was our choice to come out here, but we thought, great, it costs more but it’s OK, we’re making more. It will work out.”
Every now and then she catches up with her old friend David Albouy, the economist, and they talk about his research.
“It kind of brings up the frustration,” she said. “It’s not like we sit around thinking about tax brackets all the time, but he’s kind of a reminder.”
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