Lawmakers may nix the state income tax. Here’s how that could impact other taxes.


(Credit: Ana Baraulia)

Oct 02, 2023

The gist

Indiana lawmakers are considering eliminating the state individual income tax as part of its review of Indiana’s tax structure. 

Already state lawmakers are phasing down the state income tax. By 2027, Hoosiers will pay 2.9% on earned income, down from the current 3.15% rate. But someone making $50,000 a year would save an additional $1,450 a year if the tax was thrown out altogether. 

It also would mean Indiana could lose out on the almost $8 billion it brings in yearly — or more than a third of the state’s total tax revenue.

If state lawmakers decide to end the state income tax, Hoosiers could pay more in other taxes, such as on goods.

“If you get rid of one big revenue source you either have to spend less or find other revenue,” said Larry DeBoer, an economist from Purdue University.

What’s happening

Sen. Travis Holdman, R-Markle, said nixing the tax would be “transformational” for the state, but the State and Local Tax Review Task Force, which he chairs, is still more than a year away from making a recommendation on whether to do so. The group had its second meeting Friday.

“We’re not there yet,” Holdman told State Affairs. “If we can pull this off, we’d be glad to do that but we have to figure out a way to make it happen.” 

The task force is considering other potential changes as well, such as simply lowering the income tax rate or eliminating property taxes. But the idea that generated the most enthusiasm among Senate Republican leadership has been nixing the personal income tax.

Holdman clarified after Friday’s meeting that he personally would rather leave the local income tax in place, which generates roughly $4 billion for local communities. That means Hoosiers would still have to pay both local and federal income taxes, even if the state tax is eliminated.

Indiana General Fund Revenue
(Design: Brittney Phan)

Currently nine states don’t have an individual income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. (Washington taxes only capital gains income and New Hampshire taxes interest and dividends).

State Affairs looked at how other states have functioned without an income tax, and what doing away with it in Indiana could mean for you. Holdman pointed to Tennessee as a potential model to look at when figuring out how to make Indiana’s budget work because, he said, it’s the most similar to Indiana.

Sales taxes could increase

Probably the most feasible option to fix the budget hole would be to replace the tax dollars, at least partially, with something else.

Some states rely on higher combined local and state sales tax rates in lieu of an income tax. Tennessee, which doesn’t collect personal income taxes, has the highest average combined state and local sales tax rate in the country, with Washington falling not far behind. 

In Tennessee, consumers pay on average $9.55 in taxes for each $100 item, compared to $7 in Indiana. That’s largely because local governments in Tennessee can enact their own sales taxes, while in Indiana local governments cannot.

When looking at just the state sales tax alone, Indiana is tied for the second-highest sales tax rate in the country, along with Tennessee. That means if the state wants to up its sales tax collections, it likely would have to expand the number of goods and services the state taxes. Some states, like South Dakota and Tennessee, tax groceries, for example. 

Or, the state could allow local governments to collect sales taxes.

Increasing sales tax collection would likely be among the most popular options among Indiana lawmakers. Historically, Republican legislative leaders have shown support for taxes that can be applied to those visiting from out of state, instead of those that impact just those who live in Indiana. For example, Indiana has one of the highest gasoline taxes in the country. 

It could mean higher property taxes

Six of the nine states that don’t have income taxes have higher property taxes on owner-occupied houses than in Indiana. Most notably, Texas’ rate is nearly double that of Indiana’s. 

Property taxes are already rapidly increasing due to the rising assessed values of property. That means increasing property taxes further to make up for the budget hole likely wouldn’t be popular.

Residential property tax liability was expected to increase by more than 18% on average across the state this year, according to an analysis by the Association of Indiana Counties and Policy Analytics. Lawmakers dealt with significant pressure to address the issue during the most recent legislative session. 

Some states rely on other taxes

Some states are uniquely positioned to capitalize on other taxes. Tourism-heavy Florida, for example, allows counties to implement taxes on hotels.

Meanwhile, Alaska and Wyoming benefit from taxes on oil, a natural resource Indiana doesn’t have. 

So does Indiana have anything comparable or uniquely Hoosier to tax?

Not really, but lawmakers could legalize — and tax — marijuana. That’s unlikely. Republican leaders have repeatedly emphasized that they don’t want to legalize the product until the federal government does so. 

Even if lawmakers did have a change of heart, the money wouldn’t be enough to backfill the $8 billion loss in personal income taxes. The tax dollars from marijuana only make up a small portion of revenue in the states that do tax the product. In Colorado, for example, taxing cannabis generates $350 million, or just 1.7% of total revenues. 

Holdman said, “Nothing’s off the table.”

Cutting income taxes could mean less government spending

A majority of the nine states without an income tax spend less per person on state and local services when looking at both local and state governments combined, according to data from DeBoer. That includes Tennessee.  

Lt. Gov Suzanne Crouch, a Republican gubernatorial candidate who has recently centered her campaign around calls to “axe the tax,” has largely built her plan on less spending. Aside from looking for efficiencies, she wants to limit the state’s budget to an increase of 2% each year.

State revenues are forecast to increase 2.5% from fiscal year 2023 to FY 2024. She also wants to reduce the budget surplus to what is “reasonably necessary,” and use that to help implement tax cuts. 

Other Republican gubernatorial candidates have questioned whether those cuts can result in enough savings to completely end the individual income tax. 

Cuts in the budget could of course mean fewer government programs or a reduction in how much money schools receive each year.

How Indiana’s tax climate compares to other states

Kurt Couchman, a senior fellow in fiscal policy for Americans for Prosperity, called the state “frugal” and “responsible with taxpayer dollars.”

The Tax Foundation ranks Indiana as the ninth-most business-friendly state when it comes to taxes. 

Two former prominent Republican lawmakers warned the task force that nixing the income tax altogether could be problematic, in part because Indiana doesn’t have the climate or tourism of some states, such as Florida and Texas. Income taxes make up a larger portion of Indiana’s total revenues than 41 other states, highlighting the state’s reliance on it.

“I wonder if that’s really going to hold up,” said former Sen. Luke Kenley, who previously chaired the Senate Appropriations Committee. “If you eliminate any part of it, when you hit the next recession, the first thing that’s going to happen is they’re going to reinstate [it] even on a temporary basis.”

Kenley is concerned that should that happen, the state would implement a progressive tax rate that taxes those who earn more at a higher rate, rather than revert to the flat one now in place. 

What’s next

The task force will meet again Oct. 20 and hear from other experts, including former Rep Tim Brown, the former House Ways and Means chair. Holdman said there will be an opportunity for public testimony in the future, likely at a January meeting. 

The task force is poised to issue recommendations just before the 2025 legislative session. So any additional tax savings or hits to state revenue would be farther down the road. 

Check out our summary on TikTok.

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Header image: (Credit: Ana Baraulia)