Replacing income tax with sales tax hike would cost poor Hoosiers more, experts say

Axing Indiana’s individual income tax and replacing just half the revenue with a sales tax hike would cost the state’s poorest residents an additional $62 and hand the top 1% of earners a $30,000 tax cut, a think tank told state lawmakers Friday.

Instead of “seeking deep cuts to the income tax or even getting rid of it altogether,” Indiana should make its tax system less regressive and make “meaningful investments in (its) future,” Institute on Taxation and Economic Policy analyst Neva Butkus said. The organization leans liberal.

Indiana leaders — and political candidates — hope to slash or scrap the income tax.

That’s the driving force behind the State and Local Tax Review Task Force. But its members heard no full-throated support for the proposal on Friday, even as national experts from across the ideological spectrum offered competing advice on what to do instead.

Conservative think tanks recommended that the Indiana General Assembly cut the income tax according to a recently approved schedule, and — with “caution” — make further cuts only if lawmakers broaden the sales tax base and see higher-than-expected collections.

“We currently don’t see a proper way to replace $8 billion dollars, at least in the short run. It’s definitely not possible,” said Tax Foundation analyst Andrey Yushkov.

Reducing regressiveness

Low- and middle-income Hoosiers already pay more of what they earn in state and local taxes than high-earners, according to Butkus: the poorest 20% pay almost 13%, while the top 1% pay nearly 7%.

She called the state’s tax system “deeply regressive,” meaning that lower-income residents contribute larger shares of their income toward government services.

“Increasingly regressive state and local tax systems have contributed to a sobering level of inequality in both income and wealth across the nation,” Butkus said.

She argued that the income tax provides “some balance” because it’s a percentage of what a taxpayer earns — particularly when the tax has higher rates for higher earners. Indiana has a flat tax.

In contrast, Butkus said, sales taxes cost a larger percentage of low-earners’ income.

In an analysis conducted by her organization, axing the state’s $8 billion annual income taxing and half-replacing it with an increase in the sales tax — from 7% to 9.5% — would cost poor Hoosiers more money and save rich residents thousands.

In that scenario, the poorest 20% would pay 0.4% more of their lower incomes than under the current tax system, while the richest 5% would save about 2% of their higher incomes.

Butkus pushed lawmakers to close corporate tax loopholes — though she didn’t identify specific ones — and to create refundable tax credits for families. She also advocated for graduated income taxes and estate or inheritance structures, which are likely non-starters for the Republican-led Indiana General Assembly.

Wesley Tharpe, a senior adviser for state tax policy at the left-leaning Center on Budget and Policy Priorities, told the task force that a “stable” income tax could support a fiscally responsible approach to state finances, and warned that sharp cuts could instead hurt its efforts.

Recent income tax cuts mean Indiana is expected to forego about $900 million annually, Tharpe said — about what the state spends on the Indiana Department of Child Services.

He presented data showing little correlation between no- and low-income tax states and per-capita income growth, and between cuts and state gross domestic product growth.

And while lawmakers have fixated on Indiana’s relatively high sales tax rate — 7% ties it with two other states behind only California — Tharpe argued that it’s not a main driver of migration. People mainly move in or out to take a job, get closer to family, or experience milder winters, he said, alongside housing and cost-of-living concerns.

Others, however, said that taxes are one of the few factors actually within policymakers’ control.

Broadening the base

For former Rep. Tim Brown, who once led the powerful Ways and Means Committee, taxes are a way to change behavior.

“What are the three states that are losing people from their population last year?” Brown asked his former colleagues. “California, New York and Illinois. They have a high taxation and a high cost-of-living environment. So people are moving out.”

Illinois residents buy their cigarettes in Indiana, but Hoosiers may buy theirs in Kentucky for the same reason, he added.

Brown said the General Assembly should expand its sales tax to cover more categories, but drop the rate.

National experts echoed the idea — and made several other suggestions.

“Indiana has done a lot of things quite well over the past couple of decades and is really a leader on tax reform, but states that stand still for too long risk was falling behind,” said Tax Foundation analyst Katherine Loughead.

Indiana’s sales tax breadth was 38% in 2021, above the national median but with room for improvement, Loughead said. Breadth represents the share of the state’s economy included in the sales tax base, according to the National Conference of State Legislatures.

“That’s actually better than each of Indiana’s neighbors,” she said. “But it’s still significantly narrower than under an ideal sales tax structure where all final personal consumption would be taxed.”

Groceries are exempt from sales taxes, for example.

Loughead asserted that this attempt to shield poor grocery-shoppers from regressive taxes still applies to high-income shoppers, losing the state money without “gaining any socially desirable impacts.” If the tax base were broadened to include groceries and a large number of personal services — but the tax rate were lowered — poorer Hoosiers could benefit, she said.

The foundation also suggested that Indiana swap local income taxes for local sales taxes — an idea Brown recommended against — or at least limit local income tax growth. Without changes, the analysts cautioned, local units of government could keep raising rates when the state lowered its own and Hoosiers wouldn’t actually see a decrease in payments owed.

The group made a variety of other proposals: indexing the individual income tax’s relatively low standard deduction to inflation, increasing or indexing the property tax’s de minimis exemption, reducing the corporate income tax, letting businesses deduct the full costs of certain investments and more.

The conservative-leaning American Legislative Exchange Council (ALEC) also warned lawmakers away from over-spending, over-reliance on federal funds and over-reliance on volatile revenue sources. Chief Economist and Executive Vice President of Policy Jonathan Williams claimed the most unstable is the corporate income tax followed by the individual income tax — with retail sales taxes the most reliable of the the major three revenue sources.

More meetings to go

Task force chair Travis Holdman, a Republican from Markle, urged “moderation.”

“If we remove the individual income tax, we’re going to have to have a replacement source for that revenue,” Holdman told reporters. He said hiking the sales tax to 9.5%, as in Butkus’ modeled scenario, “is not going to work.”

Lawmakers are “taking a look at” making additional partial cuts, Holdman added.

And he said that while the task force has so far focused on cutting taxes, it can also look at spending.

In Washington State’s “priorities of government approach,” leaders analyzed the state’s needs versus its wants, then matched priorities up to a tax system that could generate the needed revenue, ALEC’s Williams said.

The two-year task force meets next in November. It’s expected to feature testimony from the Indiana Fiscal Policy Institute, Indiana-based Policy Analytics, and the conservative, Washington, D.C.-based Americans for Tax Reform. The nonpartisan Indiana Legislative Services Agency is set to present an analysis on the income tax elimination proposal.

Policy recommendations are due to the General Assembly ahead of the 2025 budget-writing session.