For most taxpayers, filing a tax return with the IRS is just step one in the annual tax ritual. But folks who live or work in seven U.S. states can skip step two — filing a state return. In Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming, legislatures haven’t adopted income tax as a means of collecting revenue. Two other states — New Hampshire and Tennessee — tax interest and dividend income but don’t tax wages.
Besides having less tax-filing paperwork, taxpayers living in these income-tax-free states get to keep more of their paycheck. But there is a trade-off.
Sources of revenue in no-income-tax states
Although bringing home a bigger paycheck has definite appeal, state governments find other ways to raise revenue to fund operations. City governments, school districts and other local entities might also impose a sales tax. With this reality, bigger paychecks are often counterbalanced with higher taxation on day-to-day costs.
The exception to this tendency is oil-rich Alaska, the largest and most sparsely populated state, which repealed its state income tax in 1980 and doesn’t impose a sales tax. Instead, the state’s budget is funded through its petroleum revenue. The Alaska Permanent Fund distributes a dividend check each year to residents. For tax year 2015, each resident’s share from the fund was $2,075.
For Florida, sales tax is a primary source of revenue. The tourist-magnet state charges 6% on each sale, admission charge, storage or rental unless the transaction is specified as exempt. Property taxes tend to be higher than the national average and fund municipalities and local governments.
Nevada funds operations with a combination of sales tax and taxes and fees on gambling. The state sales tax rate, currently at 6.85%, can run as high as 8.1 % in some municipalities. The state’s treasury brings in nearly $1 billion each year in gambling taxes and fees.
In South Dakota, state government funding comes from its 4% sales tax, as well as various other fees and taxes — a cigarette excise tax, bank franchise and alcoholic beverage tax, as well as licensing fees on coin-operated laundries. The state’s sales tax rate is below the national mean of 5.95%. With a local sales tax average of 1.83%, taxation in the state is arguably one of the best deals in the country.
Texas generates operations revenue from a state sales tax of 6.25%, with some cities, counties, transit and special purpose districts adding 2% to the sales tax bill. In all, the state collects more than 60 separate taxes, fees and assessments.
Washington also doesn’t collect income tax. Instead, substantial funding is generated largely from sales tax, which ranges from 7% to 9%, and one of the highest gas-tax rates in the nation. In 2010, Washington voters rejected a proposal to tax the state’s wealthiest residents.
Wyoming makes up revenue for its government operations through the sale of natural resources, primarily coal, as well as property tax.
In New Hampshire and Tennessee, states that don’t tax wages but do tax interest and dividend income, the budgeting method means that people with paychecks are spared from state tax withholding. While working-age wage earners get a break, retirees and others dependent on investment income have to pony up for the state tax collectors. New Hampshire makes up revenue with one of the highest property-tax rates in the country, as well as with one of the highest in-state college tuition rates. Tennessee imposes the highest sales tax in the country, averaging 9.45%.
Arguments for and against state income tax
On the face of it, states without an income tax have strong appeal. Proponents say higher paychecks for workers make it easier for states to create jobs and retain an educated workforce.
Still, states with no income tax can face unique problems. In Alaska, for example, plunging oil prices have led to a $3.8 billion state budget deficit. That has lawmakers in Juneau considering a range of options, including a sales tax or state income tax.
Some argue that the lack of a state income tax causes a disproportionate tax burden on poor residents. Essentially, this is because income taxation has bracket parameters based on your adjusted gross income that limit taxation costs.
In Washington, for example, the Institute on Taxation and Economic Policy calculates that the poorest 20% of state residents pay 16.9% of their annual income in sales and gas taxes, compared with just 2.4% for the wealthiest 1% of residents.
If you live in a no-income-tax state — or you’re considering moving to one — you’ll have to dig a bit deeper into the state’s tax code to gain a true sense of how these other taxes affect your finances.