Jeremy Lin of the Houston Rockets returned on Monday night to Madison Square Garden, which used to be his home court in the days of Linsanity not so long ago. Mr. Lin thrived on the energy of the New York crowd, but one thing he probably doesn't miss is the taxes.
Neither Texas nor Houston has an income tax, saving him about a million dollars a year.
The prospect of higher marginal tax rates in states like New York and California raises concerns about the impact of taxes on the behavior of high-income individuals. Will Wall Street executives and fund managers flee to low-tax jurisdictions like Florida and Texas?
Some argue that higher state and local taxes are self-defeating, encouraging the rich to move to cheaper locales, work less or restructure investments to avoid tax. Others point out that higher taxes pay for public goods like better schools and public parks, making some locations more attractive places to live and work despite (or because of) the higher taxes.
How sensitive are high-income individuals to marginal tax rates? One challenge in the research is finding good data on the salaries and the behavioral responses of the rich. People tend to hold salary information close to the vest.
But there is one group of highly paid professionals whose salaries and relocation behavior are public: professional athletes. Two new papers in the Journal of Sports Economics use variation in state tax rates to test how sensitive these athletes' salaries are to state and local taxes.
One paper, by the economists James Alm, Bill Kaempfer and Edward Batte Sennoga, investigates whether differences in state and local individual income taxes in major league baseball cities affects free-agent player salaries. It does.
The extensive data on baseball player performance helps the econometric effort here: the study's model estimates what salary a free agent ought to be able to get on the open market, and then looks to see how much the variation in state and local taxes accounts for the variation from this estimate. As the authors point out, while the past statistical performance of baseball players isn't a perfect proxy for future performance, it is a pretty good predictor of future salary, which is what matters for the study.
The authors' basic specification finds that each percentage point of an income tax raises free-agent salaries by $21,000 to $24,000. This means that low-tax locales like Florida and Texas have a “home field advantage†in the free-agent market.
In other words, state and local taxes are capitalized into salaries, with teams in high-tax jurisdictions forced to offer higher pretax salaries. Free agents indeed negotiate with an eye toward after-tax income. At least in baseball, the presence of higher local taxes doesn't typically affect the quality of teams, as owners adjust the salary offers to account for tax. Those taxes do, however, put the owners of teams in high-tax jurisdictions at a competitive disadvantage in the sense that they must pay more to get comparable free agents.
In the N.B.A., the luxury tax acts as a more effective constraint on player salaries than it does in Major League Baseball. The second paper, by Nolan Kopkin, a Ph.D. student at Cornell University, looks at the effect that variation in state and local income tax rates have on the labor migration decisions of N.B.A. free agents. The study finds that an increase in the marginal income tax rate leads to a decrease in the average skill of the N.B.A. free agents that migrate to that team. Unlike in baseball, basketball teams in high-tax jurisdictions actually end up w ith a worse free-agent talent pool, all else equal.
These papers confirm the broader point that the economic incidence of a tax may not fall on the nominal taxpayer. In baseball, the players do not shoulder the burden of the tax. The economic burden may fall on the owners themselves, in the form of lower profits, or perhaps the fans in the form of higher ticket prices. While the players technically remit the tax, they are no worse off on an after-tax basis.
In basketball, by contrast, taxes aren't fully capitalized into salaries. On the margin, the better players migrate to lower-tax jurisdictions. In a sense, the fans pay an implicit tax in the form of teams that perform worse.
Of course, because of the unique nature of the data set, the broader policy implications of these papers are somewhat limited. For most employers outside professional sports, there is no luxury tax or salary cap. Most employers are probably more like a baseball team, with its relatively ineffective luxury tax, than an N.B.A. team. As state and local marginal tax rates rise, we can expect higher salaries to partially offset the higher taxes.
On the other hand, behavioral responses to tax are constrained by frictions, like the cost of moving and the limited availability of comparable job opportunities. It's easier for Mr. Lin to move to Houston than it is for a star trader or investment banker.
These papers do serve as a useful reminder that if the goal is to remedy income inequality, state and local taxes are a weak policy instrument. To the extent that tax policy is used to achieve redistribution, redistribution should take place at the federal level. (Few people will give up citizenship to avoid taxes.) State and local taxes should be used to pay for public goods like infrastructure, parks, law enforcement and schools.
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For further reading on the impact of state and local tax rates on player salaries, see James Alm, William Kaempfer, and Edward Batte Sennoga, Baseball Salaries and Income Taxes: The ‘Home Field Advantage' of Income Taxes on Free Agent Salaries, and Nolan Kopkin, Tax Avoidance: How Income Tax Rates Affect the Labor Migration Decisions of NBA Free Agents, both in volume 13 of the Journal of Sports Economics (2012).
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer
