The golfer Phil Mickelson, who often has his name in the sports pages for his athletic feats, has recently grabbed the headlines for an unconventional reason—he has politely protested California’s new maximum tax rate of 13.3 percent. For Mickelson, who pulls down $45 million per year, that tax generates about $6 million in added revenues for a cash-hungry California; he can then deduct 40 percent of that $6 million in California taxes from his federal income tax. That tax two-step leaves him about $3.6 million short. In exchange, he gets little if anything from California in return.
Mickelson quickly came under attack from powerful political forces that regard the payment of high taxes by others as one of the solemn duties of citizenship. Of course, he was only saying aloud what other professional athletes were thinking quietly—but prudence then took over. Athletes over their lifetimes can easily earn more from their endorsements than they can for success in competition, so they have to keep a low profile lest they offend any significant group of potential customers.
Mickelson downplayed his public broadside on the ground that financial matters are personal issues only. He of course knows full well that many prudent athletes have followed Tiger Woods in moving to Florida precisely because it has no income tax. Instead, Florida relies on a combination of sales and property taxes to fund its public operations.
Many tax theorists decry that regressive strategy, which they claim puts a disproportionate burden of taxes on the poor, who spend a far higher fraction of their incomes on the necessities of life. Minnesota’s Governor Mark Dayton, for instance, recently increased his state’s income tax on high earners on the view that progressive taxation is needed to make the rich pay their fair share of taxes—provided, of course, that they stay around to let the Governor repair Minnesota’s shaky finances.
The Rich Vote With Their Feet
Savvier minds at the state level take quite a different view. Without using the political science lingo, these public officials are well aware of the important role of exit rights in the operation of our federal system. In the United States, any person can move freely from one state to another. That migration sets up a competition between states to attract high-income individuals who bring in far more than they take out.
States like Florida and Texas give high-income individuals a better fiscal deal than the one they receive in places like debt-ridden California and Minnesota. In fiscally prudent states, sales taxes are computed without reference to wealth and property taxes are determined without reference to the personal income of the owner. With the notable exception of California’s broken Jarvis-Gann real estate taxation, those property taxes are based solely on the property’s value. Low taxes lure rich people into such states, and these affluent people often bring their employees and suppliers along with them.
At one time, California had learned this lesson. Prior to 1982, California imposed an inheritance tax on all individuals dying within the state. But the practice backfired revenue-wise. Retired persons of means fled the state to escape the inheritance tax, often moving to nearby Nevada, which had no estate tax, taking their income and wealth with them. This cost California lost revenues from income, real estate, and sales during the retirement years of those high earners. The interstate competition thus drove California voters to repeal, by referendum, the inheritance and gift taxes in order to keep those revenues in state.
In large part, the exit right works because it can be unilaterally implemented, without the blessing of others in the community. For just that reason, the exit right is the mark of a free society. The ability to leave also induces others to enter with their own wealth and initiative. Only places like the old Soviet bloc kept their citizens captive to their national homelands, to their own long-term ruination.
Today’s voters in California and Minnesota have lost sight of the wisdom behind California’s 1982 decision to repeal the gift and inheritance taxes. Following the athletes, other entrepreneurs and high-income earners will surely exercise their exit rights. In the face of interstate competition, the game of massive redistribution is not sustainable.
The Limitations of the Exit Right
Unfortunately, the exit right does not offer a perfect remedy against the dangers of government overreach. States like California and Minnesota always have some wiggle-room in the way they impose tax burdens. Folks usually prefer to stay in their old haunts, surrounded by a network of friends and business connections built up over the years. These personal and professional benefits are not easily transferable to other jurisdictions. Thus, if the financial equities between the two locations are close, the rich are likely to stay home.
But what happens when they decide to go? Here the painful truth is that folks like Mickelson cannot carry their property out on their backs when they leave. Sure, they can sell the property to someone else, but only at a discount, given that the new entrant has to face the same high tax rates that Mickelson wants to flee. The new owner will thus reduce the purchase price to reflect his total tax burden, leaving Mickelson with a capital loss, which he cannot escape by leaving the state.
Sometimes, the danger is even greater for individual property owners. California is not only known for its high marginal tax rates. It is also known for highly restrictive land use regulations, especially on undeveloped real estate that is located in coastal zones.
I recently discussed the power of the state to impose unbounded environmental mitigation obligations on landowners as the price for new development. This is just part of a battery of regulations that can sharply cut down the value of a property by forcing, for example, any would-be developer to foot the cost of some public improvement project. Some developers can protect themselves from these regulations by buying land only at a sharp discount, which reflects the risk that the development may never get off the ground.
Often these no-growth policies drive potential developers to seek greener pastures elsewhere, which is often exactly what the local citizenry wants. The developer’s exit right, however, offers no protection whatsoever for the current landowner who, whether he holds or sells, has to eat another large capital loss. That problem is not likely to hurt folks like Mickelson, who are selling developed land, but it surely wreaks devastation on the owners of prime development sites.
The Eminent Domain Solution
What, then, should be done about this situation? Government has a potential obligation to pay just compensation to offset the cumulative costs of its regulations upon future development rights. That compensation requirement introduces a commendable form of fiscal discipline on state governments. The obligation to provide for compensation requires the state to pay a price for land use restrictions. In principle, the greater the restrictions, the greater the compensation that the state owes to the affected landowners.
At this point, the local government has to ask whether it can raise taxes from its citizenry to cover the cost of the development restrictions that it wants to impose. The obligation thus encourages local governments to think long and hard before imposing such restrictions. The greatest benefit of the just compensation requirement is often found in the transactions that don’t take place precisely because the price is too high.
Here is one story of how this has played out. Over twenty years ago, the United States Supreme Court decided in Lucas v. South Carolina Coastal Council that the state had to pay market value for a plot of land, which was determined to be $850,000. Once it had paid full value for the land, the state was ordered to take title to it. How was it to raise the money? Clearly, the usual environmental claim that the vacant plots of land were critical for the ecological health of the barrier dunes was just cheap talk, which is easier to maintain when the courts let the regulation be imposed as a matter of right. But the situation is otherwise when the government has to come up with money from the public treasury to vindicate the public right.
In this instance South Carolina found a way to raise the money, which was to sell off the land to private developers. Today, large homes sit on both lots of land. It would have been a lot easier to just let Lucas build on his land in the first place.
Unfortunately, states have all too many ways today to avoid taking direct financial responsibility for the cost of land use restrictions. The decision in Lucas has been confined to cases where the regulation in question removes all economic value from the use of the land. Savvy regulators thus studiously avoid outright prohibition, and instead resort to constant delay, onerous procedural requirements, and strict design limitations to achieve the same effect. The Supreme Court has failed to extend Lucas to apply to restrictions that deprive owners of most of the value of their land, so that pretextual land use restrictions—designed as de facto prohibitions on development—now abound.
It should be evident that the Mickelson episode offers an instructive window into our complex federal system. For Mickelson, the exit right would serve as a check on state power, which it is, but only to a limited degree. In order to craft an efficient system of restrictions on state power, it is necessary to insure that states and their citizens also feel the pain of their efforts to single out the rich for special treatment.
A three-fold program is thus in order. First, progressive taxation should be abandoned in favor of a flat income or consumption tax. Second, there should be strict limitations on the ability of states to impose onerous restrictions on land use development. Finally, the exit right offers a simple, low-cost way to supply partial protection against excessive taxes and regulation for current residents. Under current law, the only part of the system that is firmly in place is the exit right. Unfortunately, it will be used ever more frequently as states fail to observe the other two constraints. Competition between states may be imperfect, but, at present, it is by far the best counterweight to state aggrandizement.
Richard A. Epstein, Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, Laurence A. Tisch Professor of Law at New York University, and senior lecturer at the University of Chicago, researches and writes on a broad range of constitutional, economic, historical, and philosophical subjects. He has taught administrative law, antitrust law, communications law, constitutional law, corporate law, criminal law, employment discrimination law, environmental law, food and drug law, health law, labor law, Roman law, real estate development and finance, and individual and corporate taxation. His publications cover an equally broad range of topics. His most recent book, published in 2013, is The Classical Liberal Constitution: The Uncertain Quest for Limited Government (2013). He is a past editor of the Journal of Legal Studies (1981–91) and the Journal of Law and Economics (1991–2001).