South Carolina’s tax paradox: High rates, low bills

For the second time in a year, S.C. lawmakers were caught flat-footed this week by public backlash over the consequences of their still-evolving plan to cut the state’s top income tax rate.

That was the takeaway when members of the S.C. House Ways and Means Committee scrambled under public pressure Tuesday to push through a bill adopting President Donald Trump’s 2025 federal income tax cuts at the state level — less than a month before the April 15th tax filing deadline. Without the legislation, South Carolina taxpayers will owe state taxes on income that is newly exempt from federal taxation. In other words, without a law to “conform” with the updated federal tax code for this tax cycle, state taxpayers would pay old rates for items cut by the feds, leading to confusion and more — particularly for tax preparers.

Among other popular changes, this new tax conformity bill would slash taxes on tips and overtime and give residents 65 and older an additional $6,000 income deduction. The price tag? Almost $300 million in lost revenues that lawmakers will have to find a way to offset in this year’s budget if the bill passes the full House and Senate.

So why could the measure still fail in one or both chambers? Because it conflicts with another major legislative priority this session — lowering the state’s top income tax rate, which also costs millions in lost revenues. And to see why, experts say, you have to understand the central paradox of Palmetto State tax policy: S.C. has the highest official tax rate in the Southeast but some of the lowest actual tax bills in the region.

And the reason for that paradox is simple: S.C. is one of only five states that applies its tax rate to what’s called “federal taxable income” — that is, your income after federal deductions, rather than before. Put simply, S.C. is taxing considerably less income at a slightly higher rate. And that’s what keeps taxes low for most taxpayers.

In fact, it’s why the average S.C. filer can theoretically be in the state’s top 6% bracket while only paying about 2.5% of their real income in taxes — and more than 40% of filers pay no state income tax at all.

But to cut that official top rate without bleeding red ink, lawmakers have decided to apply the new, lower rate to income before federal deductions instead of after.

Which is why the legislature’s first attempt to meaningfully lower the rate collapsed last year when state budget analysts testified that it would raise taxes on 60% of filers — the result of taxing a larger income number at a lower rate.

The case for a rate cut

It’s all very complicated.

Following last year’s initial failure, House budget writers regrouped and produced a new bill that cut the top income tax rate from 6% to 5.39%, cutting taxes for 39% of filers, raising taxes for 27% and leaving them the same for the rest.

Last month, the S.C. Senate passed that House bill, but further lowered the rate to 5.21%, increasing the number of filers who’d get a tax cut to 43% — and more than doubling the cost of the tax cut to $309 million.

Despite the political and practical difficulties, supporters of the plan say the move is necessary to boost state competitiveness with neighbors like North Carolina at 3.99% and Georgia at 5.19%.

What’s more, they argue, the high official rates can actually reduce individual enterprise, particularly among small business owners, who often file as individuals and wind up paying something much closer to the official rate.

Or as the S.C. Chamber of Commerce summed up the issue in its Roadmap for Tax Reform: “South Carolina is by no means a high tax state in the main, though it can feel that way for certain taxpayers. The problems, rather, come down to questions of tax structure.”

Sam Aaron of the right-leaning S.C. Policy Council expanded on that argument in a Wednesday interview.

“Whenever you decrease your income taxes, you’re freeing up capital for someone to use,” Aaron said. “And you’re going to see an increase in capital investments and spending.”

But the real goal, Aaron notes, is to match Florida’s rate of 0% — a goal the current bill nods at by imposing automatic tax cuts in future years when there’s a budget surplus of $200 million or more.

“In our view, philosophically, yes, that’s where we’d like to end up,” he said of eliminating the income tax. “With less revenue going to state government, you’re going to have to run a leaner machine and adjust your budget accordingly.”

Competitiveness measures: good roads and schools

On the other side of the aisle, the left-leaning Institute on Taxation

and Economic Policy (ITEP) calculates each state’s overall tax rates from every source — income, sales, property and fees — based on income.

Its findings for South Carolina’s current tax system? The bottom 20% of state earners pay the highest overall tax rate at 10.1%. Middle-income residents pay 9.5%. And the top 1% pay 6.5%.

Cutting the top income tax rate and paying for it by breaking with the federal income rules would cut the overall tax burden of those at the top of that distribution and raise it for those closer to the bottom.

“These are pretty deep and regressive tax cuts,” said Neva Butkus, senior policy analyst with ITEP, in a Wednesday interview. “And that money’s got to come from somewhere.”

Specifically, she argued, if lawmakers really mean to move rates toward zero, it will have to come out of the things the state spends most of its money on — schools and teachers, roads and bridges, health care and public safety.

“South Carolina has been growing fast with its current tax code,” Butkus said. “And those are the real competitiveness issues.”

And at the end of the day, she argued, tax cuts are just the wrong investment for a state already struggling with infrastructure, education, health care and more.

“Using the tax code to invest in families and workers as opposed to cutting taxes disproportionately for the top 5% of income earners, that’s where you’re going to see growth,” she said. “For the amount of money that these plans cost, so much more could be done to invest in the people of South Carolina.”

For now, those questions reside in the House, where members will have to vote soon on the Trump tax cuts and whether to accept the Senate’s changes to their income tax bill. Lawmakers in both chambers are expected to take final action on the bills before this year’s legislative session ends in May.