Michigan’s Income Tax

1. Michigan’s Income Tax Paul L. Menchik Professor of Economics Michigan State University

2. Michigan’s Income Tax • A major pillar of Michigan’s financial system raising $7.3 billion in fiscal year ending 9/30/2007. • Close second to Sales and Use tax which raised $7.9 billion. • Provides 55% of General Fund General Purpose Revenue and 16% of School Aid Fund

3. Ours is a “Flat Tax”—one single tax rate currently (and temporarily) at 4.35%--and personal exemptions of $3,500, “adult dependent” exemption of $2,200, child exemptions of $600 plus “special exemptions” of $2,200 (for blind or disabled, deaf, unemployed compensation, and senior status).

4. The income tax act contains both refundable and non refundable tax credits, which can be thought of as “tax expenditures”, e.g. property tax credit, home heating credit, adoption credit, stillbirth credit, tribal credit, city income tax, other state income taxes, farmland preservation, rehabilitation of historic resources, college tuition, contribution to community foundations, homeless shelters, food banks or kitchens, Michigan public colleges, universities, museums, and public broadcasting stations, and vehicle donation credits. • In tax year 2006, $963 million was paid in refundable credits and $130 million in nonrefundable credits. In recent years credits have been growing faster than revenues.

5. Tax Rate History • The tax base devolves from the federal definition of income (adjusted gross income) subject to state additions and subtractions. • The history of the tax rate parallels a roller coaster ride. The initial rate was 2.6% in 1967, increasing to 3.9% in 1971, to 4.6% in 1975, was briefly 5.6% in 1982, and back to 4.6% the same year. • The rate was increased to 6.35% in 1983, 5.35 in 1984, 5.1% in 1985, and 4.6% in 1986.

6. The Ride Continues • During the last 20 years, the rate was lowered to 4.4% in 1994, followed by a series of phased reductions (passed in 1999) lowering the rate to 3.9% in 2005. • Public Act 94 of 2007 increased the rate to 4.35 (effective 10/1/2007) but also phases in rate reductions starting in October 2011 with the rate falling to 3.9% in October of 2015.

7. Principles of Taxation • Equity horizontal- equal treatment of equals. vertical—unequal treatment of unequals • Efficiency—Comparisons to other states can be useful here • Simplicity • Exporting—useful in sub national analyses

8. Horizontal Equity • An income tax looks fairly good compared to (say) a sales tax only on goods. • Our income tax has a quite flagrant violation of horizontal equity—treatment of sources of income received by seniors. We are an outlier in preferential treatment-almost no pensions are subject to tax and some income from assets as well. A tabulation from the ORT reveals that the net amount of income tax paid by seniors is negative. The “seniors premium”, the gap between the effective rate between seniors and other taxpayers– 2.17%--ranks number one!

9. Vertical Equity • States and nations generally exact a higher percentage of income tax from higher income people. Hence the ratio of tax paid to income rises with income—this is what is meant by a “progressive” income tax. If T represents the income tax paid by a household, and Y is income T/Y (the “effective” tax rate) increases with income.

10. However, it should also be noted that the presence or absence of progressivity is a public choice. • Jurisdictions may have different tastes regarding the distribution of tax burden.

11. Vertical Equity • Unlike most states, Michigan does not have a graduated income tax. Forty four jurisdictions (states plus DC) have an income tax. • 2 only tax property income. • 6 have a flat income tax, • 36 have graduated income taxes. The lack of rate graduation limits potential progressivity.

12. In spite of Michigan’s Income tax being flat, it still is progressive to some extent. That is because of the personal exemptions and the credits, especially the property tax credit, that result in the effective tax rate increasing with income. • Based on 2006 data, the effective rate only becomes positive at an adjusted gross income of $16,000 and rises to 2.3% above $50,000.

13. Efficiency • Efficiency, or lack of it, refers to the degree to which a tax distorts individual behavior in the attempt to mitigate the burden of tax paying. One source of inefficiency results when individuals choose not to locate in a region because of the tax regime. • Michigan’s income tax is among the lowest in the nation. In 2006, it ranked 37th of 41 states with a general income tax, when measured as a percentage of personal income, and 35th in income tax per capita. • Michigan’s income tax revenue was 40 percent below average on a per capita basis, and 36 percent below average on a percentage of income basis. (The current tax rate would probably lower these percentages by 10 to 26% and 30% or so).

14. Simplicity • A cost of taxation is the additional resources that must be used in enforcing and complying with a tax, and by government to administer the tax. • Since Michigan’s income tax piggybacks, uses a similar income definition– AGI--to the federal income tax, compliance costs are kept low. In comparison, the fact that there is no federal parallel to the state sales tax, individual states must provide their own accounting and administrative superstructure to operate it.

15. Exportability • In a sub national setting, it is in the interest of taxpayers of one state to try to arrange for taxpayers from other states to contribute to their budget. • One way state residents can do this is by exploiting the federal tax deductibility of state and local income taxes. An additional dollar of state income taxes paid by an federal income tax itemizer can cost him or her 1- mtr when mtr stands for one’s federal marginal tax rate.

16. Exportability • While most taxpayers do not itemize, roughly 36 percent do, weighted by dollars, most do. The likelihood of itemization sharply increases with income, 5% itemize in the AGI levels of $5-$10k, 30% at 40 to 50k, 74.5% at 75 to 100k, and 95% at 200-500k. It was estimated in Michigan at the Millennium that 20% of state income tax payments were exported to “Washington” via federal deductibility.

17. That number may be different today for three reasons, a) lower federal income tax rates, b) the interaction with the federal Alternative Minimum Tax, and c) the increasing inequality of income in Michigan. The first two factors suggest a lower degree of exportability, the last suggests a higher degree.

18. Demographic Change and the Income Tax • Michigan’s income tax does not age well. The preferential treatment given to senior source income causes revenues to lag as the state ages and the state is aging fast. Under either a fast, moderate or slow economic growth scenario the only demographic group that will experience any growth in absolute numbers during the next ten years are the 65 and over population. That group will be growing at 2.8% per year while all other group will contract (Census estimates and research from the CRC). This factor contributes to the state’s chronic structural deficit (CRC). It may be politically difficult to ameliorate this problem completely but perhaps nominal pension exclusions could be frozen.

19. Anemic Revenue Growth • During the last decade, income tax revenue growth has been “anemic” at best, for several reasons: policy—rate reductions, sluggish growth in personal income, growth in credits against the tax, the aging (coupled with our policies), but also because our income tax is not “elastic”.

20. Elasticity • The term “elasticity” is the way economists refer to the relationship of one variable to another, in this case income tax revenues to income. By having a flat rate instead of a graduated tax, Michigan’s income tax is far less elastic that those of most other states.

21. An Alternative Income Tax • A graduated income tax of equal yield could have a number of benefits • Partially mitigate the strong trend towards income inequality in Michigan • Increase Michigan income by increases in the “federal offset” • Increase “elasticity”, reduce long run fiscal stress on state budget • More tax “winners” than “losers”

22. Michigan’s changing income distribution

23. The Trend in Income Distribution

24. The Changing Income Distribution • During the last 30 years, the share of income received by the top quintile rose from 40.93 to 49.53 percent • The proportionate shares fell for all of the other four quintiles • Economics teaches us the case for progressive taxation depends on the degree of inequality, more inequality implies more progressivity

25. Deductibility and the Federal Offset • A graduated income tax would necessarily increase the flow of funds from Washington to Michigan. Other states benefit much more than Michigan from the deductibility provision. • Both presidential candidates claim they will “fix” the AMT problem, and higher federal marginal rates at top income brackets (Obama) would increase the offset to Michigan even more!

26. A Graduate Income Tax • Single/married filing separately –marginal tax rates by taxable income • $1 - $13,000 2.9% • $13,001 - $26,000 3.9% • $26,001 - $39,000 4.9% • >$39,000 5.9% • Married filing jointly • $1 - $26,000 2.9% • $26,001 - $52,000 3.9% • $52,001 - $78,000 4.9% • >$78,000 5.9% • The breakeven thresholds for taxable income compared to the current rate of 4.35% are $50,322 for singles and $100,644 for joint returns. Compared to the previous rate of 3.9%, the breakeven thresholds would be $39,000 for singles and $78,000 for joint returns.

27. Most Taxpayers Receive a Tax Cut • The analysis is net of all credits and state refunds but not the federal offset • Based on all returns with positive taxable income: • 11.6% of singles would receive a tax increase (88.4% with tax cut); 18.6% of married couples would pay more (81.4% with a tax cut); and 20.7% of married filing separate would pay more (79.3% with a tax cut). • Overall, 85.3% of taxpayers would receive a tax cut and 14.7% would receive a tax increase. • The calculations were done using 2006 tax data, based on tax law for 2008 (exemption amounts and tax rate).

28. Most taxpayers gain, Michigan gains, the state budget would be placed on firmer long-run footing Remaining Question: IS A GRADUATED INCOME TAX POLITICALLY ACHIEVABLE?