Personal Income Tax

1. Personal Income Tax Brunori Chapter 6

2. General Introduction • Personal income taxes have grown steadily until it is one of the most important revenue sources for state governments. • The recent downturn in revenue collected from the personal income tax can largely be attributed to high unemployment and underemployment. • Consumption, business, excise, and other taxes have been limited by political, economic, and technological changes. The personal income tax has remained relatively free from many pressures that have plagued other taxes. • Paradoxically, the income tax faces the most opposition from state legislators, despite producing tremendous amounts of revenue and enjoying relatively widespread public support. • Part of that opposition is grounded in the belief that people’s wages should not be taxed. • Part of the resistance also reflects the belief that income taxes deter economic growth. Political leaders often believe that income taxes place their states at a competitive disadvantage.

3. Public Acceptance • The public has expressed little dissatisfaction with the state income tax. • The public’s acceptance of the state income tax contrasts sharply with its attitude towards the federal income tax, which along with the property tax, is one of America’s least favorite levies. • In the past four decades, a time of record-setting budget surpluses and deficits, Republicans and Democrats alike have generally look for other ways than eliminating the personal income tax to reduce tax burdens.

4. Consistent Performance • The personal income tax was once seen as an unstable source of income for the states. • Many public finance experts believed that while revenue would increase rapidly under good economic conditions, it would decline with equal rapidity in leaner times. • Recent history, however, has shown that the state personal income tax revenue has grown immensely through good times and bad.

5. Low Rates/Federal Deductibility • Most states impose relatively low rates, especially compared with income tax rates set by the federal government. • The states with the highest marginal rates also offer the most general exemptions and standard deductions to ease the tax burden on low-income and middle-income taxpayers. • The federal income tax may help promote the public’s acceptance of the state tax in another way. For Americans who itemize their federal tax returns, the state personal income tax is deductible. Although only a small percentage of American citizens itemizes, this group is one of society’s most politically active. • The state income tax also meets the criterion of transparency. The tax is highly visible mainly because it is automatically withheld from tax payers’ paychecks. • The small percentage of the average person’s pay withheld for state income tax purposes pales compared with the amount withheld for federal income taxes.

6. Modest Compliance and Administrative Burdens • Because most Americans are subject to state income tax withholding, the taxes is largely collected and remitted to the state long before returns must be filed. • Accounting procedures also help ease the administrative burdens and facilitate compliance to the tax. • Because 28 states use federal adjusted gross income to determine state taxable income, in these states, taxpayers prepare their federal returns and simply transfer the adjusted gross income amount to this day returns. • The taxes is even more attractive to administrators. State revenue department spent very little time monitoring compliance with the income tax, largely because of the widespread withholding of state income taxes. • Because most taxpayers must use federal income is the starting point for determining state income tax liability, they have strong motive for paying the full amount of the tax. State tax evasion almost always requires federal tax evasion as well. • Cooperation between the states and the internal revenue service (IRS) helps ease administration of the tax. Almost every state has an agreement with the IRS to share information. • In many respects, state revenue departments have essentially delegated personal income tax auditing to the federal government.

7. High Level of Fairness • One of the most powerful justifications for the personal income tax is that it is viewed by many as the most equitable of all state taxes. • Most observers view fairness in terms of progressivity. Others believe that proportional taxation is the key to fairness. But virtually everyone agrees that a fair tax minimizes regressivity. • States without a personal income tax tend to have more regressive tax systems overall. • All states impose income taxes that are at least mildly progressive because they exempt some portion of income up to a certain amount. • Most states use a graduated rate schedule, which taxes income at higher marginal rates as income increases. • A single flat rate on all income, which creates a more regressive system, is typically addressed through exemptions and deductions. • In the 1990s, most state adjustments benefited the wealthy more than the poor. • By 2005, most state income, tax regimes could be considered only mildly progressive. Most states had low rates and relatively few designated brackets. • Still, the income tax satisfies the requirements of vertical equity, far more than any other state tax. • The tax does less well in satisfying the requirements of horizontal equity. • The failure to achieve horizontal equity illustrates one of the personal income taxes most significant problems. Overreliance on the tax leads to political pressure to provide more exclusions, deductions, and credits and, in turn, to a narrowing of the tax base. States must raise rates to collect sufficient revenue.

8. Political Pressure • The effect of anti-tax politics on state income taxes is one of the most serious problems facing state governments. While the tax has grown in relative importance as a source of revenue (as incomes have grown), legislators often do not turn to the tax when looking for ways to generate new revenue. Rather, state legislators tend to favor adjusting less progressive taxes. • When states must raise additional revenue, they are far more likely to increase sales and use taxes (by either broadening the base or enacting rate hikes) than personal income taxes. Conversely, states that can afford to reduce tax burdens are far more likely to cut personal income taxes through exemptions and deductions or rate adjustments, and to cut the more regressive consumption taxes. • Political leaders primarily concerned with economic growth and job creation have demonstrated a strong bias against policies that hinder– or give the perception of hindering – these two goals. • This perception may continue because so few states conduct incidence studies on the effects of their tax policy decisions. • Legislators, however, always have an eye towards helping – or at least not harming – those who wield economic power in the state. Political support, campaign contributions, and networks of voters are at stake. The general lack of information about who pays and benefits and to what degree gives those with powerful economic interest greater leverage in the decision-making process. • More cynically, perhaps, legislators might intentionally decide to reduce income tax burdens, knowing that the wealthier segments of society will benefit most. Wealthier individuals are more likely to vote – and to contribute to political campaigns.

9. Federal Income Tax Changes • In recent years, national political leaders have proposed dramatic revisions to how the federal government collects revenue. Many of these proposals have called for the elimination of the federal income tax and the adoption of some type of national consumption tax. • Eliminating, or even significantly altering, the federal income tax would create serious problems for the states. • As noted, most states base their tax systems to some extent on the federal income tax.

10. Outlook for the Personal Income Tax: Guarding against Overreliance • The income tax is likely to dominate state public finance in the next half-century the same way that the sales tax dominated the last half-century. The tax will remain an important source of revenue because it is relatively easy to administer, has demonstrated consistent growth, and is widely accepted by the citizens. • Solutions to many fiscal problems will be delayed as the personal income tax continues to raise ever-increasing revenue. • Despite lawmakers-bias to cut rather than raise personal income taxes, the tax has become the dominant source of state revenue. • Overreliance may pose a problem for the income tax itself. A slow-growing economy, the aging workforce, decreasing sources of other revenue, and expanding public services needs could result in higher personal income tax rates. Public support could erode quickly if states significantly increase rates. • Higher rates also often lead political leaders to grant more and more expensive deductions, exemptions, and credits to various groups. Such tax preferences increase the tax’s complexity and often lead to greater compliance and administrative burdens. • Perhaps ironically, one key to maintaining a viable personal income tax that will be capable of funding public services may be to strengthen other state taxes. Greater reliance on consumption and corporate income taxes could eliminate the need to raise personal income tax rates and further complicate the tax system.