Personal Income Tax Highlights

PERSONAL INCOME TAX HIGHLIGHTS

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The personal income tax can be—and usually is—the fairest tax. When properly structured, it makes wealthier taxpayers pay their fair share, eases the tax load somewhat on middle- income families and completely exempts the poor. Because the personal income tax is the only major progressive tax levied by states, it provides an important counterbalance to regressive sales, excise and property taxes.

How it works

Almost all states with personal income taxes tie their income tax base to federal tax rules. This means that income taxpayers can do their federal income taxes and then copy their total income from the federal tax forms to their state tax form. This time-saving step makes income taxes easier to file—and makes it easier for tax administrators to monitor compliance.


Tax Rates

Most states use graduated rate schedules where the marginal tax rates are higher as taxable income increases. In a graduated tax rate system, different marginal rates are assigned to different taxable income brackets. The table at above shows an example in which the first $25,000 of taxable income is taxed at 2 percent, income from $25,000 to $40,000 is taxed at 4 percent, income from $40,000 to $100,000 is taxed at 6 percent and income over $100,000 is taxed at 8 percent.

What confuses some people is that they look at a tax table like this, know that they earn $45,000 per year, for example, and conclude that they must have to pay 6 percent of their income in tax. But that isn’t the way it works at all.

First, the tax rate table is based on taxable income, not total income. Thus, someone making $45,000 per year probably has taxable income under $40,000 after deductions and exemptions are subtracted—and taxable income is what determines your tax rate. So this person is probably only paying tax at the 2 percent rate.

Second, because these tax rates are marginal tax rates, even if a family does have taxable in-come of $45,000, only the last $5,000 of that will be taxed at 6 percent. Marginal rates apply only to taxable income over the amount where the tax bracket starts. This means that the effective tax rate paid at any income level (that is, the percentage of your total income you pay in tax) will always be lower than the top marginal rate.

Revenue and Stability

Because of its direct link with growth in personal income, revenue from an income tax grows with a state’s economy. In fact, the more progressive the income tax, the more it grows. Why? Because virtually all income growth over the past decade has been concentrated in the top of the income scale. Thus, a state that has high rates on the wealthy captures this growth better than a state with low rates on the well-to-do. Progressive income taxes will usually grow faster than personal income over time. This is important because the cost of providing public services often grows faster than income as well.

Of course, in a severe recession, personal income tax collections will decline. But in the long run, the personal income tax is the most reliable source of revenue to fund public services.

How Fair Is Your Income Tax?

Capital Gains Tax Breaks

High nominal tax rates on the rich are indeed the simplest way to make the wealthy pay their fair share. But high rates don’t do much good if there are major tax shelters for the wealthy in the tax law. The federal income tax provides a special tax break from dividends and capital gains income. Since most dividend and capital gains income goes to the wealthiest Americans, this tax break mainly benefits the wealthy while offering only a pittance to middle- and low-income families.

A general state capital gains tax break is highly unlikely to benefit a state’s economy, since any investment encouraged by the capital gains break could take place anywhere in the United States or the world. Most states currently do not have a tax break for capital gains.

Pension Tax Breaks

Many states provide much more generous tax breaks for pension benefits than for other income sources. This type of exemption creates two glaring problems of tax equity: first, it provides a tax break to taxpayers at all income levels. The benefits of the wealthiest executive receive the same treatment as the benefits of the lowest-paid worker. Second, it provides special treatment for non- working taxpayers, with no comparable break for the earned income of otherwise identical seniors.

Limiting pension tax breaks to low- and middle-income retirees—or replacing the pension tax break with a more general elderly exemption that applies to both earned income and unearned income—are two approaches to tax reform that would improve the perceived fairness of state income taxes.

The Importance of Indexing Income Taxes for Inflation

Many features of the personal income tax are defined by fixed dollar amounts. For instance, income taxes usually have various rates starting at different income levels. If these fixed income levels aren’t adjusted periodically, taxes can go up substantially simply because of inflation. This hidden tax hike is known as “bracket creep.” The way the federal personal income tax and some states deal with this problem is by “indexing” tax brackets for inflation. Unless these progressive tax breaks are indexed, they will gradually become less valuable over time—imposing a hidden tax hike on the low- and middle-income taxpayers for whom they are most valuable.

Deduction of Federal Income Taxes from State Taxable Income

Another pitfall for state income taxes is the deduction for federal income taxes paid. Since the federal personal income tax is progressive, this deduction significantly reduces the state income taxes paid by the wealthy. In fact, for people in the top federal bracket, the state deduction for federal income taxes effectively lowers a state’s top marginal tax rate by about a third. For low- and middle-income taxpayers, on the other hand, this tax break offers little or no relief.

Tax Breaks for Middle- and Low-Income Families

There are a number of ways, other than low tax rates, to keep income taxes affordable for middle- and low-income families. Large standard deductions and exemptions provide relief to all income groups, but are more significant to middle- and low-income families than to the well off. For instance, $10,000 worth of exemptions amounts to 25 percent of income for a family earning $40,000. But the same exemption offsets only 2 percent of income for a family making $500,000.

Targeted tax credits like the Earned Income Tax Credit are an even more effective (and less costly) way of making income taxes progressive. Because the benefits of these credits can be designed to phase out above a specified income level, these credits can be targeted to the low-income families who need them most, and the cost of the credit can be kept to minimum.

Conclusion

State governments rely on three main sources of revenue—income, sales and property taxes. Of these, only the income tax is progressive. For this reason, an effective income tax, with graduated rates and a minimum of regressive tax loopholes, is the cornerstone of a fair state tax system. Even the most progressive income taxes are usually insufficient to offset the unfairness of sales and property taxes. But a progressive income tax makes the difference between extreme and mild tax unfairness at the state level.

If you are interested in learning about filing initiatives and referenda in Washington State please click here.

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