We have written about urban legends that never seem to die on several occasions this year. Another one – that “everyone” itemizes their deductions for tax purposes – underlies a proposal that appears to be circulating just below the surface of the ongoing budget debate. While a formal proposal has yet to surface, well-sourced rumors suggest that the essence of the proposal involves raising all of the state’s personal income tax rates except for the 9.3 percent rate – the highest rate other than the millionaire surcharge – and lowering the state’s sales tax rate. The result would be a net increase in state revenues that could be “explained” away in whole or in part by assuming that taxpayers would benefit from the substitution of a tax that is deductible for federal tax purposes – the income tax – for a tax that is not – the sales tax.
As with all budget proposals, however, the devils and the urban legends are in the details:
- First, according to the latest data from the Internal Revenue Service (IRS), in 2008 only 38 percent of California’s personal income tax taxpayers itemized deductions on their federal return.
- Second, relatively few low- to middle-income taxpayers itemize, while virtually all high-income taxpayers itemize their deductions. Yet, the proposal under consideration appears to be structured to disproportionately raise taxes at the bottom of the income distribution, while imposing a relatively small increase at the top of the income distribution. Last year’s temporary increase in tax rates had a similar impact, as discussed below.
- Third, low- to middle-income taxpayers get a smaller benefit from deductibility than do those at the high-end of the income distribution. That’s because the “benefit” from deductibility corresponds to a taxpayer’s marginal tax rate – the rate applied to their last dollar of income. Thus, in 2009, a married taxpayer filing a joint return with a taxable income of $40,000 would pay $0.15 less in federal income taxes for each extra dollar of state taxes if they itemize, while a taxpayer with a taxable income of $400,000 would pay $0.35 less in federal taxes for each additional dollar in state income taxes paid.
- Fourth, and perhaps most importantly, targeting the bottom, rather than the top, of the income distribution is bad economic policy. As we’ve previously argued, economists agree that in bad economic times, necessary tax increases should target high-income taxpayers, who are more likely to save a share of their income, rather than low- to middle-income taxpayers, who are more likely to spend every dollar they earn and thus keep dollars moving through local communities.
Yes, low-income taxpayers would pay less if the state’s sales tax rate were reduced. However, “back of the envelope” calculations based on Institute on Taxation and Economic Policy data and our own calculations of the impact of last year’s rate increase suggest that low- to middle-income taxpayers would still be disproportionately affected by the rumored proposal.
We are strongly “on the record” in support of a balanced approach to addressing the state’s budget shortfall: one that involves prudent reductions and prudent revenue increases. Unfortunately, however, this is one proposal that, if the facts match the rumors, doesn’t meet the “prudent” test.
— Jean Ross