April 14, 1999

Reducing Alabama's Income Tax on Working-Poor Families:
Two Options

by
Nicholas Johnson

Summary

Alabama's income tax on poor working families is among the nation's very highest. Alabama is the only state that levies income tax on a family of four with income as low as $4,600 — barely one-quarter of the federal poverty line. A two-parent family of four with income at the poverty line in 1998 paid $408 in Alabama income taxes, more than in all but two of the 41 states that levy income taxes.

This income tax burden has the effect of making poor working families poorer. This is particularly problematic at a time when state welfare policy strives to encourage low-income families to work themselves off welfare and out of poverty. Other states have recognized the disadvantages of continuing to tax families at very low income levels; indeed, Alabama is the only state that has enacted no legislation in the 1990s to increase the income level a family can earn before it begins to owe tax or to reduce the tax burden on families with poverty-level incomes.

Other portions of Alabama's tax system also weigh heavily on families struggling to make ends meet. Alabama's sales tax rate is among the highest in the nation, and — unlike sales taxes in a majority of other states — the Alabama sales tax applies to groceries. The sales tax also applies to clothing and other necessities.

Proposals to relieve the burden of taxes, particularly income taxes, on low-income Alabama families have been recommended and discussed at various times in the past. In the early 1990s, for example, a tax reform commission suggested exempting poor families from the income tax entirely. Most recently, in the 1998 legislative session and in the 1998 gubernatorial campaign, policymakers have proposed increasing Alabama's tax deduction for dependent children from its present level of $300 to as much as $1,500.

Raising the dependent deduction to $1,500, as discussed last year, would be of modest benefit to poor families. For example, the change would increase the income level at which a two-parent family of four begins owing tax, from $4,600 to about $7,500. For a family with income at the poverty line, as well as for taxpayers at higher income levels, the larger deduction would reduce income tax liability by about $60 per child. The annual revenue loss would total about $76 million.

For approximately the same cost, about $70 million a year, a more targeted strategy such as an Earned Income Tax Credit could accomplish far more tax reduction for low- and moderate-income Alabama families who work and who have children. The income level at which a two-parent family of four begins owing tax could be more than tripled from $4,600 to about $14,900. For a family with income at the poverty line, the credit would reduce income tax liability by about $297. The benefits of such a credit would be concentrated on families with incomes below $31,000.

For families with children with very low incomes, an Earned Income Tax Credit would have an additional important feature. Unlike the increase in the dependent deduction, the EITC would be "refundable"; that is, if the amount of the credit exceeded a family's income tax liability, the balance of the credit would be returned in the form of a tax refund. This refund would help families to meet the burden of other taxes levied in Alabama, such as Alabama's sales tax on food.

The targeted nature of an EITC would also help bring the state's tax burden on poor families more in line with the taxes the state levies on higher-income families. At present, Alabama collects more than twice as high a share of poor families' incomes than of more affluent families' incomes. By targeting a tax cut on low- and moderate-income families, the state could reduce that imbalance.

 

Alabama's Taxes on Working-Poor Families

Income taxes

More than a decade ago, the federal government recognized the inconsistency of encouraging poor families to work and then levying taxes that pushed them deeper into poverty. President Ronald Reagan spoke forcefully in the mid-1980's about the foolishness of taxing poor households deeper into poverty. In 1986, as part of an overall tax reform package, the federal government eliminated income tax liability for poor families. Since then, 22 of the 41 states with income taxes likewise have eliminated income tax liability for poor families, and another eight states have substantially reduced that tax liability.

Alabama, however, continues to levy substantial income taxes on working-poor families, and the burden of this tax is among the highest in the nation.

Sales and other taxes

Alabama's income tax is not the only aspect of its tax system that weighs particularly heavily on low-income families. The combination of the low income tax threshold with gasoline taxes, property taxes, and in particular Alabama sales taxes gives Alabama overall one of the nation's most burdensome state and local tax systems for the poor.

Total tax burdens on poor families in Alabama commonly exceed a thousand dollars a year. The poorest 20 percent of married non-elderly couples, with an average income of $12,200, pay on average $1,415 a year in Alabama state and local taxes, according to a 1995 study by the Institute on Taxation & Economic Policy. Two-thirds of that tax bill is in the form of sales and excise taxes.(3)

The overall tax burden

The high taxes on the poor are somewhat surprising because in general Alabama is a low-tax state, with total state and local taxes as a percent of income about one-fifth lower than the national average.(4) But because of Alabama's high income taxes on the poor, its heavy reliance on sales and excise taxes, its lack of a food tax exemption and its high sales tax rates, Alabama's tax system as a whole is far more burdensome on low-income families than upper-income families. Among non-elderly married couples, the poorest 20 percent pay 11.6 percent of their incomes in state and local taxes, compared with 4.8 percent paid by the wealthiest 1 percent of couples. The 1995 ITEP study found that Alabama is one of only nine states that tax low-income families more than twice as heavily as upper-income families.

 

Using the Income Tax to Relieve Taxes for the Poor

To understand how the income tax system could be changed to reduce taxes on the poor, it is useful to review the current system. For a working-poor family, the amount of income subject to tax is presently reduced by the following exemptions and deductions:

These exemptions and deductions are subtracted from a family's income. The Alabama tax rate schedule — two percent of the first $1,000, four percent of the next $5,000, and five percent of the remainder — is applied to the balance to compute tax liability for the year.

For poor families, this tax structure differs in two important respects from the tax structures of other states. First, the exemptions and deductions available to low-income families are lower than those available to similar families in most other states. For a single-parent family of three with poverty-level income of $13,000, Alabama exemptions and deductions total $5,600. By contrast, exemptions and deductions for similar families in other states average $10,500, nearly twice the level in Alabama. In only nine other states are they as low or lower than in Alabama. Higher exemptions and deductions tend to mean lower tax liability for poor families, because exemptions and deductions can reduce substantially, or even eliminate, the amount of a poor family's income that is subject to taxation.

Second, Alabama is somewhat unusual in that it offers no tax relief provisions, such as tax credits, that are specifically targeted to low-income families. Altogether, 24 of the 41 states with income taxes reduce the taxes paid by low- or moderate-income families with tax relief provisions targeted on the poor. Such forms of tax relief are particularly prevalent in states with low deductions and personal exemptions. Seven of the nine states in which deductions and exemptions are as low as those in Alabama use mechanisms such as low-income tax credits, "no-tax floors," or other provisions to reduce or eliminate the tax on low-income working families. In some states, these tax credits can be quite large, worth several hundred or even a thousand dollars. By contrast, Alabama offers no tax relief to poor families.

Different states have chosen different paths to relieving taxes on the poor, and these paths provide models that Alabama could follow. In evaluating the appropriateness of any approach to reducing the income tax burden on the poor in Alabama, the following five questions may be helpful to consider.

The remainder of this paper reviews two specific proposals for reducing the income tax on low-income families in light of these five questions.

 

Reducing Taxes on Working-Poor Families Through an Increased Dependent Deduction

It has been suggested that the dependent deduction be increased from its current level of $300 to $1,500. Such an increase would provide an across-the-board income tax cut to all Alabama families with children, including both poor and non-poor families. The change would have the following impacts.

As shown in Table 1, lower-income families who pay Alabama income tax at rates below the maximum rate would get less than the maximum benefit from an increased deduction. And Alabama would remain one of fewer than six states that levy income tax on families with income as low as half the poverty line.(6)

Table 1.
Tax Under Current Law and Under Increase in Dependent Deduction
Married Couple With Two Children
Family income Tax under current law (dependent deduction is $300) Tax with dependent deduction increased to $1,500 Amount of tax cut
50 percent of poverty line ($8,328) $102 $13 $89
Full-time, minimum-wage earnings ($10,712) $178 $83 $95
100 percent of poverty line ($16,655) $408 $288 $120
125 percent of poverty line ($20,819) $581 $461 $120

Note: Poverty line is the federal poverty threshold for 1998.

 

 

Reducing Taxes on Working-Poor Families Through an Earned Income Tax Credit

An alternative method of reducing taxes on low- and moderate-income working families would be to offer an Earned Income Tax Credit. State EITCs provide credits to low- and moderate-income working families with children. (Most also provide small credits to very low-income individuals and couples who are not caring for children in the home.)

Since 1997, five states have enacted new Earned Income Tax Credits or expanded existing state EITCs, bringing the total number of states with EITCs to ten. EITCs have been enacted in states led by Republicans, in states led by Democrats, and in states with bipartisan leadership. State EITCs are based on the federal EITC, which is available to working families with two or more children whose incomes are below about $31,000, to working families with one child whose incomes are below about $27,000, and in much smaller amount to childless individuals and couples with incomes below about $10,000. The amount of a state EITC is typically set as a percentage of the federal credit — anywhere from 5 percent to 50 percent. In most states, EITCs are refundable; that is, if the amount of the credit exceeds a family's income tax liability, the balance may be refunded in the form of a payment.(7)

It would be straightforward for Alabama to enact an EITC of its own.

For families with slightly higher incomes, the EITC would not provide refunds, but the impact on state income tax liability would be substantial. For example, a family of four with income at the poverty line in 1998 paid $408 in income tax. An Alabama EITC set at 10 percent of the federal credit for that family would equal $297, leaving a net income tax liability of $111 — a tax cut of nearly three-fourths. (See Table 2.)

Table 2.
Alabama Earned Income Tax Credit
Married Couple With Two Children
Family income Tax under current law Tax (refund) after Alabama Earned Income Tax Credit set at 10 percent of federal credit Value of credit
50 percent of poverty line ($8,328) $102 ($231) $333
Full-time, minimum-wage earnings ($10,700) $178 ($206) $384
100 percent of poverty line ($16,655) $408 $111 $297
125 percent of poverty line ($20,819) $581 $372 $209

Note: Poverty line is the federal poverty threshold for 1998.

 

Conclusion

By many measurements, Alabama is a low-tax state. But for poor families, Alabama's tax burden is unusually high. Its income taxes on poor families are among the nation's highest, and its sales and excise taxes — in particular, its sales tax on food — also are unusually burdensome on poor families.

Increasing the dependent deduction would reduce the level of income taxes on poor families and would increase the income level at which working families begin paying income taxes. The change would be worth up to $120 for a family with two children — a substantial benefit. But Alabama's income tax on poor families would remain among the nation's highest, and the increase in the dependent deduction would do nothing to offset the regressiveness of state and local sales, excise and property taxes. Working families that are very poor would not benefit at all. A substantial portion of the benefits from this tax change would go to middle- and upper-income taxpayers.

By contrast, enacting an Alabama Earned Income Tax Credit would provide greater benefits to low-income families, at a similar or lower cost to the state treasury. It would accomplish this by targeting the tax cut to working families with incomes below $31,000. Although many poor families would continue to owe some income tax, the tax reduction — up to $380 per family — would be greater than under the increase in the dependent deduction. Similarly, the income a family could earn without incurring income tax liability would be higher with the EITC than with the increased dependent deduction. In addition, a refundable EITC for very poor families would help to offset the burden of the sales and excise taxes and other taxes.


Endnotes:

1. The states, in addition to Alabama and Virginia, are Arkansas, Mississippi, South Carolina, Tennessee, Utah, and West Virginia.

2. "Sales Tax Facts," Vertex Inc., 1998.

3. Citizens for Tax Justice and the Institute on Taxation & Economic Policy, Who Pays? A Distributional Analysis of the Tax Systems in All 50 States, Washington, D.C., 1996.

4. According to calculations based on the U.S. Census Bureau Government Finances data for 1996, the latest available, Alabama state and local tax collections were 9.0 percent of personal income. The national average was 10.9 percent.

5. Alabama offers other deductions as well, but most of these are unavailable to many low-income families. For example, most poor families do not benefit from the deduction for federal income taxes paid because they do not have federal income tax liability, and they do not benefit from the deduction for federal FICA taxes because they do not itemize their deductions. Similarly, many poor families do not own their own homes and therefore cannot claim the deduction for mortgage interest payments. Alabama also offers some tax credits that may reduce tax liability, but poor families are unlikely to be eligible for any of the existing tax credits, most of which benefit business owners.

6. Among the five states other than Alabama that levied income taxes on families of three or four with income equal to one-half of the poverty line in 1998, one state (Hawaii) has enacted legislation that will exempt families with incomes at that level from its income tax, and another state (New Jersey) is strongly considering legislation that would have a similar effect.

7. The states that offer EITCs are Iowa, Kansas, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Wisconsin, and Vermont. For more information about state EITCs, see Rising Number of States Offer Earned Income Tax Credits, Center on Budget and Policy Priorities, September 14, 1998 (www.cbpp.org/9-14-98sfp.htm).

8. In 1998, Alabama residents claimed $768 million in federal EITC benefits. Projections from the U.S. Treasury suggest that Alabama claims will rise to $830 million annually by fiscal year 2000, which would imply that a credit set at 10 percent of the federal credit would cost $83 million. However, because this procedure assumes full participation in the state credit among residents who receive the federal EITC, it provides an upper-bound estimate of the cost of a state EITC at a given percentage of the federal credit. In practice, state EITC costs typically have been lower than the estimates derived from the above procedure, and this seems to be true for several reasons, especially in the first few years after enactment of the state credit when awareness of the credit may be limited. A more reasonable estimate would be that the cost of an Alabama EITC would equal about 85 percent of what it would cost if every person that claimed a federal credit also claimed a state credit. This figure would accurately reflect the experiences of other states that have enacted EITCs, including New York, Wisconsin and Vermont, each of which have found that the cost of a state EITC in the first year after enactment was 80 to 85 percent of the cost of the federal credit multiplied by the state percentage.