August 26, 1998
A Broad-Based Tax Rebate
Maximizes Benefits to Colorado Residents
by Nicholas Johnson and Elizabeth C. McNichol
For the second straight year, Colorado has collected revenues in excess of its constitutional spending limit. Under the provisions of the Taxpayers' Bill of Rights (TABOR) added to the state's constitution in 1992, any funds in excess of the spending limit must be returned to taxpayers unless the voters authorize otherwise. According to preliminary figures, revenue exceeded the fiscal year 1997-98 spending limit by $562 million. At least $362 million, and perhaps the full $562 million, will be available for rebates to taxpayers, depending on whether voters in November approve a plan to spend a portion of the excess on school and road construction. The General Assembly will meet in special session starting September 14 to determine how this year's rebate will be distributed to taxpayers.
Last year's rebate was made available to all Colorado adults. The broad-based nature of the 1997 rebate reflected the fact that the revenue in excess of the limit came from a variety of types of taxes paid during the preceding fiscal year by all Colorado taxpayers. The 1997 rebate was "graduated"; that is, upper-income taxpayers received somewhat larger rebates than middle- and lower-income taxpayers. As of July 31, some 2.3 million Colorado taxpayers had claimed 1997 rebates ranging from $37 to $80.
In fiscal year 1997-98 as in 1996-97, taxes paid by all Colorado taxpayers contributed to the revenue available for the tax rebate. The fastest-growing revenue source was the personal income tax, but several other major revenue sources including the sales tax and other taxes and fees also grew more rapidly than the 5.5 percent growth allowed under TABOR for the 1997-98 fiscal year. Since virtually every household at every income level in Colorado paid some form of taxes that contributed to the TABOR limit excess, the mechanism chosen to distribute the rebate should distribute the rebate to as many Colorado households as possible.
It is not feasible to rebate to every taxpayer a calculated portion of every tax paid by that taxpayer. Given the broad-based origin of the excess taxes, the taxes can best be returned to those taxpayers who paid them by directing a simple rebate to as broad a group of taxpayers as is administratively practical.
In the upcoming special session, legislators are expected to choose among distribution methods based on one or both of the state's two major taxes the income tax and the sales tax.
- All of the main proposals to distribute the rebate rely on the state's income tax system as a method of administering the rebate. In other words, under each proposal taxpayers would see the benefit of the rebate when they fill out their income tax returns for tax year 1998.
- The major proposals vary, however, in their methods of computing the amount of the rebate received by each taxpayer. The rebate could be calculated as either:
- an income tax rate reduction or a credit equal to a percent of income tax liability;
- a flat dollar credit administered on the income tax form but designated as a sales tax rebate; or
- a graduated dollar credit administered on the income tax form but designated as a sales tax rebate (the method used for the 1997 rebate).
These differing methods would distribute the revenues differently among Colorado taxpayers. They also would result in differing proportions of the total rebate remaining within Colorado and actually benefitting Colorado residents.
- If the rebate is distributed through an income tax rate reduction or as a credit based on a percent of income tax liability, many of Colorado's taxpayers would receive no benefit. Like many other states, Colorado exempts residents with income below the poverty line from income tax liability. As a result, a total of about 600,000 taxpayers would not be eligible for a rebate based on income tax liability.
- By contrast, making the rebate available both to income tax filers including those who have income tax liability and those who do not and to all adult non-filers would ensure that most of the state's taxpayers receive a share. The major reason for designating all income tax filers and all adult non-filers as eligible for the rebate, as was done for the 1997 rebate, is that all Colorado residents pay sales taxes, excise taxes, and other state taxes. An estimated 2.6 million Colorado taxpayers would be eligible for a broad-based rebate.
- Making the rebate available to all Colorado residents would enable the state to designate it as a sales tax credit, as the 1997 credit was designated. Designation as a sales tax credit is advantageous because it does not affect Colorado residents' federal income tax liability. In contrast, if the rebate were distributed as an income tax rate cut or a credit based on income tax liability, the federal tax liability of Colorado residents (primarily those with higher incomes) would increase, because the credit would reduce the amount of itemized deductions claimed on federal tax returns; as a result, a portion of the rebate would be lost to Coloradans and would serve only to increase federal tax revenue. For the state to assert plausibly that the rebate refunds a portion of sales tax paid, all of the state's residents who pay sales taxes including the 600,000 taxpayers who would be excluded under an income tax cut must receive rebates.
- Colorado families at a wide range of income levels likely would receive greater benefit from a sales tax credit than from an income tax cut. A study by Colorado Legislative Council staff of five sample married-couple families with incomes ranging from $15,000 to $130,000 found that all five would fare better under some form of a sales tax credit than under an income tax rate reduction; similarly, four of five single taxpayers at those same income levels would fare better under a sales tax credit than an income tax cut.
- The manner of distributing the rebate would also affect the extent to which a portion of the rebate benefits residents and businesses outside of Colorado. Because Colorado's constitution requires a uniform income tax rate, an income tax rate reduction would have to be extended to corporations as well as to individuals. If the rebate is distributed to business taxpayers as well as to individuals, a significant portion of the rebate would likely benefit individuals who live in other states. If the rebate increases profits of a corporation that pays Colorado taxes, for example, all owners and shareholders of the corporation, whether they live within or outside of Colorado, would benefit.
Any rebate mechanism chosen must balance administrative feasibility with the ability to reach as many as possible of the states' taxpayers. Use of credits administered through the income tax gives the ability to direct the rebate wholly to in-state residents and to limit the rebate to individual residents. Use of a flat dollar amount ensures that taxpayers who pay state taxes other than income taxes receive a fair share of the rebate. Designating a credit as a sales tax rebate means that all of the rebate will stay in Colorado rather than a portion going to the federal government or to non-Colorado residents.
Significant Aspects of TABOR Rebate Proposals
Method of Rebate Out-of-State Residents Can Be Excluded Rebate to Individuals Only Low-Income Taxpayers Are Eligible Low-Income Taxpayers Receive Same Benefit as Other Taxpayers Portion of Rebate That Goes to Federal Government Income tax rate reduction No No No No Approx. 20% Credit to individuals based on percent of income tax liability Yes Yes No No Approx. 20% Refundable flat dollar credit designated as sales tax rebate Yes Yes Yes Yes None Refundable graduated dollar credit designated as sales tax rebate Yes Yes Yes No None
The TABOR Limit
The provisions of the TABOR limit restrict the rate of spending growth by the state and local governments to the inflation rate plus the percentage change in population for the prior year. The constitutional definition of fiscal year spending is broad, and spending effectively is assumed to be equal to revenues received. As a result, the limit is applied by comparing actual revenue growth to the constitutional limit on growth. For the fiscal year beginning July 1, 1997 and ending June 30, 1998, the limit was 5.5 percent. Colorado's revenues exceeded this limit by about $562 million.(1)
Nearly all of the revenues from Colorado's General and Cash Funds are subject to the limit. The revenues in the general fund come from many sources including income taxes, sales taxes, and excise taxes such as cigarette taxes. Cash Funds include transportation-related funds, the Higher Education Fund and the Unemployment Insurance Fund as well as other smaller funds. Personal income taxes in 1998 raised about $3 billion or 41 percent of the $7.4 billion in total revenue subject to the limit; corporate income taxes raised another $0.3 billion or about 4 percent of the total. The remaining 55 percent of the revenue subject to the limit comes from other general fund taxes, including sales and excise taxes, and from the gasoline taxes, vehicle registration fees, and other revenue sources in the Cash Funds.
Where Did the Excess Funds Come From?
The excess of $562 million results from overall growth in state revenues, not simply from extraordinary growth in any one revenue source. A number of the state's major revenue sources grew more rapidly than the limit of 5.5 percent allowed under TABOR. Revenues from sources as diverse as the individual and corporate income taxes, the sales tax, the estate tax, gaming taxes, vehicle registrations, higher education revenue other than tuition, and interest income all grew more rapidly than the limit. All Colorado residents would likely pay at least one and perhaps several of these diverse types of taxes.
The largest share of total revenue growth from fiscal year 1996-97 to fiscal year 1997-98 came from the personal income tax. According to a Legislative Council estimate, personal income tax receipts grew by about $480 million, a growth rate of 18.6 percent. During times of strong economic growth such as the nation and the state currently are experiencing, Colorado's personal income taxes generally do grow faster than most other revenue sources. This past year, Colorado's growth in personal income tax revenues mirrored unusually rapid growth of the federal income tax and the income taxes of a number of states. According to the federal Congressional Budget Office and to the Colorado Legislative Council staff, much of the personal income tax growth stemmed from tax payments related to profits on investments in the stock market and from salary bonuses received by corporate executives and other high-income taxpayers. Thus Colorado's strong growth in personal income tax revenue does not appear to represent any increase in tax burden on residents relative to income, but rather just reflects normal tax payments on the higher levels of income enjoyed by some taxpayers.
Sales tax growth also was relatively strong. It rose more than $100 million from fiscal year 1996-97 to fiscal year 1997-98, an increase of about 8 percent. Since the sales tax applies to purchases of a wide range of goods, it is paid by virtually every Colorado resident. At the other extreme, an estimated $78 million in new revenue 14 percent of the total excess of revenues over the limit came from the estate tax paid by the estate of a single person, the late billionaire Bob Magness.
Taxpayers contributing to the "excess revenue" include Coloradans of all income levels. In fact, relative to their incomes it is likely that lower-income Colorado residents contributed more to the revenue counted against the TABOR limit than higher-income Coloradans. This is because Colorado's tax system is regressive, that is, its lowest-income residents pay a larger share of their income in state and local taxes than its highest-income residents. (See Figure 1 below.)
Effective State and Local Tax Rates
Fiscal Year 1994
The diversity of the revenue sources that grew faster than the TABOR limit and the range of income levels of taxpayers that contributed to those revenue sources suggest that the mechanism to rebate the funds should attempt to divide the excess among as many of the states' taxpayers as is administratively feasible.
The Major Proposals To Distribute the Rebate
Of the $562 million in revenue exceeding the TABOR limit, the amount available for rebate to taxpayers will depend on a November referendum in which voters will decide whether the state should spend $200 million from this year's TABOR excess (and a similar amount from any revenues over the TABOR limit that may occur in the next four years) on construction of roads, schools, and higher education facilities. If the referendum passes, about $362 million will be available for tax rebate. If the referendum fails, about $562 million will be available for tax rebate. Thus the special session to choose the manner of rebate will occur before the referendum that determines the amount of rebate. Whatever the size of the rebate, however, the main issues concerning how to distribute it to taxpayers will remain essentially the same.
All of the main proposals to distribute the rebate rely on the state's income tax system as a method of administering the rebate. That is, taxpayers would receive the benefit of the rebate when they compute their income tax returns for tax year 1998, just as taxpayers received the fiscal year 1996-1997 rebate on their tax year 1997 returns. The proposals vary, however, in their methods of describing and computing the rebate. The rebate could be distributed as either:
- an income tax rate reduction or a credit equal to a percent of income tax liability;
- a flat dollar amount designated as a sales tax rebate; or
- a graduated dollar amount designated as a sales tax rebate (the method used for the 1997 rebate).
Within each of these options, there are some significant choices that legislators face such as whether a check is mailed or credit given. However, the initial choice of the basic distribution method will have the most significant impact on how broad a group of Colorado taxpayers receive the rebate and how rebates are targeted.
Distribution as a Percent of Income Tax Liability
Through a Rate Reduction or Credit
One way to distribute the rebate would be to set the amount of the rebate equal to a percentage of each taxpayer's income tax liability, either by reducing the state income tax rate temporarily or by offering a credit based on tax liability. Calculating the amount of the rebate in this manner would limit it to only those taxpayers with an income tax liability.
This method would not reach those Colorado taxpayers who pay sales and other state taxes but have no income tax liability, a category that includes approximately 600,000 Colorado taxpayers. Many of those taxpayers are part-time or full-time workers whose earnings are insufficient to lift them above the Colorado income tax threshold (which was $14,000 for a single-parent family of three or $17,500 for a two-parent family of four in 1997). Others are senior citizens with similarly modest incomes.
Even among taxpayers with income tax liability, the benefits from an income tax rate cut or credit based on tax liability would vary dramatically depending on a family's income. According to Legislative Council staff, a $362 million rebate distributed through a reduction in the state income tax rate would cut the rate from 5 percent to an estimated 4.45 percent. Such a rate cut would reduce taxes for a single taxpayer with two children and an income of $15,000 by about $4. A similar taxpayer with income of $50,000 would receive an estimated Colorado income tax reduction of about $175; after the increase in federal income taxes that the wealthier family would pay, the net reduction would be about $150. For a taxpayer with income of $130,000, the estimated net benefit would be $420.(2)
Under an income tax rebate, a significant portion of the rebate would go to the federal government rather than to Colorado taxpayers. Under current federal income tax law, taxpayers who itemize deductions are allowed to deduct state income taxes paid. If a taxpayer subsequently receives a refund of taxes that were deducted in a prior year, the refund amount must be added to taxable income; the additional income increases federal tax liability. Legislative Council staff estimate that distributing the rebate as a percent of income tax liability could increase residents' federal tax liability by an amount equal to 22 percent of the rebate as much as $122 million depending on the total amount of the tax rebate.
If a rebate based on a percent of each taxpayer's liability were administered by lowering the income tax rate temporarily, an additional proportion of the $362 million to $562 million would be diverted from Colorado residents. Because Colorado's constitution requires a uniform income tax rate, any rate reduction would have to be extended to corporations as well as to individuals. Business taxes ultimately are paid by individuals. If the rebate is distributed to business taxpayers as well as to individuals, a significant portion of the rebate would likely benefit individuals who live in other states. If the rebate increases business profits, for example, all owners and shareholders of the Colorado business, no matter where they reside, would benefit. Similarly, if the rebate allows prices to be cut slightly, consumers nationwide could benefit. As a result, Colorado residents would not receive the full $362 to $562 million rebate.
Distribution of a Flat Dollar Amount Designated
as a Sales Tax Rebate through the Income Tax
Another method to distribute the rebate would be to provide a refundable flat dollar credit designated as a sales tax rebate for taxpayers and distribute the sales tax rebate through the income tax. The rebate could be set at a flat dollar amount because it is likely that virtually all taxpayers would have paid at least the amount of the credit in sales and excise taxes during the year.
A major advantage of a credit designated as a sales tax rebate rather than an income tax rebate is that it is likely that this type of rebate would not be taxable under the federal income tax. The reason that a sales tax credit would not affect liability is that taxpayers cannot deduct state sales tax payments from their income tax; thus, a refund of sales taxes need not be counted as income. The determination of whether the credit is taxable under the federal income tax is made by the Internal Revenue Service. Whether the IRS would consider a flat dollar credit a sales tax rebate is likely to depend in part in ensuring that a broad group of taxpayers are eligible for the credit. It would not be plausible to assert that a credit distributed through the income tax is a sales tax credit if it is distributed only to those with income tax liability.
For instance, the fact that the 1997 rebate was distributed to all taxpayers is one reason that the Colorado Department of Revenue considers it a sales tax rebate, not an income tax rebate. Although the IRS has not ruled specifically on the 1997 rebate, the Department of Revenue has determined that IRS statutes and regulations do not require the Department to count the credit when it reports income tax refunds to the IRS.
If a $562 million rebate were distributed as a flat credit to the estimated 2.6 million income tax filers and adult non-filers, each person would receive roughly $215. A $362 million rebate would lead approximately to a $138 credit. Such an amount would offset a portion of the state taxes paid by Colorado families of all income levels.
Distribution of a Graduated Dollar Amount Designated
as a Sales Tax Rebate through the Income Tax
Another option for the rebate is a graduated sales tax credit similar to the credit used to distribute the 1997 TABOR rebate. Like a flat sales tax credit, a graduated sales tax credit would be administered through the income tax but would be available to all Colorado adults, whether or not they have income tax liability. Like a flat credit, a graduated credit could be limited only to Colorado residents, excluding out-of-state residents and corporations. Moreover, if it is clearly designed to offset sales taxes and other taxes other than the income tax, it presumably would not increase recipients' federal tax liability.
Unlike a flat credit, however, a graduated credit would provide larger benefits to taxpayers with higher incomes and smaller benefits to taxpayers with lower incomes. In this respect, it would somewhat resemble a reduction in the income tax rate or a credit based on income tax liability. The manner in which the credit were structured would determine the relative benefits received by low-, middle- and high-income taxpayers.
The 1997 TABOR Rebate
Amount of Rebate per
Number of Tax Returns Claiming
Rebate as of June 30, 1998
Single taxpayers Under $15,000 $37 473,946 $15,000 to $100,000 $60 502,378 Over $100,000 $80 12,467 Married filing jointly Under $15,000 $74 63,413 $15,000 to $100,000 $120 513,875 Over $100,000 $160 86,145 Total, all returns 1,652,224 Source: Colorado Department of Revenue
The 1997 graduated sales tax credit provided a credit to all Colorado income tax filers and all adult non-filers. Most Colorado taxpayers received $60 a person, but taxpayers with incomes over $100,000 received $80 and taxpayers with incomes under $15,000 received just $37. Table 2 shows the numbers of returns filed for each size rebate.
The 1997 rebate amounts of $37, $60 and $80 will not be sufficient to distribute the 1998 rebate, because the 1997 rebate only totaled $140 million, while the 1998 rebate will total 2 ½ to four times as much. However, the basic structure of the 1997 rebate could be maintained, with each income group receiving an approximately proportionate increase in the size of its credit. Under this method, the governor's office estimates that the credits for low-, moderate-, and upper-income families would be $95, $119 and $152 respectively per adult, assuming the referendum passes in November. If the referendum fails, credit amounts would be $147, $236 or $309. The amounts would be doubled for married couples.
A more steeply graduated sales tax credit was proposed in House Bill 98-1417. With a $362 million rebate, this bill would provide an estimated credit of $81 to taxpayers with incomes up to $25,000 and $259 to taxpayers with incomes above $80,000. For taxpayers with incomes between $25,000 and $80,000, the credit would rise on a sliding scale, with the exact credit amount equal to 0.324 percent of income. Again, the credit would be doubled for married couples.
Comparing Proposals' Impact on Taxpayers at Various Income Levels
Table 3, based on calculations performed by Legislative Council staff, shows the impacts on taxpayers at various income levels of some of these approaches: a pure income tax rate reduction, a graduated credit similar to the credit enacted last year, the graduated credit proposed in HB 98-1417, and a "blended" approach that dedicates 45 percent of the total funds available for tax rebate to an income tax rate cut and the remainder to a sales tax credit. They take into account the increased federal taxes that taxpayers who itemize their deductions would have to pay under the rate reduction and blended approaches.
Most of the families shown in Table 3 would fare better under a sales tax credit than under an income tax rate reduction or under a blended approach. Nine of the ten families all but the single taxpayer earning $130,000 would fare best under at least one of the versions of a sales tax credit. Six of the ten families studied would fare better under either of the versions of a sales tax credit shown than under an income tax rate reduction.
The families shown in Table 3 should not be viewed as a representative cross-section of Colorado families. In general, Colorado residents are less well-off than most of the taxpayers shown in the table. The Census Bureau reports that median household income in Colorado, including some forms of income not subject to tax, is roughly $41,000, lower than the incomes of eight of the ten sample families analyzed. According to Internal Revenue Service statistics for 1996, about 52 percent of all joint tax filers and 93 percent of single tax filers have annual incomes of $50,000 or less.(3) Over a quarter of taxpayers have reported incomes below $15,000. The estimated impacts of the various proposals on families earning $15,000 to $50,000 therefore are particularly worthy of note, since those taxpayers are likely to be more representative of typical Colorado taxpayers than the other sample taxpayers. As Table 3 shows, taxpayers in the $15,000 to $50,000 income range would receive the greatest benefits from sales tax credits relative to an income tax rate reduction.
Impact of $362 Million TABOR Rebate on Sample Three-Person Families
By Income Level and Marital Status
Married Couple with One Child
Proposal $15,000 $50,000 $60,000 $80,000 $130,000 Income tax rate reductiona $0 $150 $194 $236 $420 Graduated sales tax credit - based on 1997 structure 190 304 304 304 396 Graduated sales tax credit - HB 98-1417 method 162 324 388 518 518 Combination of rate reduction and sales tax credit (HB 98-1412 method)a 106 237 256 275 409
Single Person with Two Children
Proposal $15,000 $50,000 $60,000 $80,000 $130,000 Income tax rate reductiona $4 $150 $164 $236 $420 Graduated sales tax credit - based on 1997 structure 95 152 152 152 198 Graduated sales tax credit - HB 98-1417 method 81 162 194 259 259 Combination of rate reduction and sales tax credit (HB 98-1412 method)a 55 153 159 191 292 Figures show rebate amounts if the November referendum passes.
a Net of federal income tax increase.
Source: Center on Budget and Policy Priorities. Adapted from Colorado Legislative Council Staff et al, The FY 1997-98 TABOR Refund, August 19, 1998, with data for single taxpayers provided by Legislative Council staff and estimated size of credit based on 1997 structure provided by Office of the Governor.
1. This figure is subject to final auditing; the final calculation is expected to be available shortly before the special session begins.
2. If the amount of rebate to be distributed through an income tax rate cut were $562 million, the tax rate would have to decline from 5 percent to an estimated 4.14 percent, and the amounts of the net tax reductions for the sample families shown would be proportionately higher.
3. Those statistics do not include taxpayers whose income was too low to file tax returns; if they did, these percentages would be higher.