April 14, 1999
Reducing Alabama's Income Tax on Working-Poor Families:
by Nicholas Johnson
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
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.
- Alabama's income tax threshold the income level at which families begin paying income tax for single-parent families of three or for two-parent families of four in 1998 was $4,600. Alabama's threshold is the lowest among the 41 states plus the District of Columbia with income taxes.
- Alabama's 1998 income tax for a family of four with income equal to full-time minimum-wage earnings $10,712 was $178, the second highest tax on a family with that income level in the nation (only Kentucky's tax was higher). For a family of three with full-time minimum-wage earnings, the tax was $218, third-highest in the nation.
- Similarly, Alabama's 1998 income tax for a family of four with income at the poverty line was $408. For a family of three with income at the poverty line the tax was $333. In each case, the tax was the third highest in the nation, behind only Kentucky and Hawaii. Hawaii's tax on poor families is scheduled to decline substantially by next year, leaving only Kentucky with a higher tax on families at the poverty line.
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.
- Alabama gets a larger share of its state and local tax collections from sales taxes and from excise taxes (such as gasoline taxes and utility taxes) than most other states. Sales and excise taxes in Alabama account for 51 percent of all state and local revenue, compared with an average of about 36 percent nationwide. These taxes are regressive, which means they absorb a much larger proportion of the incomes of lower-income households than of higher-income households.
- Alabama is one of just 15 states that taxes food at the same rate as other goods. The tax on food is more burdensome on low-income families than on middle- and upper-income families, because poorer families spend a much higher proportion of their incomes on food than wealthier families. Of the 15 states that fully tax food, seven offer some form of low-income tax credit that helps offset the burden of the food tax. This means that Alabama is one of just eight states that provides no relief for the food tax whatsoever. (One of those eight states, Virginia, is scheduled to begin phasing out its food tax in January 2000.)(1)
- In addition, low-income families pay sales tax on other necessities ranging from clothing to school supplies. Combined state and local sales taxes in Alabama can range from 7 percent to as high as 11 percent. Sales tax rates are higher than anywhere else in the country in the localities with sales tax rates at the upper end of this range.(2)
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:
- A personal exemption of $3,000 for a married couple or a head of household;
- A standard deduction of 20 percent of income, but not more than $2,000 for a head of household or $4,000 for a married couple; and
- A dependent deduction of $300 per child.(5)
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.
- Benefits. How much would typical working-poor families actually benefit from each change? That is, what would be the actual impact on families' tax bills?
- Cost. How much would it cost in lost revenue to the state?
- Targeting. Would most of the total benefits go to low-income families, or would a substantial portion go to middle- and upper-income families who currently benefit from other tax-reducing features of Alabama's tax structure, such as the deductions available for federal income taxes, FICA taxes, and mortgage interest?
- Work incentive. Would the change relieve the taxes on poor families as they enter the workforce? Would it help, rather than hinder, efforts to support a family on low-wage earnings?
- Impact on overall tax fairness. Would the change help to offset the effect of other, more regressive taxes, such as the sales tax on food?
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.
- Benefits. The maximum value of an increase in the dependent deduction from $300 to $1,500 would be $60 for each dependent claimed on the tax form. This amount reflects the increase in the deduction ($1,200) multiplied by the state's top income tax rate of 5 percent.
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)
- Cost. The Legislative Fiscal Office estimates that increasing the dependent deduction from $300 to $1,500 per dependent would cost about $76 million per year when fully in effect.
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.
- Targeting. An increase in the dependent deduction would not be targeted to low-income families. Any taxpayer with taxable income over $3,000, which includes virtually all middle- and upper-income Alabama taxpayers with dependents, would receive the maximum $60 per dependent benefit from the increase in the deduction. Thus, a substantial portion of the $76 million tax cut would go to higher-income families and not to poor families.
- Work incentive. With an increase in the dependent deduction, a two-parent family of four would not owe any income tax until its income reached about $7,500, a boost of about two-thirds from the present level of $4,600. This would help families entering the workforce, but still would impose substantial amounts of taxes on families with incomes well below the poverty line.
- Impact on overall tax fairness. The increase in the dependent deduction would provide benefits to families across the income scale and therefore would not make the Alabama tax system substantially less regressive. It would reduce families' income tax levels, but it would not offset other taxes, such as sales and excise taxes, that are the most burdensome for working-poor families.
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.
- Benefits. The tax benefit of an Alabama EITC would vary by income level, as the federal credit does. Families with no earnings would receive no credit. For families with very low earnings, the value of the EITC would increase as earnings rise. For example, an Alabama EITC set at 10 percent of the federal credit would provide a family with two or more children an EITC equal to four cents for each dollar up to $9,540 earned in 1999. The maximum benefit for a family with two or more children would be $382; the phase-in rate and the maximum benefit would be somewhat less for a family with one child. Families would be eligible for the maximum credit until income reached $12,460. Smaller credits would be available to families with incomes between $12,460 and $26,928 for families with one child and between $12,460 and $30,580 for families with two or more children.
- Cost. A state EITC set at 10 percent of the federal credit, as described above, would be expected to cost about $71 million in FY 2000; a state EITC set at 15 percent of the federal credit would cost about $105 million, while a state EITC set at eight percent of the federal credit would cost about $56 million.(8)
- Targeting. An EITC is a tax credit for low- and moderate-income working families and thus would be well-targeted to address the problem of high taxes on the working poor. Working families with children who have incomes below about $31,000 would be eligible, with the largest share of EITC benefits going to working families with children with income below the federal poverty line. Despite this targeting, the credit would still be available to a substantial portion of taxpayers. About 455,000 Alabama taxpayers, or one out of every four tax filers, claimed the federal EITC in 1996; those taxpayers would be eligible for a state EITC as well.
- Work incentive. For families entering the workforce, a state EITC would act as a wage supplement, increasing in value as earnings rose. Moreover, it would dramatically increase the income level at which a working family in Alabama must first pay taxes. An Alabama EITC set at 10 percent of the federal credit would offset income tax entirely for a family of four with income up to about $14,900, more than triple the present threshold of $4,600. This change would benefit a wide range of families that are working but whose earnings are low. For instance, Alabama would no longer levy income tax on a family of four with full-time, minimum-wage earnings.
- Impact on overall tax fairness. Because it would be well-targeted to those families bearing the highest tax burden, an Alabama EITC would make the state's overall tax system substantially fairer. Moreover, if the EITC were made refundable, it could actually provide cash payments to families that would help them pay the hundreds of dollars in sales and excise taxes that state and local governments levy on food and other necessary purchases. For example, if Alabama created an EITC set at 10 percent of the federal credit, a family of four with income at half the poverty line would receive a credit of about $333. Of that amount, $102 would offset pre-credit Alabama income tax liability. The remaining portion $231 would be refunded to the family in the form of a cash payment. That amount would recompense the family for a portion of the sales, excise, and other taxes paid during the year, which as noted above typically cost a family several hundred dollars a year.
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.)
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.
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.
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.