The Impact of State Income Taxes on Low-Income Families in 2008

PDF of this Report (21pp.)

By Phil Oliff and Ashali Singham[1]

November 4, 2009

View the most recent version of this report:
The Impact of State Income Taxes on Low-Income Families in 2011
Revised April 17, 2012

Related Areas of Research

Summary

While some working-poor families get help lifting themselves out of poverty through exemptions from state income taxes, in many states they continue to face substantial state income tax liability. An analysis of state income tax systems for the 2008 tax year shows that:

  • In 16 of the 42 states that levy income taxes, two-parent families of four with incomes below the federal poverty line are liable for income tax;
  • In 12 states, poor single-parent families of three pay income tax;
  • And 26 states collect taxes from families of four with incomes just above the poverty line.

These findings are based on the federal poverty line for 2008: $22,017 for a family of four and $17,165 for a family of three.

Given states’ balanced budget requirements and current dire fiscal conditions, they will have limited opportunities to reduce taxes on poor families anytime soon. Nonetheless, doing so should remain a priority for states that still have such taxes. Taxing the incomes of working-poor families runs counter to the efforts of policymakers across the political spectrum to help families work their way out of poverty. The federal government has exempted such families from the income tax since the mid-1980s, and a majority of states now do so as well.

Eliminating state income taxes on working families with poverty-level incomes gives a boost in take-home pay that helps offset higher child care and transportation costs that families incur as they strive to become economically self-sufficient. In other words, relieving state income taxes on poor families can make a meaningful contribution toward “making work pay.”

Some states levy income tax on working families in severe poverty, the analysis shows. Six states — Alabama, Georgia, Illinois, Indiana, Montana, and Ohio — tax the income of two-parent families of four earning less than three-quarters of the poverty line ($16,513). And three states — Alabama, Georgia, and Montana — tax the income of one-parent families of three earning less than three-quarters of the poverty line ($12,874).

In some states, families living in poverty face yearly income tax bills of several hundred dollars. In 2008, a two-parent family of four with income at the poverty line owed $483 in Alabama, $311 in Oregon, $272 in Hawaii, and $268 in Iowa. Such amounts can make a big difference to a family struggling to escape poverty. Other states levying tax of more than $200 on families with poverty-level incomes were Georgia, Illinois, Indiana, and Montana. At the other end of the spectrum, a growing number of states offer significant refunds to low-income working families, primarily through Earned Income Tax Credits.

From 2007 to 2008, income tax treatment of poor families improved in a number of states, but worsened in others. At least 10 states implemented measures to shield more low-income families from the income tax or to reduce the taxes they owe. Hawaii, Michigan, and West Virginia, which in 2007 levied some of the highest taxes on low-income families, made major improvements in 2008.

Unfortunately, a number of other states increased income taxes on poor families. This did not come in the form of actual rate increases but because provisions designed to protect low-income families from taxation — including standard deductions, personal exemptions, and low-income credits — were not adjusted to keep up with inflation. These increases come amidst high levels of poverty, resulting from the national recession and ensuing high levels of joblessness and wage cuts.

Overall, despite recent improvements in states’ tax treatment of low-income families, there remains much to do. Some of the states with the harshest tax codes have not improved for many years, and some recent improvements were not enough to exempt very poor families from income taxes.

To reduce or eliminate income taxes on low-income families, states can choose from an array of mechanisms. They include state Earned Income Tax Credits (EITCs) and other low-income tax credits, setting reasonable levels below which no tax is owed, and personal exemptions and standard deductions at levels adequate to shield poverty-level income from taxation. Some states go beyond exempting poor families from income tax by making their EITCs or other low-income credits refundable so that if the amount of these credits exceeds a family’s tax liability, the state provides the family a refund for the difference. These policies provide a substantial income supplement to families struggling to escape poverty, and they are relatively inexpensive to states, since these families have little income to tax.

Methodology

This analysis assesses the impact of each state’s income tax in 2008 on poor and near-poor families with children. Broad-based income taxes are levied in 41 states and the District of Columbia. Two family types are used in assessing taxes’ impact: a married couple with two dependent children, and a single parent with two dependent children.[2] The analysis focuses on two measures: the lowest income level at which state residents are required to pay income tax, and the tax due at various income levels. [3]

A benchmark used throughout this analysis is the federal poverty line — the annual estimate of the minimum financial resources required for a family to meet basic needs. The Census Bureau’s poverty line for 2008 was $17,165 for a family of three and $22,017 for a family of four. [4] It is generally acknowledged that attaining self-sufficiency requires an income level substantially higher than the federal poverty line, so if anything this analysis understates the extent to which state income tax provisions might impede the ability of poor families to move up the economic ladder.

Many States Continue to Levy Substantial Income Taxes on Poor Families

The Tax Threshold

One important measure of the impact of taxes on poor families is the income tax threshold — the point below which it owes no income tax. Tables 1A and 1B show the thresholds for a single parent with two children and for a married couple with two children, respectively.

  • In 12 states, the threshold is too low to exempt from income taxes a single-parent family of three at the $17,165 poverty line. In the remaining 30 states with income taxes, the threshold is above the poverty line, so families at that level of earnings pay no income tax or receive a refund.
  • In 16 states, the threshold is too low to exempt from income taxes a two-parent family of four at the $22,017 poverty line. The remaining 26 states with income taxes have thresholds above the poverty line (See Figure 1, below).
  • Six states — Alabama, Georgia, Illinois, Indiana, Montana, and Ohio— tax families of three or four in severe poverty, meaning those earning less than three-quarters of the federal poverty line. That income level in 2008 was $12,874 for a family of three and $16,513 for a family of four.
  • While most states set income tax thresholds high enough to exempt from taxes a family of three where the employed person works full-time at minimum wage, seven do require such a family to pay: Alabama, Georgia, Hawaii, Illinois, Montana, Ohio, and Oregon.
  • California has the nation’s highest threshold. There is no income tax on a family of three making under $45,900 or a family of four making under $48,300. Those levels are more than twice the poverty lines for families of those sizes.

Taxes on Poor Families

Several states charge those living in poverty several hundred dollars a year in income taxes — a substantial amount for a struggling family. Tables 2A, 2B, 3A, and 3B show these amounts.

  • The tax bill for a poverty-line family of four exceeds $200 in eight states: Alabama, Georgia, Hawaii, Illinois, Indiana, Iowa, Montana, and Oregon.
  • As noted above, a majority of states do not tax families with poverty-level income.
  • There are 14 states that not only avoid taxing poor families but also offer tax credits that provide refunds to families with income at the poverty line. These credits act as a wage supplement and income support, helping to assist families’ work efforts and reduce poverty. The amount of refund for families with income at the poverty line is as high as $1,699 for a family of four in New York.

Taxes on Near-Poor Families

Studies have consistently found that the basic costs of living — food, clothing, housing, transportation, and health care — in most parts of the country exceed the federal poverty line, sometimes substantially.[5] So, many families with earnings above the official federal poverty line still have considerable difficulty making ends meet.

In recognition of the challenges faced by families with incomes somewhat above the poverty line, the federal government and state governments have set eligibility ceilings for some programs, such as energy assistance, school lunch subsidies, and in many states health care subsidies, at 125 percent of the poverty line ($21,456 for a family of three, $27,521 for a family of four in 2008) or above.

A majority of states, however, continue to levy income tax on families with incomes at 125 percent of the poverty line. Tables 4A and 4B show these amounts.

  • In 26 states, two-parent families of four earning 125 percent of the poverty level are taxed, with the bill exceeding $500 in nine states: Alabama, Arkansas, Georgia, Hawaii, Indiana, Iowa, Kentucky, Oregon, and West Virginia.
  • Twenty-four states tax families of three with income at 125 percent of the poverty line.

How Can States Reduce Income Taxes on Poor Families?

States employ a variety of mechanisms to reduce income taxes on poor families. Nearly all states offer personal exemptions and/or standard deductions, which reduce the amount of income subject to taxation for all families, including those with low incomes. In a number of states, these provisions by themselves are sufficient to lift the income tax threshold above the poverty line. In addition, many states have enacted provisions targeted to low- and moderate-income families. To date, 24 states have established an Earned Income Tax Credit based on the federal EITC, which is a system for reducing the tax obligation of working-poor families, mostly those with children.[6] Some states offer other types of low-income tax credits, such as New Mexico’s Low-Income Comprehensive Tax Rebate. Finally, a few states have a “no-tax floor,” which sets a dollar level below which families owe no tax but does not affect tax liability for families above that level. A $20,000 no-tax floor, for example, means that a family making below that amount owes no taxes, but once income surpasses that level the tax is owed on all taxable income from one dollar up.

Why Does This Report Focus on the Income Tax — A Tax That Is Arguably the Fairest State Tax?

In most states, poor families pay more in consumption taxes, such as sales and gasoline taxes, than they do in income taxes. They also pay substantial amounts of property taxes and other taxes and fees. Why then does this report focus on the impact of state income taxes on poor families?

First, because the income tax is a major component of most state tax systems — making up 36 percent of total state tax revenue nationally — the design of a state’s income tax has a major effect on the overall fairness of the state’s tax system.

Second, it is administratively easier for states to target income tax cuts to poor families than it is to cut sales or property taxes on those families. That is because information on a taxpayer’s income is available at the time the income tax is levied. Sales tax, on the other hand, is collected by merchants from consumers with no knowledge of income level; and property taxes are passed through from landlords to renters. As a result, the most significant low-income tax relief at the state level in the past decade has come by means of the income tax.

Third, families trying to work their way out of poverty often face an effective tax on every additional dollar earned in the form of lost benefits such as income support, food stamps, Medicaid, or housing assistance. Income taxes on poor families can exacerbate this problem and send a negative message about the extent to which increased earnings will improve family well-being.

This report emphasizes that many states’ income taxes leave considerable room for improvement. But it is important to recognize that a state tax system that includes an income tax — even one with a relatively low income threshold — typically serves low-income families better than a state tax system that does not include an income tax at all. The reason is that most states’ income taxes, even those that tax the poor, are progressive; that is, income tax payments represent a smaller share of income for low-income families than for high-income families. By contrast, the other primary source of tax revenue for states, the sales tax, is regressive, consuming a larger share of the income of low-income families than of high-income families.

States that rely heavily on non-income taxes tend to have higher overall taxes on the poor than do other states. Seven states — Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming — do not appear in this report because they do not levy income taxes. Their heavy reliance on the sales tax renders their tax systems very burdensome for low-income families. Conversely, two states with income taxes but no general sales tax — Montana and Oregon — are shown in this report to impose above-average income tax burdens on the poor, despite some recent improvement. While there is room for further improvement in this aspect of their income taxes, these two states still have less regressive tax systems overall than the average state because they do not levy general sales taxes.

Some States Made Significant Improvements for 2008, While Others Moved Backwards

From 2007 to 2008, a number of states made significant improvements in their income-tax treatment of the poor. Unfortunately, another group of states increased taxes on poor families, though by smaller amounts. See Tables 5, 6, and 7.

Some States Improved in 2008

At least 10 states implemented policy changes for the 2008 tax year to reduce income taxes on poor families or to increase poor families’ tax refunds, in some cases significantly. Highlights of these changes include the following:

  • The District of Columbia’s EITC increased to 40 percent of the federal credit from 35 percent, raising its income tax thresholds and cutting taxes for poor families.
  • Hawaii increased its low-income refundable tax credit. In 2008 the maximum credit grew to $85 per exemption from $35. In addition, the highest income at which families can qualify for the credit rose to $50,000 from $20,000. This expansion significantly increased Hawaii’s income tax threshold and cut tax liabilities for poor families by roughly a third relative to 2007. Despite this and other improvements to Hawaii’s tax treatment of low income families in recent years, however, Hawaii continues to levy some of the highest income taxes in the nation on families living in poverty.
  • Louisiana implemented an EITC at 3.5 percent of the federal credit. The EITC significantly increased Louisiana’s threshold and cut poor families’ income tax liability by more than half compared to 2007. While these changes were a major improvement, Louisiana still imposed the 15th highest income taxes in the nation on families of four with income at the poverty line in 2008.
  • Maryland increased its EITC to 25 percent of the federal credit from 20 percent and increased the personal exemption to $3,200 from $2,400. These changes raised the state’s income tax threshold and significantly increased the income tax rebates the state provides to poor families.
  • Michigan implemented an EITC at 10 percent of the federal credit in 2008. The credit lifted Michigan’s threshold from well below the poverty line in 2007 to slightly above the poverty line in 2008. After implementing the EITC Michigan went from imposing a substantial tax liability on families living in poverty to offering those same families a substantial tax rebate.
  • New Jersey expanded its EITC to 22.5 percent of the federal credit in 2008 (and will further expand it to 25 percent in 2009), increasing the state’s threshold, and the size of the tax rebate that the state provides to poor families.
  • North Carolina implemented an EITC at 3.5 percent of the federal EITC (to grow to 5 percent in 2009). The credit increased North Carolina’s threshold, completely exempting poor families of three from taxation, and significantly reduced the income taxes paid by poor families of four.
  • Oklahoma increased the standard deduction and reduced the tax rate on income over $15,000 (which is the state’s top bracket). The state also expanded a credit offered to families with children. These changes increased Oklahoma’s threshold above the poverty line for a two-parent family of four.
  • Oregon’s EITC increased to 6 percent of the federal credit from 5 percent, modestly raising the state’s threshold and decreasing the income tax paid by low-income families. Despite this change Oregon still imposes among the highest tax liabilities on low-income families in the country.
  • West Virginia ’s new low-income tax credit took full effect in 2008. The credit significantly increased the state’s threshold, which had been the lowest in the country, and substantially reduced the income taxes paid by poor families. West Virginia’s threshold in 2008 increased to slightly below the poverty line for a family of four, and rose above the poverty line for a family of three.

Other States Stood Still or Moved Backwards

Most states showed no improvement in 2008, with many getting somewhat worse in their tax treatment of low-income families. In more than half of all states with an income tax the threshold decreased relative to the poverty line for families of four.

A Few States Exempted Poor Families from Taxation; Far More Saw Their Thresholds Fall Relative to the Poverty Line

  • Two-parent families of four were taxed in 16 states in 2008, two fewer than in 2007.
  • In 12 states, poor single-parent families of three were taxed, three fewer than in 2007.
  • Only one state, Michigan, raised its threshold above the poverty line for both two-parent families of four, and one-parent families of three in 2008.
  • In 23 states, the income tax threshold declined relative to the poverty line for two-parent families of four, forcing families deeper into poverty or closer to being in poverty to pay income taxes. See Table 7. As noted below, the reason is that many states’ tax systems are not indexed to keep up with inflation.

Poor Families’ Taxes Increased in Several States

The amount of tax levied on families with income at the poverty line, as shown in Table 6, rose in a number of states from 2007 to 2008.

  • Of the 16 states that taxed poor families of four in 2008, nine levied a higher tax on these families in 2008 than in 2007, even after adjusting for inflation. Among these states, the average tax levy increased to $202 from $184, an inflation-adjusted increase of 10 percent.
  • In some states, the increase was quite substantial. Poor families of four saw their inflation-adjusted tax liabilities increase by 46 percent in Mississippi, 45 percent in Arkansas, and 18 percent in Missouri.

Why Some States’ Income-Tax Treatment of the Poor Is Worsening

In the 23 states where income tax thresholds fell relative to the poverty line in 2008, and the nine states where the tax levied on poor families grew more than inflation, it was not because of explicit policy changes. Rather, tax thresholds fell and tax bills rose because states failed to update their standard deductions, personal exemptions, and low-income credits to keep up with inflation.[7] For example, poor families of four in Mississippi, which does not adjust its standard deduction, personal exemption, or dependent exemption for inflation, saw their income tax levies rise to $73 in 2008 from $48 in 2007. Had the state adjusted its exemptions and standard deduction for inflation, tax liabilities would have grown by only two dollars for these families.

Most States Have Made Substantial Progress Since the Early 1990s, but Others Lag Severely Behind

Overall, States’ Income-Tax Treatment of the Poor Has Improved Greatly

Since the early 1990s, states generally have reduced the amount of tax owed by working-poor families. From 1991 to 2008, the number of states levying income tax on poor, two-parent families of four decreased to 16 from 24. Over that same span, the average of state tax thresholds increased to 116 percent of the poverty line from 84 percent. And many of the 16 states that still tax poor families of four have reduced the taxes levied. From 1994 to 2008, the average tax levied fell by 41 percent, after adjusting for inflation. Tables 5, and 6, and 7 show these changes over time.

A Few States Tax the Incomes of the Poor More Heavily than in the Early 1990s

A smaller number of states stand out for their lack of progress between the early 1990s and 2008 in reducing income taxes on the poor.

  • In Arizona, Connecticut, Mississippi, and Ohio, the income tax threshold has fallen compared to the poverty line since 1991. In Connecticut, the threshold has fallen over that time to 109 percent of the poverty line from 173 percent.
  • In four states — Georgia, Iowa, Mississippi, and Ohio — the income tax on families of four with poverty-level incomes has risen since 1994 even after accounting for inflation. As Table 6 shows, the inflation-adjusted increase was 32 percent in Georgia and 8 percent in Ohio. In Iowa, such families’ tax liability increased to $268 from zero — the highest dollar increase in any state. In each of these states, the reason for the tax increase is that personal exemptions, credits, or other features designed to protect the incomes of low-income families from taxation have eroded due to inflation.

Conclusion

Too many states continue to tax the income of poor families and in some cases, the poorest. Improvements made by some states in 2008 were partially offset by backsliding in others. A number of states implemented or improved EITCs or other low-income credits. In more than half of all states with an income tax, however, the income tax thresholds fell relative to the poverty line for families of four. The longer trend is more positive: income taxation of poor families has decreased since the early 1990’s — but even over that period some states have increased taxes on families in poverty. There is a broad range of affordable mechanisms for exempting the poor from the income tax. States that continue to tax poor families should examine these options and choose policies that help working-poor families succeed.

Click here for the PDF of the State-By-State Data Tables (12pp.)

Click here to for the Full Report and State-By-State Data Tables (21pp.)

End Notes:

[1] Additional data analysis for this report was provided by Cathy Collins, Alexander Flachsbart, Michael Leachman, Michael Mazerov, Elizabeth McNichol, Jon Shure, and Erica Williams.

[2] The married couple is assumed to file a joint return on its federal and state tax forms, and the single parent is assumed to file as a Head of Household. Each family is assumed to include one worker. In each family, the children are taken to be ages four and eleven.

[3] This report takes into account income tax provisions that are broadly available to low-income families and that are not intended to offset some other tax. It does not take into account tax credits or deductions that benefit only families with certain expenses, nor does it take into account provisions that are intended explicitly to offset taxes other than the income tax. For instance, it does not include the impact of tax provisions that are available only to families with out-of-pocket child care expenses or specific housing costs, because not all families face such costs. It also does not take into account sales tax credits, property tax “circuit breakers,” and similar provisions, because this analysis does not attempt to gauge the impact of those taxes — only of income taxes.

[4] Specifically, this report uses the Census Bureau’s weighted average poverty thresholds, available at http://www.census.gov/hhes/www/poverty/threshld/08prelim.html.

[5] See, for example, Sylvia A. Allegretto, Basic family budgets: Working families’ incomes often fail to meet living expenses around the U.S., Economic Policy Institute, September 2005.

[6] The 24 states are the District of Columbia, Delaware, Illinois, Indiana,Iowa, Kansas, Louisiana, Maine, Maryland,Massachusetts, Michigan, Minnesota, Nebraska, New Jersey,New Mexico, New York, North Carolina, Oklahoma, Oregon, Rhode Island, Vermont, Virginia, Washington and Wisconsin. For more information on state EITCs, see Jason Levitis and Jeremy Koulish, “State Earned Income Tax Credits: 2008 Legislative Update,” Center on Budget and Policy Priorities, Oct. 8, 2008.

[7] The poverty line increases each year to account for the higher cost of food, shelter, and other necessities.

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