State Income Tax
Burdens on Low-Income Families in 1997:
Assessing the Burden and Opportunities for Relief
IV. Strategies for Relieving State Tax Burdens on Poor Families
There are a host of ways that states can modify their tax systems to reduce the tax burden on the poor. This paper focuses on strategies related to the income tax for a number of reasons. It is relatively easy for states to alter their income tax provisions to relieve the burden of the income tax on the poor because information on the taxpayer's income is available at the time the tax is levied. The design of other major taxes makes such efforts much more cumbersome. For example, the sales tax is collected by merchants from consumers without regard to their income level and property taxes are passed through from property owners to renters as part of a rent payment. The income tax, on the other hand, is calculated as a percentage of a taxpayer's total income and thus offers a number of opportunities to reduce directly the burden of taxes on the poor.
There are three basic features of a standard income tax structure that states use to reduce or eliminate the income tax burden on low-income families: the personal and dependent exemptions, the standard deduction, and credits. The role of each of these in reducing the amount of taxes paid by a taxpayer can be seen by examining a typical income tax calculation.
The total amount of income tax owed by any taxpayer is determined in a number of steps. First, the taxpayer's total gross income is determined by adding all income sources subject to a particular state's income tax. Next, this amount (the adjusted gross income) is reduced by any exemptions and deductions allowed. This determines the total amount of income subject to taxation. Next, the state's tax rate is applied to that amount to determine the amount of tax owed. Finally, any credits allowed are applied to reduce the total amount of taxes owed.
In addition, some states have enacted provisions that eliminate any income tax liability for taxpayers with income below a set level, regardless of whether the calculations described above would yield a tax liability. These provisions are known as no-tax floors.
Each of these elements that provide tax relief for low-income taxpayers is described in more detail below. Some combination of these strategies is generally used to achieve the goal of reducing the burden of state income taxes on low-income families.(1)
Increasing Personal and Dependent Exemptions
Personal and dependent exemptions are subtractions from income. These exemptions reduce the amount of income that is subject to tax. They can be structured in a number of ways. In 1997, most states set a specific amount to be subtracted for each taxpayer and each dependent. Some states instead set one amount for the taxpayer and a different amount for dependents.(2) Furthermore, nine states used personal or dependent credits as an alternative to personal or dependent exemptions.(3) Unlike exemptions, which reduce taxable income, credits are subtracted from taxes that otherwise would be owed. This is an important distinction for the design of low-income tax relief and will be explained further below.
A personal exemption operates in a fairly straightforward way to reduce taxes. It reduces the amount of taxes owed by reducing the amount of income that is subject to taxation. For example, a family of four with total income of $12,000 in a state with a personal and dependent exemption equal to $1,000 would owe taxes on only $8,000 of that income ($12,000 minus four times $1,000) before any other tax provisions were taken into account. The higher the amount of the personal exemption, the more income that is sheltered from taxes. If a state wants to use the personal exemption to reduce taxes on low-income taxpayers, it can simply increase the amount of the exemption.
While increasing personal or dependent exemptions or credits may be a simple way to provide income tax relief to low-income families, it is also potentially quite expensive because the benefits are available to high-income taxpayers as well as low- and moderate-income families. The cost of increasing a personal or dependent exemption or credit that is, the additional revenue foregone by the state can be mitigated in a number of ways. Using a personal credit rather than an exemption is one way to target relief to low-income households and reduce costs. Another way to better target low-income tax relief is to reduce and phase out the value of the exemption or credit at higher income levels. These options are described in more detail below.
Differences Between Personal Exemptions and Personal Credits Although both personal exemptions and personal credits ultimately reduce the amount of taxes owed, they work in somewhat different ways. Because an exemption reduces taxes indirectly by reducing the total amount of taxable income, the ultimate value to a taxpayer of a personal exemption is the amount of the exemption multiplied by the applicable tax rate. A credit, on the other hand, is subtracted directly from the amount of taxes owed. Therefore, the value of a credit generally is its face value. Consider the following two examples:
A B Income $12,000 $12,000 Minus: Personal Exemptions 4,000 6,000 Equals: Taxable Income 8,000 6,000 Multiplied by: Tax Rate .04 .04 Equals: Tax $320 $240
In example A, a family of four with income of $12,000 and a personal exemption of $1,000 per family member would have taxable income of $8,000. If the tax rate were four percent, the taxes owed would be $320. If, as in example B, the personal exemption were raised to $1,500 per family member, the $6,000 total exemption that the family is eligible for would reduce its taxable income to $6,000 and the tax liability would be lowered to $240. Thus, raising the personal exemption by $500 per person, or a total of $2,000 for a family of four, resulted in tax savings of $80. This equals the amount of the increase in the exemption ($2,000) multiplied by the four percent tax rate.
C D Taxable Income $12,000 $12,000 Multiplied by Tax Rate .04 .04 Equals: Tax Before Credits 480 480 Minus: Personal Credit 160 240 Equals: Tax $320 $240
A tax credit works in a different way because a credit directly reduces the amount of tax owed. Therefore, when a personal or dependent credit is increased, the family tax liability is reduced by the full amount of the credit change. In example C, a family of four with taxable income of $12,000 subject to a four percent tax rate would face a tax of $480 before credits. If the personal credit equaled $40 per person, the family could claim a total personal credit of $160, and its tax liability after subtracting the credit would be $320. If, however, the personal credit were raised to $60 per person, as in example D, the family could claim a total personal credit of $240, and its taxes would be reduced to $240. Thus, an increase of $20 in a personal credit would lead to a tax savings of $80 for a family of four.(4)
There is a difference between exemptions and credits in terms of the impact on families of different income levels if a state has a graduated rate structure. For example, consider a state with two income tax brackets: a lower bracket which taxes income below $20,000 at a four percent rate and a higher bracket which taxes income of $20,000 or more at five percent. In this case, the value of increasing a personal exemption by $1,000 would be $40 for a taxpayer in the lower tax bracket. For a taxpayer in the higher bracket, however, the value would be $50 because of the higher tax rate. On the other hand, a credit equal to $40 for all taxpayers would reduce the taxes of both these taxpayers by that amount regardless of income level. For this reason, the benefit from a personal or dependent credit is likely to represent a greater share of income for lower-income households than for those at higher incomes and so may be a better targeted and less costly tool to use when the objective is low-income tax relief.
The fact that a credit is worth the same amount to all taxpayers, regardless of the tax rate they pay, while the tax savings from an exemption depends on the tax rate applied to that exemption, can have implications for the choice of methods used to reduce income tax burdens on the poor. In a state with a flat rate income tax that is, a state in which all taxpayers are subject to the same tax rate regardless of level of income the impact of increasing an exemption will be the same as that of increasing a credit if the credit is equal to the exemption times the applicable tax rate. In a state with a progressive rate structure, a credit would provide better targeting to low-income taxpayers at a lower cost.
Phasing Out Personal Exemptions or Credits Both personal exemptions and credits may be phased out as income increases. This can provide the full benefit of the exemption or credit to low- and moderate-income households while lowering the total cost of the tax relief cost. For example, under the federal income tax, the personal exemption phases out for high-income taxpayers. The amount begins to decline at $181,800 of income for joint filers and at $121,200 for single filers. The box on the next page shows how the federal personal exemption phase-out works.
Ten states incorporated the federal personal exemption phase-out into their own tax systems in 1997 Colorado, Idaho, Minnesota, New Mexico, North Carolina, North Dakota, Rhode Island, South Carolina, Utah, and Vermont. Four other states California, Connecticut, Nebraska, and Wisconsin use state-specific methods to phase out their personal exemptions, personal exemption credits, or standard deductions for families with income above a specific level.
Increasing the Standard Deduction
Most state income taxes include provisions that allow the deduction of certain taxpayer expenditures from income before taxes are computed. Taxpayers typically are given the choice of listing itemized deductions, which reflect specific taxpayer expenditures, or taking the standard deduction. The standard deduction is a subtraction from income of a fixed amount that is allowed any taxpayer, although the amount of the standard deduction allowed may vary with family structure, with size, or in a few states with income. In this typical structure, taxpayers using the standard deduction tend to be lower- and middle-income taxpayers who do not own homes. Homeowners are more likely to itemize their deductions because mortgage interest and property tax payments frequently lift their deductible expenses above the standard deduction amount. (States such as Illinois and Ohio that do not allow itemized deductions typically also do not allow standard deductions.)
As with increasing personal and dependent exemptions, raising the standard deduction increases the tax threshold, or income level at which families begin to pay taxes. It also reduces the amount of taxes owed by families with incomes above the threshold level. Relative to increasing personal and dependent exemptions, however, raising the standard deduction may be less costly because not every taxpayer would benefit from the increase; most of those who itemize their deductions would not be affected by the change. As a result, while the benefits of the standard deduction, like the personal exemption, theoretically rise with income in states with a graduated rate structure, most taxpayers in tax brackets with higher marginal rates itemize and do not take the standard deduction. Thus, the benefits of a higher standard deduction would tend to be targeted on low- and moderate-income households.
The federal income tax establishes a personal exemption phase-out threshold at a specific amount of adjusted gross income (AGI) for each filing status. The phase-out levels are:
Single Filers $121,200 Heads of Households $151,500 Joint Filers $181,800
Taxpayers with adjusted gross incomes above these thresholds gradually lose the value of their personal exemptions. The phase-out occurs over the next $122,500 of income, regardless of filing status. For each $2,500 of income over the phase-out threshold level, the personal exemption is reduced by two percent. Thus in 1997, when the personal exemption equaled $2,650, each personal exemption was reduced $53 for each $2,500 in income over the threshold level. Once income exceeds the phase-out levels by more than $122,500, the exemption is completely eliminated. The table below shows the effects of the personal exemption phase-out at different income levels for single taxpayers.
Single AGI Personal Exemption Per Person Reduction in Exemption Amount Reduced Exemption Amount $120,000 $2,650 $ 0 $2,650 125,000 2,650 106 2,544 200,000 2,650 1,696 954 225,000 2,650 2,226 424 244,000 2,650 2,650 0
Another way to increase a state's income tax threshold is to set a "no-tax floor," or an income amount below which no taxes are owed. No-tax floor provisions supersede all other provisions of the income tax for taxpayers whose incomes fall below the specified level. Thus, with a no-tax floor in place, a family that would otherwise owe income taxes but whose income falls below the floor would face no income tax liability. For example, a family of four in Oklahoma with income of $12,200 in 1997 would have owed $68 under the state's regular income tax structure. But because the state had a no-tax floor of $12,200, families with income up to this level owed no state income taxes.
One area of concern in the design of no-tax floors is the impact on taxpayers with income just above the floor. If the normal structure of the income tax takes effect immediately above the tax floor, families benefiting from a no-tax floor can find themselves faced with an income tax "cliff" where a single additional dollar of income triggers a significant amount of tax, sometimes $100 or more. For this reason, most of the states that use a no-tax floor also phase in the underlying tax obligations over a relatively short range of income above the floor. For example, Iowa has an alternative tax under which families with income above the no-tax floor pay the lesser of the alternative tax or regular tax amounts. Nevertheless, families in states with no-tax floors with income just above the floor typically face high tax rates on each additional dollar they earn in the transition range.(5)
A no-tax floor keeps the cost of income tax relief down by targeting relief exclusively on families with income below a specified level. Of the seven states that used a no-tax floor, only Nebraska set its level high enough to eliminate income taxes on all poor families in 1997. Massachusetts set its floor below the poverty level for two-parent families of four; Iowa, Maryland, New Jersey, Oklahoma, and West Virginia set their no-tax floors below the poverty level for both families of three and four. (6)
Another strategy available to states for increasing income tax thresholds and reducing income taxes on low-income families is to provide income tax credits specifically for low-income taxpayers. A tax credit is a fixed amount subtracted directly from an individual's tax liability. Credits available only to low-income taxpayers are thus a targeted and efficient way of increasing the tax threshold and reducing the tax liability for low-income families. Credits that are refundable that is, credits for which the taxpayer receives the entire value even if the credit amount exceeds the amount of taxes owed can also serve to offset the burden of other state and local taxes and supplement wages for families at low income levels.
In 1997, some form of low-income credit was used in 17 states.(7) Nine states had an earned income tax credit (EITC) in 1997. States with low-income credits other than the EITC in 1997 included Arizona, Connecticut, the District of Columbia, Georgia, Kentucky, Maine, New Mexico, and Pennsylvania. Massachusetts and New York had both EITCs and other low-income credits. In some cases, these credits were simply a flat amount per dependent or household member. Arizona, for example, had a $30 credit per household member for families with incomes below $20,000. Other states had credits that equalled a percentage of the tax liability, with the percentage based on income. Three states had low-income credits that acted very much like no-tax floors. For example, Pennsylvania families of four with income below a set level $20,600 for a family of four in 1997 qualified for a "tax forgiveness" credit equal to 100 percent of their tax bill. The percentage of tax forgiven by the credit declined sharply as family income rises; a family of four with income over $21,500 received no credit.
Iowa, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Wisconsin had state earned income tax credits (EITC) in 1997. State EITCs, which are modeled on the federal EITC, provide a credit to low- and moderate-income working families with children and to very low-income individuals and couples who are not caring for children in the home. The credit amount is determined by the family's earnings and number of children. Five of the state EITCs available in 1997 were refundable. Like the federal EITC, which is among the most effective government programs in lifting children out of poverty, these refundable credits served to supplement the earnings of these families, offset the burden of other taxes, and complement efforts to help families make the transition from welfare to work.(8)
In recent years, state EITCs have enjoyed growing popularity. Eight of the nine state EITCs have been adopted since passage of the federal Tax Reform Act of 1986, which eliminated federal income tax liabilities for poor families. State EITCs can easily be piggybacked on the federal EITC by adopting federal eligibility criteria and expressing the state EITC as a percentage of the federal EITC. Appendix I summarizes the structure of state EITCs in the nine states that use them.(9)
In addition, beginning in 1997 Indiana offered an "earned income deduction" that was unrelated to the EITC. The deduction was available to families with children with incomes below $12,000, and was calculated for each family by subtracting the family's income from $12,000. For instance, a family with income of $10,000 qualified for a $2,000 deduction.(10)
Other Design Issues
Personal exemptions, credits and standard deductions are often set at a fixed dollar amount which can only be increased through specific actions by state lawmakers. In some 12 states in 1997, however, personal exemptions or standard deductions were indexed for inflation.(11) For federal taxes, these amounts are adjusted automatically each year to account for the effects of inflation. In this way, the value of the exemption, credit, or deduction is maintained. In nine of these states, this indexing was the result of the state beginning their income calculation with federal taxable income.
The value of personal exemptions did not increase compared to last year in nearly three-quarters of the states with tax thresholds below the poverty level in 1997 for families of four. One of the reasons that many state income tax thresholds fell further below the poverty line in 1997 compared to the previous year is because most states did not act to increase their exemptions or credits. So, while the costs faced by poor families increased and were reflected in a higher poverty level, the income tax threshold did not also increase. One way to partially address this problem is to index personal exemptions or standard deductions to inflation so that they will automatically increase as the cost of living increases.
Income Tax Rate Reductions Are Often of Small Benefit to Low-Income Taxpayers
Between 1994 and 1997, 20 states cut their income taxes by substantial amounts.(12) These tax cuts provided an opportunity for states to employ some of the strategies described above to provide tax relief to low-income taxpayers. While some states did increase their tax thresholds by raising exemptions or deductions or increasing or establishing no-tax floors or low-income credits, a substantial amount of the tax cutting activity in recent years has focused on cutting income tax rates. Of the 12 states that enacted the largest personal income tax cuts between 1994 and 1997, nine lowered income tax rates and a tenth state provided refunds that were similar in effect to rate reductions.(13) Four of these states Michigan, New Jersey, Ohio, and Oregon still have income tax thresholds below the poverty line.
Rate cuts would appear to benefit all taxpayers regardless of income. However, the benefit for low-income taxpayers of an income tax rate reduction is generally very small.
- A number of state income tax systems use graduated income tax rate structures with higher rates for high-income taxpayers. Some states have focused in recent years on reducing the top income tax rate; such actions disproportionately benefit high-income taxpayers.
- Even if a rate reduction is made across-the-board, reducing the rate for each tax bracket, it provides a larger dollar benefit for high-income taxpayers than for low-income taxpayers. For example, consider a state with an income tax with a flat rate of five percent and exemptions and deductions that total $10,000 for a family of four. A rate reduction from five percent to 4.5 percent would reduce the taxes of a family earning $20,000 by only $50. The same rate cut would reduce the taxes of a family earning $100,000 by $450 nine times more than the cut for the lower- income taxpayer. Moreover, the lower-income family's reduction amounts to 0.25 percent of its income, while the wealthier family's taxes are cut by 0.45 percent of income.
- In addition, as this report shows, many states exempt their lowest-income residents from the personal income tax. Residents that pay no income tax, of course, will receive no benefit from a rate reduction.
California is an example of a state where a reduction in tax rates provided no tax relief for low-income taxpayers. In 1995, California had eight graduated tax brackets. The top two brackets were tax rates of 10 percent and 11 percent, which applied to married filers with taxable income over $220,000. These top two brackets, which had been instituted in 1991 as a temporary rather than permanent feature of the tax code, were eliminated in 1997. As a result, the marginal tax rate for taxpayers with incomes above $220,000 dropped to 9.3 percent. While this provided a substantial tax cut for high-income taxpayers in the state and cost the state over $700 million in revenue, it provided no tax relief for poor taxpayers.(14)
Even a rate reduction targeted to lower-income taxpayers may not result in significant tax relief. New Jersey enacted a substantial rate cut that was phased in starting in 1994. New Jersey has a graduated income tax with five brackets. The rate reduction enacted was larger for the lowest income brackets than for the upper brackets. The rate for taxable income of less than $20,000 was lowered by 30 percent from 2.0 percent to 1.4 percent. A family of four earning $15,000 had their taxes reduced by $60 as a result of the rate cut, while the taxes of a family earning $150,000 were reduced by over $1,300. Despite the rate reductions, a family of four at the poverty line owes $160 in New Jersey income taxes in 1997.
Rate reductions are among the least efficient ways to relieve the tax burdens of the working poor. Changes in personal exemptions, standard deductions, tax credits or no-tax floors are far better choices for providing tax relief to those most in need of it at a modest cost.
Many low-income working families face a heavy state and local tax burden. Eliminating state income taxes on the poor can help prevent taxing these families deeper into poverty. Relieving tax burdens on low-income working families can also improve their ability to remain self-sufficient. Although progress is being made in relieving the burden of income taxes on poor families, half the states with income taxes still require two-parent families of four with income at the poverty level to pay income taxes, and almost half impose income taxes on single-parent families of three with poverty-level income. Even families with minimum-wage income that falls far below the poverty line are required to pay income taxes in a significant number of states.
It is not necessary for states to impose income taxes on poor families. Half the states have already eliminated the tax burden on poor families. There are many ways to structure a state income tax to do so. Most of the 21 states that do not tax poor families of three or four allow relatively large deductions from income for all taxpayers through personal and dependent exemptions and the standard deduction. Some 23 states have adopted additional measures that target relief on low-income families.
The relatively good fiscal condition that many states have enjoyed in recent years has led to the adoption of income tax cuts in many states. Despite this opportunity, many states continue to tax the poor. As these favorable fiscal conditions remain, states are continuing to consider tax cuts. The opportunity is open for states to make changes in their income tax provisions that will relieve tax burdens on poor families both in the interest of fairness and in order to further the objective of allowing parents who work to support their families adequately.
State Earned Income Tax Credits in 1997
In 1997, nine states had state earned income tax credits. State EITCs are tax credits for low-income working families that are based on the federal EITC. This table displays four major features of the EITC in each state:
- Whether the credit is refundable, that is, whether the full amount of the credit could be received even if it exceeded the amount of state income tax owed. The federal EITC is refundable.
- The percentage of the federal EITC at which the credit is set.
- Whether the credit is adjusted for family size beyond the adjustment in the federal EITC. The federal EITC benefit structure distinguishes only between families with one child and those with more than one child.
- Whether workers without qualifying children who qualify for the federal EITC are eligible to receive the state credit.
State Earned Income Tax Credits in 1997
State Refundable? Percent of Federal
Iowa No 6.5% No Yes Maryland No 50.0% No Yes Massachusetts Yes 10.0% No Yes Minnesota Yes 15.0% No Yes New York Yes 20.0% No Yes Oregon No 5.0% No Yes Rhode Island No 27.5% No Yes Vermont Yes 25.0% No Yes Wisconsin Yes 1 Child - 4.0%
2 Children - 14.0%
3+ Children - 43.0%
Yes No Note: In 1998 the Minnesota credit will equal 25 percent of the federal credit for families with children. Beginning in 1998 and continuing through 2002, the Rhode Island credit is declining from 27.5 percent to 25 percent as part of an overall reduction in the state's income tax rate.
1. Additional discussion may be found in Steven D. Gold and David S. Liebschutz, State Tax Relief for the Poor, 2nd ed., Center for the Study of the States, Albany, NY, 1996.
2. New York allowed exemptions for dependents only. Connecticut allowed only a personal exemption, but its value depended on the family structure: the exemption for single taxpayers without children was $12,000, for single heads of household it was $19,000, and for married couples regardless of the number of children it was $24,000.
3. The nine states are Arkansas, California, Delaware, Iowa, Kentucky, Nebraska, Ohio, Oregon and Wisconsin. Ohio has personal and dependent exemptions in addition to the personal and dependent credits. Two other states have credits for children that are similar to dependent credits. Louisiana has an "education" credit for all dependents in grades K-12. North Carolina has a child credit available to married couples with incomes below $100,000 and heads of households with incomes below $80,000.
4. Personal credits generally are limited to the amount of the before-credit tax liability. If the credit to which the taxpayer is entitled exceeds that amount, the taxpayer does not receive the difference as a tax refund.
5. Tax cliffs are not unique to states with no-tax floors. Similar cliffs can exist when low-income credits of a fixed amount are used to offset tax liability. In 1997, for example, in the District of Columbia, a two-parent family of four with income of $17,500 received a low-income credit of $602 which fully offset the usual tax liability at that income level. If such a family earned $17,501, however, it was no longer eligible for the credit and faced a tax liability of $602.
6. In Maryland, the no-tax floor is called the "poverty-level subtraction," but the 1997 amount of the subtraction was actually slightly less than the 1997 poverty level. In Maryland, Massachusetts, and Iowa, while the no-tax floor is below the poverty level, families of three or four with two children pay no tax at the poverty level due to other credits.
7. An 18th state, Arkansas, allowed low-income taxpayers to pay a reduced amount based on a "low-income tax table"; this reduction was similar in its effect to a credit.
8. For further discussion of the effectiveness of the federal EITC, see Strengths of the Safety Net, Center on Budget and Policy Priorities, March 1998.
9. For further information on state EITC programs, see State Earned Income Tax Credits Build on Strengths of the Federal EITC, Center on Budget and Policy Priorities, February 1998.
10. The deduction was not available to families who received less than 80 percent of their income from wages, salary, tips and self-employment income.
11. Two additional states, Michigan and Nebraska, will begin indexing their personal exemptions in the future; Kentucky and Wisconsin will begin indexing their standard deductions in the future. Maine tax law calls for indexing both the personal exemption and standard deduction, but indexing of the personal exemption occurs only when when inflation exceeds 3 percent.
12. In each of the 20 states discussed here, the personal income tax cuts totaled at least one percent of annual income tax collections.
13. For further discussion of the kinds of tax cuts enacted in the 1990s, see Are State Taxes Becoming More Regressive?, Center on Budget and Policy Priorities, October 29, 1997.
14. California has subsequently cut taxes in ways other than rate reductions, but those cuts have not benefitted low-income taxpayers either.
Chapter I. Summary
Chapter II. State Income Taxes on Poor Families in 1997
Chapter III. Recent Changes in State Income Tax Burdens on the Poor
Chapter IV. Strategies for Relieving State Tax Burdens on Poor Families
Chapter V. Conclusion
Appendix I: State Earned Income Tax Credits in 1997