The Impact of State Income Taxes on Low-Income Families in 2009

Summary

State income taxes affect working-poor families in different ways. Some states’ tax codes help working-poor families lift themselves out of poverty. Others push them deeper into poverty. An analysis of state income tax systems for the 2009 tax year shows that:

• In 13 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 11 states, poor single-parent families of three pay income tax;
• And 25 states collect taxes from families of four with incomes just above the poverty line.

These findings are based on the federal poverty line for 2009: $21,947 for a family of four and $17,102 for a family of three.

Some states levy income tax on working families in severe poverty. Five states — Alabama, Georgia, Illinois, Montana, andOhio — tax the income of two-parent families of four earning less than three-quarters of the poverty line ($16,460). 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 ($12,827).

In some states, families living in poverty face yearly income tax bills of several hundred dollars. In 2009, a two-parent family of four with income at the poverty line owed $468 in Alabama, $266 in Hawaii, $225 in Iowa, and $225 in Montana. Such amounts can make a big difference to a family struggling to escape poverty. Other states levying tax of more than $150 on families with poverty-level incomes were Georgia, Illinois, Ohio, and Oregon.

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 (EITCs). Twenty-one states use the tax code to reduce poverty for families with two children and minimum-wage income, for example.

Over the last two decades, states have made significant progress in reducing the tax liabilities of low-income families. In 1991, over half of the states with an income tax levied taxes on two-parent, two-child families living with poverty-level income, whereas in 2009 fewer than one-third of these states levied taxes on such families.

There was important progress in 2009, as states implemented changes – mostly enacted before the recession – that reduced taxes for low-income working families. The number of states levying income tax on working-poor families of four declined from 16 states in 2008 to 13 states in 2009. And the taxes levied by those remaining 13 states also declined.

In the face of state fiscal problems, however, this progress has ground to a halt. Since the beginning of 2009, few states have enacted reforms to improve the tax treatment of low-income workers.

To some degree the slowing of progress has been inevitable. States’ balanced budget requirements and current dire fiscal conditions have restricted states’ ability to reduce taxes on poor families.

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.”

Of particular concern, a number of states are considering budget balancing measures that would roll back targeted tax reductions for the working poor. New Jersey’s governor and Washington, D.C.’s mayor have proposed decreases in the EITC. Georgia’s legislature is considering eliminating the refundable portion of the state’s low-income credit. Virginia enacted a budget that prevents an increase in the federal EITC from flowing through to the state’s EITC. These changes would increase taxes on hundreds of thousands of poor and near-poor working families with children.

States have other gap-closing options at their disposal that do not reverse the progress they have made in mitigating the tax liabilities of low-income workers and that would be better for the economy.

Given these alternatives, states need not dismantle efforts to reduce poverty and encourage work. Rather they should preserve these efforts and build upon them when their fiscal situation improves.

Methodology

This analysis assesses the impact of each state’s income tax in 2009 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.^[1] 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. ^[2]

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 2009 was $17,102 for a family of three and $21,947 for a family of four. ^[3] 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 a family 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 11 states, the threshold is too low to exempt from income taxes a single-parent family of three at the $17,102 poverty line. In the remaining 31 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.
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  In 13 states, the threshold is too low to exempt from income taxes a two-parent family of four at the $21,947 poverty line. The remaining 29 states with income taxes have thresholds above the poverty line (See Figure 1).
• Five states — Alabama, Georgia, Illinois, 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 2009 was $12,827 for a family of three and $16,460 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 the minimum wage, eight do require such a family to pay: Alabama, Georgia, Hawaii, Illinois, Missouri, Montana, Ohio, and Oregon.
• New York has the nation’s highest threshold for 2009. There is no income tax on a family of three making under $34,600 or a family of four making under $40,300. Those levels are well above the poverty lines for families of those sizes.

Taxes and Tax Credits for 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 $150 in eight states: Alabama, Georgia, Hawaii, Illinois, Iowa, Montana, Ohio, and Oregon.
• As noted above, a majority of states do not tax families with poverty-level income.
• There are 17 states that not only avoid taxing poor families but also offer tax credits that provide refunds to families of three or four with income at the poverty line. These are the 17 states shown at the bottom of Table 2A. 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 $1,940 for a family of four in New York.
• In addition to those 17, there are four other states that tax some or all families with incomes at the poverty line, but provide refundable credits to families with two children and full-time, minimum-wage income.

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.^[4] 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 ($21,378 for a family of three, $27,434 for a family of four in 2009) 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 25 states, two-parent families of four earning 125 percent of the poverty level are taxed, with the bill exceeding $500 in eight states: Alabama, Arkansas, Georgia, Hawaii, Iowa, Kentucky, Oregon, and West Virginia.
• Twenty-two 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 mechanism for reducing the tax obligation of working-poor families, mostly those with children.^[5]

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.

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

Since the 1990s, Most States’ Income-Tax Treatment of the Poor Has Improved Greatly

While a substantial number of states continue to tax the poor, since the early 1990s, states generally have reduced the amount of tax owed by working-poor families. From 1991 to 2009, the number of states levying income tax on poor, two-parent families of four decreased to 13 from 24. Over that same span, the average of state tax thresholds increased to 120 percent of the poverty line from 84 percent. And many of the 13 states that still tax poor families of four have reduced the taxes levied. From 1994 to 2009, the average tax levied fell by 42 percent, after adjusting for inflation. Tables 5, and 6, and 7 show these changes over time.

From 2008 to 2009 alone, there was significant progress, based largely on measures enacted prior to the recession. Three states that previously levied income tax on poor families of four — Kentucky, North Carolina and West Virginia — no longer do so. And average taxes paid by families with incomes at the poverty line in the 13 states that still tax the poor declined by 18 percent.^[6] Specific policy changes for 2009 include:

• Indiana increased its EITC from 6 percent to 9 percent of the federal credit. This change raised the state’s threshold for single-parent families of three above the poverty line, and significantly reduced the tax liabilities of poor, two-parent families of four.
• Michigan increased its EITC from 10 to 20 percent of the federal credit. This increase boosted the size of the rebate that the state provides to poor families by over $200.
• New Jersey increased its EITC from 22.5 percent to 25 percent of the federal credit, increasing the state’s threshold and the size of the tax rebate that the state provides to poor families.
• North Carolina increased its EITC from 3.5 percent to 5 percent of the federal credit, lifting the state’s threshold above the poverty line for a family of four.
• Oklahoma continued to phase in an increase in its standard deduction, lifting the state’s tax threshold further above the poverty line.

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 2009 in reducing income taxes on the poor and near-poor.

• In California, 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 110 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 30 percent in Georgia and 3 percent in Ohio. In Iowa, such families’ tax liability increased to $225 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.

Progress Is Threatened in 2010

States’ fiscal troubles are significantly slowing their progress in reducing the tax liabilities of poor families. Faced with budget deficits, few states since 2009 have revised their tax systems to improve their tax treatment of low income families.

Beyond limiting new measures to reduce the tax liabilities of poor families, fiscal problems have prompted some states to consider measures that increase income taxes for poor and near-poor families. For example:

• Georgia’s legislature is considering eliminating the refundable portion of the state’s Low Income Credit. Under this proposal, a low-income taxpayer would not be able to claim the portion of the credit that exceeds his or her tax liability. Had this proposal been in effect in 2009, a two-parent, two-child family with income at half the federal poverty line ($10,974) would have lost its eligibility for a $32 tax credit.
• New Jersey’s governor has proposed cutting the state’s earned income tax credit from 25 to 20 percent of the federal credit. Had this occurred in 2009, a family of four with income at the poverty line would have lost almost $250.
• Virginia enacted a budget that requires that, in tax year 2010, families compute their state EITC based not on the current federal EITC but rather on the EITC as it existed under pre-2009 federal law. Had this change taken effect in 2009, a two-parent family with three children with income at 125 percent of the federal poverty line would have paid $205 in additional income taxes.
• Washington D.C.’s mayor has proposed reducing the city’s EITC from 40 to 39 percent of the federal credit. Had the District’s EITC been 39 percent of the federal credit in 2009, a family of four with income at the poverty line would have lost $49.

These measures would increase poverty and reduce the after-tax incomes of working families already hit hard by the recession. As a result, they would be more harmful to states’ economies than other budget-balancing measures. This is because lower-income people spend nearly all of the money they make, mainly on necessities. So for every dollar they lose, the total amount of spending in the economy drops by around a dollar. That puts more jobs at risk — such as at stores where low-income people shop — and weakens a recovery. By contrast, high-income people are generally able to save part of any extra income they receive. So for every dollar they lose in income, total spending drops by less than a dollar, say, 90 cents. Thus, tax increases that mostly affect higher-income families and corporations have less of an impact on aggregate demand and are better for the economy and jobs.^[7]

Conclusion

Too many states continue to tax the income of poor families and in some cases, the poorest. Over time, states have made significant progress in improving the tax treatment of these families. In 2009, however, that progress slowed significantly, as fiscal problems constrained states’ ability to advance targeted tax reductions. To address budget deficits, some states have proposed or enacted tax policy changes that would reduce after-tax incomes for the working poor. This approach to budget balance is misguided. States have other gap-closing options at their disposal that do not reverse the progress they have made in mitigating the tax liabilities of low-income workers and would be better for the economy. Despite their fiscal troubles, states should prioritize preserving this progress and build upon it when their budget outlook improves.