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BHI Policy Studies
Number 6
May 1994
James P. Angelini
David G. Tuerck
Howard R. Wright
The Graduated Income Tax:
Who Wins, Who Loses?
Can Massachusetts reduce taxes for 92 percent of its residents without reducing government services? Yes, say proponents of a graduated income tax (GIT) that will go before Massachusetts voters in the November election. This proposal would amend the state constitution to require the imposition of a graduated (or "progressive") tax on personal income. An accompanying measure would replace the flat tax imposed under present law (5.95 percent, except for certain unearned income taxed at 12 percent) with the rate structure shown in Table 1.
Table 1
Tax Brackets by Indicated Tax RateFiling Status Tax Rate 5.5% for taxable income less than 8.8% for taxable income of 9.8% for taxable income greater than Married Filing Jointly $81,000 $81,000-$150,000 $150,000 Single $50,200 50,200-90,000 90,000 Head of Household $40,500 40,500-75,000 75,000 Married Filing Seperately $60,100 60,100-120,000 120,000
The proposed measure contains a number of additional features, including relief for MWRA ratepayers, an increase in the no-tax threshhold, a child care tax credit and an increase from $1,000 to $2,000 in the deduction for dependents. It also phases out the personal exemption ($4,400 for married and $2,200 for single taxpayers) for taxpayers whose adjusted gross income exceeds a certain threshold.
GIT proponents appear to be staking their appeal to the voters on the claim that winners from the GIT would vastly outnumber the losers. Even if true, there is good reason why a claim of this kind should not be so appealing.
There is, for example, the inadvisability of removing the existing constitutional barrier to tax progressivity. By doing so, Massachusetts voters would dangle further temptation before an already tax-hungry state legislature. There is also the questionable basis of the claim that the proposal would not reduce revenues or, therefore, government services (which is to say that the proposal is "revenue neutral").
Taxpayers now subject to the higher rates imposed by the grad tax pay about 35 percent of Massachusetts income taxes. The fraction paid by taxpayers who would, in the years ahead, become subject to higher rates by increasing their taxable income is, as we suggest below, substantially larger. Because of the negative effect that the higher rates will exert on the willingness of these taxpayers to generate additional taxable income, the GIT would, in all likelihood, reduce tax revenues in the short run. This means that, in the short run, the GIT would force the legislature either to cut services or to raise taxes.
As for the long run, the GIT has just the opposite effect: It increases the revenues collected from taxpayers and thus the amount of money the state has available to spend. This is because of growth in the economy and therefore of taxable incomes that automatically drives taxpayers into higher brackets. This growth causes taxpayers to pay more in taxes, even if the GIT is indexed against inflation and even if the legislature never raises tax rates again.
This long-run effect of the GIT puts into perspective the claim that, under the GIT, the winners vastly outnumber the losers. The authority for this claim is a study by the Massachusetts Department of Revenue (DOR), which finds that about 92 percent of the taxpayers affected by the grad tax would gain while only 8 percent would lose in 1995. Those found to lose consist almost entirely of high-income filers (in particular, married filers making more than $100,000).
The obvious question is, however, "What about beyond 1995?" Can middle-income filers expect to be better off under the GIT in future years? In particular, can they expect to be better off over the rest of their working lives, as their taxable incomes rise in response to career improvements and other factors? Unfortunately, the DOR study provides no answer.
Winners and Losers
In an effort to fill this gap, we examined the effect on combined federal and state tax liabilities of 180 hypothetical Massachusetts taxpayers before and after adoption of the GIT. For each such taxpayer, we show how much the taxpayer would win or lose as a result of adoption of the GIT.
Should we expect losers as well as winners? The answer is, "Yes." Many middle-income taxpayers can expect to be worse, not better off, over their working lives as a result of the GIT.
The reason is that, measured in "real," inflation-adjusted dollars, taxpayers normally experience growth in their taxable incomes over their working lives. Not only do they receive salary increases, but, at different points in their careers, they and their spouses expand their working hours, enter or re-enter the labor force and earn income on their savings. For the period 1981-1991, the real, taxable income per Massachusetts taxpayer grew at an average annual rate of about 2.5 percent.
Taxpayers typically report relatively low incomes early in their income-earning years. A GIT benefits taxpayers during these years by subjecting them to lower rates. As their real incomes grow, however, some taxpayers automatically ratchet themselves into the higher tax brackets mandated by the GIT. Any tax saving that these taxpayers enjoy while subject to the lower brackets are thus offset at least in part by tax losses incurred later on.
In order to determine how much a given taxpayer would win or lose, we computed the effect of the GIT on both federal and state liability (this is because state income taxes are deductible against federal taxes). In our analysis a taxpayer wins by the amount that his combined state and federal tax liability falls and loses by the amount his combined state and federal tax liability rises.
We distinguish taxpayers according to (1) filing status, (2) present age, (3) present income, (4) expected growth of income (in real dollars), and (5) expected retirement age. Taxpayers are assumed to have a present age of 25, 35 or 45 and to retire at age 65 or 70. Income is assumed to grow at 1, 2, 2.5, 3 or 4 percent. We detail our other assumptions on page 4, below.
For each hypothetical taxpayer, we computed the total, accumulated change in federal and state tax liability that will take place over the taxpayer's working life. We then added the change in both accumulated tax liabilities and reported the result in Tables 2, 3 or 4 , as appropriate. Each number indicates the amount by which the indicated filer's tax liability would fall (negative number) or rise (positive number) under the GIT.
Findings
Our analysis shows that, while some middle-income taxpayers would gain under the grad tax, many others would lose. In general, a taxpayer gains more (loses less), the lower his starting income and the less his income can be expected to grow over his working life. (Note that there are several exceptions, however.)
While we cannot, with this analysis alone, determine what fraction of middle-income taxpayers would gain or lose, we can safely conclude that any characterization of the grad tax as a "middle-class tax cut" is highly misleading. Many thousands of middle-income taxpayers would surely lose.
The Murphy Brown Tax
One reason why so many middle-income taxpayers would lose is because of what amounts to a hidden fourth bracket that the GIT would impose. This bracket results from the phase-out of the personal exemption that would take place at incomes exceeding a certain threshold. Because taxpayers lose 2 percent of their personal exemption for every $1,000 by which their gross income exceeds this threshold, they are effectively taxed at a higher rate.
For a married taxpayer making between $100,000 and $150,000 in taxable income, for example, the statutory marginal rate is 8.8 percent. But, under the GIT, taxpayers falling (roughly) into this range must give up 2 percent of their personal exemption for every $1,000 in additional income that they earn.
Table 2
Net Change in Tax Liabilities Under the GIT
Married Filing Jointly
Age 25 Age 35 Age 45 Income: $30,000 Income: $50,000 Income: $50,000 Income: $70,000 Income: $70,000 Income: $90,000 Growth 65 70 65 70 65 70 65 70 65 70 65 70 1% -7,608 -8,470 -11,656 -13,195 -7,573 -8,856 -6,957 -6,443 -5,390 -5,997 -656 1,415 2% -9,302 -10,781 -7,241 -4,821 -7,610 -7,296 86 4,364 -3,479 -1,763 4,336 9,457 2.5% -10,333 -11,380 -1,232 3,951 -5,524 -3,492 4,897 11,294 -1,862 1,247 7,104 13,627 3% -9,726 -8,407 5,805 14,530 -2,916 1,142 10,106 19,807 48 4,713 9,769 18,465 4% -2,012 4,747 26,231 45,774 4,578 13,867 24,002 42,090 4,537 12,555 16,130 30,295
Single
Age 25 Age 35 Age 45 Income: $25,000 Income: $35,000 Income: $35,000 Income: $55,000 Income: $55,000 Income: $75,000 Growth 65 70 65 70 65 70 65 70 65 70 65 70 1% -4,978 -5,830 -6,797 -7,498 -4,282 -5,356 2,026 3,776 94 1,072 9,930 13,524 2% -5,746 -5,747 -1,144 1,189 -3,126 -2,290 9,233 14,396 3,024 5,790 14,405 21,189 2.5% -3,787 -2,224 3,310 7,902 -1,378 646 13,920 21,308 4,616 8,584 17,055 25,199 3% -918 2,157 9,361 16,829 911 4,397 19,095 28,842 6,389 11,888 19,690 29,658 4% 8,335 16,873 25,424 40,530 7,256 14,977 31,053 47,571 10,692 19,246 25,387 39,912
Head of Household
Age 25 Age 35 Age 45 Income: $25,000 Income: $35,000 Income: $35,000 Income: $55,000 Income: $55,000 Income: $75,000 Growth 65 70 65 70 65 70 65 70 65 70 65 70 1% -12,397 -14,437 -14,507 -16,891 -6,444 -9,965 -4,916 -5,010 -3,934 -4,155 3,352 5,704 2% -13,750 -16,247 -11,110 -10,100 -6,883 -9,108 1,238 4,792 -1,782 -193 7,424 12,235 2.5% -13,845 -14,817 -4,653 -1,544 -5,553 -5,042 5,104 10,438 -389 2,254 9,662 16,141 3% -10,001 -8,103 1,044 6,453 -3,366 -1,118 9,479 17,232 1,171 5,016 12,100 20,177 4% 628 7,142 14,360 27,473 1,455 7,154 20,374 34,899 4,746 11,466 17,462 29,993
Explanation
Negative numbers indicate the amount by which the taxpayer's combined state and federal tax liability would fall under the GIT over the rest of the taxpayer's working life. Positive numbers indicate the amount by which that liability would rise. Thus a married 35-year-old taxpayer earning $50,000, who expects his income to grow by 2.5 percent and to retire at age 65, would pay $5,553 less under the GIT. The same taxpayer earning $70,000 would pay $4,897 more.
Assumptions
Taxpayers filing married and head of household have two children, one born when the taxpayer is 25 and the other when he is 30. At age 50, the filer loses one dependent deduction and age 55 the other. All filers rent until they purchase their own homes. Married filers purchase a home at age 30 and single and head-of-household filers at age 40. Home buyers take out a 30-year mortgage of $120,000 at 8 percent interest. State filers take a deduction of of $600 for children under twelve, except when taking a deduction or credit for child care. Federal deductions are phased out as income exceeds $108,450. At age 65, state filers receive an additional $700 ($1,400 for married filers), and federal filers add the same amount to their standard deduction.
Parents are assumed to incur $4,800 in child care expenses for two children over a period of four years. Under present law, filers deduct this amount; under the GIT, they take a proposed tax credit of 12 percent of this amount. Under the GIT, the personal exemption is reduced by two percentage points for each $1,000 by which the filers gross income exceeds a certain threshold, depending on filing status: married - $100,000; single - $60,000; and head of household - $80,000.
All amounts are in real, inflation-adjusted dollars. Deductions and exemptions not indexed for inflation are deflated at the rate of 5.63 percent per year. This is equal to , where .017 and .0743 are, respectively, the estimated real rate and the current rate on long-term governmment bonds. We assume that all income is "5.95 percent" income, (mainly, wages, business income or interest from Massachusetts banks).
James P. Angelini is Associate Professor of Accounting and Taxation at Suffolk University. David G. Tuerck is Executive Director of the Beacon Hill Institute and Professor and Chairman of the Department of Economics at Suffolk University. Howard R. Wright is Research Economist at the Beacon Hill Institute.
Format revised on 19-Apr-2005 2:05 PM
