Trend No. 2: Income Tax Reform

June 28, 2012

Most economists agree that tax systems should have broad bases and low rates: if targeted deductions, credits and exclusions are avoided, substantial revenue can be raised with low tax rates.  Such tax systems reduce political distortions of economic decision-making and promote overall economic growth, says Joseph Henchman, an attorney and policy analyst at the Tax Foundation.

Unfortunately, many states have adopted the precise opposite principle: high tax rates on a relatively narrow tax base.  Although "tax reform" can mean different things to different people, the term generally refers to tax changes that broaden the base and lower the rate, thereby bringing tax systems into line with the efficiency rule enumerated above.

An exemplary case of income tax reform occurred during the recent recession in Rhode Island.  Beginning in 2010 with bipartisan support, the state simplified its previously complex tax system while remaining revenue neutral.

  • Previously, the state had a five-bracket income tax with a top rate of 9.9 percent, in addition to an optional flat tax.
  • The reform eliminated the optional flat tax system and the alternative minimum tax.
  • It also reduced the number of tax credits and disallowed the itemization of deductions, forcing taxpayers instead to use a standard deduction.
  • The resultant savings allowed for the standard deduction to be increased, augmenting the aggregate progressivity of the reform.
  • Finally, lawmakers reduced the number of brackets from five to three and reduced the top tax rate from 9.9 percent to 5.99 percent.

Other states -- California and Illinois, specifically -- are spearheading the movement in the wrong direction.

  • California reported in 2008 that its various credits, deductions and exclusions reduced individual income tax collections by approximately $36 billion, or 39 percent.
  • Put another way, only 61 percent of income earned in California is subject to the individual income tax.
  • Illinois boosted its tax rate by 67 percent (from 3 percent to 5 percent) in 2011 and actually expanded the tax preferences in its tax code.
  • All in all, 11 states have increased income tax rates since 2007 while nine have decreased them.

Source: Joseph Henchman, "Trend #2: Income Tax Reform," Tax Foundation, June 14, 2012.

For text:

http://taxfoundation.org/article/trend-2-income-tax-reform

 

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