Monthly Archive: January 2013

State Income Tax Reform

There has been a lot of discussion by State revenue departments lately about how income tax reform at the Federal level will have uneven and unpredictable effects at the State level.  However, some savvy proactive States have dramatically lowered income tax or eliminated income tax entirely. These tax-free States are years ahead of the Federal tax reformers  and are sending a wakeup call to the rest of the States to move forward with their own tax reform as soon as possible.

Many States are just starting to see that Federal income tax reform will cause havoc on state revenue collection.  For example, some of the Federal reformers want to eliminate certain write-offs.   If mortgage interest and charity deductions were not tax-deductible at the Federal level, States that allow these deductions to taxpayers would be in a bind.  Politics aside, a State that disagreed with the Federal elimination of mortgage interest and charity deductions would have logistical nightmares to convert the Federal AGI and Net Income to State net taxable income.  California for example uses Federal itemized deductions to compute net taxable California income.  If California would follow these proposed changes in Federal law, taxpayers who live in California will be hit with both Federal and State tax increases.

There are many folks in California far from wealthy, who would get particularly hard hit with Federal tax reform.  Lets take Mr and Mrs Smith and their three dependent children. The  Smiths make $100,000 per year W2 income and have $20,000 of interest on a mortgage and give $5000 to charity.  In 2012 they pay to the IRS $4,361 and to CA $1,357.    If Congress eliminates the mortgage and charitable deduction, the Smith Family pays $6,499 to IRS and $2,692 to CA.  This is a 49% increase in Federal tax .  However California increases Smith’s tax by 98%. Go around the country and each State will be somewhat different, from no effect at all to dramatic increases.

Would California change their entire tax infrastructure to “add back” mortgage interest and charity donations, even though the IRS now excludes these  deductions?  How many years would the California legislators take to fix this problem?  Other States that “piggyback” on exactly the Federal taxable income would be in even a worse predicament.  Would those States change all their tax laws and computer programs to in effect ignore federal tax reform?  No one can answer that question with certainty.

Another question to ask: Would Congress lower tax rates sufficiently to offset the charity and mortgage write-offs?  Again no one really knows.  However, if history is any guide, once deductions are eliminated, tax rates will always over time creep back up.  This is exactly what happened back in the 1980s during the Reagan tax reform movement.  The Tax Reform Act of 1986 lowered most income tax to a top rate of 28% in exchange for eliminating a lot of tax loopholes.  But guess what?  Loopholes are back, and tax rates keep rising possibly to 39% or more in 2013.

In conclusion I believe the American income tax infrastructure is so riddled with inefficiency and loopholes that the income tax Code as it stands now needs to be totally scrapped.   A new more efficient tax collection infrastructure needs to be implemented to collect larger tax revenue streams. Real tax reform would look to a national sales tax, a flat tax on income, and perhaps a value added tax on production.   Anything less at the Federal level would cause a political and logistical nightmare for the States. Finally, States that do collect income tax should take note of the very healthy economy of Texas and other tax-free States that have eliminated income tax.  Perhaps true tax reform may need to begin at the State level after all?