To bridge budget gaps this year, several states are levying large taxes on high-income earners and raising sales taxes. But a taxpayer group sees flaws.
Think millionaires are the only folks facing tax hikes this year and next? Think again. At least half a dozen states raised income tax rates for their highest earners this year. In many cases, the increases affect employees earning $150,000 or less annually.
"I wish we had a better term for these taxes than millionaire taxes because the threshold in which they kick in keeps dipping lower and lower," said Joseph Henchman, tax counsel at the Tax Foundation, a nonprofit taxpayer group that monitors federal, state and local levies.
The Tax Foundation released its first midyear analysis on state taxes July 29. The organization typically publishes annual reports. This year, however, the organization released an early review due to the large number of states that have changed their tax codes in the past several months. The most high-profile example is California. The state faced a $24 billion budget deficit. Earlier this week, California Gov. Arnold Schwarzenegger cut spending by $16.1 billion in order to balance the state budget and stop issuing IOUs to vendors. Five months ago, the state also raised income taxes for all brackets by 0.25 percentage points, retroactive to the start of the year.
California is far from the only state to raise income taxes to balance the budget. Hawaii, New York, Delaware, New Jersey, Oregon and Wisconsin all raised taxes on workers in the top income brackets.
- Hawaii: The state added three new income tax brackets in May. Before the changes, the state levied an 8.25% tax on all income above $48,000 a year. Under the new rules, which are retroactive to Jan. 1, income of $150,000 or more is taxed at 9%. Wages greater than $175,000 are taxed at 10%. Incomes of $200,000 or more are taxed at 11%.
- New York: The Empire State raised taxes on earners making $200,000 a year or more. Workers earning $200K saw their state taxes increase from 6.85% to 7.85%. Workers earning $500K per year saw an even greater increase, from 6.85% to 8.97%. The new rates are retroactive to the start of the year and are intended to last three years. They do not include local taxes. Cities such as New York City charge heads of households as much as 3.2% on all annual income over $60,000.
- Delaware: This state increased its top income tax rate a percentage point to 6.95% in July. The new rate, which impacts those earning more than $60,000 a year, is expected to take effect Jan. 1, 2010.
- New Jersey: The Garden State levies the highest property taxes in the nation. The state now also has the distinction of being one of the most expensive places for "millionaires" to live in terms of income tax. The state added three new tax brackets this year for earners making $400,000 or more. The income tax rate for employees earning $400,000 jumped to 8% from 6.37%. Those earning $500,000 will pay 10.25%. Workers making seven figures or more will pay an income tax rate of 10.75% on every dollar at or above the $1 million mark. The new tax rates are intended only for the 2009 tax year and are retroactive to Jan 1.
- Oregon: This state adopted two new brackets for top earners. Now, residents earning more than $125,000 will pay 10.8% instead of 9%. Those earning more than $250,000 will pay 11%. The new rates apply to tax years after Jan. 1, 2009, and before Jan. 1, 2012. In 2012, the state plans to reduce the 10.8% rate to 9.9%. The impact of the hikes may not be as bad as it first appears, however, since Oregon does allow residents to deduct federal taxes from their state taxes.
- Wisconsin: In June, the state added a new tax bracket for people earning more than $225,000 a year. The tax rate on these earners rose from 6.75% to 7.75%.
The state tax hikes combined with proposed federal increases on high-income workers may effectively raise the marginal tax rate well above 50% for those in the top brackets. In states with "millionaire taxes," many may see their taxes jump to 55%.
States are overhauling their tax systems in an attempt to bridge massive budget gaps. High unemployment, combined with plummeting property values, last year's stock market declines and reduced consumer spending, has left many states facing revenue shortfalls of crisis proportions. Receipts from income taxes on income, property, sales and capital gains have fallen drastically for many states.
"Obviously states have been having trouble trying to balance their budgets right now," said Mark Robyn, a staff economist at the Tax Foundation.
Tax Foundation economists say the focus on hikes for the highest earners may backfire for some states. Raising taxes on people earning above $100,000 a year -- about 126% more the average American's annual salary of $44,254 -- does give states more income in the short run. But in the long run it can discourage high earners from producing more, curb their business investments and push them to move to nearby states with lower income tax rates, said Henchman. Relying on high earners can also leave states vulnerable to future budget shortfalls, since high earners tend to rely more on capital gains and bonuses to pad their incomes -- both of which fluctuate wildly depending on the state of the economy and the markets.
"Rather than just take a politically unpopular minority of people to fund their services, they should focus on broad-based taxes," said the Tax Foundation's Robyn. "That is really only a temporary band-aid that can hurt economic performance in the long term."
Many state officials say they have little choice but to raise rates on the rich. Many argue that they can't cut state services any more and need to raise revenues somewhere. They're loath to raise corporate taxes for fear that businesses will cut back on hiring.
Wages have remained stagnant for many in lower income brackets. And many state officials fear that additional taxes levied on working-class or middle-class consumers will only further curb consumer spending, reducing both business profits and tax receipts.
Still, some states are not hoping that the "rich" will solve all their budget problems. Other states are turning to sales tax increases and additional taxes on alcohol and cigarettes to pay for services. Massachusetts, for example, has raised its sales taxes 25% to 6.25%. California has raised its sales tax to 8.25%, the highest in the nation.
"This is definitely going to be a problem going forward," says Kail Padgitt, an economist at the Tax Foundation focusing on sales tax. "In Massachusetts, it's easy to drive over to New Hampshire (where there is no sales tax) and purchase goods there. This can hurt the state's competitiveness."
Not all states are responding to budget shortfalls with tax hikes. Maine actually plans to lower its tax rates for high-income earners starting Jan. 1, 2010. Workers earning annual salaries between $20,150 and $250,000 will see their rate drop from 8.5% to 6.5%. Employees earning more than $250,000 a year will see their rates decrease to 6.85% from 8.5%. Vermont and North Dakota are also reducing income tax rates this year.
Those who didn't see tax increases this year, however, could see them next year. As unemployment continues to rise, states will see more pressure on their budgets. That could lead to additional shortfalls and tax increases, said Henchman, of the Tax Foundation.
"Right now a lot of states closed their budgets gaps," he said. "But given that the national economy, if it has recovered, is only starting the recovery, the fact is that state government revenues will not be bouncing back during fiscal year 2010. At best they will plateau and, at worst, budget gaps will continue to open, requiring spending cuts or tax increases."