Agenda - Council - 01/13/1981 - Laserfiche WebLink

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MINNESOTA Connections Indexing the State Income Tax: Is It Working as Intended? By Bill Blazar and Margo Stark In 1979, the Minnesota legislature passed a law that was designed to keep inflation from pushing taxpayers into higher income tax brackets. The law "indexed" the state's personal income tax to the consumer price index (CPII - Le., it tied the standard deduction, tax brackets, personal credits, and the low-income credit to increases in the CPt. The Minnesota Project staff has analyzed the effects of this indexing as part of its study of state and local tax policies in Minnesota. The four main questions considered were: How has in..ng affected tax liability? Whom h exing helped? How will in ng affect state revenues? What changes are needed? How has indexing affected tax liability? The 1979 indexing law provides that, after 1980, the $2,000 ceiling on the standard deduction will rise annually by the rate of increase in the CPI. (The deduction is subtracted from adjusted gross income before tax rates are applied). Also under the new law, the tax brackets, which determine tax rates, were pegged to 85 percent of the rate of increase in the CPt. The table accompanying this article compares M.ota's unindexed tax brackets fa ~ with indexed tax brackets for 1980. (The 1980 brackets are based on estimates used by the commissioner of revenue for setting income-tax withholding rates). n effect, the indexing law expands each 1978 bracket upward by 85 percent of the rate of increase in the CPt. During 1979, the brackets were expanded by about 10 percent (Le., 85 percent of the 11.8 percent increase in the CPI). During 1980, the CPI is expected to rise another 11.2 percent. Hence, the 1979 brackets will be expanded by about 9.5 percent (85 percent of 11.2 percent). In 1978, the lowest income tax bracket (1.6 percent) was for taxable income up to $500. For 1980, the 1.6 percent bracket will have been expanded in all by about 20 percent of $500, so that the first $600 of taxable income will be taxed at the lowest rate. At the other end of the scale, the 16 percent ../'( -I '- bracket, which started at $27,500 in 1978, will start at $33,000 for 1980 taxes. According to preliminary estimates, the median family income for 1980 is $23,500 for a family of four. (Half of Minnesota's families have incomes above this level and half have incomes below this level.) If the tax brackets had not been indexed, roughly $3,500 of a $23,500 income would be taxed at a rate of 15 percent. With indexing, the top bracket for the family with 1980 median income will be 14 percent. Whom has indexing helped? As the table shows, the state's income tax brackets are much smaller and closer together at the lower end of the income scale. This means that people with lower incomes move fairly rapidly into higher brackets as their incomes increase. Once above the $12,000- MINNESOTA INCOME TAX BRACKETS 17.... ...... ....CllIl ....... O33.CllIl 15.u.. ...- - "'.CllIl ...... .12..... 12'" ".CllIl ...... OJ_ "'^ t5,CICIO ".CllIl .... ,.... ".CllIl .... I2.CllIl ".000 3'5" ..... 1918 "'.CllIl ...... "5.0D0 12'" .W..., ...... "."" ...... ...... .... ".1llO ,.... ...... .... .~.... 3.'" 01"" - 1.6" 1980 c,/ 15,000 bracket, however, the brackets get larger. Thus, at higher income levels, taxpayers tend to stay in a given bracket despite substantial increases in their taxable income. Because the higher tax brackets are larger, indexing brackets benefits people with high incomes more than it benefits people with low incomes. For example, a family whose taxable income was $4,000 in 1978 could have $800 more in taxable income this year and still not shift into a higher tax bracket. A family whose taxable income was $20,000 in 1978 can make up to $4,000 more in taxable income in 1980 before moving into the next highest tax bracket. How will indexing affect state revenues? Coupled with the state's progressive rate structure and more generous tax credits, indexing will cause state revenues to fall behind inflation, when inflation is defined as the rate of increase in the CPI. To understand why, it is instructive to look at the family with a median income in 1978 (20,243 for a Minnesota family of fourl. If this family's income had kept pace with the CPI, it would have risen to $25,166 in 1980. If this family takes the standard deduction, indexing causes the family's tax liability in real dollars (Le., dollars adjusted for inflation) to increase by 1.2 percent in 1980.1 If the family's income continues to rise at the same rate in 1981, its tax liability in real dollars would increase by another .49 percent (assuming the rate of increase in the CPI is the same for 1981 as for 1980). Minnesotans' incomes, however, have not kept pace with inflation between 1978 and 1980. Instead they only increased by 15 percent, while the CPI was rising by 23 percent. Thus, the family of four whose income was $20,243 in 1978 is likely to have an income of only $23,349 in 1980, a decrease of 7.2 percent in real income. At the same time, indexing will result in a 10.7 percent reduction of the family's tax liability in real dollars. In other words, the family~s tax liability will decrease faster than its income. If the rate of growth in incomes and the CPI is the same for 1981 as for 1980, the family will experience a 3.2 percent reduction in real income, compared with a 4.8 percent reduction in real tax liability. In sum, if Minnesotans' incomes keep