States encounter the effects of income tax fluctuations
The Tax Foundation reported that in 2011, Illinois was suffering from an $8.5 billion backlog of unpaid bills and other financial troubles. In an effort to improve its financial situation, the state raised its flat individual income tax from three percent to five percent, and increased the corporate income tax from 7.3 percent to 9.5 percent. These increases generated between $7 billion and $8 billion in additional tax revenue each year.
Under the Taxpayer Accountability and Budget Stabilization Act, the increases were scheduled to partially sunset in 2015. The state plans to proceed with the tax cuts and announced that for income earned on, or after Jan. 1, 2015, the individual tax rate reverts to 3.75 percent and the corporate rate (excluding S corporations) will be 5.25 percent.
While tax reductions are welcome news for most, The New York Times (the Times) reported that new Gov. Rauner’s “campaign promises are about to meet budget realities.” Illinois faces $2 billion less in revenues for this year while the state continues to struggle to pay its bills. The Times points to the fact that Moody’s Investor Services has downgraded Illinois five times in five years and given it the lowest credit rating among the 50 states.
Another problem is that revenue from corporate income tax collections are declining faster than expected. In Illinois’ three-year budget projection, the revised figure for fiscal year 2015 is $2.7 billion, down from 2014’s $3.14 billion. The downward trend is puzzling because, as indicated by the Institute for Illinois’ Fiscal Sustainability (Institute) in November of 2014, “[n]early all indicators point to positive economic growth in the State of Illinois for the fifth consecutive year in 2015 but due to a change in income tax rates, state government finances remain in crisis.”
Here are some of the highlights that the Institute cited:
- Improvement in unemployment, which fell from 11 percent in January 2010 to 6.7 percent at the end of September 2014;
- Increases in gross receipts of individual income taxes for the first quarter of fiscal year 2015, which at $4.1 billion were $102 million more than forecasted; and
- Positive trends in underlying factors, such as the housing market, employment, manufacturing, and monetary policy.
Despite these bright spots, the Times acknowledged that the governor “found a budget worse than he had expected—rife with accounting shenanigans and budgeting gimmicks, not to mention core structural gaps.” Even so, he insists that he will enact meaningful changes.
At the end of 2014, numerous outlets confirmed that Massachusetts had satisfied all the requirements necessary for automatic tax decreases to take effect on Jan. 1, 2015. As anticipated, Masslive.com announced that the personal income tax fell from 5.2 percent to 5.15 percent as of Jan. 1, 2015, after the state collected $1.59 billion in taxes, which is 1.5 percent more as compared to a year ago. Despite the increased figures versus a year ago, “[t]ax collections missed the monthly benchmark by $9 million and are trailing the fiscal 2015 benchmark by just over $40 million.”
Massachusetts faces a situation similar to Illinois'. According to the Massachusetts Budget and Policy Center (Center), lawmakers enacted various tax reductions from the late 1990s to 2002, before the dot.com bubble burst. As a result, the state has had difficulty maintaining its investments in “key public investments,” including investments in schools, colleges, subways, highways, and public safety.
A Center fact sheet revealed that within a series of phased, automatic cuts, three areas of cuts, in particular, have been costly, resulting in a combined revenue loss of $3.3 billion annually:
- The cuts from 5.95 percent to the current 5.15 percent in the tax rate applied to wage and salary income, costing about $1.9 billion;
- A cut from 12 percent to the current 5.15 percent in the tax rate applied to dividend and interest income, costing about $880 million; and
- A doubling of the personal exemption, the amount people can deduct from their taxable income, from $2,200 to $4,400 for single filers and from $4,400 to $8,800 for married couples, costing about $540 million.
With respect to the personal income tax, there have been a total of three rounds of cuts which are listed below:
- Effective Jan. 1, 2015, the tax rate fell from 5.2 percent to 5.15 percent, which will cost $70 million in lost revenue for fiscal year 2015, which ends in June 2015;
- Effective January 2014, the tax rate fell from 5.25 percent to 5.2 percent; and
- Effective January 2012, the tax rate fell from 5.3 percent to 5.25 percent.
The Center estimates that cuts to the personal income tax rate will cost Massachusetts close to $400 million annually for fiscal year 2016 and beyond. And if the additional triggers are satisfied, the personal income tax will fall again, in three stages, to five percent by 2018.
The Center provided a map of the revenue-related triggers that lawmakers established in 2002:
- Annual state tax revenues during the prior fiscal year must grow at least 2.5 percent faster than the rate of inflation;
- This revenue growth must be "baseline" growth, meaning the effects of any mid-year tax law and/or administrative tax changes have been factored out of the growth calculation; and
- Positive revenue growth must be sustained for each of three consecutive, three-month periods in the current fiscal year, relative to the corresponding three-month periods in the prior fiscal year.
The scheme’s configuration may continue to pose challenges for lawmakers because even during periods of revenue declines, the trigger mechanism can still result in tax reductions. As the Center notes, “[d]eep cuts in funding for essential public investments can compromise the state's long-term economic strength and harm the current and future well-being of the people who live and work here in Massachusetts.”