1. State and Local Public Finance Professor Yinger Spring 2019
Lecture 9
State and Local Sales and Income Taxes

2. Class Outline Sales Taxes Efficiency Equity Administrative Issues
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Class Outline
Sales Taxes
Efficiency
Equity
Administrative Issues
Income Taxes
Design of Federal Tax
Link to State Income Taxes
Design of Local Income Taxes

3. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Sales Tax Distortion
All taxes cause distortion (i.e. inefficiency), measured by excess burden.
The sales tax is no exception.
A sales tax distorts choices between taxed and untaxed items.
All else equal, the best tax has the lowest excess burden.

4. The Market for Taxed Goods
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Sales Tax Distortion, 2 P Q S
S + Tax D P1 P2 Q2 Q1
Excess Burden
ΔP = t ΔQ
Government Revenue
The Market for Taxed Goods

5. Excess Burden And Policy
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Excess Burden And Policy
Distortions are smallest for taxed goods with inelastic demand, such as medicine or cigarettes (but equity effects differ!).
Distortions arise when goods are taxed and services are not.
Distortions may arise when intermediate goods or services (i.e. inputs) are taxed.
Taxes can reduce distortions when there are externalities.

6. The Market for Taxed Goods
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Sales Tax Distortion, 3
Tax to Offset Externality P Q
S = PMC
S + Tax = PMC + SMC D P1 P2 Q2 Q1
Excess Burden Avoided with Tax = SMC
ΔP = t ΔQ
Government Revenue
PMC = Private marginal cost
SMC = Social marginal cost
The Market for Taxed Goods

7. Excess Burden And Policy, 2
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Excess Burden And Policy, 2
Driving (=gasoline use) causes air pollution and emits greenhouse gases; a gas tax therefore promotes efficiency by discouraging driving!
The federal gas tax has declined 40% in real terms since 1993.
One study finds that new fuel-efficiency standards for new cars will cost the U.S. 6 times as much for the same reduction in gas use as setting the gas tax at $0.45 per gallon. See Karplus, New York Times, February 21, 2013.

8. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Sales Tax Incidence, 2
Some sales taxes are specific, such as so-called “sin” taxes, and may not distort due to externalities.
General sales taxes sometimes exempt certain things, such as many services, and therefore cause distortion between taxed and untaxed items.
Sales taxes can be seen as a tax on consumption, and therefore distort the choice between work and leisure.
The labor supply elasticity is small, so little shifting into leisure occurs, and the tax falls mainly on consumers.

9. Sales Tax Incidence, 3 P Q S S+tax D P1=P3 P2
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes P Q S
S+tax D
P1=P3 P2
Many goods have elastic supply curves, so most of the burden of sales tax differences falls on consumers.
Sales Tax Incidence, 3

10. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Sales Tax Incidence, 4
The ratio of consumption to income declines as income rises.
In other words, rich people save a larger share of their income.
So a sales tax is regressive overall.
Some components of a sales tax (e.g. a sales tax on luxury goods or services) might be progressive.

11. Sales Tax Incidence, Cont.
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Sales Tax Incidence, Cont. Y T
Progressive
Proportional
Regressive

12. A Key Administrative Issue In The Design Of A Sales Tax
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
A Key Administrative Issue In The Design Of A Sales Tax
According to a famous U.S. Supreme Court decision, sales taxes on mail order or internet sales could only be collected if the seller has a business “nexus” in a state.
This decision was based on the inter-state commerce clause of the U.S. Constitution, which prohibits one state from placing an undue burden on businesses in other states.
It cost the states billions of dollars and was a major source of distortion.
This decision was overturned in June 2018.
Internet companies can now be required to collect sales tax for every state, regardless of their presence in the state.

13. Administrative Issue, Point 1
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Administrative Issue, Point 1
The sales tax is actually a sales and use tax.
A resident of State X owes the sales tax to State X even if he or she buys something subject to the sales tax in State Y and then brings it home.
The new Supreme Court decision helps with internet sales, but does not eliminate all administrative problems.
The use tax is still hard to administer in some cases:
Massachusetts police parked at New Hampshire liquor stores.
Interstate agreements to share credit card information for large purchases in one state delivered to another without collection of sales taxes (unless the new Supreme Court decision is applied to these sales).

14. Administrative Issue, Point 2
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Administrative Issue, Point 2
States were working on common definitions of goods and services and common rates to try to get around the burden argument at the heart of the old Supreme Court decision.
This effort was called the Streamlined Sales Tax Project and 22 states had joined.
The question now is whether these burden-minimizing efforts will continue now that internet firms can be required to collect sales taxes even if the current burdens remain.

15. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
The Federal Income Tax
We start with the federal income tax because most state taxes are linked to it.
We will discuss the broad issues in the design of the federal income tax.
Then we will turn to state and local income taxes.

16. Federal Income Tax Design
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Federal Income Tax Design
Comprehensive Income - Exclusions = Adjusted Gross Income - Exemptions - Deductions (Itemized or Standard) = Taxable Income × Tax Table = Gross Tax - Tax Credits = Net Tax

17. Exclusions & Exemptions
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Exclusions & Exemptions
Exclusions
Interest income on municipal bonds
Implicit rent on owner-occupied housing
Exemptions (Eliminated by the 2017 Tax Cuts and Jobs Act, TCJA)
Personal exemptions ($4,050)
Exemptions for dependents
Exemptions for age and some categories of disability

18. Deductions Itemized Deductions
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Deductions
Itemized Deductions
Mortgage interest on primary residence (and some secondary)
Property taxes on primary residence (and some secondary)
State income taxes (or state sales taxes—but not both!)
Charitable contributions
Excess medical expenses
Standard Deduction
Fixed amount (used by most taxpayers)
$12,700 for joint return (increased to $24,000 by TCJA)
Limited to $10,000 by TCJA

19. Federal Tax Expenditures
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Federal Tax Expenditures
Relating to State and Local Government, FY2007
Tax Expenditure for:
$(billions)
State and Local Tax Deductions
44.1
Real property
13.8
Income
26.2
Sales
3.0
Personal property
1.1
Tax Exempt Bonds
36.3
General
27.9
Private Activity
8.3
Total
80.5
From: Gravelle and Gravelle, NTJ, Sept. 2007

20. Tax Calculations Tax Tables Separate tables for married and single.
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Tax Calculations
Tax Tables
Separate tables for married and single.
A marriage penalty for equal-earning couples due to standard deduction.
A marriage bonus for one-earner couples due to broader brackets.
The alternative minimum tax (AMT) tries to ensure that exemptions and deductions do not push the average tax rate too low.
The AMT affects a growing number of taxpayers
And serves to reclaim some revenue lost to other provisions.
Tax Credits
Earned income tax credit

21. Tax Table, Joint Returns, 2017 (2018)
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Tax Table, Joint Returns, 2017 (2018)
Taxable Income
Marginal Rate
10%
39.6%
$18,650
$470,700
$9,525
37.0%
$500,000

22. Marginal To Average Rates
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Marginal To Average Rates
The translation from marginal to average rates is complicated.
Marginal rate tables are highly misleading due to phase outs and the EITC.
All the other features of the tax code affect average rates.
Deductions are particularly powerful at the highest income levels.

23. Tax Table For Joint Returns
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Tax Table For Joint Returns
Possible
Marginal Rate
Schedule
with
Phase Outs
Taxable Income
Marginal Rate
10%
39.6%
$18,650
$470,700

24. The Earned Income Tax Credit
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
The Earned Income Tax Credit

25. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes

26. Possible Average Rate Figure
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Possible Average Rate Figure
Comprehensive Income T Y
Itemized Deductions,
AMT
Zero Income Amount (Exemptions + Standard Deduction)
EITC ?
After 2017 TCJA?

27. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Source: IRS. Note that negative rates form the EITC cannot be identified in the IRS data.

28. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
State Income Taxes
State income taxes are less progressive than the federal income tax.
States worry about scaring away high-income residents, although I have not seen any evidence that this is a large effect.
State top rates go as high as 13.3 % (California), and 8 states have a flat rate.
Seven states do not have an income tax, and two states only tax investment income.
For more, see: individual-income-tax-rates

29. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Tax Reform Act Of 1986 (TRA)
Remarkable bi-partisan reform that closed loopholes (favored by liberals) and lowered marginal rates (favored by conservatives).
These two are linked—broadening the base makes lower rates possible.
Since then loopholes have been added at a furious pace.
This reform also shifted the burden from individuals to corporations.

30. Link To State Income Taxes
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Link To State Income Taxes
Most state income taxes either
A. use federal taxable income and their own tax tables, or
B. set their tax as a percentage of federal tax.
The “A” states gained from base broadening in the 1986 TRA.
The “B” states lost from the shift away from individual income taxes in the 1986 TRA.

31. The Tax Cuts and Jobs Act of 2017 (TCJA)
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
The Tax Cuts and Jobs Act of 2017 (TCJA)
The same issues arise with TCJA. Possible revenue raisers for states:
“Personal Exemption Elimination
The federal tax bill will repeal personal exemptions. Ten states currently couple their state personal exemption with the federal personal exemption. Given that the federal personal exemption was eliminated, these states could see a revenue gain, absent a change in state law.
Alternative Inflation Measure
The legislation eliminates the use of the traditional CPI-U (consumer price index for all urban consumers) measure for inflationary adjustments to the tax system. Instead, the bill imposes the slower growing, chained CPU measure. This will affect tax brackets, the standard deduction, the Earned Income Tax Credit (EITC) phasein/phaseout thresholds.
Modifications to Other Deductions
Modifications to the deduction for home mortgage interest, nondisaster casualty losses, and moving expenses have been estimated to increase federal revenues. This would also increase revenues in the states that incorporate these changes.”
See: states.aspx

32. The Tax Cuts and Jobs Act of 2017 (TCJA) 2
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
The Tax Cuts and Jobs Act of 2017 (TCJA) 2
Possible revenue losers for states:
“Standard Deduction
Twelve states conform to the federal standard deduction [and will lose revenue from its increase]. For states that use federal taxable income as their starting points, the increase in the standard deduction will decrease revenues unless actions are taken to decouple.
Pass-Through Deduction
The new law will allow a new deduction of 20 percent of qualified business income from certain pass-through entities [with income limits]. The deduction is only allowed in computing and reducing taxable income, not federal AGI, so only the few states that conform to FTI would be affected by this change, which would reduce revenues unless they decouple from this provision or switch to federal AGI as a starting point.
[This provision may encourage some business entities to switch from the corporate to the individual income tax.] State corporate income tax is already declining rapidly as a revenue source for states, so this could potentially add to that trend with more businesses moving to the individual tax code. Some tax experts have speculated that states may consider eliminating the corporate income tax entirely and look at broader taxes imposed on all forms of business entities, such as Ohio’s commercial activity tax or Texas’ margin tax.”
See:

33. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
State Reponses
Some states have responded to TCJA by changing their tax code.
To offset the loss of itemized deductions for state taxes, New York passed an optional employer-base payroll tax as an alternative to the state income tax.
With this approach, state income taxes are paid by the employer but the incidence probably falls on the worker.
As a result, the worker’s income is equivalent to income after state taxes and hence to income with a deduction for state taxes.
However, some experts caution against major changes in state taxes.
See: Burman and Sammartino, responses-tcjas-salt-deduction-limit-may-be-costly-and-favor-high-income- residents and Leachman and Mazerov budget-and-tax/how-should-states-respond-to-recent-federal-tax-changes

34. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Local Income Taxes
A few cities (e.g. Baltimore, Detroit, New York) have income taxes of their own, usually linked to their state tax.
Most local income taxes are limited to wages and salaries and take the form of either
an earnings tax (with the legal incidence on the worker)
a payroll tax (with the legal incidence on the firm)
Ohio allows school districts to levy an income tax (at a specified rate).

35. Payroll taxes do this automatically.
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Commuter Taxes
A few cities (e.g. Newark, San Francisco, Cleveland, Philadelphia) collect taxes on the wages and salaries earned by non-residents within the city.
Payroll taxes do this automatically.

36. This happened in Pittsburgh.
State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Commuter Taxes, 2
Commuter taxes only work if cities have access to them but suburbs do not.
The first claim on taxable resources goes to the jurisdiction of residence. So if a city passes an income tax, the suburbs can pass one and claim all the taxes paid by their commuting residents—with no increase in the tax on those residents!
This happened in Pittsburgh.

37. State and Local Public Finance Lecture 9: State and Local Sales and Income Taxes
Commuter Taxes, 3
Commuter taxes have the advantage that they can help satisfy the benefit principle—people who benefit from the services in the city where they work help pay for these services.
Commuter taxes have the disadvantage that they may encourage firms (not households) to leave a city (so they can pay lower wages), although the evidence on this effect is mixed.