The vast majority of the attention given to the Bush tax cuts has been focused on changes in top marginal rates, the treatment of capital gains income, and the estate tax.  But another, less visible component of those cuts has been gradually making itemized deductions more unfair and expensive over the last five years.  Since the vast majority of states offering itemized deductions base their rules on what is done at the federal level, this change has also resulted in state governments offering an ever-growing, regressive tax cut that they clearly cannot afford. 

In an attempt to encourage states to reverse the effects of this costly and inequitable development, the Institute on Taxation and Economic Policy (ITEP) this week released a new report, "Writing Off" Tax Giveaways, that examines five options for reforming state itemized deductions in order to reduce their cost and regressivity, with an eye toward helping states balance their budgets.

Thirty-one states and the District of Columbia currently allow itemized deductions.  The remaining states either lack an income tax entirely, or have simply chosen not to make itemized deductions a part of their income tax — as Rhode Island decided to do just this year.  In 2010, for the first time in two decades, twenty-six states plus DC will not limit these deductions for their wealthiest residents in any way, due to the federal government's repeal of the "Pease" phase-out (so named for its original Congressional sponsor).  This is an unfortunate development as itemized deductions, even with the Pease phase-out, were already most generous to the nation's wealthiest families.

"Writing Off" Tax Giveaways examines five specific reform options for each of the thirty-one states offering itemized deductions (state-specific results are available in the appendix of the report or in these convenient, state-specific fact sheets).

The most comprehensive option considered in the report is the complete repeal of itemized deductions, accompanied by a substantial increase in the standard deduction.  By pairing these two tax changes, only a very small minority of taxpayers in each state would face a tax increase under this option, while a much larger share would actually see their taxes reduced overall.  This option would raise substantial revenue with which to help states balance their budgets.

Another reform option examined by the report would place a cap on the total value of itemized deductions.  Vermont and New York already do this with some of their deductions, while Hawaii legislators attempted to enact a comprehensive cap earlier this year, only to be thwarted by Governor Linda Lingle's veto.  This proposal would increase taxes on only those few wealthy taxpayers currently claiming itemized deductions in excess of $40,000 per year (or $20,000 for single taxpayers).

Converting itemized deductions into a credit, as has been done in Wisconsin and Utah, is also analyzed by the report.  This option would reduce the "upside down" nature of itemized deductions by preventing wealthier taxpayers in states levying a graduated rate income tax from receiving more benefit per dollar of deduction than lower- and middle-income taxpayers.  Like outright repeal, this proposal would raise significant revenue, and would result in far more taxpayers seeing tax cuts than would see tax increases.

Finally, two options for phasing-out deductions for high-income earners are examined.  One option simply reinstates the federal Pease phase-out, while another analyzes the effects of a modified phase-out design.  These options would raise the least revenue of the five options examined, but should be most familiar to lawmakers because of their experience with the federal Pease provision.

Read the full report.

The vast majority of the attention given to the Bush tax cuts has been focused on changes in top marginal rates, the treatment of capital gains income, and the estate tax.  But another, less visible component of those cuts has been gradually making itemized deductions more unfair and expensive over the last five years.  Since the vast majority of states offering itemized deductions base their rules on what is done at the federal level, this change has also resulted in state governments offering an ever-growing, regressive tax cut that they clearly cannot afford. 

In an attempt to encourage states to reverse the effects of this costly and inequitable development, the Institute on Taxation and Economic Policy (ITEP) this week released a new report, "Writing Off" Tax Giveaways, that examines five options for reforming state itemized deductions in order to reduce their cost and regressivity, with an eye toward helping states balance their budgets.

Thirty-one states and the District of Columbia currently allow itemized deductions.  The remaining states either lack an income tax entirely, or have simply chosen not to make itemized deductions a part of their income tax — as Rhode Island decided to do just this year.  In 2010, for the first time in two decades, twenty-six states plus DC will not limit these deductions for their wealthiest residents in any way, due to the federal government's repeal of the "Pease" phase-out (so named for its original Congressional sponsor).  This is an unfortunate development as itemized deductions, even with the Pease phase-out, were already most generous to the nation's wealthiest families.

"Writing Off" Tax Giveaways examines five specific reform options for each of the thirty-one states offering itemized deductions (state-specific results are available in the appendix of the report or in these convenient, state-specific fact sheets).

The most comprehensive option considered in the report is the complete repeal of itemized deductions, accompanied by a substantial increase in the standard deduction.  By pairing these two tax changes, only a very small minority of taxpayers in each state would face a tax increase under this option, while a much larger share would actually see their taxes reduced overall.  This option would raise substantial revenue with which to help states balance their budgets.

Another reform option examined by the report would place a cap on the total value of itemized deductions.  Vermont and New York already do this with some of their deductions, while Hawaii legislators attempted to enact a comprehensive cap earlier this year, only to be thwarted by Governor Linda Lingle's veto.  This proposal would increase taxes on only those few wealthy taxpayers currently claiming itemized deductions in excess of $40,000 per year (or $20,000 for single taxpayers).

Converting itemized deductions into a credit, as has been done in Wisconsin and Utah, is also analyzed by the report.  This option would reduce the "upside down" nature of itemized deductions by preventing wealthier taxpayers in states levying a graduated rate income tax from receiving more benefit per dollar of deduction than lower- and middle-income taxpayers.  Like outright repeal, this proposal would raise significant revenue, and would result in far more taxpayers seeing tax cuts than would see tax increases.

Finally, two options for phasing-out deductions for high-income earners are examined.  One option simply reinstates the federal Pease phase-out, while another analyzes the effects of a modified phase-out design.  These options would raise the least revenue of the five options examined, but should be most familiar to lawmakers because of their experience with the federal Pease provision.

Read the full report.

This week the Oklahoma Policy Institute released a report urging, among other things, that one of the state’s more ridiculous tax breaks be eliminated — specifically, the state income tax deduction for state income taxes.  This deduction was created not as a result of careful consideration and debate among Oklahoma policymakers, but rather as an accidental side-effect of the state’s “coupling” to federal income tax rules.  And as the New Mexico Legislative Finance Committee politely points out, while the deduction may make some sense at the federal level, the rationale for providing it at the state level is “less clear.”

Citing figures provided by ITEP, the Oklahoma Policy Institute notes that only one out of four Oklahomans would be affected by eliminating this deduction, and roughly 58% of the overall tax hike would be borne by those richest 5% of Oklahomans.  This is a predictable result of the deduction only being available to itemizers.  In total, the state could collect an additional $118 million in revenue each year by eliminating the deduction — revenue that could go a long way toward preserving important public services.

State income tax deductions for state income taxes have been receiving a growing amount of attention.  Last year, Vermont limited its deduction to a maximum of $5,000, while just last week New Mexico Governor Bill Richardson signed a budget eliminating his state’s deduction entirely.  The Georgia Budget and Policy Institute (GBPI) also highlighted the benefits of eliminating this deduction in a policy brief released just a few weeks ago.

In total, seven states currently offer this deduction: Arizona, Georgia, Hawaii, Louisiana, Oklahoma, Rhode Island, and Vermont.  Eliminating the deduction in each of these states is long overdue.

This week, the Institute on Taxation and Economic Policy (ITEP), in partnership with state groups in forty-one states, released the 3rd edition of “Who Pays? A Distributional Analysis of the Tax Systems in All 50 States.”  The report found that, by an overwhelming margin, most states tax their middle- and low-income families far more heavily than the wealthy.  The response has been overwhelming.

In Michigan, The Detroit Free Press hit the nail on the head: “There’s nothing even remotely fair about the state’s heaviest tax burden falling on its least wealthy earners.  It’s also horrible public policy, given the hard hit that middle and lower incomes are taking in the state’s brutal economic shift.  And it helps explain why the state is having trouble keeping up with funding needs for its most vital services.  The study provides important context for the debate about how to fix Michigan’s finances and shows how far the state really has to go before any cries of ‘unfairness’ to wealthy earners can be taken seriously.”

In addition, the Governor’s office in Michigan responded by reiterating Gov. Granholm’s support for a graduated income tax.  Currently, Michigan is among a minority of states levying a flat rate income tax.

Media in Virginia also explained the study’s importance.  The Augusta Free Press noted: “If you believe the partisan rhetoric, it’s the wealthy who bear the tax burden, and who are deserving of tax breaks to get the economy moving.  A new report by the Institute on Taxation and Economic Policy and the Virginia Organizing Project puts the rhetoric in a new light.”

In reference to Tennessee’s rank among the “Terrible Ten” most regressive state tax systems in the nation, The Commercial Appeal ran the headline: “A Terrible Decision.”  The “terrible decision” to which the Appeal is referring is the choice by Tennessee policymakers to forgo enacting a broad-based income tax by instead “[paying] the state’s bills by imposing the country’s largest combination of state and local sales taxes and maintaining the sales tax on food.”

In Texas, The Dallas Morning News ran with the story as well, explaining that “Texas’ low-income residents bear heavier tax burdens than their counterparts in all but four other states.”  The Morning News article goes on to explain the study’s finding that “the media and elected officials often refer to states such as Texas as “low-tax” states without considering who benefits the most within those states.”  Quoting the ITEP study, the Morning News then points out that “No-income-tax states like Washington, Texas and Florida do, in fact, have average to low taxes overall.  Can they also be considered low-tax states for poor families?  Far from it.”

Talk of the study has quickly spread everywhere from Florida to Nevada, and from Maryland to Montana.  Over the coming months, policymakers will need to keep the findings of Who Pays? in mind if they are to fill their states’ budget gaps with responsible and fair revenue solutions.

In the wake of the worst fiscal crisis in decades, several states -- most notably, New York and Hawaii -- have recently adopted income tax increases targeted at upper-income individuals and families. As the Center on Budget and Policy Priorities has documented, they may well be joined by several other states in the coming months as more lawmakers realize that this is the most responsible way to address budget shortfalls.

Critics of progressive income tax increases like to suggest that such changes will only spur the wealthy to pack up and head to more tax-friendly climes like, say, Wyoming or South Dakota. Yet, as ITEP observed earlier this week, at least three of the states that turned to income tax increases during the last fiscal crisis (New York, New Jersey, and Connecticut) saw an upturn in the number of affluent taxpayers over the ten year period from 1997 to 2006. Guess it's hard to find the equivalent of Per Se or Le Bernardin in Sioux Falls!

In unusually difficult times like these, one of the most responsible decisions a policymaker can make is to keep all revenue options on the table. Unfortunately for residents of Minnesota and Hawaii, their governors have approached the current crisis with exactly the opposite mentality. Governor Tim Pawlenty of Minnesota and Governor Linda Lingle of Hawaii have clung to the "no new taxes" mantra in recent months, despite the passage of responsible revenue-raising packages by the legislature of each state. Prominent in each of those packages were progressive income tax hikes.

In Hawaii, despite the Governor's veto, as well as her repeated assertions that any tax increase would be economically damaging for the state, the legislature managed to pass the revenue package over the Governor's stubborn opposition. The bill raises income taxes on single Hawaii residents earning over $150,000 per year, and married couples earning over $300,000.

Minnesota thus far has not been so lucky. Less than a week ago, Governor Pawlenty vetoed a tax package (based on the House and Senate bills we described last week) containing progressive income tax increases. So far that veto has held up, as proponents of the bill appear to be just a few votes shy of an override. Deeper cuts in public services or increased borrowing (the preferred solution of the Governor) may be turned to next in order to win wider support for the package.

It's probably not often that they are mentioned in the same breath, but both Hawaii and Vermont took steps this week towards using progressive tax increases to help close anticipated budget gaps. In the Aloha State, the Legislature approved a measure that, among other changes, would raise income tax rates for married couples with incomes over $300,000 (and for single people with incomes above $150,000). Governor Linda Lingle has already threatened a veto, but the Legislature may have the votes needed for an override.

The road ahead is a little less certain in the Green Mountain State. The House earlier this month passed legislation to raise additional revenue and the Senate is on the verge of doing so, but substantial differences will have to be resolved before any bill reaches the Governor's desk. The centerpiece of the House's approach is a temporary income tax surcharge that would last three years and that would raise rates by one-tenth of a percentage point for lower-income Vermonters and by one-half a percentage point for upper-income residents. Conversely, the Senate seeks to reduce income tax rates and to generate revenue for the state budget by boosting alcohol and tobacco taxes.

Hawaii and Vermont do share at least one thing in common -- a major flaw in their tax codes in the form of preferences for capital gains income. To date, Hawaii legislators have chosen to leave this flaw in place. Vermont's Senators would pare it back, but use the revenue resulting from such an improvement to reduce income tax rates, particularly for upper income taxpayers. Yet, as recent columns in the Honolulu Star Bulletin and Burlington Free Press observe, both states could improve tax fairness and their fiscal outlooks by repealing those preferences and devoting the funds directly towards deficit reduction rather than further tax cuts. For more on state tax preferences for capital gains income, see this report from ITEP.

As state policymakers craft their budgets for the upcoming fiscal year, they must confront a pair of daunting challenges, one fiscal, the other economic. The budget outlook for the states is, at present, the most dire in several decades. In this context, then, states must find ways to generate additional revenue that create neither additional responsibilities for individuals and families struggling to make ends meet nor additional distortions in the economy as a whole.

For nine states -- Arkansas, Hawaii, Montana, New Mexico, North Dakota, Rhode Island, South Carolina, Vermont, and Wisconsin -- one straightforward approach would be to repeal the substantial tax breaks that they now provide for income from capital gains. In tax year 2008 alone, these nine states are expected to lose a total of $663 million due to such misguided policies, with individual losses ranging from $10 million to $285 million per state. A new ITEP report explains that repealing these tax preferences would help states reduce their large and growing budgetary gaps, enhance the equity of their current tax systems, and remove the economic inefficiencies arising from such favorable treatment.

This report explains what capital gains are, how they are treated for tax purposes, and who typically receives them. It also details the consequences of providing preferential tax treatment for capital gains income for states' budgets, taxpayers, and economies in nine key states. Lastly, it responds to claims about both the relationship between capital gains preferences and economic growth and the role capital gains taxation plays in state revenue volatility. (Appendices to the report provide detailed state-by-state estimates of the impact of repealing capital gains tax preferences.)

Read the report.

Anyone compiling a list of similarities between Hawai'i and the Cayman islands can now add "aspiring tax haven" to "sparkling beaches" and "mild climate." Late last month, Hawai'i Governor Linda Lingle signed into law a measure that will cap the premiums tax paid by so-called captive insurance companies in the hope of luring more of those companies to the Aloha State. (A captive insurance company is a subsidiary of a larger company that insures that larger company's property or employee benefits.)

Using tax policy to try to influence business location decisions is questionable enough on its own, but it's especially troubling in this case, since captive insurers can enable major corporations to avoid millions of dollars in federal taxes annually.

As reported earlier this year, Wells Fargo, by establishing a captive insurer in Vermont, will receive "tax breaks totaling at least hundreds of millions of dollars over the next 30 to 40 years"; ADM, Heinz, Alcoa, and Sun Microsystems may already be following suit. So, policymakers in Hawai'i may think that they're bringing more jobs to their shores, but what they're really doing is using scarce tax dollars to make federal taxes scarcer still.

The Hawaii Legislature, in accordance with that state's Constitution, recently approved a measure to provide temporary but targeted tax rebates. The rebates are expected to range in value from $160 for married couples with adjusted gross incomes of less than $5,000 to $90 for couples with incomes between $50,000 and $60,000; couples with incomes above that range will not be eligible for the credit, while individuals would receive smaller rebates over the same income range.

The rebates are prompted by a constitutional requirement that tax refunds be distributed whenever the state's general fund experiences a budget surplus of 5 percent or more of state revenue in two consecutive years. The wisdom of reducing taxes, even temporarily, in response to such relatively small surpluses is certainly questionable, but the need to improve the fairness of Hawaii's tax system is not. According to the Center on Budget and Policy Priorities, a family of four earning just enough to reach the federal poverty level paid $546 in Hawaiian income taxes in 2006, the second highest amount in the country. Consequently, offering targeted tax rebates - rather than flat amounts as had been past practice - is a welcome change, but is ultimately insufficient. As the Honolulu Star Bulletin observed, a better approach would be to institute a state Earned Income Tax Credit (EITC) as numerous other states have done.

In a welcome trend, lawmakers and advocates in Connecticut, New Jersey, North Carolina, Nebraska, New Mexico, Montana, Hawaii, Utah, Ohio, and Iowa are considering enacting Earned Income Tax Credits ... or expanding existing EITCs. The federal EITC has been hailed by policymakers of all stripes as an especially effective tool for lifting working families out of poverty. At the state level, the EITC offers the additional benefit of helping to offset the regressive sales and property taxes that hit low-income families hardest. To find out more about whether EITC legislation is active in your state, check out the Hatcher Group's State EITC Online Resource Center.

After abandoning earlier efforts to pass targeted income tax cuts for working families, Hawaii policymakers are poised to enact tax measures that largely benefit wealthy taxpayers. For more on how this plan would affect Hawaii's income tax threshold-- and more on the distribution of tax cuts under the new plan, click here. The Honolulu Star-Bulletin tells it like it is here.