Since the passage of the 1986 Tax Reform Act, federal tax law has given state lawmakers a clear incentive to rely on income taxes, instead of sales taxes, to fund public investments. This is because state income taxes can be written off by federal taxpayers who itemize their deductions, and sales taxes generally cannot. Even with temporary legislation in place that does allow a sales tax deduction, states that rely heavily on sales taxes — and not at all on income taxes — are essentially choosing to ignore what amounts to a federal "matching grant" for states that rely heavily on progressive income taxes.

A new joint report from ITEP and United for a Fair Economy's Tax Fairness Organizing Collaborative quantifies the cost of this choice in seven states that currently have no broad-based income tax — and that make up the gap by leaning heavily on the sales tax. The report shows that collectively, these seven states could reduce the federal taxes paid by their residents by $1.7 billion a year if they enacted a revenue-neutral reform that replaces sales tax revenue with a flat-rate income tax, and that the same states could save their residents $5.5 billion a year in federal taxes by enacting a similarly revenue-neutral shift to a graduated-rate progressive income tax.

Read the report.

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.

Read ITEP's New Report: Who Pays? A Distributional Analysis of Tax Systems in All 50 States

By an overwhelming margin, most states tax their middle- and low-income families far more heavily than the wealthy, according to a new study by the Institute on Taxation & Economic Policy (ITEP).

“In the coming months, lawmakers across the nation will be forced to make difficult decisions about budget-balancing tax changes—which makes it vital to understand who is hit hardest by state and local taxes right now,” said Matthew Gardner, lead author of the study, Who Pays? A Distributional Analysis of the Tax Systems in All 50 States. “The harsh reality is that most states require their poor and middle-income taxpayers to pay the most taxes as a share of income.”

Nationwide, the study found that middle- and low-income non-elderly families pay much higher shares of their income in state and local taxes than do the very well-off:

-- The average state and local tax rate on the best-off one percent of families is 6.4 percent before accounting for the tax savings from federal itemized deductions. After the federal offset, the effective tax rate on the best off one percent is a mere 5.2 percent.

-- The average tax rate on families in the middle 20 percent of the income spectrum is 9.7 percent before the federal offset and 9.4 percent after—almost twice the effective rate that the richest people pay.

-- The average tax rate on the poorest 20 percent of families is the highest of all. At 10.9 percent, it is more than double the effective rate on the very wealthy.

“Fairness is in the eye of the beholder.” noted Gardner. “But virtually anyone would agree that this upside-down approach to state and local taxes is astonishingly inequitable.”

The “Terrible Ten” Most Regressive Tax Systems

Ten states—Washington, Florida, Tennessee, South Dakota, Texas, Illinois, Michigan, Pennsylvania, Nevada, and Alabama—are particularly regressive. These “Terrible Ten” states ask poor families—those in the bottom 20% of the income scale—to pay almost six times as much of their earnings in taxes as do the wealthy. Middle income families in these states pay up to three-and-a-half times as high a share of their income as the wealthiest families. “Virtually every state has a regressive tax system,” noted Gardner. “But these ten states stand out for the extraordinary degree to which they have shifted the cost of funding public investments to their very poorest residents.”

The report identifies several factors that make these states more regressive than others:

-- The most regressive states generally either do not levy an income tax, or levy the tax at a flat rate;

-- These states typically have an especially high reliance on regressive sales and excise taxes;

-- These states usually do not allow targeted low-income tax credits such as the Earned Income Tax Credit; these tax credits are especially effective in reducing state tax unfairness.

“For lawmakers seeking to make their tax systems less unfair, there is an obvious strategy available,” noted Gardner. “Shifting state and local revenues away from sales and excise taxes, and towards the progressive personal income tax, will make tax systems fairer for low- and middle income families. Conversely, states that choose to balance their budgets by further increasing the general sales tax or cigarette taxes will make their tax systems even more unbalanced and unfair.”

Implications for State Budget Battles in 2010

“In the coming months, many states’ lawmakers will convene to deal with fiscal shortfalls even worse than those they faced last year,” Gardner said. “Lawmakers may choose to close these budget gaps in the same way that they have done all too often in the past—through regressive tax hikes. Or they may decide instead to ask wealthier families to pay tax rates more commensurate with their incomes. In either case, the path that states choose in the upcoming year will have a major impact on the wellbeing of their citizens—and on the fairness of state and local taxes.”

As the fiscal contagion spreads among the states, policymakers are clearly casting about for ways to close large and growing budget deficits. In Nevada, Governor Jim Gibbons may be open to tax increases in light of a shortfall that is projected to reach $1.8 billion over the next two and half years, but he has also floated the idea of 'voluntary' payroll reductions of 5 percent. New Hampshire faces an approximately $600 million budget gap over the same period, with lawmakers weighing such options as selling state properties, legalizing gambling, or deferring needed payments to the state pension fund. Florida may have to confront an eye-popping deficit of $6 billion over just 18 months, driving elected officials to think about raiding a variety of trust funds and imposing a 4 percent across-the-board cut in agency budgets.

Of course, these three states have more in common than difficult days ahead. They also share a steadfast refusal to levy a personal income tax. Rather than continue to cast about for half-measures and temporary fixes -- or, worse, policies that would undermine working families' already precarious economic situations -- policymakers in states like Nevada, New Hampshire, Florida, Washington, and Tennessee need to acknowledge the elephant in the room and consider whether the tax policies that brought them to this point are the ones that will carry them to a better future.

As we mentioned last week, this is the season for fiscally irresponsible sales tax holidays to purportedly give relief to working people on their back-to-school shopping. Sales tax holidays are a bad idea for the states' budgets and tax-payers alike. Low-income families probably cannot time their purchases to take advantage of a sales tax holiday, and it can be an administrative headache for retailers and government. Sales tax holidays are also poorly targeted to low-income individuals compared to other policy solutions such as low-income tax credits.

Now another group of states is ready to forgo needed tax revenue in exchange for a few dollars off the purchase price of various goods. These states include Alabama, Iowa, Missouri, North Carolina, Tennessee, and Virginia among others with holidays scheduled Friday through Sunday.

Meanwhile, a Birmingham News editorial points out that the sales tax holiday is a "gimmick" that has allowed state lawmakers to divert attention from their outrageously regressive tax code. Alabama is one of only two states that doesn't exempt or provide a low-income credit for its sales tax on groceries. If that were done, Alabama consumers would save far more money than they do on a three-day sales tax holiday (an average family of four would save about seven times as much). But instead of exempting groceries from sales taxes or raising the state's second-lowest in the nation income tax threshold, lawmakers pretend to help low-income Alabamians with a few tax-free shopping days a year.

Georgia's sales tax holiday began on Thursday and exempts articles of clothing costing less than $100, personal computers cheaper than $1500, and school supplies under $20. This week, the Atlanta Journal-Constitution mentioned some of the more amusing exemptions covered by that state's sales tax holiday. These exemptions include corsets, bow ties and bowling shoes. As the author noted, guys headed to their first day back in school "might combine the bow ties and bowling shoes, then just head straight for the restroom to collect their free swirlie." The article also mentions ski suits, highly unlikely to be big sellers in Georgia, and adult diapers, seemingly unrelated to the average family's back-to-school needs. Georgia lawmakers may want to revise their list of exemptions to concentrate on discounting necessities, or better yet, end this farce once and for all.

The Tennessee legislature last week passed a resolution directing the state comptroller to conduct an analysis of the revenue effects of instituting combined reporting in the state. If adopted, Tennessee would become the sixth state in five years to enact this reform (a total of twenty-one states currently have combined reporting requirements).

Combined reporting reduces corporate tax avoidance by requiring a corporation operating in multiple states to include all the profits of its subsidiaries in one report. Without combined reporting, companies with out-of-state subsidiaries and sufficient resources are able to make use of creative accounting practices to artificially shift profits to low-tax states. This both reduces Tennessee's revenues and creates an uneven playing field for business. This report from the Center on Budget and Policy Priorities explains in more detail why combined reporting is so important, and highlights some recent trends in states' interest in adopting the measure.

The Tennessee Comptroller's report will be ready by December.

According to the Tennessee Department of Revenue, state and local governments in Tennessee lose over $3.5 billion per year as a result of sales tax exemptions. Just five years ago, that number was only $2.2 billion. Five years before that, only $1.1 billion was lost annually.

So why is this number so large? And why is it growing so quickly? The answer to the first question is especially interesting in light of the fact that Tennessee is one of a minority of states that continues to tax groceries. Exempting groceries is widely recognized as an easy way to reduce the disproportionate impact that sales taxes have on the poor, but Tennessee doesn't do this. So where is the money going? For one thing, less than 40 percent of potentially taxable services in the state are actually taxed. Despite the gains in revenue and in fairness to be had from taxing services, haircuts, taxidermy, limousines, dating services, and many others remain tax-free in the state.

This also helps explain why the losses to the state have grown more than three-fold in the last decade. It is no secret that the U.S. has steadily been moving towards a more service-based economy. As this has happened, consumption has been shifted into purchases that are tax free under Tennessee law. This shift in the economy has a lot to do with why one University of Tennessee professor believes that only 48% of Tennessee's sales are subject to the sales tax. In 1979, it is estimated that that number was 65%.

But services don't explain the entire loss. Under pressure from organized interest groups, year after year, Tennessee legislators continue to add more exemptions to the tax code. This year alone, football merchandize, solar panels, and flatbed farm trucks were proposed to be made exempt from the sales tax. Exemplifying the problem perfectly was one bill that proposed to exempt mulch from taxation. Upon being introduced, a long list of goods including fencing wire and machine oil were added to the bill, ballooning its cost from $88,000 to $1.3 million per year.

This problem is by no means unique to Tennessee. As one South Carolina newspaper recently pointed out, shrinking sales tax revenues are partially a result of "small, targeted tax cuts [that] get even less scrutiny -- and make even more of a mess of our Swiss-cheese tax code". But this problem is especially noteworthy in Tennessee because the state lacks a broad-based income tax. With Tennessee state and local governments relying almost exclusively on sales taxes for revenue, these kind of exemptions are cutting into the fiscal foundation of public services. Tennessee state and local sales tax rates have already been raised to levels that are among the highest in the nation in order to make up for this lost revenue.

This week the Tennessee General Assembly adjourned after passing legislation that increases the state cigarette tax by 42 cents a pack and also reduces the state's sales tax on food from 6 to 5.5 percent. Progressive groups like Tennesseans for Fair Taxation are calling the reduction in the grocery tax "a very positive first step that we can build [on] as we move forward."

In a move towards a more progressive tax structure, lawmakers in both Tennessee and South Carolina have floated plans to eliminate or reduce the sales tax on groceries. However, several competing proposals are under discussion in both states, and a political food fight of sorts has broken out.

In Tennessee, the Democrats in the House of Representatives have proposed a targeted food sales tax exemption for milk, eggs, and baby formula. Meanwhile, some Senate Republicans are lining up behind the bizarre idea of completely eliminating the state sales tax on groceries for a single month.

Tennessee's neighbor to the east is also grappling with various tax cut proposals. The South Carolina Senate Finance Committee passed a measure that would phase out the state sales tax on food over three years. The proposal is competing against a House measure that would reduce the top income tax rate.

Many have expressed concern over South Carolina's ability to pay for either measure, noting (wisely) that reducing revenues during a time of budget surpluses can lead to budget deficits down the road. There are ways to make tax breaks for food more targeted to those who need them the most (ways to get the most "bang for their buck" in other words). But almost any tax break on food would be more progressive than lowering the top income tax rate. For more on the best ways to target tax breaks to those who could really use them, read ITEP's policy brief on providing targeted tax relief for residents who need it the most.

Four states - Mississipi, Tennessee, Arkansas, and Idaho - are currently debating ways to reduce the sales taxes paid on food. But how (or whether) to pay for the cuts and who should benefit remain key sticking points.

On Thursday, the Mississippi House of Representatives passed (91-27) a "tax swap" bill that would cut the state's sales tax on groceries in half and raise the tax on cigarettes to $1 per pack. The bill still faces significant challenges before becoming law, however, since key members of the Senate oppose it and Governor Haley Barbour vetoed a similar bill last year. Although the plan's reliance on revenue from cigarette taxes is not a long-term solution, it does offer a temporary mechanism to make up the revenue that would be lost from a cut on the sales tax on food.

In Tennessee, a similar "tax swap" is under consideration. However Gov. Phil Bresden has expressed reluctance to link a cigarrette tax increase with a grocery tax reduction, and has instead proposed using revenue from a cigarette tax increase for education funding.

Arkansas Gov. Mike Beebe signed a grocery tax reduction into law on Thursday that will reduce the state's sales tax on groceries from 6% to 3% effective July 1st. However, no funding mechanism was enacted to make up for the decreased revenue, as lawmakers instead decided to rely on a projected surplus to pay for the proposal.

In Idaho, Gov. Butch Otter continues to struggle with the state legislature over how best to enact a grocery tax credit. Otter's proposal would target low-income Idahoans with a credit of up to $90, while the House's newly passed version would give a smaller grocery tax credit (up to $50) to a broader range of residents.

While the Democratic takeover of the House of Representatives (and apparently also the Senate) on Tuesday has has given new hope to advocates of progressive tax policies at the federal level, the results of ballot initiatives across the country indicate that state tax policy is also headed in a progressive direction.

In the three states where they were on the ballot, voters rejected TABOR proposals, which involve artificial tax and spending caps that would cut services drastically over several years. Washington State defeated repeal of its estate tax. Several states also rejected initiatives to increase school funding which, while based on the best intentions, were not responsible fiscal policy. Two of four ballot proposals to hike cigarette taxes were approved and the night also brought a mixed bag of results for property tax caps.

Taxpayer Bill of Rights (TABOR):
Maine - Question 1 - FAILED
Nebraska - Initiative 423 - FAILED
Oregon - Measure 48 - FAILED
Voters in three states soundly rejected tax- and spending-cap proposals modeled after Colorado's so-called "Taxpayers Bill of Rights" (TABOR). Apparently people in these three states had too many concerns over the damage caused by TABOR in Colorado. Property Tax

Caps:
Arizona - Proposition 101 - PASSED - tightening existing caps on growth in local property tax levies.
Georgia - Referendum D - PASSED - exempting seniors at all income levels from the statewide property tax (a small part of overall Georgia property taxes. (The Georgia Budget and Policy Institute evaluates this idea here.)
South Carolina - Amendment Question 4 - PASSED - capping growth of properties' assessed value for tax purposes. The State newspaper explains why the cap would be counterproductive.
South Dakota - Amendment D - FAILED - capping the allowable growth in taxable value for homes, taking a page from California's Proposition 13 playbook. (The Aberdeen American News explains why this is bad policy here - and asks tough questions about whether lawmakers have shirked their duties by shunting this complicated decision off to voters.)
Tennessee - Amendment 2 - PASSED - allowing (but not requiring) local governments to enact senior-citizens property tax freezes.
Arizona's property tax limit will restrict property tax growth for all taxpayers in a given district. South Dakota's proposal was fortunately defeated. It would have offered help only to families whose property is rapidly becoming more valuable, and those families are rarely the neediest. Georgia's is not targeted at those who need help but would give tax cuts to seniors at all income levels. The Tennesse initiative, which passed, is a reasonable tool for localities to use, at their option, to target help towards those seniors who need it.

Cigarette Tax Increase:
Arizona - Proposition 203 - PASSED - increase in cigarette tax from $1.18 to $1.98 to fund early education and childrens' health screenings.
California - Proposition 86 - FAILED - increasing the cigarette tax by $2.60 a pack to pay for health care (from $.87 to $3.47)
Missouri - Amendment 3 - FAILED - increasing cigarette tax from 17 cents to 97 cents
South Dakota - Initiated Measure 2 - PASSED - increasing cigarette tax from 53 cents to $1.53. While many progressive activists and organizations support raising cigarette taxes to fund worthy services and projects, the cigarette tax is essentially regressive and is an unreliable revenue source since it is shrinking.

State Estate Tax Repeal:
Washington - Initiative 920 - FAILED
Complementing the heated debate over the federal estate tax has been this lesser noticed debate over Washington Stats's own estate tax which funds smaller classroom size, assistance for low-income students and other education purposes. Washingtonians decided it was a tax worth keeping.

Revenue for Education:
Alabama - Amendment 2 - PASSED - requiring that every school district in the state provide at least 10 mills of property tax for local schools.
California - Proposition 88 - FAILED - would impose a regressive "parcel tax" of $50 on each parcel of property in the state to help fund education
Idaho - Proposition 1 - FAILED - requiring the legislature to spend an additional $220 million a year on education - and requiring the legislature to come up with an (unidentified) revenue stream to pay for it.
Michigan - Proposal 5 - FAILED - mandating annual increases in state education spending, tied to inflation - but without specifying a funding source. The Michigan League for Human Services explains why this is a bad idea.
Voters made wise choices on education spending. The initiative in California would have raised revenue in a regressive way, while the initiatives in Idaho and Michigan sought to increase education spending without providing any revenue source. Alabama's Amendment 2 takes an approach that is both responsible and progressive.

Income Taxes:
Oregon - Measure 41 - FAILED - creating an alternative method of calculating state income taxes. Measure 41 was an ill-conceived proposal to allow wealthier Oregonians the option of claiming the same personal exemptions allowed under federal tax rules and would have bypassed a majority of Oregon seniors and would offer little to most low-income Oregonians of all ages.

Other Ballot Measures:
California - Proposition 87 - FAILED - would impose a tax on oil production and use all the revenue to reduce the state's reliance on fossil fuels and encourage the use of renewable energy
California - Proposition 89 - FAILED - using a corporate income tax hike to provide public funding for elections
South Dakota - Initiated Measure 7 - FAILED - repealing the state's video lottery - proceeds of which are used to cut local property taxes
South Dakota - Initiated Measure 8 - FAILED - repealing 4 percent tax on cell phone users.

While the governor of Tennessee, Bill Bredeson, stumps to promote the state's ongoing sales tax holiday as a means of reducing the state's taxes, his Republican gubernatorial opponent, Jim Bryson, is discussing more permanent changes in tax policy. Bryson correctly asserts that abolishing the regressive food tax would bring more lasting relief, but he offers no replacement revenue source. As Tennessee is already a low-tax state, a new source of revenue must take the place of the regressive food tax if it is abolished. To read more on the food tax and options for revenue replacement, click here.

Sales tax holidays are growing in popularity this year with four more states, Alabama, Maryland, Tennessee and Virginia, joining nine others and the District of Columbia in waiving sales and use taxes for a limited time during July and August. To see a list of participating states and tax holiday dates, click here.

As ITEP staff told USA Today earlier this week, "This tax break makes sense for lawmakers because it's cheap and avoids real reform." State legislatures claim that tax holidays alleviate the tax burden on working families and jump-start local retail businesses. In reality, however, sales tax holidays are a political gimmick that probably helps consumers less than proponents claim.