Colorado’s Election Day Choice on Income Taxes

On Election Day, Coloradans will get to decide on two competing measures on income taxes: an initiated statute that would cap income taxes at the current 4.4 percent rate; and a constitutional amendment that would authorize a graduated-rate individual and corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax., paired with an initiated statute setting new rates, with a top rate of 8.4 percent.

Under Amendment 87, Colorado’s constitution would permit a graduated-rate income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities., and the new higher rates would initially be set at 7.4 percent above $500,000, 7.9 percent above $750,000, and 8.4 percent above $1 million. Rates and brackets could be changed by the legislature at any time.

The proposal also embeds an extreme marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples. since bracket widths are the same for single filers and married couples filing jointly. A couple earning $25,000 each faces a marriage penalty of $125. A couple earning $500,000 each faces a marriage penalty of $16,575.

Colorado had a graduated-rate income tax until 1987, when it became the first state to switch from a graduated- to single-rate income tax. (Several other states have always had flat income taxes.) Before the transition, Colorado’s top rate had been 8 percent on income above $10,000 for 24 years. The new top rate became 5 percent, which had previously been the marginal rate between $4,000 and $5,000 in income (about $12,200 to $15,250 in today’s dollars).

The flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. rate has been reduced multiple times and now sits at 4.4 percent. This is a feature of flat taxes: a rate on all income is harder to raise and more attractive to cut. Should Amendment 87 pass, the initial replacement rate schedule will only impose higher rates on income above $500,000, but the new rates would be statutory, while the authorization for a graduated-rate tax would be enshrined in the constitution, permitting the legislature to adjust rates later.

Currently, Colorado’s constitution “require[s] all taxable net income to be taxed at one rate, excluding refund tax credits or voter-approved tax credits, with no added tax or surcharge.” As amended, the provision would “require all taxable net income to be taxed with no added surcharge,” which eliminates the prohibition on a graduated-rate schedule but doesn’t entirely make sense. The unusual construction, however, has a purpose: by only eliminating constitutional language rather than adding any, the amendment can be ratified with a simple majority. Ordinarily, Colorado constitutional amendments require 55 percent to pass.

Colorado’s 731,000 small businesses employ almost 49 percent of all Colorado employees, and the vast majority of these businesses are pass-through businesses (e.g., S corporations, partnerships, and LLCs), meaning that their income is taxed on owners’ individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source return. According to Internal Revenue Service data, of the state’s 53,640 filers with adjusted gross incomeFor individuals, gross income is the total of all income received from any source before taxes or deductions. It includes wages, salaries, tips, interest, dividends, capital gains, rental income, alimony, pensions, and other forms of income. For businesses, gross income (or gross profit) is the sum of total receipts or sales minus the cost of goods sold (COGS)—the direct costs of producing goods above $500,000—those subject to higher marginal rates under the proposed tax increase—30,850 receive partnership or S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT).  income, and 14,310 have other business or professional income. Households earning $500,000 or more earn 27 percent more in business income than they do in wage income. In other words, high tax rates on those with incomes above $500,000 function, to a considerable degree, as higher taxes on small business ownership.

Higher rates would reduce small business profitability and put Colorado’s small businesses at a competitive disadvantage against out-of-state rivals. The result would be some combination of reduced investment and growth, business attrition, lower wages, and higher prices.

Economic decisions are made on the margin. When the tax rate on the next dollar of income rises, business owners are likely to hire fewer workers, delay capital investment, and scale back expansion plans. They may also try to raise prices. (Whether they have the ability to raise prices will depend significantly on the conditions under which their competitors are operating.)

Colorado’s higher tax rates, moreover, would apply to many people who aren’t what we ordinarily think of as wealthy. Many filers will report $500,000 or more in income only once or twice, such as when they sell their business or an investment property. For them, this is a surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. on retirement or the return on many years of entrepreneurship and risk-taking, where most of the gains are realized at once rather than spread out over the many years of work that went into earning them.

High top rates have backfired elsewhere. In California, where voters approved increases to top rates in 2012, a combination of out-migration, reduced in-state investment, slower economic growth, and tax avoidance strategies eroded an estimated 61 percent of the anticipated revenue gains and did broader harm to the state’s economy. New Jersey’s Department of the Treasury assessed that the 2004 adoption of a new top rate of 8.97 percent above $500,000 increased out-migration by 20,000 over the next five years. And in New York, the Citizens Budget Commission found that the state’s share of the nation’s millionaires fell from 12.7 percent in 2010 to 8.7 percent in 2022, estimating that the state would have collected an additional $10.7 billion in individual income tax revenue in 2022 had the share remained constant.

The measure raises the corporate income tax rate as well, establishing a graduated-rate income tax even though progressive rate schedules make very little sense for corporate income taxes. The size of a business is largely irrelevant to the income of shareholders. A low-income household might have shares of some of the world’s largest businesses in their 401(k), while wealthy households might have an ownership stake in a small corporation.

Colorado, like most states, uses single sales factor apportionmentApportionment is the determination of the percentage of a business’s profits subject to a given jurisdiction’s corporate income tax or other business tax. US states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders., meaning that a corporation is taxed by Colorado based on its share of sales in Colorado. As economists have noted, this functionally means that the corporate income tax functions as a tax on sales into the state, which shows up in higher prices. The tax is not costless for the state, nor simply borne by investors.

In stark contrast to Amendment 87, another measure on the ballot, Proposition 136, would statutorily cap individual and corporate income tax rates at their current rate of 4.4 percent. As a statutory change, it also only requires a simple majority to pass, but it is not particularly binding. Voters could later repeal it with another simple-majority vote, and the legislature can amend statutes, so it imposes no new restriction on the legislature’s ability to raise income tax rates beyond the political constraint of adopting something contrary to a prior vote of the people. The significant constraint is TABOR, which already requires voter approval of any rate increase. Proposition 136 primarily functions as an alternative to Amendment 87, which would override its key provisions if both passed.

If both Amendment 87 and Proposition 136 pass, the one with the most votes would prevail on any conflicting provisions. This means that if both passed with Proposition 136 receiving more votes, graduated rate taxation would be permitted, but the top rate could not exceed 4.4 percent. A straightforward reading of both measures suggests that, if Proposition 136 received more votes, it would strike rates above 4.4 percent, leaving high income entirely untaxed given how the Proposition 87 statute is written. Such an outcome, however, is clearly not intended and would create other textual tensions, so it seems probable that courts would allow all higher income to be taxed at 4.4 percent. The state’s ballot information book (the “Blue Book”), however, acknowledges that the outcome of any conflict of the two measures is unclear and would have to be resolved by the courts.

At a 4.4 percent rate, Colorado is competitive with regional peers, many of which have cut income tax rates in recent years. But states are increasingly diverging on income taxes, with many pursuing low rates while a smaller number of states double down on much higher rates. Voters will get to decide which side of the divide Colorado joins.

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