When Alaska’s legislature convenes in the year’s fourth special session on Monday, the Last Frontier State will test the frontiers of 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. policy by considering a new twist on a very old tax.
America’s second-newest state is considering one of America’s oldest taxes—a capitation or head taxA head tax, also known as a poll tax or capitation, is a flat or uniform tax levied equally on every taxpayer. Unlike an income tax, it is a fixed amount and not based on how much one earns, nor does it change based on any taxpayer circumstance or action. —but one structured as a statewide capped payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. . Alaska, which forgoes an 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 of tax revenue in the U.S. and a statewide sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. (though some local jurisdictions impose their own sales taxes), has faced consistent revenue shortfalls in recent years, the result of low oil prices. Governor Bill Walker (I), who has previously contemplated the adoption of an individual income or sales tax, is now calling legislators back into session to consider a payroll tax proposal. It’s an unusual approach—but is it a good one?
Payroll Taxes Elsewhere
There is precedent for Governor Walker’s proposal, though it is scant. Only one state currently imposes a statewide payroll tax outside of its unemployment insurance (UI) tax. Nevada’s Modified Business Tax (MBT), which is remitted by employers (not individuals) on aggregate gross wages (of all employees) above $50,000 per quarter at a rate of 1.475% is currently the only somewhat comparable statewide example.
Payroll taxes or their analogues are somewhat more common as local taxes, though typically structured as local wage or earned income taxes. Most Ohio localities impose municipal income taxes with a base of earned income and net profits of business, and local governments in Pennsylvania can impose an earned income tax, which falls on wage and self-employment income. In some cases in Ohio, both the domiciliary locality and the one in which the income is earned will impose the tax, and there is not always a deduction for taxes paid, which can result in double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. when one lives and works in different jurisdictions.
There are other examples as well. Alabama localities can impose an occupational tax on gross wages (Birmingham’s is 1 percent), and some transit authorities, including the New York Metropolitan Transit Authority and two such entities in Oregon, are funded in part by regional payroll taxes. San Francisco has a payroll expense tax, imposed at a rate of 0.711 percent. Often these taxes are structured in this way so that cities with larger wage than income bases (that is, people work in the city but live outside it) can capture that additional revenue. Sometimes it may be a case of local tax authority working around statutory constraints. The Nevada MBT, imposed by a state that otherwise forgoes both individual and corporate income taxes, is intended as a simple, low-rate business tax, though of course the economic incidence is on wage earners.
A statewide, earner-remitted payroll tax would, therefore, be unique among states. The closest analogue to the proposed cap is the federal Social Security wage cap, which exists because Social Security was originally conceived, or at least marketed, as a social insurance program, necessitating taxes that resembled premiums. (There is no wage ceiling on the regular or additional Medicare taxes.)
Economic Considerations
The governor’s proposal has economic advantages over a traditional income tax, and in fact approximates a consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. economically.
An income tax can be conceptualized as a tax on consumption plus the change in savings, while a consumption tax is equal to income less the change in savings. The key difference, therefore, between a traditional individual income tax and a consumption tax (like, for instance, a well-structured sales tax) is that under the latter, the tax does not fall on the returns to savings or capital income. At the margin, whatever you tax, you get less of—so by taxing savings and investment as well as consumption, an income tax creates a disincentive to economic growth. Taxing the return to savings distorts work effort by lowering the pay-off to work: those who work today, planning on consuming in the future, will be able to consume less in the future for a given hour of work. A tax on the return to savings is like a sales tax that increases the cost of future consumption; each additional hour of labor produces fewer goods at a later date.
It is, however, possible to structure an income tax that has the economic effects of a consumption tax—what can be called a “consumed income tax.” In practice, no one does this, at least not in the United States. However, a payroll tax, by exempting nonwage income like interest, dividend, and capital gains income, is essentially neutral with regard to consumption and savings in the long run. You can almost think of it like the extension of the Roth IRA treatment to all income, at least under Alaska taxes: while you pay a tax on investments up front, the gains are exempt. Under a life cycle analysis, where lifetime income and lifetime consumption should be more or less equal, a tax falling exclusively on earned income is economically similar to a consumption tax.
Policy Considerations
The economic similarity between the governor’s payroll tax proposal and a well-structured consumption tax makes this proposal significantly more attractive than prior ones, and eliminates one of the concerns voiced by those who favor a sales tax. There remain, however, several other important considerations:
- Any new tax requires new tax administration, although a payroll tax should be easier to administer than a broader income tax. It also means the creation of an entirely separate type of tax, whereas a statewide sales tax could actually contribute to simplification by unifying the local tax bases, and possibly even unifying the patchwork of reporting and remittance requirements, across the state.
- Because it’s a hybrid tax, and falls under the header of a modified capitation tax, an Alaska resident with taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. in another state wouldn’t be able to take a credit for taxes paid to that second state from their Alaska liability. Nor would they be able to claim their liability under the federal income tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. for state and local taxes paid, which applies to income (or sales) and property taxes, but not to, say, a capped hybrid head tax. This concern would be less salient if the state and local tax deduction were repealed as a federal tax reform pay-for, as is currently being considered, though the issue of credits for taxes paid to other states would remain.
- Those who file jointly at the federal level would have to file separately at the state level, because it’s a head tax, not an income tax, and therefore not amenable to joint filing.
- While the governor has touted the proposal as avoiding the complexity of apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. , there is some question as to whether that would prove true for many taxpayers with income in multiple states. Presumably a nonresident who works in Alaska a few months a year is expected to remit the tax, but surely not on all their income, wherever earned, which would be unconstitutional. Allocating income and withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. tax across multiple states isn’t new—it’s a regular feature of state income taxes—but it does have to be done, and is contemplated in the bill with language pertaining to wages from sources in the state, or connected therewith.
- The initial low rate may not last, especially given that the projected revenue would only fill a small portion of the budget hole. Connecticut became the most recent state to adopt an income tax in 1991, and what began as a 4.5 percent 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. is now a seven-bracket PIT with a top rate of 6.99 percent.
- The Alaska legislature still must grapple with the more fundamental question of whether it needs a new tax. There is no doubt that the revenue shortfall is serious, but the state also finds itself in a unique situation, not only with its reserves but also with the degree to which, due to many years in which the state till was flush with oil revenue, relatively few cost controls were imposed. Significant spending cuts have been adopted in recent years, and though revenues are growing again, they may or may not prove adequate in coming years.
A new tax, once adopted, is rarely repealed. Therefore, particularly given the state’s substantial reserves (despite the difficulty in accessing them), the legislature must decide whether the current shortfall represents a long-term structural condition for which additional revenues would be desirable indefinitely, or whether it would be better to forestall consideration of a new tax that is likely to stick around.
Alaska repealed an income tax once, but it might be asking too much to believe that, if revenues recovered, the state could do it again.
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