“Who Pays?” Doesn’t Tell Us Much About Who Actually Pays State Taxes

Yesterday, the Institute on Taxation and Economic Policy (ITEP) issued the sixth edition of its “Who Pays?” report, which attempts to quantify the distributional impact of the 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. codes of all 50 states and the District of Columbia. The publication’s “Inequality Index” is widely cited, particularly since many states which are widely touted as having competitive tax codes rank poorly on ITEP’s measure of income inequality. Given the prominence of this study, it is worth considering what it can and cannot tell us.

In practice, the “Who Pays?” report is overwhelmingly a measure of the progressivity of the 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 not of the tax code as a whole. States with flatter income taxes, or which forgo an income tax altogether, rank very poorly under ITEP’s methodology regardless of what the rest of their tax code looks like—because, to a significant extent, the rest of the tax code is omitted from ITEP’s analysis.

All distributional analyses are estimates and require certain stylized assumptions to be made, assumptions which won’t perfectly correspond with the real world. It’s important, though, for those assumptions to be as realistic as possible, and in this, ITEP’s approach has some serious shortcomings and relies on extremely outdated taxpayer data. Here are some points to bear in mind when considering ITEP’s results.

• “Who Pays?” ignores wide swaths of the tax code.

  The ITEP study looks at income, sales and excise, and property taxes. It omits a range of taxes which tend to be highly progressive (that is, falling more heavily on higher-income individuals), like inheritance and estate taxes, real estate transfer taxes, leasehold taxes, and insurance premium taxes. It is difficult to make claims about the distributional impact of state and local taxes when important–often highly progressive–sources of tax revenue are excluded from the analysis. Because ITEP’s methodological notes are limited, moreover, we know very little about how they treat certain taxes—for instance, how their model distinguishes the distributional effects of a gross receipts taxA gross receipts tax, also known as a turnover tax, is applied to a company’s gross sales, without deductions for a firm’s business expenses, like costs of goods sold and compensation. Unlike a sales tax, a gross receipts tax is assessed on businesses and apply to business-to-business transactions in addition to final consumer purchases, leading to tax pyramiding. from those of a 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. .

• The 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. , commercial property taxes, and other progressive taxes are largely excluded from analysis.

  Although ITEP has generally favored higher corporate income taxes and clearly regards them as progressive, a state’s corporate income tax does almost nothing to improve the state’s progressivity in “Who Pays?” That’s because ITEP rightly observes that the burden of corporate income taxes is borne by owners/investors, wage earners, and customers, and that much of the burden is “exported” to investors, customers, and even employees in other states and around the world. So far, so good. This assumption is certainly correct. But ITEP’s solution to this problem is to take a significant fraction of corporate income tax burdens allocated to out-of-state payers and simply exclude it entirely from the analysis. The excluded portion disproportionately falls on higher-income owners of capital, thus making state tax codes look significantly less progressive by its omission.

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  The same effect is present in ITEP’s analysis of commercial real property and business tangible personal property taxes. Recognizing that much of this burden falls on out-of-state individuals, the majority of the burdens of these taxes are factored out of the analysis. The burdens of other states’ corporate income and property taxes, falling on high earners in a given state, are not included as an offset. The result? Two highly progressive taxes–the corporate income tax and property taxes on businesses–barely show up in ITEP’s analysis. Little wonder ITEP finds that state tax codes are almost invariably regressive, when the study functionally omits some of the most progressive provisions.

• Preferential tax treatment of low-income retirees doesn’t count.

  Retirees, and particularly low-income retirees, often receive extremely generous treatment under state and local tax codes. These preferences for low-earning seniors are omitted entirely from ITEP’s analysis, which expressly excludes retirees.

• ITEP uses a controversial approach to calculating tax distributions.

  ITEP uses a “snapshot” rather than lifetime income approach in calculating tax distributions, which yields findings of substantially greater regressivity. For instance, a law school student can show up as extremely low-income, and have outlays well in excess of income, but it is not very meaningful to think of someone with a future of high income as being subject to regressive taxation. The same goes for a wealthy retiree with more assets than income. A better methodology would recognize the difference between stocks and flows.

• The study considers state tax codes in a vacuum.

  There may be value in examining the progressivity or regressivity of state and local tax structures on their own, but actual taxpayers also pay federal taxes, which tend to be quite progressive and yield a progressive overall tax structure. Notably, ITEP’s methodology always leads to the same conclusion: that virtually all state tax codes are too regressive. New Jersey has a progressive individual income tax with a top rate of 10.75 percent and a corporate income tax rate of 11.5 percent. The state also levies an inheritance taxAn inheritance tax is levied upon an individual’s estate at death or upon the assets transferred from the decedent’s estate to their heirs. Unlike estate taxes, inheritance tax exemptions apply to the size of the gift rather than the size of the estate. . Nevertheless, ITEP only regards this highly progressive taxA progressive tax is one where the average tax burden increases with income. High-income families pay a disproportionate share of the tax burden, while low- and middle-income taxpayers shoulder a relatively small tax burden. code as slightly progressive, giving it an Inequality Index score of +0.6 percent. By way of contrast, the worst-ranking state in the study has a score of -12.5 percent.

• The analysis is based on extremely old data.

  The sixth edition of “Who Pays?” is based on 2018 laws, 2015 population levels, and 1988 federal tax data. Data availability issues often require using modeling inputs that are at least a few years old, but the datasets used by ITEP’s model haven’t been published in decades, so ITEP continues to rely on IRS taxpayer data from tax year 1988. So much has changed over the past 30 years that, whatever adjustments ITEP makes to bring the figures up to date, their reliability is suspect.

ITEP does deserve credit for an important methodological improvement in the latest edition. In the past, we have criticized their inclusion of what they term the “federal offset”–in fact, the state and local 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. –as if it were a state, rather than a federal, tax policy. By cherry-picking one regressive provision in an otherwise highly progressive federal tax code and applying it in an analysis of state taxes, ITEP made every state’s tax code look significantly more regressive.

Now that the state and local tax deduction is capped at $10,000 under the new federal tax law, ITEP made the decision to remove the “federal offset” from its methodology altogether rather than scaling it down based on a $10,000 cap. This change is likely responsible for the fact that five states and the District of Columbia are now shown as having mildly progressive state tax codes, whereas prior editions unconvincingly asserted that every single state had a regressive taxA regressive tax is one where the average tax burden decreases with income. Low-income taxpayers pay a disproportionate share of the tax burden, while middle- and high-income taxpayers shoulder a relatively small tax burden. code.

The “Who Pays?” study undoubtedly tells us something about the relative progressivity or regressivity of state tax codes, but by omitting so much of the tax code and relying so heavily on outdated taxpayer data, it ultimately tells us very little about who really pays state and local taxes.

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