Governors and legislators have initiated 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. rate-cutting conversations in at least 18 states—and in about a dozen of those states, there may be some real traction behind the efforts. That makes for a stark contrast with another set of states in which policymakers are keen on hiking taxes on high earners and increasing the tax burden on investment.
Three states are exploring full-fledged wealth taxes, as we’ve discussed previously. Several others are considering mark-to-market treatment of capital gains income or changes to estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. es—including eliminating step-up in basisThe step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This often reduces the capital gains tax owed by the recipient. The cost basis receives a “step-up” to its fair market value, or the price at which the good would be sold or purchased in a fair market. This eliminates the capital gain that occurred between the original purchase of the asset and the heir’s acquisition, reducing the heir’s tax liability. .
And then there are the states—most notably Connecticut, Maryland, New York, and Oregon—where, despite robust revenues, some lawmakers are champing at the bit to raise taxes on higher-income households, sometimes to extraordinary levels.
An Oregon proposal could yield an effective state and local marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. of almost 30 percent on some small business owners’ income, meaning that 70 percent could go to federal, state, and local income taxes alone, to say nothing of other taxes.
Legislation in New York would bring state and local taxes on long-term capital gains income as high as 29.776 percent, considerably higher than the 20 percent rate imposed by the federal government. (The federal Net Investment Income Tax can add another 3.8 percent.) Combined federal, state, and local rates on short-term capital gains would exceed 70 percent in New York City, and combined with the effects of inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. , taxes this high would more than wipe out the gains from many investments.
Maryland policymakers are also considering a higher tax on capital gains income, while Connecticut legislators are exploring a wide range of tax hike proposals, including one that would create a top 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. rate of 10.65 percent on ordinary income and 15.65 percent on capital gains income, raise 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. to 13.8 percent (including a permanent “surcharge”), establish a new statewide property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. on commercial or residential property valued at more than $1.5 million, and impose a tax on digital advertising despite a similar digital advertising tax being struck down in Maryland. (Fortunately for residents of the Nutmeg State, that omnibus tax-hiking bill doesn’t look like it will go anywhere.)
Many states have graduated-rate income taxes, though they are declining in prevalence. Most states, moreover, tax capital gains income at ordinary rates, in contrast to federal treatment, under which long-term capital gains are taxed at a preferential rate. But these new proposals would see state income taxes on high earners, and particularly on their business and investment income, soar to astonishing heights—and they come at a time when individuals and businesses have greater mobility than ever before, and when many other states have prioritized creating a competitive tax environment.
Consider New York S.2162, which would add an additional 7.5 percent tax on capital gains income for a single filer with more than $400,000 in income (all income, not just capital gains income) and 15 percent over $800,000. For joint filers, the thresholds are only marginally higher: $500,000 and $1 million. (The fact that bracket widths are not doubled for joint filers creates a new 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. atop the others already present in New York’s income tax code.)
New York’s top state income tax rate is 10.9 percent, and New York City imposes a tax of 3.876 percent, for a combined 14.776 percent rate on residents of the Big Apple. The top 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. would more than double that rate, to 29.776 percent, and the 20 percent federal tax on long-term capital gains income and the 3.8 percent Net Investment Income Tax yield a 53.576 rate on long-term capital gains and an astonishing 70.576 percent rate on short-term gains.
In a state and city known for its financial markets, that’s devastating.
Imagine you invested $10,000 in an S&P 500-indexed fund on January 1, 2019, holding the investment for three years. The S&P 500 rose more than 19 percent over that period, yielding a gain of $1,904. Pretty good, right?
Not really, given that inflation eroded 15.1 percent of the value over those three years.
The combined long-term capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. rate of 53.576 percent would be imposed on the nominal gain of $1,904, yielding a tax liability of $1,020. But the taxpayer’s residual ($884 in nominal gains plus the $10,000 originally invested) is only worth $9,460 in 2019 dollars. In real terms, governments claimed $1,020 in taxes while the investor lost $540.
This isn’t some implausible hypothetical. This is the actual S&P 500 market performance and actual inflation over the past three years.
New York’s existing top individual income tax rates only kick in at particularly high levels of income, but a wealthy investor with a little over $1 million in income would face a marginal capital gains tax rate of 52.326 percent, yielding $996 in tax liability and a loss, in real terms, of $519.
Investors’ losses to inflation are one of the reasons why the federal government taxes long-term capital gains at a preferential rate. The other reason, of course, is to encourage investment. Under S.2162, investment clearly wouldn’t be a priority in New York. Nor would retaining wealthy investors, who would be heavily incentivized to move. Only your home state can tax capital gains income, a fact that won’t be lost on high earners who might still need to spend some time in New York, but don’t have to live there.
The Oregon proposal, embodied in HB 2673, is at least more conventional. It would raise income tax rates, to 11 percent over $125,000 in income and 13 percent over $500,000 for single filers ($250,000 and $1 million for joint filers).
Now, $125,000 (or $250,000 for joint filers) is very good money, and nothing to sneeze at. But it’s not most people’s idea of being fabulously wealthy, either. The bill would make Oregon’s income taxes the quickest to hit double-digit rates. Hawaii imposes a 10 percent marginal rate starting at $175,000 for single filers, while California does not do so until $312,686 (at a 10.3 percent rate). New Jersey and the District of Columbia wait until filers (single or joint) reach $1 million in income to impose their 10.75 percent top rates, and New York’s penultimate 10.3 percent rate kicks in at $5 million.
Meanwhile, the Portland area has local taxes that make those other states look like taxpayer paradises. Yes, even compared to New York City.
In addition to a top state income tax rate of 9.9 percent, Portland residents face a county pre-K tax of 3 percent, a regional supportive housing tax of 1 percent, two transit taxes for a combined 0.8737 percent on wages, and, for business income, a county tax of 2.6 percent and a city tax of 2 percent. To make matters worse, the state imposes a so-called Corporate Activity Tax (CAT) of 0.57 on business gross receipts. That’s a lot of taxes.
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. es are, as the name implies, imposed on gross revenues, not on profits or net income, so to facilitate an apples-to-apples comparison, we need to make certain assumptions. Assuming an average profit margin of 7 percent for a small business, and accounting for a subtraction of 35 percent of the greater of labor costs or the cost of goods sold, a typical small business might face the equivalent of a 6.82 percent income tax under the CAT.
Add it all up and a Portland small business owner could already face a marginal rate of 26.2 percent on the share of their income paid to themselves in wages, and 25.3 percent on any other business income distributions. House Bill 2673 would raise the top rate by 3.1 percentage points, yielding an all-in state and local income tax rate of 29.3 percent. The federal income tax and the uncapped portion of federal 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. es (on Medicare) yield an extractive rate of 70.1 percent for a typical Portland small business owner.
These states aren’t in financial crisis; their revenues are growing. These tax proposals have been justified as ensuring that the wealthy pay their “fair share.” An objectively agreed-upon definition of fairness is elusive, as policymakers well know. But there are some observable realities, and one of them is this: plenty of other states are ready to welcome these well-off taxpayers with open arms.
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