Giving Credit Where Credit is Due: Reducing Inequality with a Progressive State Tax Credit

• Author: Eric Kades
• Position: Thomas Jefferson Professor of Law at William & Mary Law School.
• Pages: 359-423

Giving Credit Where Credit is Due: Reducing Inequality with a Progressive State Tax Credit Eric Kades * TABLE OF CONTENTS Introduction .................................................................................. 360 I. Income Inequality, Federal Tax Progressivity, and State Tax Regressivity .................................................................. 363 A. The Inequality Revolution Since 1980 .................................. 363 B. The Normative Case for Progressive Taxation ...................... 368 C. Federal Tax Progressivity ...................................................... 373 D. State Tax Regressivity ............................................................. 377 II. Deductions and Credits, Progressive or Regressive, and Interactions Between National and State Taxation ....................... 386 III. Modeling a Progressive State Tax Credit (“PSTC”) .................... 389 A. An Overview .......................................................................... 390 B. Computing Aggregate State Tax Payments ........................... 393 C. Constructing the PSTC .......................................................... 395 D. Explaining Key Choices Made in Constructing the PSTC ................................................................................ 398 1. Choosing the Income Level at Which the 100% Credit Begins to Phase Out ................................... 398 2. Choosing the Rate of the Phase Out ................................ 399 3. Ensuring Revenue Neutrality .......................................... 401 IV. Estimating the Impact of the PSTC Across the 50 States ............. 402 V. The PSTC and the Constitution’s Uniformity Clause .................. 408 Copyright 2016, by ERIC KADES. * Thomas Jefferson Professor of Law at William & Mary Law School. Thanks to Eric Chason, Brian Galle, Mark Gergen, Edward Kleinbard, Daniel Shaviro, Kirk Stark, Bill Richardson, Ted Sims, and Ed Zelinksy for comments on earlier iterations of this Article. Thanks also to other participants at meetings of the American Law & Economics Association, the Canadian Law & Economics Association, and the National Tax Association; and thanks to the University of Minnesota Law School workshop participants. 360 LOUISIANA LAW REVIEW [Vol. 77 Conclusion .................................................................................... 414 Appendix A. Credit in Dollar Amount and as Percent of State Taxes and Income, by State ............................................. 417 Appendix B. Comparing Effective Tax Rates: Current v. Under the PSTC, by State ............................................................. 420 INTRODUCTION Anyone not living in a cave knows that since about 1980, income inequality in America has exploded. Top incomes have soared while middle and lower class paychecks have stagnated. 1 Just as income inequality has exploded, so too has the scholarly literature surrounding inequality. 2 Commentators have proposed a number of stock policy measures to deal with inequality, from increasing the minimum wage to reinvigorating unions to imposing a global tax on capital. 3 This Article, by contrast, takes a new tack. First, it identifies a key driver of today’s income inequality entirely within the control of governments: unfair, regressive state taxation. Second, it proposes a novel means of ameliorating that inequality through the use of a federal income tax credit. Simply put, the tax regimes of all 50 states 4 are unfair. From the perspective of fairness and equity, tax systems come in three flavors. If the percent of income paid in taxes—the “average” or “effective” tax rate— increases with income, the tax is progressive; if this percent is equal across all incomes, it is a “flat” tax; and if percent tax burdens fall as income rises, the tax is regressive. The federal income tax is and always has been 1. See infra Figure 1 (charting sharp rise in top incomes since 1980) and Figure 2 (showing essentially no real incomes gains for middle and lower classes). 2. The literature on income and other forms of inequality is growing prodigiously. Perhaps the most pathbreaking work on the current inequality trend is Thomas Piketty & Emmanuel Saez, Income Inequality in the United States, 1913-1998 , 118 Q. J. ECON. 1 (2003). 3. Paul Krugman, Liberals and Wages , N.Y. TIMES, July 17, 2015, at A27 (making the case for raising minimum wage); ROBERT REICH, SAVING CAPITALISM: FOR THE MANY, NOT THE FEW 183–92 (2015) (arguing for legal change to reinvigorate unions); THOMAS PIKETTY, CAPITAL IN THE TWENTYFIRST CENTURY 447–67 (Arthur Goldhammer trans., 2014) (advocating global tax on capital). 4. Throughout this Article, “state taxation” is used as a shorthand for “state and local taxation.” 2016] GIVING CREDIT WHERE CREDIT IS DUE 361 progressive—the percent of total income paid in federal taxes rises with income. 5 Although the flat tax rate structure has advocates, 6 it is hard to find friends of regressive taxation. Yet, despite the almost complete absence of express support for regressive taxation, it turns out that every single state in the United States taxes regressively. 7 This regression occurs primarily because widely used, highly regressive sales taxes and potentially regressive property taxes outweigh slightly progressive state income taxes—for those states that tax income. States that lack income taxes and rely almost exclusively on sales and property taxes have the most regressive overall tax systems. 8 One of the most egregious examples is the state of Washington, where the lowest-income households must devote 16.8% of their income to state taxes while those at the top pay less than 2.8%. 9 This is an astounding level of regressivity, and many states have only modestly less regressive tax systems. 10 Regressive state tax schemes gratuitously contribute to inequality. Some of the market forces driving the divergence between the top 1% and everyone else are so elemental that governments can do little to counteract them. 11 Taxation, however, is an animal entirely of government creation and entirely under government control. It is disturbing and perverse that 5. See TAX FOUND., FEDERAL INDIVIDUAL INCOME TAX RATES HISTORY (2013), http://taxfoundation.org/sites/taxfoundation.org/files/docs/fed_ individual _rate_hhistory_nominal.pdf [https://perma.cc/Q7BD-FMMR]. Marginal tax rates that increase with income ensure the progressivity of a tax, and the federal income tax has always had such a structure. This was true even for precursors of the modern federal income tax, enacted in 1913, which had relatively high exemptions—that is, a marginal tax rate of 0% for most taxpayers. Id . 6. The most influential version of a flat tax proposed a flat tax on consumption—income less savings. ROBERT HALL & ALVIN RABUSHKA, THE FLAT TAX, at xiv–xvi (1995). Republican presidential candidate Steve Forbes did much to popularize the flat tax during the 1996 Republican primaries and continues to advocate for such a tax. Steve Forbes, The Tax Code: Make It Flat , FORBES (Mar. 7, 2014, 9:00 AM), http://www.forbes.com/sites/steveforbes /2014/03/07/the-tax-code-make-it-flat/ [https://perma.cc/YW73-4LHR]. 7. CARL DAVIS ET AL., INST. ON TAXATION & ECON. POLICY, WHO PAYS? A DISTRIBUTIONAL ANALYSIS OF THE TAX SYSTEMS IN ALL 50 STATES 1 (5th ed. 2015). 8. Id . 9. Id. at 123. 10. Id . at 4 (Table, “ITEP’s Terrible 10 Most Regressive State and Local Tax Systems”). 11. See infra text accompanying notes 33–40 (describing skill-biased technical change and winner-take-all markets). 362 LOUISIANA LAW REVIEW [Vol. 77 state tax codes are “piling on” to inequality instead of offsetting it, as the federal income tax does. However, tax codes, both state and federal, are notoriously difficult to amend. Their fundamental features reflect major ideological battles, such as between the wealthy and the poor, the owners of capital and the laborers, or the city dwellers and the rural inhabitants, to give just three common examples. Their details contain provisions of vital importance to special interest groups large and small. This political fact would seem to make the lament of the previous paragraph about state tax regressivity pointless. Serious tax reform is very difficult to effectuate at the state level, and so it is unlikely that more than a few states will remedy, even partially, their regressive tax systems. Indeed, the trend has been in the other direction: state tax codes are becoming more regressive, rather than less. 12 This Article proposes an innovative federal tax solution that offers a maneuver around state roadblocks that would eliminate unfair taxation across every state in one fell swoop: the progressive state tax credit (“PSTC”). The basic idea is to give poorer households a 100% credit for all of their estimated state tax payments, including income, sales, and property taxes. As income rises, the percent of the credit would decline, and the most affluent households would pay a “negative credit” or surcharge to fund the tax relief for their lower income counterparts. The PSTC is especially well-suited to counteract, at least partially, growing American income inequality. Two important, novel facets of the PSTC bear highlighting in this introduction. First, some of its effects vary from state to state. Although the 100% credit for the poorest households would operate symmetrically across states, the rates at which the credit phases out and the surcharge increases with income in each state would depend on the extent of regressivity in the state’s tax system. Second, to prevent states from exploiting the credit by raising their taxes and shifting the burden onto the federal government, and thus in substance, onto all Americans, the PSTC is designed so that it raises the same amount of revenue as the current tax code in each state—that is, it is “revenue neutral” at the level of each state and thus nationally as well...