February 10, 2005

Introduction

Responsiveness in state revenue collections to changes in revenue sources has been increasingly important in recent years. Economic fluctuations have the potential to disrupt state revenue collections and the resulting funding for needed services. Beginning with former Governor Olene Walker’s tax reform proposal, attention has been directed to an overhaul of Utah’s state personal income tax system. All revenue generated from Utah personal income tax collections is constitutionally designated for education; to add stability to the educational tax structure, a new proposal has been presented that would simplify the state personal income tax by lowering the tax rate and broadening the base by eliminating deductions. The proposal would also decrease taxes for individuals living below the poverty line.

Flat Tax Overview

Under a flat income tax system, all income is taxed at the same rate on a broadly defined base. Flat income taxes usually feature low rates and offer a limited number of deductions and exemptions. With a flat income tax, tax liability increases proportionally as income increases. Many proponents of a flat tax advocate that the flat tax would solve myriad problems ranging from compliance to complexity in state income tax systems. A flat tax is inherently simpler in that individuals do not need to keep track of allowances and deductions. Flat taxes promote equality by applying one tax rate for all individuals (thresholds are usually set to exempt individuals from paying taxes who are in the lowest-income range) and low rates stimulate investment and economic growth, which in turn leads to more revenue for the state.

Opponents, however, claim that by nature the flat tax violates notions of equity and fairness by taxing both the rich and poor at the same rate. They argue that it is necessary to look beyond a simple tax rate and take into consideration the value of money to different income groups. Opponents also argue that more clarification of the term “income” and what counts as “income” is needed to avoid shifting tax burdens off the upper class and onto lower income groups.

Experience With Flat Taxes

In the United States, six states have implemented a flat state income tax: Colorado, Illinois, Indiana, Massachusetts, Michigan and Pennsylvania. Figure 1 shows tax rates, exemptions, deductions and income tax as a percentage of total tax revenue collections for each of the six states. Data for Utah is included in this analysis to offer points of comparison. As can be seen, none of the states imposing a flat income tax allow for standard deductions and they only offer a very limited number of itemized deductions; Colorado has implemented a very simple flat tax and does not allow any additional deductions, exemptions or credits. Colorado’s tax, however, is imposed on federal taxable income which implicitly allows for federal standard or itemized deductions and personal exemptions. Most states base the tax on federal adjusted gross income, a broad measure of income, and then provide some exemptions, deductions, and credits from that income. Pennsylvania has the broadest flat tax, with its own definition of gross income and no personal exemptions or standard deductions.

The addition of deductions, exemptions and credits can affect the elasticity of tax revenues in relation to income. Theoretically, a flat rate income tax with no exemptions and credits should have income elasticity equal to one. Allowing taxpayers the opportunity to apply credits or exemptions to their state income tax can skew revenue sensitivities to below or above one.

Each of the states shown in Figure 2 experienced some fluctuation in revenues due to economic changes. It is clear, however, that three states have a more stable income tax than the others; Indiana, Illinois, and Pennsylvania adhere to the most basic principles of a true, simple flat tax. They only allow very limited deductions and tax a broad definition of income.

Economic fluctuations hit Colorado, Michigan and Massachusetts especially hard, and these states experienced serious budget shortfalls as a result. The main budget problems for these states stemmed from revenue shortfalls caused by the impact of the recession on employment and capital gains income. While Colorado did experience revenue declines due to its reliance on the tech sector, a sharp decline in tourism following the September 11, 2001 terrorist attacks contributed to its shortfall.

Elasticity & Progressivity

Research on tax base elasticities in both the long run and short run conducted by Donald Bruce, William F. Fox and M.H. Tuttle at the University of Tennessee reveals that long run elasticity is higher in states where the highest tax bracket occurs at lower income levels (as in Utah). Their findings suggest that this increase in elasticity occurs as more taxpayers are subject to higher tax rates.[1] In other words, by having a larger base subject to the maximum tax rate, state personal income revenue collections are more sensitive to fluctuations in personal income due to the wider range of incomes. States with more progressive income tax structures also are prone to high long-run income elasticities.

States that adopt a flat income tax give up the opportunity to create a more progressive tax structure. Overall progressivity of their tax system will depend on how other taxes are structured, but even a flat tax can be made more progressive with the introduction of large exemptions for lower income taxpayers. As can be seen from Figure 4, major cities in each state with a flat income tax vary in terms of progressivity. Considering each of the cities in the flat-tax states mentioned above, Salt Lake City is more progressive than any of them, with an index of 0.743.[2]

States with progressive income taxes have more elastic revenues, which has both positive and negative implications. On the one hand, more elastic taxes grow at a faster rate as income grows; on the other hand, less elastic taxes are more stable and do not fall as much when income growth slows. Figure 3 reveals that in the long-run, states with a flat income tax are not necessarily more stable (less elastic) than states with other tax systems. With the exception of Indiana, which is an outlier in the group and is very sensitive with a long-run elasticity measurement of 2.435, it is erroneous to claim that only those states with flat taxes experience lower long-run elasticity.

Several other states with progressive income tax systems have lower long-run income elasticities despite the idea that increased progressivity leads to higher income sensitivity. It is important to note that Utah’s tax system is essentially a flat tax system by default due to its low top-income brackets and lack of indexing for inflation. This may explain why it appears more inelastic than other states with progressive tax systems.

Conclusion

When considering policy changes to Utah’s tax system, it is helpful to consider the experience of other states that have implemented a flat tax. Broad-based flat income taxes, like those in Pennsylvania, Indiana, and Illinois, do appear to be more stable, providing revenues that do not suffer declines as severe as other states during recessions. The tradeoff that comes with greater stability, however, is slower revenue growth during positive economic cycles. Slower growth may be desirable to those who prefer to limit government growth, but because of the income tax’s tie to education funding in Utah, slower growth may be undesirable to those looking for greater increases in education funding during economic expansion years. In addition, a flat income tax carries less opportunity to craft a progressive tax system that eases burdens on low-income taxpayers. Although Utah’s income tax seems flat by default, because most full-time workers are paying the highest tax rate, Utah’s overall tax system is currently more progressive than any of the flat-tax states.

Endnotes

[1] Bruce, Donald, William F. Fox and M.H. Tuttle. “Tax Base Elasticities: A Multi-State Analysis of Long-run and Short-run Dynamics.” University of Tennessee, 2004, 20.

[2] Progressivity is measured by dividing the percentage tax burden at the $25,000 income level and the percentage tax burden at the $150,000 level.

This research brief was written by Research Analyst Holly Farnsworth with assistance from Executive Director Steve Kroes. Ms. Farnsworth and Mr. Kroes may be reached for comment at (801) 355-1400.  They may also be contacted by email at: holly@utahfoundation.org or steve@utahfoundation.org. For more information about Utah Foundation, please visit our website: www.utahfoundation.org.