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Analyzing Recent State Tax Policy Choices Affecting Low-Income Working Families

The Recession and Beyond

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Document date: November 15, 2006
Released online: November 15, 2006

Brief #3 in the series "Perspectives on Low-Income Working Families"

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).

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This policy brief offers a framework for analyzing state tax changes affecting low-income working families from 2002 to 2006. This timeframe encompasses the difficult choices states faced in the latest recession and the years just beyond as state revenues recovered. Lessons learned about how state tax policy choices affected low-income families during and immediately after the recession can help states refine their choices in the future.

States often raise taxes during recessions, and depending on the design, those tax increases can fall hard on lower-income families. Policymakers may be particularly concerned with tax increases affecting low-income working families during times of fiscal stress because budgets for programs that assist these families are often cut at the same time (Rivlin 2002).

One reason that recessions can have such a substantial effect on state taxes and spending is that every state except Vermont has some sort of balanced budget requirement. So, unlike the federal government, states must balance expenditures and revenues in any given budget cycle (typically one year). States can have rainy-day funds that allow money to be carried over from good years to lean years. Before the recession that began in 2001, 47 states had such funds (Gonzalez and Levinson 2003). Faced with falling revenues, states can spend down rainy-day funds, increase borrowing, increase taxes, or reduce spending. All these factors played a role in state budget adjustments during the last recession.

State tax policies affect low-income working families in distinct ways. Though the level of state taxes may vary by state, most low-income working families can expect to pay broad-based income and sales taxes.1 And as a share of income, low-income families can expect to pay more state income and sales taxes than high-income families in the same state (McIntyre et al. 2003). On the other hand, states also use the personal income tax to supplement the incomes of low-income working families with credits such as the earned income tax credit (EITC), which can also be used as a powerful tool to offset tax increases elsewhere.

Many states start taxing families at lower incomes than the federal income tax, so even a family exempt from federal personal income taxes will often owe these state taxes. For example, a single parent with two children could earn $34,600 before owing federal income taxes in 2005 (author's calculations). This same family would owe tax in every state that has a broad personal income tax except California (Levitis and Johnson 2006).2 State sales taxes can also be significant for low-income working families. On average, low-income families spend a greater portion of their earnings on items subject to sales taxes than higher-income families (Burman, Gravelle, and Rohaly forthcoming). Policies that rely on increasing sales taxes can fall particularly hard on low-income families. Some states alleviate this burden by exempting purchases of food, medicine, and clothing from the sales tax.

When making tax policy choices, state policymakers can use several policy levers, including altering the amount of income subject to various tax rates, altering the tax rates applied to various amounts of income, changing the amount of income exempted from tax based on marital status or family size, and providing tax credits to subsidize certain activities such as working or raising children. These choices dictate how heavily tax burdens fall on low-income working families.

During the latest recession, states began by exhausting rainy day funds and later increased taxes. In many cases, states limited taxes for low-income working families rather than increasing them. Notably, between state fiscal years 2002 and 2006,3 14 states used EITCs to provide tax relief to low-income families. Five states implemented a new EITC and nine states (including the District of Columbia)4 increased an existing EITC. In contrast, Colorado eliminated its EITC due to insufficient revenues, and Maine temporarily implemented a small EITC reduction from 2002 to 2005. Five other states left their EITCs unchanged. When states did increase taxes, tobacco taxes were the most likely to be targeted.5

Notes from this section of the report

1. Several states are notable exceptions. Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming have no, or only a very limited, income tax. Delaware, Montana, and Oregon have no sales tax. Alaska and New Hampshire have neither a broad-based income tax nor a sales tax.

2. These thresholds take into account only income tax provisions that are broadly available to low-income families and are not intended to offset other taxes.

3. For almost all states, the fiscal year lasts from July 1 to June 30. Exceptions to this standard are Alabama and Michigan (October 1–September 30), New York (April 1–May 31), and Texas (September 1–August 31). Fiscal years are named for the year in which they end; for example, FY 2002 for most states begins on July 1, 2001, and ends on June 30, 2002.

4. For the purposes of this discussion, the District of Columbia is considered a state.

5. While the burden of tobacco taxes generally falls disproportionately on low-income individuals, those same individuals receive a health benefit if the taxes work to discourage smoking.

Note: This report is available in its entirety in the Portable Document Format (PDF).

Topics/Tags: | Economy/Taxes | Families and Parenting | Poverty, Assets and Safety Net

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