An analysis of the Montana state individual income tax

Transcription

1 University of Montana ScholarWorks at University of Montana Graduate Student Theses, Dissertations, & Professional Papers Graduate School 1971 An analysis of the Montana state individual income tax Thomas Edward Romine The University of Montana Let us know how access to this document benefits you. Follow this and additional works at: Recommended Citation Romine, Thomas Edward, "An analysis of the Montana state individual income tax" (1971). Graduate Student Theses, Dissertations, & Professional Papers This Thesis is brought to you for free and open access by the Graduate School at ScholarWorks at University of Montana. It has been accepted for inclusion in Graduate Student Theses, Dissertations, & Professional Papers by an authorized administrator of ScholarWorks at University of Montana. For more information, please contact

2 AN ANALYSIS OF THE MONTANA STATE INDIVIDUAL INCOME TAX By Thomas E. RomI ne B.S., Eastern Montana College, 1968 Presented in partial fulfillm ent of the requirements for the degree of Master of Science UNIVERSITY OF MONTANA 1971 Approved by; Dean, Graduate School Date

3 UMI Number: EP39276 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. UMT O 9rt*tion Publiah»i>g UMI EP39276 Published by ProQuest LLC (2013). Copyright in the Dissertation held by the Author. Microform Edition ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code ProQuest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml

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5 TABLE OF CONTENTS Page INTRODUCTION... 1 PART I, STATE INCOME TAX DEVELOPMENT AND CONFORMITY Chapter I. INCOME TAX DEVELOPMENT... 6 II. THE CONFORMITY PRINCIPLE I I I. CLASSIFICATION OF CONFORMITY METHODS Federal Adjusted Gross Income Less Deductions Method Federal Adjusted Gross Income Method Percent of Federal Tax Method IV. ANALYSIS OF THE METHODS...23 Federal Adjusted Gross Income Less Deductions Method Percent of Federal Tax Method Federal Adjusted Gross Income Method PART I I. THE MONTANA INCOME TAX V. DEVELOPMENT OF THE INCOME TAX IN MONTANA...33 VI. THE PRESENT TAX L A W...38 V II. ANALYSIS AND RECOMMENDATIONS... 4l Need fo r Change Revenue Considerations Form Itemized Deductions Income S p littin g Capital Gains D vldends Exempt Ions

6 Page SUMMARY... APPENDIX BIBLIOGRAPHY......

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8 LIST OF TABLES Table Page 1. State Tax Revenues Montana Income Tax Rates Montana Income Tax Receipts Progress)vity of the Montana Income T a x Progressivlty of the Montana Income Tax Montana Income Tax Distribution I Federal Income Tax Return Statistics For Montana Montana Exemptions I Tax Liabilities Under the Proposal Itemized Deductions Distribution for Montana I Federal Income Tax Return Statistics for Montana I Projected Revenue Gain from Disallowance of Various Itemized Deductions Montana The Distribution of Exemptions Montana

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10 INTRODUCTION Purpose and Scope The purpose of this study is to trace the origin and growth of the Montana Individual Income Tax, to analyze it, and to make recommendations for Improvements. it is hoped that this study w ill determine ways in which to make the Montana Income Tax more effective in terms of taxpayer compliance, administration by the state, revenue potential, and to the extent allowed by the previous c rite ria, fairness to the taxpayer. In this regard, questions of the equity of the Montana Income Tax are considered; however, the main emphasis and overriding factor is that of practicality. Equity considerations are assumed to be basically the concern of the federal government because of the prohibitive costs to the state of administering and auditing any special Montana features designed to make the tax more equitable. The federal government has seen f i t to Include numerous special features in the Internal Revenue Code and can be reasonably expected to continue this practice. The increasing complexity of the federal law would seem to provide an impetus to the states to reexamine their own income tax laws in the hope of providing some re lie f to their taxpayers as well as their own administrative and auditing functions. Studies along this line for the state of Montana have been neither extensive nor detailed. Essentially studies of the Montana Income Tax have been limited to two studies, the Montana Tax Study of 1966 and the Montana Fiscal Affairs Study of 1970, conducted by the Bureau of

11 -2 " Business and Economic Research at the University of Montana at the direction of the Montana Legislature, Both of these studies dealt with the broad spectrum of all types of tax revenues, as well as state and local expenditures, with property taxation receiving heavy consideration. Concerning the income tax, the emphasis of these studies seemed to be on fairness, equity, and progressivity. Because of the increasing complexity of the tax laws and the lack of study on the Montana Income Tax, a need for further study would seem to be ju stified. In addition, the income tax is now Montana's largest single source of revenue and its importance is further increased by the large number of people who are directly affected by it. Also, during the recent 1971 Legislature several proposals for changes in the income tax law were Introduced and discussed. This current interest in the Montana Income Tax would seem to enhance further the need for such a study. Ljmi tations There are seyeral limitations with regard to the scope of this study. First, corporate taxation as well as taxation of estates and trusts w ill not be considered. The study is limited to taxation of the individual and unless otherwise stated, all references to the income tax should be considered as relating to the individual income tax. Second, the desirability of the income tax as opposed to any other methods of taxation w ill not be considered. This study is limited to the improvement of the income tax and does not go into matters of tax burden or desirability or equity of alternate methods of taxation.

12 "3 ^ In this regard, consideration is not given to the fixing of particular rates although explanatory comments on revenue projections are included as well as comments concerning the general revenue potential of particular methods of income taxation. These comments w ill generally be limited to discussion of tax bases, and the generally accepted desira b ility of a large tax base. Whether or not the income tax is the most effective, e ffic ie n t, and equitable method of providing Montana with her needed revenue is a question to be resolved elsewhere. Some general explanatory comments on Income taxation w ill be Included to provide the reader with a brief history of the tax. Third, administrative organization Is not within the confines of this study. Considerations of ease of administration and costs of administration w ill be included, but the actual administrative organizational structure is deemed to be outside the scope of this study. Basically, administrative considerations in this paper are limited to administrative convenience and of cost sayings to be realized by that convenience. Fourth, generally, the material in the text can be considered as limited to December 31, 1970j however, a few important developments occurring in the firs t months of 1971 have been considered and mentioned in the paper. Specifically, certain legislation concerning the Montana Income Tax and action in the courts concerning state sovereignty and Internal Revenue Code Conformity w ill be reviewed. Défini tions of Terms Conformity; the method used by the states to key their income tax law to the federal law. It is an implied measurement of the

13 sim ilarity of a state's income tax to the Internal Revenue Code. Compliance costs: those costs in time and money incurred by taxpayers to keep the necessary records for taxation, to f ile their income tax, and to remit the tax. Administrative costs; those costs Incurred by government to levy and collect the tax. Income splitting: the method whereby married taxpayers combine their individual Incomes and then assign half to each for income tax purposes. Tax base; the dollar amount of items which are subject to income taxation. Percent of Federal Tax Method: the method of income taxation whereby the state income tax lia b ility is determined by taking a percentage of the heretofore determined federal income tax lia b ility which may undergo some adjustment and modification from the actual federal tax lia b ility. Federal Adjusted Gross Income Less Deductions Method: the method of income taxation whereby the base for the state income tax lia b ility is the federal adjusted gross income, line 18 on the 1970 federal return 1040, less itemized deductions and possibly exemptions. Federal Adjusted Gross income Method; the method of income taxation whereby the base for the state income tax lia b ility is the federal adjusted gross income. Research Method The research method used in this study is one largely of review

14 - 5 - and analysis of the state income tax laws. Numerous books, periodicals, and government publications were consulted as well. In addition, a certain amount of direct information was obtained from the Montana State Board of Equalization.

15 PART I. STATE INCOME TAX DEVELOPMENT AND CONFORMITY

16 CHAPTER I INCOME TAX DEVELOPMENT A few thoughts about income taxation are in order before proceeding into more detailed data. "Taxes are the price we pay for our civilized society," wrote Justice Oliver Wendell Holmes. The income tax Is probably a unique form of tax In that: Few taxes have a more readily appreciated impact upon the taxpayer than those upon his income. Individual income is more than just the means of supplying bread and butter to the family table. It constitutes, as well, a symbol of social status, and it is not surprising that taxes levied upon income become extremely controversial measures, especially when levied at rates graduated according to the amount of income. An income tax is chosen as a method of taxation for a variety of reasons. First, it Is a logical way to go about raising revenue as all tax revenues come out of income directly or indirectly anyway. The income tax is a flexible tax source that is very conducive to special functions and motives as witnessed by the multitude of special features in the current Internal Revenue Code. In this regard, money can be directed towards desired areas, for example the investment credit provision of late or the current and long time deduction for charitable contributions. Speaking of the emergence of the income tax, D. 0. Kineman wrote in 1909, that, Vorrest H. Anderson, Executive Budget State of Montana (Helena: State of Montana, 1971), p. 40.

17 " 7"... people have turned to an income tax because they believe in the theory that individuals should contribute to the support of the government according to a b ility and that income is the most just measure of such a b ility. They expect success because they are possessed of the characteristic American optimism, and know l i t t l e of the d iffic u ltie s of administering such a law. Regardless of the reasons for its start, the fact remains that the income tax is with us in some forty-three states and there are numerous administrative problems that have accompanied its growth as w ill become quite evident throughout the remainder of the paper. Before proceeding with the development of the state income tax, the perspective of the remainder of the text should again be made clear. Regardless as to why or how the income tax began, it is the point of view of this paper, as expressly stated e a rlie r, that matters of equity are primarily le ft up to the federal government. The role of the income tax on the state level is not exactly the same as the role of the tax on the federal level. As was pointed out In one book, "on the state and locql level, the basic purpose of taxation is simply to raise the funds to finance governmental expenditures." it Is with this In mind that we proceed with income tax development in the states. Hawaii levied its income tax in 1901 while s t ill a territo ry, but the firs t state to levy an income tax successfully was Wisconsin in Wisconsin's success has been largely attributed to three administrative features (1) centralized state control, C2) personnel selected through a merit system, and (3) the required use of information ^Clara Pennlman and Walter W, Heller, State Income Tax Administration (Bratt1eboro, Vermont: Vermont Printing Company, 1959), p.5. 3 John H. Wicks, ed., Montana Tax Study (Pitkin, Colorado: Pitkin Publishing Company, 1966), p. 2.

18 - 8-4 at source returns for wages, interest, dividends, and so forth. Before 1920, eight more states had joined Wisconsin with another five states following suit during the 192G's. During the 1930's the major push for income taxation was evidenced by seventeen states enacting the tax. There was then a lag in state adoption of the income tax until 1961 when West Virginia adopted the income tax. At the end of 1970, forty-three states had an individual income tax. The most recent states enacting the tax include Maine and Illin o is which adopted their Income taxes in 19&9, and Pennsylvania and Rhode Island with their income taxes becoming effective for tax years ending after December 31, 1970, and for tax years beginning after December 31, 1970, through June 30, 1971, respectively. However, of these forty-three states, New Hampshire and Tennessee tax income from intangibles only, the Connecticut tax is on only capital gains, and the New Jersey tax levies only New York residents working in New Jersey^ In recent action by those states without a state income tax, Washington voters turned down a proposed income tax November 3, 1970; a proposed income tax in South Dakota failed to pass in the Legislature in March of 1971; and, in Ohio a personal income tax was introduced into the General Assembly on March 16, 1971.^ There seems to be a clear trend toward state adoption of the income tax and, in addition, in those states with an existing income ^Pennlman and Heller, State Income Tax Administration, p. 1. ^State Tax Guide Report Bulletin 13 (March 31, 1971) (Englewood C liffs, New Jersey; Prentice Hall, 1971), pp. 1-4.

19 -9 - tax, the trend is toward increasing rates and increasing relative revenues as opposed to other state taxes. See Table 1. For data on individual state Income tax rates, see Appendix II. Another discernible trend of state income taxes is one of increasing conformity to the federal law. Most of the federal laws and the changes in those laws eventually seem to be incorporated into the state income tax laws although often there is a considerable lag. Each state's use of federal Income tax rules is detailed in Appendix I and the corresponding notes. As can be determined from Appendix i, nineteen states follow a general method of conformity. Some twenty-seven states use a specified figure from the federal income tax return as a 6 computation starting point. The present level of conformity has come a long way since 1959 when only Iowa, Kentucky, Vermont, and Montana followed this practice.^ Gjb id.. p ^Pennlman and Heller, State Income Tax Administration, p. 237.

20 :ü CD D I I % TABLE I 8 STATE TAX REVENUES (Ail Figures in Millions) C5-3 CD C 3. CD CD D IC a o 3 O 3" & O c % Year Total Individual 1ncome Taxes Percent Corp. Income Tax Percent Sales & Gross Rec. Percent Prop. Percent Other Percent 1902 $ 156 $ $ $ ,608 $ *70 ' 4 $ , , , , , , , , , , , , , ,918 1, , , , ,243 3, , , , ,125 3, , , , ,380 4, , , , ,927 2, , , , ,400 6, , , , Source: Historical Statistics of the United States, Colonial Times to Commerce, Bureau of the Census, I960). Governmental Finances Issues (U.S. Dept, of Commerce, Bureau of the Census.) 1957 (U.S. Dept, of in 1958 and subsequent

21 CHAPTER I I THE CONFORMITY PRINCIPLE Conformity Is the method or the p rin c ip le o f keying the sta te income tax to the Internal Revenue Code. I t would appear that conformit y, in some degree or another, is becoming generally accepted, but is not w ithout opponents and v a lid arguments against i t. The main arguments against conform ity center around the in te rre la te d concepts o f loss o f state sovereignty, sta te revenue dependency upon the federal government through the federal tax law, equity to the taxpayer, and the concept dealing w ith c o n s titu tio n a l problems and arguments. The f i r s t three concepts are so in te rre la te d they should perhaps be discussed together. A ll o f these concepts are concerned w ith the retention by the state o f a control over its own a ffa ir s. is by d e fin itio n the use o f federal law fo r sta te purposes. Conformity When th is is done, the a va ila b le a lte rn a tiv e s to the state are lim ite d. State and federal objectives, may not always be the same and when a s ta te 's sovereignty is lessened, p o lic y c o n flic ts w ill in e v ita b ly re s u lt. This in i t s e lf would seem to question the wisdom o f conform ity to the In te r nal Revenue Code. In a d d itio n, any special features designed to make the tax more equitable to the taxpayers o f the sta te can not be in tro duced i f a conform ity p rin c ip le is follow ed; or i f special features are introduced i t is at the expense o f conform ity. When a sta te loses its sovereignty, its a b il i t y to make the law - 11-

22 its e lf; revenue dependency, in some degree or another, Is the result. Such dependency on the federal government differs largely with the income tax methods employed by the state as w ill be pointed out in a later section. Generally, however, it can be said that any changes in the Internal Revenue Code may have a substantial effect on the amount of revenue to be realized by a state that bases its income tax on that law. A d iffic u lty arises, especially for the state that bases its law on the current Internal Revenue Code and therefore automatically includes any changes in the law. For this state, d iffic u lty in projection of revenues and in providing for state revenue needs is the result. Presumably, if the Legislature was not in session in a year that the federal government made material changes in the Internal Revenue Code, the state could be caught high and dry without enough revenue to meet expenditures or in a situation with non-budgeted excess revenues. This unnecessary variation of revenue creates d iffic u ltie s and could necessitate the calling of a special session of the Legislature at wasted time and expense to the citizens of the state. It would also be d iffic u lt for administrators to run their programs and plan for the future when the availab ility of specified funds is uncertain. Therefore, as a practical matter, it would seem to be wise not to allow state income taxes to depend excessively on federal law. In addition to the preceding arguments, there are constitutional, arguments against conformity. States cannot tax interest on U. S. o b ligations, so conformity is limited by law. For those federal returns containing interest on U. S. obligations, an adjustment must be made before figuring the state tax.

23 -1 3 But, the much more serious constitutional consideration of conformity is whether the state can delegate its tax policy making powers to another body in this case the federal government. This question, of course, depends on the individual constitutions of the states and it appears that a sizable number of the states could adopt a policy of 8 conformity without a constitutional amendment. However, a recent Minnesota Supreme Court decision could have an effect on the adaptation of conformity. Minnesota keyed her income tax to that of the currently changing Internal Revenue Code in 1961, but the recent decision stated that a state legislature cannot delegate its legislative powers to an 9 outside source. If this decision is followed by other states, conformity may be greatly reduced or a change in state constitutions w ill have to come about. Many states have avoided this problem by keying their state income tax to the Internal Revenue Code as of a specific date, either updating it periodically or leaving it at that date. Other states have simply avoided the legal problem with an amendment to their constitution. The position of this paper is that conformity is a desirable approach and that the trend of states toward conformity is ju stified. Basically, there are two arguments for conformity re lie f to the preparers of tax returns and administrative advantages. It would seem that the increasing complexity of the federal income tax would furnish an Q Charles Travis Hayes, A Critical Study of Individual Income Tax Conformity in.kentucky (Columbia, Missouri: University of Missouri, 1968) p. 50. Estate Tax Guide Report Bulletin 9 (March 2, 1971) p. 2.

24 impetus fo r the states to provide fo r easy compliance and since the income tax is self^assessed, ease o f compliance would seem o f fu rth e r value. When a state conforms to the Internal Revenue Code i t assures i t s e lf th a t, fo r state income tax purposes, taxpayer compliance w il l be simple and fru s tra tio n, expense, inconvenience, and money costs w ill be reduced fo r the taxpayer. As conform ity eases taxpayer compliance, i t also reduces adminis tra tiv e d if f ic u lt ie s. Revenue can be collected more e f f ic ie n t ly and economically i f an active p ra ctice o f conform ity is follow ed. As stated e a r lie r, the income tax is e s s e n tia lly a self-imposed tax that requires honesty on the part o f the taxpayer and his fa ith in the a d m in istra tive organization to adm inister the tax f a i r ly. Fairness is usually taken to mean th a t equals are treated equally--m ore s p e c ific a lly that i f a taxpayer pays his r ig h tfu l amount o f taxes that someone who has the same amount o f income and le g a lly allowable exemptions, deductions, and credit s, is paying the same amount o f tax. What th is b o lls down to is fa ith that the ad m in istra tive organization makes sure th a t everyone pays th e ir legal tax l i a b i l i t y. The necessity fo r good adm inistration was i l l u s trated in the comment made in one book th a t, "th e miserable fa ilu r e of sta te income taxation p rio r to 1911 p la in ly demonstrated th a t the unprodded taxpayer is no taxpayer at a ll. " ^ ^ For an adm inistering organization to accomplish its job e ffe c tiv e ly i t must do the fo llo w in g th in gs; ^^Penniman and H e lle r, State Income Tax A d m in istra tio n, p. 113<

25 -1 5-1) educate and assist the taxpayer in the preparation of his return, 2) identify and locate the taxpayer and his income, 3) collect the tax, both current and delinquent, 4) check the mathematical accuracy of the tax returns and the honesty of the figures, 5) solve questions of equity, taxpayer disputes, and so forth. ^^ It is the position of this paper that the Internal Revenue Service can best accomplish the above objectives and that it would therefore be to the individual state's advantage to rely as much as possible on the Internal Revenue Service through conformity to the Internal Revenue Code since almost no taxpayers incur a state income tax lia b ility without also incurring a federal income tax lia b ility. By use of conformity, information reported on federal returns and checked and verified by the Internal Revenue Service is identical to information reported on state returns so that further checking and verification is either eliminated or minimized. There are several reasons why the internal Revenue Service can perform auditing functions better than individual state administering organizations. The 1RS over the years has built up an effective organization and the public has acquired a general awareness of their a b ility ; therefore, it can be reasonably assumed that taxpayers are not as conscientious about filin g state returns as they are federal returns. Out of financial practicality the states cannot hope to match the excellent enforcement machinery of the 1RS and their electronic data processing fa c ilitie s which were Installed in 1959 and have been said to represent the most important concept in tax administration Ib id., pp

26 since the adoption of withholding. In addition there exists a formal information exchange system by which the states have direct access to data reported on federal returns. Before 1950 such a system was informal and amounted to l i t t l e more than a transcript service. The formal system was the result of a 1949 conference called by the Treasury Department which resulted in agreements with South Carolina, Wisconsin, Colorado, Kentucky, and Montana. Although a beginning, the results of this program were not fully satisfactory and the system was not extended until 1957 when a comprehensive agreement with Minnesota led to the current extensive system of information exchange. Nor can the present cooperation between states and the federal government be considered static since numerous proposals for further federal-state cooperation have been suggested including collection of state income taxes by the Internal Revenue Service. In addition, states can make use of the growing body of federal decisions and administrative rulings and therefore save time and money in the settlement of taxpayer disputes. If any problems arose the taxpayer would firs t deal with federal authorities and the decisions made at that level would eliminate the need for further action at the state level. Not only does the state receive the administrative advantages, but the taxpayer avoids further.inconvenience and expense by not having to go through perhaps long and tedious discussions with state authorities. William H. Smith, "The Internal Revenue Service Meeting the Challenge of Tax Administration," Vital Speeches of the Day, Vol. XXXVI, No. 21 (August 15, 1970), p. 665.

27 However, as was so aptly pointed out in a national periodical, "Success of States in using the tape-swapping agreements to catch taxpayers therefore w ill depend to a considerable extent on how closely a State has based its own tax law and tax return on the federal models. In summary, it would seem to appear that there are overriding advantages to conformity. The disadvantages would seem to depend on the degree of conformity that the state uses. There are several things that can be done to aid conformity and yet w ill not significantly cause loss of state sovereignty, revenue dependency, or constitutional problems. In conforming states, such matters as rates, exemptions, and credits are usually le ft to the discretion of the legislature or the state tax administering organization. In addition, modifications can be introduced affecting the definition of income or deductions thus maintaining a degree of state sovereignty. However valid the arguments against conformity would seem to be, it should be recognized that there are definite practical limitations on how far states can go to individualize their income tax. At some point the costs of administering and auditing special features become prohibitive. In addition, the concept of income is generally well accepted and the extent to which one could d iffe r from the federal definition of income would appear to be minimal. ^^"For This Year's Tax Returns: The Closest Check Yet." U.S. News and World Report, Vol. LXIV, No. 10 (March 4, 1968), p. 73.

28 CHAPTER I I I CLASSIFICATION OF CONFORMITY METHODS Federal A djusted Gross Income Less Deductions Method Having presented the case for conformity, there is s t ill a question as to how best to implement such an approach. There are basically three methods of income taxation being used by states which conform to the federal law. The firs t method to be examined w ill be that of the Federal Adjusted Gross Income Less Deductions Method which was defined on page 4. This approach is the most common method of conforming to the federal law. One of the states using this method Is Montana whose case w ill be dealt with separately in another section. In essence, states using this method follow the federal law right down the line from gross income to itemized deductions. Federal tax credits are generally not allowed nor is the deduction of state Income taxes. Most states using this method do allow a deduction for federal income taxes. This method is one that is conducive to numerous modifications and states make use of this in matters of adjusted gross income, itemized deductions, exemptions, or tax credits. In addition to Montana,, the surrounding states of Idaho and North Dakota, as well as nine other states, use this method. See Appendix I. Idaho adopts the federal law as of a particular date, currently January 1, 1970, with certain modifications. Idaho taxpayers are instructed to prepare their federal return fir s t and then to base -18-

29 their Idaho figures on the federal amounts. Idaho taxpayers start with the federal adjusted gross; line 18 on form 1040, 1970; and apply the applicable modifications. There are ten possible modifications and it can be reasonably assumed that a substantial number of returns w ill require some adjustment. Itemized deductions for Idaho are basically the same as for the federal government except that the minimum standard deduction is not allowed nor are the franchise and state income taxes. The resident receives a credit against the Idaho tax for income taxes paid to another state i f a reciprocal agreement exists. As stated above. North Dakota also uses the Adjusted Gross Income Less Deductions Method. The starting point for taxpayers is the federal adjusted gross income figure. Most North Dakota taxpayers probably have to adjust their federal tax figures for North Dakota tax purposes. The federal itemized deductions are automatically allowed except for the unusual feature of allowing all medical expense. The only other states following this practice are Mississippi and Minnesota. Arizona differs by having no floor on the deduction, but they do lim it the deduction to $1,200 for taxpayers over 65. Federal Adjusted Gross Income Method The second method to be examined is the Federal Adjusted Gross Income Method. Basically, this method uses the federal adjusted gross income figure and disallows itemized deductions. Currently, all states using this method apply a fla t rate as opposed to a progressive rate

30 on taxable income. figure is also made. Some modification of the federal adjusted gross Presently, there are three states using this method Indiana, Michigan, and Illin o is. In addition, there is a proposal before the Ohio General Assembly for an income tax using this method. Indiana became the firs t state to use the Federal Adjusted Gross Income Method in I 963. From the federal adjusted gross income figure, Indiana taxpayers subtract exemptions and income exempt from state tax by law. Taxpayers add all federally allowed deductions for state income or property taxes. Itemized deductions are not allowed. Deductions are limited to business deductions only. The current Indiana rate of 1% is then applied. Compliance in Indiana is relatively easy and since there are only four modifications most taxpayers have few adjustments. However, some d iffic u lty in this area is created because Indiana follows the federal law in effect January 1, I 969. By specifying the Internal Revenue Code of a specific date, subsequent changes are not automatically incorporated into the law. Michigan taxpayers have the option of electing the current federal adjusted gross income figure as a computation starting point, or the federal adjusted gross figure based on the Internal Revenue Code as of December 31, The reason for the use of the election of a particular date is because of constitutional arguments concerning the delegation of the state legislature's power. This point w ill receive more detailed attention in a later section. Although there are a number of modifications, compliance is relatively easy for most Michigan taxpayers. There are no itemized

31 deductions nor an optional standard deduction. A tax credit is allowed for income taxes paid to other states as well as credit for Michigan city income taxes, property taxes, and contributions to educational institutions. The starting computation figure for Illin o is taxpayers is the federal adjusted gross figure based on the Internal Revenue Code in effect on January 1, treatment nor are dividends. Capital gains are not given any special No itemized deductions nor optional standard deduction are allowed either. Percent of Federal Tax Method The third method to be examined is the Percent of Federal Tax Method which is currently the law in Alaska, Nebraska, Vermont, and Rhode Island. This method has the closest tie -in to the federal law since all provisions are im plicitly accepted for the state income tax because the base for the state income tax is the federal income tax lia b ility. Alaska was the firs t state to use this method having adopted it in 1963 for tax years 1964 and thereafter. The starting computation point for the Alaska taxpayer is the federal adjusted gross income figure to the extent that it is Alaska income. Cost of living allowances which are exempt from federal tax are added. Other common modifications may also apply. Most Alaska taxpayers w ill have to recompute their federal income tax lia b ility. The Alaska tax lia b ility is calculated as a fla t rate, currently 16%, of the federal tax as adjusted based on federal rates in effect December 31, This method allows

32 the use of federal tax credits before applying the Alaska tax rate. Both Nebraska and Vermont enacted the Percent of Federal Tax Method In 196? to take effect after January 1, The Nebraska tax is a fla t percentage of the adjusted federal income tax lia b ility without regard to federal tax credits. Rates are fixed by the State Board of Equalization by November 15 of the previous year. Since the state board has this fle x ib ility in the fixing of rates, the effect of any federal law changes that alter total revenue can be adjusted and their effects eliminated. The Vermont tax applies a fla t percentage to the adjusted federal income tax lia b ility. For Vermont, the adjusted federal income tax lia b ility accepts the retirement income, investment, foreign tax, and tax-free covenant bonds credits; but disallows any other credits or any surtax. Credits are allowed against the tax for any excess income taxes paid to the federal government due to tax changes after January 1, 1968, plus 6% interest. If any modifications apply, the advantages of conformity are considerably reduced. Rhode Island has a new income tax law which w ill become effective on tax years after December, The tax base for the Rhode Island tax is also tied directly to the Internal Revenue Code with a computation starting point being federal adjusted gross income.

33 CHAPTER IV ANALYSIS OF THE METHODS As is readily apparent from the preceding sections, there are major differences between the various methods of conformity. Each method has its own advantages and disadvantages. Federal Adjusted Gross Income Less Deductions Method The Federal Adjusted Gross Income Less Deductions Method, the most widely used method, has the specific advantage of providing a state income tax form most similar to the federal form. Because of this, there is apt to be easier taxpayer compliance, since fillin g out the state form is largely an Item for item duplication of the federal form. The retention of state sovereignty and the recognition of individual taxpayer situations are best facilitated by this method since, with the inclusion of itemized deductions, there are more items to which the state can give special treatment. The amount of federal exemptions is not automatically followed in this method as they are in the Percent of*federal Tax Method nor is the progress!vity of the rates. Therefore, when state objectives d iffe r from federal objectives, matters of income, deductions, exemptions, credits, or rates may be adjusted to meet those objectives. There are, however, several disadvantages to this method. First, by allowing itemized deductions, the tax base is narrowed. A broad " 2 3 -

34 tax base is generally considered desirable since a large base permits lower rates in order to achieve the same amount of revenue. There Is a certain psychological value in lower rates as taxpayers tend to per^ ceive the tax system as being less drastic. Second, states using the Federal Adjusted Gross Income Less Deductions Method usually have a number of modifications. Idaho and North Dakota each have ten modifications without regard to exemption differences. Since this method has more items to modify than the other methods, the liklihood for a large number of adjustments is greater. By permitting several modifications further auditing and mechanical checking is necessitated. Greater inconvenience to the preparer also results. if states did not desire to incorporate any modifications in its system, other than those legally required by constitutions, it would seem that the Percent of Federal Tax Method would better fa c ilita te such an approach. Third, use of the Federal Adjusted Gross income Less Deductions Method creates d iffic u lty in administrative verification simply because there are more items to verify. This method requires the use of a large form which is its e lf cumbersome the use of the more efficient IBM-type card form is not fa cilitated by this method. For many taxpayers it is beneficial to itemize on the state return even though they do not itemize on the federal and by so doing the entire burden of checking and verifying itemized deductions is put on the state. This situation usually arises because of the allowance of federal income taxes as a deduction on the state return. Currently, seventeen states allow this practice. See Appendix I.

35 Fînally, there is the matter of itemized deductions themselves. In addition to the administrative and compliance d iffic u ltie s associated with itemized deductions, there are serious questions as to the fairness and need for these deductions. The rationale for allowing itemized deductions is based essentia lly on the following: 1) to allow for the deduction of certain items that are costs of obtaining nonbusiness income such as deductions for interest, child care expenses, and most of the miscellaneous deductions, 2) to relieve undue hardship effecting a b ility to pay such as deductions for medical expenses and casualty losses, 3) to encourage the direction of resources to socially desirable objectives such as the deduction for charitable contributions, and 4) to fa c ilita te intergovernmental cooperation such as the deduction for state and federal taxes. However, the d iffic u lty of allowing itemized deductions is that,... while the time-honored deductions allowed may have some relationship to the a b ility to pay, their relationship is not greater or subject to any sounder economic ju stification than could be urged for numerous other personal expense items which are not deductible. 5 This can be made more apparent by analyzing several of the commonly itemized deductions individually. Contributions were firs t allowed as a deduction in 1917 out of fear that high taxes would decrease the amount of contributions to various institutions and charitable organizations. By allowing their deduction, the relative cost of a contribution Is lowered thus providing an incentive to contribute. Whether this is valid at the national level is Immaterial to this study, but there is serious question as to whether allowing the deduction on ^^Richard Goode, The Individual Income Tax (Washington, D.C.: The Brookings lnstitute~t964), p. I Dean E llis, "The Battle For Income Tax Simplification The Oregon Story." National Tax Journal, Vol. XV, No. 3» (September, 1962),

36 26 the state level acts as an incentive. In fact, a study of the state of Oregon and surrounding states determined that there was no difference in the level of contributions between the income tax states and the 16 sales tax states. Taxes are basically payments for consumption of public goods and services. In this regard, there is no more justification for their deduction than for any other consumptive expenditure. With respect to intergovernmental cooperation, the deduction does mitigate against the danger of confiscatory combinations of tax rates by various governmental units. However, the threat of confiscation would seem to be brought on mainly by the federal income tax system and thus outside the interests of this study other than to the extent that such deduction serves to make the tax bite less painful. The allowance of property taxes and interest as deductions are other examples of allowing a deduction of a purely consumptive nature that has no more justification than any other personal expenditure. Deductions for taxes and interest on homes also serves to discriminate against the renter and can hardly be considered fa ir. The deductions for medical expenses and for casualty losses would seem more ju stified than the other deductions in terms of relieving hardships brought on by involuntary expenditure. The key word is involuntary and it should be kept In mind that in the case of medical expenditures many are of a voluntary nature. in addition there is a question as to how much re lie f is given to the taxpayer in the form of state tax reduction due to the relatively low rates imposed by l^lbid., p. 253.

37 the states. Concerning casualty losses, the floor of $100 on such losses appears questionable. It would seem that if re lie f of hardship was the rationale for the deduction, that a floor related to income would be better. A question of fairness is also involved here as was pointed out in one book. "Through the casualty loss deduction, the government in effect acts as a coinsurer, with its participation varying according to the taxpayer's marginal rate."^^ In summary when one adds the dubious rationale behind itemized deductions and the narrowing of the tax base with disadvantages from both an administrative and compliance viewpoint, the removal of itemized deductions would seem to be indicated. Percent of Federal Tax Method The advantages of the Percent of Federal Tax Method all revolve around the simplicity afforded by this method. It is the simplest of all the conformity methods. First, there is the extreme ease of calculation with this method since all that is required is to apply a percentage to the taxpayer's previously calculated federal income tax lia b ility. Depending on the state objectives, taxpayers are usually required to make few modifications. See pages 21 and 22. Second, there Is real ease in administering the tax. Almost all checking and auditing is le ft up to the federal government. The federal tax lia b ility is assumed to be correct, if the Internal Revenue i^goode, The Individual Income Tax, p. 163.

38 - 28- Service finds fault with it later, the state can adjust the state tax lia b ility at that time. All that remains to the state is the mechanical process of verifying the lia b ility computation. Third, because of the close tie to the federal, the advantages of conformity are heightened. This method requires the least amount of exchange of information between the federal and state governments making for even greater administrative savings. Also, avoidance would appear to be very d iffic u lt under this method. However, the above advantages are seriously limited with the introduction of modifications to the federal figures. In any case where income that is state tax exempt under law, i.e. interest from U.S. ob ligations, was reported on the federal return an adjustment must be made. As was noted on pages 21 to 22, the four states currently using this method have initiated other modifications and adjustments to arrive at an adjusted federal tax lia b ility. In this regard, the use of a non- current Internal Revenue Code requires additional adjustments. As with all methods, when adjustments and modifications are required, the advantages of conformity are reduced, but any modification made using the Percent of Federal Tax Method necessitates a complete refiguring of the federal tax. A major criticism of this method is the limitation of state alternatives. This method im plicitly embodies all of the federal provisions by basing its tax on the end figure on the federal return. The disadvantages of this type of conformity, through the loss of state sovereignty and through revenue dependency on the federal law, were pointed out on pages Those arguments are especially valid

39 -29 concerning the Percent of Federal Tax Method, for the only real course the state has in determining its own finances is in the setting of rates. Modifications must be kept at a minimum if any of the conformity advantages of this method are to be maintained. States have different ways of adapting to this problem as was noted on pages Nebraska uses the federal tax lia b ility without regard to federal tax credits and allows the State Board of Equalization to have authority to change the rates. So the state is put in a d iffic u lt position. Complete conformity severely limits state sovereignty and may not, in fact, be legally possible; while incomplete conformity, through the use of adjustments and modifications, destroys the very advantages that were sought by conformity in the firs t place. Federal Adjusted Gross Method The distinctive feature of this method is the disallowance of itemized deductions, which were discussed on pages There are numerous advantages to this method. First, the calculation of the tax is a relatively easy matter since you use only the one federal figure, federal adjusted gross income. In fact, calculation of the tax is probably simpler under this method than any of the others considering the effect of modifications. Obviously, the Federal Adjusted Gross Income Less Itemized Deductions Method is more cumbersome because of the inclusion of itemized deductions. Because of the fewer items involved, it can reasonably be expected that there w ill be fewer modifications using the Federal Adjusted Gross Income Method. The Percent of Federal Tax and the Federal Adjusted Gross Income Method would be simple to calculate for taxpayers who do not have to

40 30- make any modifications. Both essentially require the use of only one figure from the federal return, federal tax lia b ility and adjusted gross income, respectively. The difference would be that in the Federal Adjusted Gross Income Method a subtraction for exemptions might be necessitated before applying the state tax rate. But it seems inevitable that most states are going to have at least some special modifications. With the introduction of even a single modification, the calculation advantages of the Percent of Federal Tax Method are seriously reduced as the federal tax lia b ility must be recalculated before applying the state rate. No recalculation is necessary under the Adjusted Gross Method; although, certain additions and deletions might be necessary. Also, the concept of income is reasonably well established while concepts of allowable deductions are more nebulous. Therefore, it is reasonable to assume that fewer modifications would apply to the Federal Adjusted Gross Income Method than for either of the other two methods. Second, use of the Federal Adjusted Gross Income Method makes for a larger tax base than the other methods. Although many reductions in the tax base may be considered desirable, the advantages of keeping the base as broad as possible cannot be disregarded. See pages Third, concerning retention of state sovereignty, the problems \ of the Percent of Federal Tax Method are not present with the Federal Adjusted Gross Income Method. It is the position of this paper that enough state sovereignty can be maintained through the limited use of modifications to adjusted gross income and through the use of exemptions, tax credits, and tax rates. Fourth, the administrative advantages of conformity are readily

41 apparent in this method. The factors relating to ease of taxpayer compliance likewise relate to ease of administration by the state. There is an exchange of only one figure between federal and state, and all that remains to be checked by the state are any modifications and the mathematical accuracy to the return. Since itemized deductions do not come into play, state auditing can be concentrated oyi matters of unreported income and on the verification of modifications to income. Finally, this method Is fairer to the taxpayer because of the disallowance of itemized deductions. See pages 24^27. Taxpayers with the same Income and exemptions w ill pay the same tax. If adjustment for hardship is deemed necessary, such as hardship brought on by medical expenses, such adjustment can come about through the use of a tax credit. However, matters regarding equity and taxpayer fairness are best left up to the federal government when those matters have an adverse effect on taxpayer compliance, state administration, and revenue potential. The arguments against this method basically consist of arguments for itemized deductions and arguments showing the loss of state sovereignty as compared to the Federal Adjusted Gross Income Less Deductions Method. These arguments have been dealt with in earlier sections and in the last few pages. Their case is weak. The use of the Federal Adjusted Gross Income Method retains the desirable amount of state control over its tax policies and revenue needs and yet maximizes the ad- ' vantages offered by conformity. In summary of Part I, state income tax development was traced up to the present. The conformity principle was examined in detail and the paper concluded that conformity was a desirable objective.