A Fair Share Tax Proposal for Pennsylvania: How to Raise Revenues While Sparing Most Pennsylvanians

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1 412 N. 3 rd St, Harrisburg, PA By Marc Stier and Stephen Herzenberg December 20, 2016 A Fair Share Tax Proposal for Pennsylvania: How to Raise Revenues While Sparing Most Pennsylvanians Executive Summary The State of Pennsylvania desperately needs new, recurring revenues, both to overcome a serious structural deficit that may lead to devastating budget cuts and to restore and enhance public education, human services and environmental protection. If Pennsylvania keeps taxing under current law, while spending to maintain even the current level of services, it will face a large and growing structural deficit. For the budget year beginning July 2017, the lowest estimate of that deficit is $1.7 billion. By the structural deficit climbs to $3 billion and keeps growing by more than $175 million per year thereafter. One barrier to raising revenues is the reluctance of legislators on both sides of the aisle to place additional taxes on Pennsylvania s poor and middle-class. That reluctance is well motivated. Over the last 25 years, incomes for the richest Pennsylvanians have been rising fast while incomes for all other Pennsylvanians have been stagnant. Despite that, Pennsylvania s tax system is profoundly unfair, as it taxes those with the lowest incomes at a rate triple those with the highest incomes. Moreover, the structural deficit is not a result of higher spending but, rather, of cuts to taxes, especially corporate taxes, that fall on the very rich. The uniformity clause of the Pennsylvania Constitution which prohibits the taxation of any class of income at more than one rate makes it difficult to create a tax system that places more of the burden of state government on those most able to afford it. But there is much that can be done within the limits of the Constitution to raise revenues fairly. This policy brief proposes a series of tax increases that, taken together, would close the structural deficit and provide revenues necessary to meet the needs of the state, while sparing low- and middle-income people from most of the additional tax burden. We propose that the state: Bifurcate the personal income tax into two parts and raise the tax rate on what we call income from wealth dividends; net income from a business, profession, or farm; capital gains; net income from rents, royalties, patents, and copyrights; gambling and lottery winnings; and income from estates or trusts. Raising the tax on income from wealth from the current 3.07% to 4.0% would bring in an estimated $788 million in new revenue. At a rate of 4.5%, the tax would bring in $1.2 billion. Over two-thirds of the new revenue would come from families in the top 5% of income; 82% would

2 come from families with incomes of $101,000 or more. Raise the tax rate on wage and interest income from the current 3.07% to 3.25%, while expanding the tax forgiveness program to reduce taxes on those with the lowest incomes. This would raise revenues by a net of $375 million. Expand the sales tax base to include goods and services that are more likely to be purchased by those with high, rather than low, incomes. Combined with a credit to low-income families for the sales tax they pay, this would net $338 million in new revenue. Eliminate corporate tax loopholes by instituting combined reporting of corporate taxes while lowering the tax rate. This would net $200 million in new revenue. Institute a modest severance tax of 6.5% on natural gas drilling with an impact fee credit. This would raise $218 million. Raise the minimum wage to at least $10.10 per hour, which would increase income and sales tax revenues while reducing state expenditures for Medical Assistance. The net contribution to deficit reduction would be $225 million. Together, these proposals would generate $2.56 billion which would close the structural deficit and provide some margin for investment in education, human services, and the environment. Moreover, these revenues would not only recur, but increase over time, freeing the state from the vise of structural deficits far into the future. P a g e 2

3 THE FISCAL CLIFF IN 2017 AND THE NEED FOR NEW REVENUES Pennsylvania again faces a fiscal cliff in the year that begins on July 1, According to the Independent Fiscal Office (IFO), maintaining the current level of government services and investments will require $1.7 billion more in revenue than the state will take in under current law. 1 The IFO projects the structural deficit the deficit in a budget that maintains current services will grow in future years. If the state generates revenue under current laws and maintains the current level of services, the projected deficit reaches $3 billion in and continues to grow by $175 million per year thereafter. And even at that level of spending, the state s contribution to the education of our children, the provision of services to the elderly, disabled, and ill and the protection of our environment would remain inadequate. The alternative to raising new revenues is severe cuts to the only areas of the state budget that are not mandatory: education, human services, and environmental protection. We ve seen what budget cuts of this magnitude do to the people of Pennsylvania, and we know that the consequences are unacceptable. WORKING PEOPLE AND THE MIDDLE CLASS SHOULD BE SPARED AS FAR AS POSSIBLE While the state desperately needs new revenue, working people and the middle class should not be asked to pay more taxes, in so far as possible. This is true for two reasons: First, as figure 1 shows, income inequality has been rapidly growing in Pennsylvania. Incomes have been stagnant for the bottom 99% while they have grown rapidly for the top 1%. Given this extraordinary growth in income inequality, there is little justification for increasing taxes on working people or the middle class. Indeed, a truly equitable tax system made impossible by the uniformity clause of our Constitution, which prohibits taxing any class of income at higher (or graduated) rates as income increases would place the burden of closing the structural deficit on the richest Pennsylvanians. 1 Independent Fiscal Office, Commonwealth of Pennsylvania Economic and Budget Outlook: Fiscal Years to ; P a g e 3

4 Figure 1 Second, while a tax system that aims to correct growing inequality would tax those with higher incomes at a higher rate than those with lower incomes, Pennsylvania s tax system does the opposite. Taxes in Pennsylvania today are extremely unfair because they put the burden of taxation on those least able to pay, and they have been that way for decades. Pennsylvania is one of the terrible ten states with the most unfair tax systems in the country as identified by the Institute on Tax and Economic Policy (ITEP). 2 Figure 2 shows that people in the quintile with the lowest incomes pay 12% of their income in taxes while those in the middle quintile pay only 10.3% and those in the those in the top 1% pay only 4.3%. This is backwards. An equitable tax system is one in which those with the highest incomes pay a higher, rather than lower, percentage of their income in taxes. Our tax system is unfair both because we rely heavily on sales and property taxes that fall more heavily on lower-income groups and because our state s flat income tax falls nearly equally on all income groups (unlike graduated income taxes, which impose higher tax rates as income increases). 2 Institute on Taxation and Economic Policy, Who Pays, Fifth Edition, January accessed May 7, P a g e 4

5 Figure 2 As the tables in the appendix show, every one of the states in close proximity does a better job than Pennsylvania and sometimes much better of limiting the tax burden on those with low incomes. A third reason to limit the burden of new taxes on working people and the middle class is that the fiscal cliff is largely a product of recent reductions in corporate taxes. We do not face a structural deficit because government is larger than it has been in the past. The opposite is true. As we have demonstrated, government in Pennsylvania is smaller today than it has been for most of the last 25 years. And taxes have not been reduced for individuals and families. Our fiscal difficulties arise because we have cut corporate taxes, which fall most heavily on those with higher incomes. From to , taxes on corporations were, on average, 22.25% of all general fund revenues. If taxes on corporations provided the same share of general revenues in , total general revenue would be $2.39 billion higher than projected this year. There would be no structural deficit, and there would be more money to fund education and other vital public services. The structural deficit in Pennsylvania is not something that just happened. It was created by an effort, begun under Governors Ridge and Rendell and then heightened under Governor Corbett, to reduce taxes on the corporate sector. Not only were these tax cuts fiscally irresponsible in that they were not paid for P a g e 5

6 with new revenues, but there is no evidence that job growth in Pennsylvania relative to the rest of the country has improved. 3 Thus, the most appropriate way to respond to the fiscal cliff we are facing is to raise revenues not on working people and the middle class but on those who can most afford it: corporations and the wealthy. A PROGRESSIVE REVENUE PROPOSAL We do not know how Governor Wolf will propose to raise revenues in 2017, and we do not know what state legislators will accept. Under the current political circumstances, the General Assembly may not be willing to raise revenues enough or from the right people. But now is the time to take a longer-term perspective and set forth ideas for creating a more equitable tax system in Pennsylvania. Here we propose five tax ideas (and another policy, raising the minimum wage) that can be implemented in the near future and that would go far in protecting low- and middle-income Pennsylvanians while raising substantial amounts of new revenue. We leave aside for now our recent proposal to partially or fully eliminate the uniformity clause, which would allow for an even more equitable tax system. Note that our estimates of the revenue that these proposals will raise are based on our analysis of this year s budget, (and for the sales tax expansion proposal, last year s budget). We expect that revenue from these proposals in will be slightly higher than those found in this paper. Tax on Personal Income from Wealth We put forward our proposal for creating a tax on income from wealth in the spring of It was soon turned into legislation introduced by Senators Haywood, Costa, Hughes, Leach and Farnese. Instead of increasing the personal income tax (PIT) rate on all income, we propose bifurcating the current PIT. We would create a new tax on what we call income from wealth, which, as we define it, includes dividends; net income from a business, profession, or farm; capital gains; net income from rents, royalties, patents, and copyrights; gambling and lottery winnings; and income from estates or trusts. If we tax income from wealth at a rate of 4.0% rather than the current rate of 3.07%, the state would raise $788 million more in revenues. Income from wealth tends to be concentrated among those with higher incomes. Thus, as figure 3 shows, creating a 4% tax on income from wealth would add little to the tax burden on low- and middle-income Pennsylvanians and far more on the top 5% and 1%. Families in the lowest 20% arranged by income, with incomes less than $22,000, would on average pay only $4 a year. Families in the middle 20%, with incomes between $41,000 and $65,000, would on average pay only $31 a year. Even families in the 80 th through 95 th percentile, making $101,000 to $201,000, would only pay an additional $115 a year. It is only when we get to the 95 through 99 th percentile that taxes rise by more than about $2 per week. In that group, incomes range from $201,000 to $463,000 and families would on average pay $617 more per year. In the top 1%, with incomes $463,000 and above, the average family would pay $5,306. As figure 4 shows, 67% of the revenues raised would come from the top 5% of families, while 82% would come from families with incomes of $101,000 and above. 3 Pennsylvania Budget and Policy Center, Despite a Decade of Business Tax Cuts, Pennsylvania s Job Growth Ranking Has Not Improved, February 4, 2014; P a g e 6

7 Figure 3 The typical middle class family in Pennsylvania would pay an additional $31 a year under a proposal to tax income from wealth at 4%. P a g e 7

8 Figure 4 82% of the revenue generated by a 4% tax on income from wealth would come from families earning $95,000 or more. If the tax rate on income from wealth were 4.5% instead of 4%, it would bring in another $400 million more per year, for a total of $1.2 billion in new revenue. And, again, two-thirds of the revenue from the tax would come from the top 5%. As table 1 shows, if the rate is raised to 4.5% on income from wealth, families in the bottom 20% of incomes would pay on average $6 per year. Those in the middle 20% would pay on average $48. Those in the 95 through 99 th percentile would pay $949. And those in the top 1% would pay $8,157. Table 1 Change in Taxes by Income Group--4.5% tax on Income from Wealth Top 1% with incomes $426,000 and over $8,157 Next 4% with incomes between $184,000 and $426,000 $949 Next 15% with incomes between $95,000 and 184,000 $183 Fourth 20% with incomes between $60,000 and $95,000 $88 Middle 20% with incomes between $38,000 and $60,000 $48 Second 20% with incomes between $20,000 and $38,000 $18 Lowest 20% with incomes less than $20,000 $6 Source: Pennsylvania Budget and Policy Center (PBPC) based on Institute on Taxation and Economic Policy (ITEP) analysis P a g e 8

9 Personal Income Tax Increase with Expanded Income Tax Forgiveness While creating a tax on income from wealth is the most fair way to raise new tax revenue under the uniformity clause, if additional revenues are needed, a small increase in the tax rate on wages and interest, combined with an expansion of the tax forgiveness program, will also generate new revenue without placing a substantial burden on families in the bottom 60% of incomes. We estimate an increase in the tax on wages and interest from the current 3.07% to 3.25%, combined with expanding income tax forgiveness by raising the income per taxpayer that qualifies for such forgiveness from $6,500 to $8,700 (increasing the income tax threshold for a family of four to receive full or partial income tax forgiveness by $4,400, to $38,650), would raise $495 million. (Note that this does not count the revenue from increasing the tax rate on income from wealth [i.e., from classes of income other than wages and interest] because that has already been included in our earlier estimate of the revenue from raising the tax rate on income from wealth to 4%.) Table 2 shows the impact of a 3.25% tax rate on income from wages and interest, combined with expanded income tax forgiveness on different groups of families. This proposal reduces taxes for families in the lowest 20% of incomes and increases them modestly for the second and middle 20% of families. At higher levels of income, the tax burden increases slightly. Table 2 Change in Taxes by Income Group--3.25% Income Tax on Compensation and Interest Income with Expanded Tax Forgiveness Top 1% with incomes $426,000 and over $836 Next 4% with incomes between $184,000 and $426,000 $283 Next 15% with incomes between $95,000 and 184,000 $170 Fourth 20% with incomes between $60,000 and $95,000 $82 Middle 20% with incomes between $38,000 and $60,000 $29 Second 20% with incomes between $20,000 and $38,000 $7 Lowest 20% with incomes less than $20,000 -$21 Source: Institute on Taxation and Economic Policy Sales Tax Base Broadening Sales taxes are usually problematic from the point of view of fairness because they tend to take a larger share of the income of those with less income. People with lower incomes spend most of their income while those with higher incomes save some of their income. But, as we have argued elsewhere, the sales tax can be made more equitable by expanding the sales tax base to include goods and services that are now untaxed, but that are mainly consumed by those with middle and high incomes. Our proposal, which is found in table 3, proposes expanding the sales tax to goods and services that are largely consumed by those with middle and high incomes. P a g e 9

10 Table 3 Sale tax base expansion revenues in millions Goods Aircraft 5.6 Airline Catering 0.8 Rental of films 22.4 Investment in bullion and coins 9.4 Catalogs and direct mail advertising 3.6 Services Dry-cleaning 36.6 Recreational parks 13.7 Spectator sports 73.6 Theater, dance 96.5 Amusement and recreation Museums, zoos 27.3 Total Source: Governor s Executive Budget, , pp, D46-D68 Expanding the sales tax to services consumed mostly by the affluent not only makes it more equitable, but also corrects a flaw in the Pennsylvania sales tax that contributes to a rising structural deficit over time. As people consume relatively more (untaxed) services and fewer (taxed) goods, the revenue generated by the Pennsylvania sales tax does not keep up with the overall growth of the economy. Because of this, base expansion to include more services enables the sales tax to grow with incomes and generate more revenue into the future. We do not have precise estimates about the impact of this proposed expansion of the sales tax base on the fairness of the tax system, but the goods listed in table 3 were selected based on the expectation that they are largely consumed by those with higher incomes. Most of the services in table 3 are for entertainment. (The exception is dry cleaning, which we also believe is consumed mostly by higher-income households.) In a previous brief, PBPC showed that, based on the (2007) Consumer Expenditure Survey, it is mainly those with high incomes who pay for entertainment admissions, and especially for those that are expensive. Figure 4, reproduced from that earlier brief, shows that families in top 20% by income purchase more than half of all entertainment admissions. The bottom 20% of families purchase only 4% of entertainment admissions. As a share of income, the amount of money spent on entertainment admissions is similar across all income groups, but slightly higher for upper-income groups. Therefore, with respect to tax fairness, a tax on entertainment admissions would be similar to Pennsylvania flat income tax. P a g e 10

11 Figure 4 Low-income Sales Tax Credit To make a selective broadening of the Pennsylvania sales tax more equitable, we propose offering lowincome families a refundable credit that would compensate them for the sales tax they pay. We are not suggesting a rebate on the actual sales tax paid by individuals and households. The record-keeping demands for such a rebate would be impossibly onerous, and a rebate program tied to actual sales taxes paid might well trigger an objection under the uniformity clause of the Pennsylvania Constitution. But there is no constitutional barrier to creating a program under which low-income Pennsylvanians can receive a refundable credit that offsets part or all of what they pay in sales tax. We propose making most families eligible for a refundable sales tax credit if they would qualify for 100% income tax forgiveness (with the expansion of income tax forgiveness proposed above). Under that plan, a married couple with two children would receive this credit if its income was $36,400 or below. We assume here that the sales tax refundable credit is designed to cost $300 million. A this level, a family of four with two children that has an income of exactly $36,400 would likely receive a benefit of over $ We propose that Pennsylvanians file for the low-income sales tax credit once a year, at the same time they file their personal income tax form. Those eligible for full or partial income tax forgiveness would also be eligible for the sales tax credit. The sales tax credit will be deducted from any income tax owed to the state. Those who receive a refund on their income tax payments will have the sales tax credit added to their refund amount. And those who do not pay any income tax will be able to file for a sales tax credit refund. 4 In the 2014 tax year, the most recent for which statistics are available, income tax forgiveness cost Pennsylvania $282 million or an average of $229 per taxpayer eligible for tax forgiveness. There are on average about two taxpayers per tax return in Pennsylvania so a family of four could be expected to receive twice as much forgiveness, or $458. In addition, a family of four at the maximum income eligible for receiving sales tax forgiveness would receive more forgiveness than the average for a family of that size. For the 2014 income tax forgiveness on which these rough estimates are based, go to this Department of Revenue web page, table 5. P a g e 11

12 As the amount they receive from the state increases with earnings, up to the eligibility limit, the sales tax credit would strengthen the incentive to participate in the job market and work additional hours. Corporate Tax Reform We have long called for reforming the Corporate Net Income Tax by instituting combined reporting rather than the separate accounting system we currently use. Separate accounting requires corporations to pay taxes on the profits they make in Pennsylvania, but the manner in which in-state profits are calculated allows corporations to shift profits from a state with a high or moderate corporate income tax rate to one with a low or no corporate income tax. Frequently that state is Delaware, which is why this tax provision is often called the Delaware Loophole. Corporations shift profits out of Pennsylvania by charging their instate operations excessively for components that are brought into the state, for administrative overhead costs, or for use of a trademarked corporate or product name. Under the combined reporting system, all of a corporation s profits are added together and a portion is assigned to a particular state based on some formula that reflects the level of its activity, such as its sales, in that state. Combined reporting for corporate income taxes has now been adopted by a majority of the states not only because it prevents corporations from using sham accounting to avoid taxes, but because it also creates a level playing field between large multi-state corporations, which can take advantage of the Delaware Loophole, and smaller, in-state corporations that cannot do so. And, because combined reporting increases corporate tax revenue, it is possible to lower taxes for all corporations while still bringing in more revenue. Much of the benefit of a lower corporate tax rate flows to smaller, in-state corporations. It is difficult to estimate precisely how much more revenue Pennsylvania can raise through combined reporting at what level of corporate tax. But based on the last two Governor s Executive Budgets, we believe that Pennsylvania can raise at least $200 million more from corporate taxes while reducing the tax rate considerably from its current 9.99% level. 5 We propose that, in the first year the state institute combined reporting and then reduce the corporate tax rate to 8.99%. Then it can gradually lower the rate so that the corporate income tax brings in $200 million more than it is currently projected to bring in, adjusted for inflation and growth in the state s Gross Domestic Product. A Severance Tax on Natural Gas Drilling A severance tax on natural gas drilling continues to be the tax that is most broadly supported by Pennsylvanians. Also, the burden for the tax falls mostly on the natural gas industry. And to the extent it 5 In 2015, Gov. Wolf proposed implementing combined reporting while cutting the CNI rate in half over several years, to 4.99%. By full phase in, this cut in the rate (along with one other smaller change) was expected to reduce revenue from the CNI to $1.77 billion in from $2.49 billion in (see Governor s Executive Budget, p. C1-12). Thus, a 50% cut in the rate was expected to reduce revenue by only 29% as a result of additional revenue from combined reporting and, presumably, some projected corporate income growth over the four years from 2015 to If we assume growth of corporate income of 3% annually, this implies combined reporting was anticipated to raise tax receipts by about a quarter compared to separate company reporting. The 2016 Governor s Executive Budget, p. C1-14 projects that the CNI will raise $2.88 billion this year: one quarter of that is $720 million. Based on these rough calculations, the CNI at 8.99% would raise well over $200 million. P a g e 12

13 falls on consumers, most of them are not Pennsylvanians, as most natural gas produced in Pennsylvania is ultimately consumed out of state. Given the low price of natural gas, the Governor s Executive Budget (p. C-14) estimated that a 6.5% severance tax with an impact fee credit would bring in $217.8 million in its first year but raise $507 million by year five. If natural gas prices recover more fully, it could raise amounts closer to a billion dollars per year in the long run, as projected in the Governor s Executive Budget (p. C-12). Raising the Minimum Wage Policies that raise the wage and benefits floor can help increase spending and, in the process, boost local economies. An increase in the minimum wage to $10.10 an hour would raise the wages of 1.3 million Pennsylvanians, making a small contribution to reducing economic inequality in the state. An increase in the minimum wage will also help balance the budget of our state for two reasons. 6 First, hiking the minimum wage increases both sales and income tax revenues. We estimate that, had we raised the minimum wage this year, tax revenues would have increased by $121.5 million. Second, as incomes rise, more Pennsylvanians would be eligible for medical assistance provided under the Medicaid expansion rather than traditional Medicaid. The federal government pays for a much higher percentage of expanded Medicaid than traditional Medicaid. We estimated the savings this year would have been $104 million for a total of $225 million from a minimum wage increase. The Proposal as a Whole Our proposal as a whole is summarized in table 4. It would raise a total of $2.56 billion mostly from upperincome Pennsylvanians. Table 4: New Revenue Options Tax Change Revenue in Increase in tax rate on compensation and interest from 3.07% to 3.25% $495 Increase in tax rate on income from dividends, capital gains and other income from wealth to 4.5% $1,200 Expansion of income tax credit for those with low incomes ($120) Sales tax base expansion to goods and services mostly consumed by those with higher than median income Low income sales tax credit ($300) Severance tax on natural gas of 6.5% with impact fee credit $218 Increase in minimum wage to $10.10 $225 Eliminate corporate tax loopholes though combined reporting and reduce rate initially to 8.99% and then further so that CNI raises $200 million more $200 Total $2,556 $ P a g e 13

14 CONCLUSION: FAIR AND GROWING TAXES Taken together, these proposals will generate a substantial amount of recurring revenue. And, they will do so without imposing a substantial burden on working people and the middle class. So long as the uniformity clause is in place, it will be difficult to make taxes in Pennsylvania as fair as they should be and as fair as they are in neighboring states. But these proposals will take important steps toward creating a more equitable tax system in our state. And, importantly, we can expect that the revenues generated by these taxes will more than keep pace with the growth in the economy. So long as the economy generates faster growth in income from wealth than income from wages, a broad corporate income tax and the tax on income from wealth will grow faster than the current personal income tax. So long as sales of services continue to grow faster than sales of goods, an expansion of the sales tax to more services will enable the sales tax to generate more over time than the existing sales tax. As gas prices recover, the severance tax will bring substantial new revenue. Finally, this proposal would still keep taxes, and especially taxes on those with higher incomes, lower in Pennsylvania than in neighboring states. So, even if you find plausible the claim that high taxes in Pennsylvania, as compared to our neighboring states, undermine economic growth a view inconsistent with the research evidence 7 our proposal is not subject to such criticism. In fact, by finding the revenues needed not only to close the structural deficit but reinvest in education, human services, and the environment, our proposal would likely increase state economic growth. 7 Chye-Ching Huang and Nathaniel Frentz, What Really Is the Evidence on Taxes and Growth? A Reply to the Tax Foundation, Center on Budget and Policy Priorities, February 18, 2014; P a g e 14

15 Appendix: Distribution of the Tax Burden in Neighboring States Delaware Maryland P a g e 15

16 New Jersey New York P a g e 16

17 Ohio West Virginia P a g e 17