The Impact of State Income Taxes on Low-Income Families in 2010
by Phil Oliff and Nicholas Johnson November 15, 2011, Center for Budget and Policy Priorities
The successful bipartisan effort over the last two decades to reduce state income taxes on working-poor families has stalled and is in danger of reversing. No new states exempted working-poor families from income taxes in 2010, and in most of the 15 states where such families still pay income taxes, they saw their income taxes increase.
Taxing the incomes of working-poor families runs counter to decades of efforts by policymakers across the political spectrum to help families work their way out of poverty. The federal government has exempted such families from the income tax since the mid-1980s, and a majority of states now do so as well. Since 1990, the number of states with income taxes on working-poor families of four has fallen from 24 to 15, and even in the remaining 15 states, the income tax liabilities of these families have declined significantly.
Eliminating state income taxes on working-poor families helps offset the higher child care and transportation costs that families incur as they strive to become economically self-sufficient. Moreover, research increasingly makes clear that raising the after-tax incomes of poor families can boost poor children's chances of academic success and increase their earnings prospects as adults. In other words, relieving poor families of state income taxes can make a meaningful contribution toward "making work pay," and can help states cultivate the highly skilled workforce they will need to succeed economically in the future.
Despite the benefits of reducing taxes for poor families, some states required them to pay income tax bills of several hundred dollars in 2010. A two-parent family of four with annual income at the poverty line (which is $22,314 for a family of that size) owed $498 in Alabama, $292 in Hawaii, $238 in Georgia, and $234 in Oregon. Such amounts can make a big difference to a family struggling to escape poverty. Other states levying tax of more than $150 on families with poverty-level incomes were Illinois, Iowa, Montana and Ohio.
This analysis assesses the impact of each state's income tax in 2010 on two types of poor and near-poor families with children: a married couple with two dependent children and a single parent with two dependent children.a It focuses on two measures: the lowest income level at which state residents are required to pay income tax, and the amount of tax due at various income levels. We have generated the relevant data annually since the early 1990s, allowing for analysis of trends over the last two decades.b
A benchmark used throughout this analysis is the federal poverty line, or the annual estimate of the minimum financial resources required for a family to meet basic needs. The Census Bureau's poverty line for 2010 was $17,374 for a family of three and $22,314 for a family of four.c Many experts acknowledge that supporting a family requires an income level substantially higher than the federal poverty line, so this analysis may understate the extent to which state income taxes can make it more difficult for poor families to move up the economic ladder.
Some states levied income tax on working families in severe poverty. Five states — Alabama, Georgia, Illinois, Montana, and Ohio — taxed the income of two-parent families of four earning less than three-quarters of the poverty line, or $16,736. And three states — Alabama, Georgia, and Montana — taxed the income of one-parent families of three earning less than three-quarters of the poverty line, or $13,031.
Also, 23 states required families with income just above the poverty line to pay income tax in 2010, despite strong evidence that a poverty-level income is often insufficient to meet families' basic needs.
In contrast, 19 of the 42 states with income taxes exempted the poor and the near-poor from the tax, and a substantial number offered significant refunds to low-income working families, primarily through Earned Income Tax Credits (EITCs).
These findings show that that there is still significant room for improvement in many states' tax treatment of low-income families. To some degree, the slowing of progress in reducing these families' tax liabilities over the last several years has been inevitable, as states have faced the most difficult fiscal conditions in decades. But a few states have moved significantly backward in this area, raising taxes on low-income working families in order to finance tax cuts that benefit corporations and wealthy individuals. Michigan, New Jersey, and Wisconsin, for example, have scaled back their EITCs over the last two years while cutting business taxes, taxes on the wealthiest families, or both.
It is possible for states to go in the opposite direction — raising revenues overall while improving their tax treatment of the poor. Connecticut, which in 2011 enacted a new EITC while balancing its budget with a combination of spending cuts and new revenues, is the sole example from this year.
In short, states need not dismantle policies designed to reduce poverty and encourage work. Rather, they should preserve these policies and build upon them when their fiscal situation improves.
Many States Continue to Levy Substantial Income Taxes on Poor Families
The Tax Threshold
One important measure of the impact of taxes on poor families is the income tax threshold — the point below which a family owes no income tax.
- In 11 states, the threshold for a single-parent family of three is below the $17,374 poverty line for such a family (see Table 1A).
- In 15 states, the threshold for a two-parent family of four is below the $22,314 poverty line for such a family (see Table 1B and Figure 1).
- Five states tax families of three or four in severe poverty, meaning those earning less than three-quarters of the poverty line ($13,031 for a family of three and $16,736 for a family of four): Alabama, Georgia, Illinois, Montana, and Ohio.
- In nine states, a family of three where the employed person works full-time at the minimum wage owed income tax in 2010: Alabama, Georgia, Hawaii, Illinois, Mississippi, Missouri, Montana, Ohio, and Oregon. (Such a person would have an income of $15,080 under the federal minimum wage, but some states have minimum wages above the federal level; see Table 3A.)
- New York had the nation's highest income tax thresholds for 2010: $34,600 for a family of three and $40,300 for a family of four. Those levels are well above the poverty lines for families of those sizes.
Taxes and Tax Credits for Poor Families
Several states charge those living in poverty several hundred dollars a year in income taxes — a substantial amount for a struggling family.
- In eight states, a family of four at the poverty line owes more than $150 in income taxes: Alabama, Georgia, Hawaii, Illinois, Iowa, Montana, Ohio, and Oregon (see Table 2B).
- At the other end of the spectrum, 17 states not only avoid taxing poor families but also offer tax credits that provide refunds to families of three or four at the poverty line (see Tables 2A and 2B). These credits act as a wage supplement and income support, encouraging work and reducing poverty. The largest refund for families at the poverty line is $1,917 for a family of three in New York.
Taxes on Near-Poor Families
Studies have consistently found that the basic cost of living — food, clothing, housing, transportation, and health care — exceeds the federal poverty line in most parts of the country, sometimes substantially. So, many families with earnings above the official federal poverty line still have considerable difficulty making ends meet.
In recognition of the challenges faced by families with incomes somewhat above the poverty line, the federal and state governments have set eligibility ceilings for some programs, such as energy assistance, school lunch subsidies, and in many states health care subsidies, at or above 125 percent of the poverty line ($21,718 for a family of three, $27,893 for a family of four in 2010).
A majority of states, however, continue to levy income tax on families with incomes at 125 percent of the poverty line.
- Twenty-three states tax two-parent families of four earning 125 percent of the poverty level, and the bill exceeds $500 in eight states: Alabama, Arkansas, Georgia, Hawaii, Iowa, Kentucky, Oregon, and West Virginia (see Figure 4B).
- Twenty-two states tax families of three with income at 125 percent of the poverty line (see Figure 4A).
How Can States Reduce Income Taxes on Poor Families?
States employ a variety of mechanisms to reduce income taxes on poor families. Nearly all states offer personal exemptions and/or standard deductions, which reduce the amount of income subject to taxation for all families, including those with low incomes. In a number of states, these provisions by themselves are sufficient to lift the income tax threshold above the poverty line. In addition, many states have enacted provisions targeted to low- and moderate-income families. To date, 25 states have established an EITC based on the federal EITC to reduce the tax obligation of working-poor families, mostly those with children.
Some states offer other types of low-income tax credits, such as New Mexico's Low-Income Comprehensive Tax Rebate, a refundable tax credit for households with income of $22,000 or less. Finally, a few states have a "no-tax floor," which sets a dollar level below which families owe no tax but does not affect tax liability for families above that level.
Most States Have Made Substantial Progress Since the Early 1990s, but Others Lag Behind
Since the 1990s, most states' income-tax treatment of the poor has improved greatly. From 1991 to 2010, the number of states taxing poor, two-parent families of four decreased to 15 from 24. Over that same span, the average state tax threshold increased to 118 percent of the poverty line from 84 percent. And many of the 15 states that still tax poor families of four have reduced the taxes levied on those families. From 1994 to 2010, the average tax levied fell by 48 percent, after adjusting for inflation. Tables 5, 6, and 7 show these changes over time.
On the other hand, a few states tax the incomes of the poor more heavily than in the early 1990s.
- In Arizona, California, Connecticut, Mississippi, and Ohio, the income tax threshold has fallen compared to the poverty line since 1991 (see Table 7). In Connecticut, the threshold has fallen to 108 percent of the poverty line from 173 percent.
- In four states — Georgia, Iowa, Mississippi, and Ohio — the income tax on families of four with poverty-level incomes has risen since 1994 even faster than inflation (see Table 6). The inflation-adjusted increase was 39 percent in Georgia and 9 percent in Ohio. In Mississippi and Iowa, such families' tax liability increased from zero to $122 and $214, respectively; Iowa's increase was the largest in dollar terms in any state. In each of these states, the reason for the tax increase is that personal exemptions, credits, or other features designed to protect low-income families from taxation have eroded due to inflation.
Why Does This Report Focus on the Income Tax, Which Costs Poor Families Less Than Other State Taxes?
In most states, poor families pay more in consumption taxes, such as sales and gasoline taxes, than income taxes. They also pay substantial amounts of property taxes and other taxes and fees. Why, then, does this report focus on the impact of state income taxes?
First, the income tax is a major component of most state tax systems, making up 36 percent of total state tax revenue nationally. The design of a state's income tax thus has a major effect on the overall fairness of the state's tax system.
Second, the income tax plays a huge role in determining the overall impact of a state's tax system on poor families. It is administratively simple for a state to eliminate income tax for people below a given income level using the income information that people provide when the tax is levied, i.e., on their tax returns. (As this report shows, a number of states have taken advantage of this opportunity.) Sales tax, on the other hand, is collected by merchants who have no knowledge of consumers' income levels, and landlords generally pass the cost of property taxes on to renters in the form of higher rents. As a result, the most significant low-income tax relief at the state level in the past decade has come by means of the income tax.
Third, families trying to work their way out of poverty often face an effective tax on every additional dollar earned in the form of lost benefits such as income support, food stamps, Medicaid, or housing assistance. Income taxes on poor families can exacerbate this problem and send a negative message about the extent to which increased earnings will improve family well-being.
Low-income families are better off if a state has an income tax than if it doesn't, even if their state's income tax needs significant improvement. The reason is that most states' income taxes, even those that tax the poor, are progressive; that is, income tax payments represent a smaller share of income for low-income families than for high-income families. The other primary source of state tax revenue, the sales tax, is regressive, consuming a larger share of the income of low-income families than of high-income families.
States that rely heavily on non-income taxes tend to have higher overall taxes on the poor than do other states. Most of the states without income taxes rely heavily on the sales tax instead, which renders their tax systems very burdensome for low-income families. Similarly, two states with income taxes but no general sales tax — Montana and Oregon — have less regressive tax systems overall than the average state because they do not levy general sales taxes, even though they impose above-average income tax burdens on the poor.
States' recent fiscal troubles are significantly slowing their progress in reducing the tax liabilities of poor families. In the 2010 tax year only one state, Oklahoma, implemented a tax change that significantly reduced the tax liabilities of low-income families, as it continued phasing in an increase in the standard deduction. Also, Connecticut has created a new EITC, set at 25 percent of the federal credit, that will take effect in the 2011 tax year.
In addition, fiscal problems and competing priorities have prompted some states recently to enact measures that increase income taxes for poor and near-poor families. For example:
- Michigan is reducing its EITC to 6 percent of the federal credit (from 20 percent), beginning with the 2012 tax year. Had this change been in place in 2010, Michigan's threshold for two-parent families of four would have fallen from 36 percent above the poverty line to slightly below the poverty line. Families of four with poverty-level income would have seen their taxes increase by $680.
- New Jersey reduced its EITC to 20 percent of the federal credit (from 25 percent), beginning in 2010. This cut lowered New Jersey's threshold for two-parent families of four by $1,600 and raised taxes for such families at the poverty line by $243.
- Wisconsin is reducing its EITC to 11 percent of the federal credit (from 14 percent) for families with two or more children, beginning in 2011. Had this change been in place in 2010, it would have driven Wisconsin's threshold for two-parent families of four below 125 percent of the poverty line; families of four at the poverty line would have faced a $146 tax increase.
All three of these states not only have faced large budget gaps but also have cut taxes for corporations and/or wealthy individuals even as they are raising taxes on the working poor. Michigan replaced its major business tax with a different type of business tax, giving companies a net tax break worth more than $1 billion in 2012. New Jersey reduced the income tax rate for taxpayers with incomes above $400,000 by allowing a temporary rate increase to expire. Wisconsin enacted $90 million in tax cuts for corporations and high-income households. EITC cuts helped each of those states offset the revenue loss from those tax cuts.
Raising taxes on the working poor not only increases poverty, but also is more harmful to states' economies than other budget-balancing measures. This is, in part, because lower-income people spend nearly all of the money they make, mainly on necessities, so for every dollar they lose due to a tax increase, the total amount of spending in the economy drops by around a dollar. High-income people are likely to save a larger part of any extra income they receive, so for every dollar they lose due to a tax increase, total spending drops by less than a dollar, say, 90 cents. Thus, tax increases that mostly affect higher-income families and corporations have less of an impact on overall demand and are preferable for economic and job growth.
Raising taxes on the working poor can also have longer-term consequences. Recent research suggests that poverty can impair children's chances of success later in life, making them less productive contributors to their states' future economies. More specifically:
- A number of studies focused on welfare-to-work and anti-poverty programs have found that additional family income can boost the test scores of children from low-income families.
- A recent study by leading researchers finds a strong relationship between family earnings in early childhood and earnings later in life for children growing up in low-income families. The study finds that, for a child growing up in a family with income below $25,000, a $3,000 annual increase in family income when the child is under 5 years old is associated with a 19 percent increase in adult earnings and 135 additional annual work hours after age 25.
These findings have crucial policy implications. They suggest that policies such as the EITC, which boost the incomes of poor families, can increase their children's chances of success in the classroom and ultimately in the workforce. Conversely, reducing the incomes of poor families, such as the EITC cuts in Michigan, New Jersey, and Wisconsin, can diminish poor children's prospects for academic and professional success. This suggests that any budgetary savings states achieve from cutting low-income credits carry with them significant economic costs, by making it more difficult to cultivate the highly skilled workforce that states will need to succeed economically.
A number of states continue to tax the income of poor families — in some cases, very poor families. While states have made significant progress in this area over time, that progress ground to a halt in 2010, as fiscal problems constrained states' ability to advance targeted tax reductions. Moreover, some states have raised taxes on the working poor while cutting taxes for corporations and wealthy residents. Instead of undermining efforts to reduce the tax liabilities of poor families, states should preserve the progress they have made and build upon it when their budget outlook improves.
LINK: PDF of this report (19pp.)
a The married couple is assumed to file a joint return on its federal and state tax forms, and the single parent is assumed to file as a Head of Household. A few states' tax codes treat married couples with two workers differently than married couples with one worker, so each family is assumed to include one worker. For the few states whose tax codes take the age of children into account, the children are assumed to be ages 4 and 11.
b This report takes into account income tax provisions that are broadly available to low-income families and that are not intended to offset some other tax. It does not take into account tax credits or deductions that benefit only families with certain expenses; nor does it take into account provisions that are intended explicitly to offset taxes other than the income tax. For instance, it does not include the impact of tax provisions that are available only to families with out-of-pocket child care expenses or specific housing costs, because not all families face such costs. It also does not take into account sales tax credits, property tax "circuit breakers," and similar provisions, because this analysis does not attempt to gauge the impact of those taxes — only of income taxes.
c Specifically, this report uses the Census Bureau's weighted average poverty thresholds, available at http://www.census.gov/hhes/www/poverty/data/threshld/.