Tax the rich out of fairness? Not that simple.

  • Article by: TIMOTHY TAYLOR
  • Updated: May 17, 2011 - 10:00 PM
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Rich and poor by Paul Lachine/NewsArt

Should Minnesotans with high incomes pay more in state income taxes? Gov. Mark Dayton thinks so.

The top income tax bracket in Minnesota is currently 7.85 percent. Back in February, Dayton proposed a top income tax bracket of 10.95 percent, kicking in for households earning more than $150,000 (and filing taxes jointly). Earlier this week, Dayton revised this proposal so that the new top bracket would apply only to couples with taxable income above $250,000.

I'm not a no-new-taxes absolutist. I won't weep into my pillow if those with high incomes pay more taxes. However, taxation of high incomes shouldn't be viewed as a morality play about fairness, but instead as a matter of context and practicality.

Those who support raising state taxes on the rich often start by pointing out that the highest-income Minnesotans pay a lower share of their income in state and local taxes than those further down the income scale.

For example, a March 2011 report from Minnesota's Department of Revenue shows that Minnesota households with incomes from about $16,000 up to about $129,000 pay on average about 12 percent of income in state and local taxes. However, the top 5 percent of households, with incomes above $182,000, pay 10 percent of income in state and local taxes. The top 1 percent, with household incomes above $429,000, pay 9.7 percent of income in state and local taxes.

But interpreting whether this outcome is "fair" is far from straightforward.

State-level taxes are already essentially proportional to income. The middle of Minnesota's income distribution pays roughly 8 percent of total income in state taxes -- and so do the top 5 percent and the top 1 percent of the income distribution. State sales tax and taxes on motor fuels, alcohol and tobacco weigh more heavily on those with lower income, but the state individual income tax weighs more heavily on those with higher incomes. Over the income distribution, these state taxes more or less balance out.

However, local taxes -- almost entirely property taxes -- weigh much less heavily on those with higher incomes. The Revenue Department calculates that households in the middle of the income distribution pay on average 4.2 percent of income in local taxes, while the top 5 percent of households pays 1.9 percent of income on average in local taxes.

In effect, Dayton is proposing that state income taxes should be raised on those with high incomes to offset at least in part the fact that property taxes fall more heavily on those with lower incomes. To some people, this proposal seems obviously "fair." To me, all of these state and local taxes have different justifications and different possibilities for how they could be redesigned, so the fairness issues are complex and tangled.

Moreover, any discussion of tax fairness should include federal income taxes, which weigh much more heavily on those with higher incomes. The middle of the U.S. income distribution, from $34,300 to $50,000 in annual income, pays an average of 3.3 percent of income in federal income taxes. The top 1 percent, with income of $350,000 and up, pays an average of 19 percent of income in federal income taxes, according to the Congressional Budget Office.

The longstanding pattern has been that the federal government relies more on income taxes that weigh more heavily on those with high incomes, while state and local governments rely more on sales, excise and property taxes. This pattern has two underlying justifications:

First, tax revenues from those with high incomes can fluctuate considerably -- rising, say, when bonuses linked to a rising stock market are soaring, and dipping when they aren't. The federal government can deal with large drops in revenue through deficit financing. State and local governments, which need to run balanced budgets, should rely on less volatile sources of revenue.

Second, high tax brackets can discourage businesses that provide high-income jobs from locating in a jurisdiction. State and local governments must worry more about this problem than the federal government does. Relocating to another country to avoid taxes is a lot harder than moving between local areas or states.

It's hard to quantify these dangers. After all, if business location decisions were totally driven by state taxes, then much more of the U.S. economy would be located in low-tax states like Wyoming and South Dakota.

But California is the state that, over its entire suite of taxes, does the most to impose its tax burden on those with high incomes, according to cross-state data from the Institute on Taxation and Economic Policy analyzed by Minnesota's Department of Revenue. Of course, California is also a state where public finances are in ruins, in part because of what happens when a state relies too much on taxing those with high incomes, and then those revenues dry up. California has also been shedding jobs for years to states with friendlier business climates.

In comparison, looking at all aspects of state taxes, Minnesota ranks 14th among states on how heavily the tax burden falls on those with high incomes. Minnesota's top tax bracket of 7.85 percent was 10th-highest among all states at the start of 2011. Dayton's proposed new tax bracket would leave Minnesota essentially tied for the highest state income tax bracket with Hawaii and Oregon, which have top state income tax brackets of 11 percent.

A modest bump to the income taxes of those with the highest incomes may be a necessary part of an overall solution to Minnesota's budget woes. For example, having a top income tax bracket in Minnesota that matches the 8.98 percent top bracket in Iowa would pose only a modest risk to Minnesota's business climate.

But while Minnesota should seek to be No. 1 in many areas, for its own economic well-being it should not be seeking to match the nation's top state income tax brackets.

Timothy Taylor is managing editor of the Journal of Economic Perspectives, based at Macalester College in St. Paul.

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