How income inequality is keeping state coffers low

Washington's poor-heavy taxes, income inequality and decreasing state tax revenue: It's a vicious cycle.
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Washington's poor-heavy taxes, income inequality and decreasing state tax revenue: It's a vicious cycle.

This year, income inequality has caught the eye of national economists, including those on Wall Street. More recently, a growing body of local evidence has emerged to suggest that it would behoove state legislators, strapped for cash to fund public education, to take note as well.

Two recent Standard and Poor’s reports (here and here) provide evidence that growing inequality creates a drag on the overall economy that dampens job and wage gains and has significantly limited the ability of states to provide essential services. The effect is strongest in sales tax-dependent states.

The S&P investigations also suggest that income inequality has caused states' revenue to be more closely linked to the performance of the financial markets. Thus state tax revenues have become more volatile, which has made budgeting even more difficult.

Perhaps the reports' most important finding for Washington state is that “through a progressive tax structure, it's possible to counteract much of the depressing effect inequality has on tax revenue growth rates.”

States need adequate and dependable revenue streams to service debt, and they listen to credit rating agencies like S&P. Washington state in particular needs revenue to fund public education and other essential services. So, whatever their political beliefs, Washington's legislators should share the S&P's concern with income inequality. If only from a broader budget perspective. 

Some efforts have already been made to understand the effect of state taxes on income inequality in Washington state. In 2012, Washington’s Office of Financial Management was directed by the Legislature to study the interplay of personal income, wealth and state and local tax payments.

That 2012 OFM report sums up our situation: “Washington has a top-heavy income and wealth distribution, with over half of the income going to the top 20 percent of households and over half of the wealth going to the top five percent of households.”

The study also confirmed what a national organization has repeatedly found over the last two decades: Low and middle income households in Washington state pay a much greater share of their incomes in taxes than do those with high incomes. Washington households with incomes from $15,000 - $25,000 pay about 2.5 times more state and local taxes as a percentage of income than do those in the highest income group – above $140,000.

Washington’s regressive taxes include taxes on retail sales, property, gasoline, tobacco, liquor, public utilities and other excise taxes. The sales tax and the property tax are the largest individual components in the total tax burden for low income taxpayers.

How do we compare to other states on this? The Institute for Taxation and Economic Policy has compared the equity of state tax structures four times since 1996. They found that, while most states have a slightly regressive structure, Washington has led the nation in the extreme regressivity of its tax structure across all income groups. All four times.

According to the most recent of these reports, Washington's poorest families pay 16.9 percent of their income in state and local taxes. In Illinois, where poor families paid the second highest taxes, that number is 13.8 percent.

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The lowest decile group, although it has the highest apparent tax burden at 23.2%, is not shown because the OFM authors believe it may not be representative of the poorest households. It possibly includes taxpayers who may not have earned income because of bad investments in just one year.

There are policies available to states to reduce tax regressivity. Many other states use them.

To understand how Washington might do things differently, we need only look slightly south to Oregon. Rather than a sales tax, Oregon depends on graduated personal and corporate income taxes for the largest share of its revenue. The state also allows a standard deduction of up to $6,100 of a household's federal income tax and provides a tax refund for low to middle-income families based on their federal earned income tax credit.

The state's tax brackets (except the highest), deductions and exemptions are all indexed to inflation, so that they maintain their value even as the value of the dollar decreases. All of this produces a tax burden that is roughly flat across the income spectrum. (See chart below.)

Washington’s tax structure has only one progressive feature — a refundable earned income tax credit — and even that has largely been shelved.

In 2008, the Legislature adopted the Working Family Tax Exemption program, which made low income families eligible for a refund of sales taxes. But the program was never funded. A 2012 Department of Revenue report indicated that the cost to implement it in the 2013-15 biennium would have been $200 million.

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Next year, as the Legislature gathers to decide how to address Washington's revenue gap and fully fund public education, lawmakers must also review ways that the negative effects of our tax structure can be lessened. In the context of a likely protracted debate over how to fund education, both the Standard & Poor studies and the Office of Financial Management report should be consulted.

The Legislature should ask the Office of Financial Management to continue its study, which was cut short by time constraints; to suggest ways to decrease income inequality and its consequences for family and state budgets. It should incorporate the state's most recent income data. And it should be expanded to encompass the geographic distribution of income inequality.

Regressivity and its effect on inequality can be reduced if not eliminated through tax restructuring. By reducing or eliminating individual taxes paid by lower income households and by increasing those for high income households, Legislators can reduce income inequality and raise revenue for the state. (Alternatively, revenue neutral adjustments could also be made.)

And certainly, if major changes are made to the tax structure for purposes of generating more revenue in an effort to fund education, regressivity and income inequality should not be made worse.


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About the Authors & Contributors

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Dick Nelson

Dick Nelson is a former Washington State legislator. He currently contributes to the public debate on state and local fiscal issues through research and commentary. As when he was in the legislature, he prefers the Democratic Party.