Previous blog posts discussed various aspects of taxes including 1) the Alternative Minimum Tax 2) Social Security 3) Tax Withholding and now… State Income taxes. The purpose of these posts is to systematically cover the tax burden that we face as Americans.
State income taxes are an important and complex addition to the tax burden in the United States. Each state has to raise revenue to fund services and they raise this money through 1) income taxes 2) sales taxes 3) property taxes 4) corporate taxes 5) fees.
The average person doesn’t have a comprehensive understanding of state income taxes. This is because they usually know the state income tax policy of their state, but don’t realize that most states are completely different from one another in how they tax and what the impact of this taxation is. If you are looking for additional information on state income taxes, here is a great site and a list of state income tax rates.
HOW STATE INCOME TAXES ARE CALCULATED
In general, income taxes are calculated as follows:
- Determine if your state has an income tax at all; 9 states don’t have an income tax (a couple have dividends and interest income only)
- First, fill out your FEDERAL income tax form
- Then you take one of the income subtotals from the Federal tax return. Most states use your “FEDERAL TAXABLE INCOME” (line 43 on your 1040) or your “FEDERAL ADJUSTED GROSS INCOME” (line 37 on your 1040)
- Note that your adjusted gross income is ALWAYS higher than your taxable income – the difference is either your 1) itemized deductions or the 2) standard deduction. The standard deduction was $10,000 for couples (married) filing jointly in 2005 as a point of reference. Thus, all things being equal, if 2 state tax rates are the same, then the one calculated based on AGI would result in more tax than one calculated on taxable income
- After you determine your taxable line on the Federal form to start from, then you receive an exemption based on if you are single, married and the # of dependents. This basically acts as a “screening” device to see whether or not you have to file. For example, if your Federal adjusted gross income minus $2000 (if filing singly) is less than zero, then you don’t have to file in Illinois (this applies to students, children, and individuals or families with low income)
- If you still have a taxable amount after deducting your exemption, then you apply a rate to the income base. For example, in Illinois, the tax rate is a flat 3% applied to your Federal adjusted gross income less the exemption as calculated above
- Many other states have “graduated” income brackets where you have a certain amount taxed at a lower rate and then the brackets increase as your income goes up. For example, California has SIX brackets starting at 1% up to 9.3%, with a special “seventh” bracket at an extra 1% for income beyond $1 million (movie stars and investors, I guess)
- There are many unique attributes by states. Some states have different brackets for singles than married couples, and they provide extra deductions or incentives for certain items. GENERALLY, as the tax rates get higher and more graduated, there are more deductions and deviations from the “simple” method as described above. For example, the Illinois State tax form is extremely simple, and the California state tax form is relatively complex (but far less complex than a Federal tax form)
- None of this applies to Rhode Island; their tax rate is 25% of the Federal tax liability; it is like when you take a law class and they tell you that none of this applies in Louisiana because they follow the Napoleonic code; this probably makes them worse than average overall
THE BURDEN OF STATE INCOME TAXES
State income taxes vary significantly by state. Illinois is on the low end (of those states with taxes; go to the 9 without it for the best rates), with a “flat” (no brackets) 3% rate. For a long time Illinois had a 2.5% tax rate and they tacked on a 0.5% “adder” to pay for regional transportation; as always, the state lied, made the surcharge permanent, and let our public transportation rot, as a final bonus. Even at 3.0% and with no brackets (shield for those with smaller incomes) it is in the lower end overall.
The worst states (with the highest rates) are as follows:
- Arkansas (maximum 7%)
- California (maximum 9.3% with an additional 1% surcharge for incomes beyond $1M) – right next to fast-growing Nevada with no state income tax
- Georgia (maximum 6%) – right next to fast-growing Florida with no state income tax
- Iowa – 8.98% (I was surprised by how steep this rate is; you’d think they want to ENCOURAGE people to stay in Iowa)
- Idaho – 7.8%
- Maine – 8.5%
- Massachusetts – 5.3% but a flat rate on all income; note that this is almost 2x as high as Illinois
- Minnesota – 7.85% (right near South Dakota with no income tax)
- Montana – 6.9% (my grandparents are from this state; they are surprisingly “populist” and “statist” – also right next to Wyoming with no state income tax)
- Nebraska – 6.84% (like Iowa, you’d think they’d want to entice citizens a bit)
- New Jersey – 8.97% (while a super high rate, the 8.97% rate only applies to very high income earners, still a very high tax state)
- New York – 6.85% (a relative bargain, compared to New Jersey, but then you have to add in New York city taxes)
- North Carolina – 8.25% (one of the highest rates in the country, I was surprised by this)
- North Dakota – 5.54% (they must be getting killed by South Dakota on this)
- Ohio – 7.185% - another high rate, 2.5 times higher than Illinois
- Oregon – 9% (the highest rate outside California & Vermont and they are right next to Washington, which has no state income tax)
- Pennsylvania – 3.07% (not a bad rate but then Philadelphia has a tax similar to New York)
- South Carolina – 7% (high rate for a place with pretty primitive services)
- Vermont – 9.5% (the highest except for California; and right next to New Hampshire which has no state income tax at all)
- West Virginia – 6.5%
- Wisconsin – 6.75% - a high rate when compared to Illinois (3%)
- District of Columbia – 9% (almost a city tax; they also tax workers in the city; this for one of the most dangerous cities in the USA)
The states without income taxes are among the fastest growing, including:
- Nevada (ever wonder why all those California people are moving there?)
- New Hampshire (best tax situation in the high-tax northeast)
- Texas (always growing like crazy)
- Washington (best situation in the high tax Pacific Northwest)
- Florida (another massively growing state)
Another complexity of state income taxes occurs when you work in one state and have residence in another state. You generally get a credit on the state with the lower tax rate and pay the highest rates. Some states have a “reciprocal” agreement with their neighbors on taxes; I know that Illinois does with Iowa, Wisconsin, Michigan and Kentucky (?) but not Indiana. Here is a list of reciprocal agreements.
In addition to state income taxes, certain cities that have income taxes including New York & Philadelphia. New York City’s income tax rate is 4.45% at top brackets, which of course is levied on top of the State of New York income taxes and myriad other property taxes and sales taxes. See this article by the respected Manhattan Institute that shows the colossal tax burden that residents of New York City face. Philadelphia is another unique situation with a 4.5% burden on city residents and a 3.9% rate on non-residents who work in Philadelphia (a tax on the suburbs for services they don’t use). This tax funds an astounding 52% of Philadelphia’s budget as described in this interesting article, where they also cite the impact on productivity and growth. I’m sure this has nothing to do with the inexorable decline in population of Philadelphia…
STATE INCOME TAX IMPACTS
Taxes behave differently depending on the situation.
- Federal income taxes – go up when your salary and other income increases
- State income taxes – same as Federal
- Social security taxes – go up as you earn more money, but only to a point
- State sales taxes – go up as you SPEND more money, but the “rate” is always the same
- Local property taxes – go up as your property becomes more valuable
- Fees and use taxes – charged based on what you are doing
It is important to note how the taxes impact behavior – as your income increases, your incentive to minimize federal and state taxes increase. It would seem that state taxes follow the Federal tax model, except…
THAT YOU CAN AVOID STATE TAXES
Unlike Federal taxes, which can only be avoided by renouncing US citizenship (done by very, very few people), state income taxes can be avoided simply by moving to another state or claiming residency in another state. In this way, state taxes are of the few taxes that you can significantly reduce through legal activities (i.e. without tax evading).
The most mobile people who can choose where they want to put their permanent residents are the wealthy. Have you ever been to Nevada and seen the signs touting their lack of a state income tax? They are smart to publicize this, since many of the gamblers / tourists traveling through town have the ability to move their permanent residence to Las Vegas and avoid tax burdens from other states.
In addition to the wealthy, retirees also are mobile (they have the opportunity to relocate once they stop working and often downsize into a smaller house) and it is not a coincidence that many, many of them end up in either Texas or Florida. If you are on a fixed income it doesn’t make any sense to continue to reside in a state that taxes your income if it can be avoided; it is basically like throwing money away. Imagine if you were a retiree in cold, windswept, ugly Iowa (I spent many years there and can speak from experience) and are paying up to 8.98% in state income tax and you received a flyer to retire in sunny, warm Florida… and get a de-facto raise, to boot! You’d certainly consider doing that, all else being equal. From an article from the New Jersey Asbury Park Press titled “Pension Checks Leaving State” 23% of New Jersey’s pension checks went out of state, New York sent 22% out of state, Delaware sends 18% out of their checks out of state, California sends 15% out of sate, and Florida sends 13% of their checks out state. Since Florida has no state income tax, maybe that figure that is just the base percent of people going to be with their families, and even with the tax burden California only loses a bit more (the weather is nice…) but you would think that it can’t take much to push you to leave New Jersey.