Volatility of California’s Personal Income Tax Structure

Volatility of California’s Personal Income Tax Structure MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • SEPTEMBER 2017 E S xEcutivE ummary The personal income tax (PIT) is the state government’s most important revenue source. The PIT is also a highly volatile revenue stream. Its unpredictable revenue swings complicate budgetary planning and contributed to the state’s boom-and-bust budgeting of the 2000s. In a February 2017 report, we reviewed the volatility of the PIT base. In this report, we analyze how the PIT structure— its graduated rate structure and various deductions and credits—contributes to volatility. The state has made various choices about the design of the PIT. We find that about 40 percent of PIT volatility is due to choices about which types of income to tax. About another 40 percent of PIT volatility is due to the rate structure, which taxes higher incomes at higher rates. This amplifies the volatility of taxes paid by high-income taxpayers. Finally, about 20 percent of PIT volatility is due to deductions and credits, which mostly serve to reduce the tax liabilities of low-income and middle- income taxpayers, whose total income is remarkably stable. The Legislature has control over most aspects of the PIT base and structure, and could choose to reduce the volatility of this tax. The bulk of income growth over the past couple of decades, however, has gone to high-income people. If this trend continues, future actions to reduce volatility could reduce the growth of state tax revenues. Introduction programs, prisons, and other state-funded programs. In a February 2017 report, we focused on In this report, we discuss the volatility of the volatility of the PIT base—the types of income California’s personal income tax (PIT) structure. that are taxable in the state. This report focuses The PIT is state government’s most important on California’s PIT structure: how its tax rates, revenue source, contributing over two thirds of deductions, and credits further affect the volatility the state General Fund, which supports schools, of its revenue stream. universities, major health and social services AN LAO BRIEF Specifically, this report discusses: Total income is then reduced by “above the line” deductions. The federal income tax code has a • California’s PIT structure, including tax number of deductions that taxpayers are allowed rates that apply to different levels of income to claim regardless of whether they claim itemized and important deductions and credits. deductions or the standard deduction. As the name • The approximate contribution of Figure 1 different provisions Calculating State PIT Liability (tax rates, deductions, 2014 Tax Year credits) to the volatility of PIT revenue. To determine total income for federal purposes sum the following: • Wages and salaries • Some brief perspectives • Interest, dividends, and rent • Taxable pension distributions on the implications of • Business income • Capital gains PIT volatility. • Various minor sources Total income was $1.26 trillion in 2014 How Rates, Deductions, Minus and Credits Affect Federal “above the line” deductions ($21 billion) Tax Liabilities Equals Figure 1 shows how a Federal AGI ($1.24 trillion) filer’s state PIT liability is Minus calculated. The process starts Adjust federal AGI to reflect differences in state law concerning by calculating adjusted gross the definition of income and allowable state deductions ($31.5 billion) income (AGI) for federal tax Equals purposes. AGI is used as a State AGI ($1.2 trillion) starting point on the state Minus PIT form. Filers then apply Greater of itemized deductions or the standard deduction ($194 billion) adjustments, deductions, tax Equals rates, and credits to arrive at Taxable income ($1 trillion) their tax liability. In this report, Multiplied by we are focused on how these Tax rate schedule latter steps affect PIT volatility. Equals We detail this process below. Determining Federal AGI. Tax liability before credits ($69.4 billion) Calculating federal AGI begins Less with summing the types of State credits that reduce tax liability ($3.9 billion) income that are subject to the Equals federal income tax. (A detailed Final tax liability ($65.5 billion) account of the types of income that are in the PIT base can be PIT = personal income tax and AGI = adjusted gross income. found in our previous report.) 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF suggests, above the line deductions are calculated and likewise a filer who claims the standard above the line on the federal tax form that separates deduction gets no benefit from their itemized the section where AGI is determined from the deductions. Figure 2 shows a breakdown of the section where taxable income and tax liability are $200 billion in standard and itemized deductions determined. (Because filers are not required to claimed in 2014, which reduced taxable income to report above the line deductions on state returns, about $1 trillion. there are no state data showing how much was Marginal Tax Rates. The next step is to apply claimed in any year. For this report, we have the marginal tax rates to the filer’s taxable income estimated these amounts for taxpayers in different to determine the filer’s liability before credits. The income brackets based on Internal Revenue Service state PIT uses a graduated rate system, meaning data for above the line deductions claimed by that the rate that applies to each portion of a California taxpayers on their federal returns.) filer’s income increases as the filer’s income itself Determining State AGI. For the most part, increases. As shown in Figure 3 (see next page), the definition of income for tax purposes under in 2016 the first $8,015 of a single filer’s taxable California law is the same as under federal law. income is taxed at a 1 percent rate, the next $11,001 There are some exceptions, the biggest of which is is taxed at 2 percent, and so on. that Social Security income is partially taxable at Since voters passed Proposition 30 in 2012, the the federal level but tax-free at the state level. As state has imposed an additional tax of up to 3 percent the state income tax return starts with federal AGI, on high-income taxpayers (the three highest brackets it is often necessary to make some additions and shown in Figure 3). All revenue from these additional subtractions to arrive at state AGI. On net, these adjustments Figure 2 resulted in state AGI being Composition of $200 Billion in $31.5 billion lower than federal Standard and Itemized Deductions AGI in 2014. Relative to federal 2014 (In Billions) AGI, these adjustments reduce $70 state AGI for lower-income filers with relatively stable 60 incomes and increase state AGI 50 for taxpayers making more 40 than $400,000. Itemized or Standard 30 Deductions. From state AGI, 20 taxpayers deduct the greater 10 of the total of their itemized deductions or the standard Medical Other Property Charitable Mortgage Standard deduction for their filing status Expenses Itemized Taxes Contributions Interest Deduction (single, married filing jointly, Itemized Deductions head of household, etc.). A Note: Amount of total deductions utilized by taxpayers is somewhat lower than total shown here filer who itemizes cannot because the total allowable amount of itemized deductions is reduced for high-income taxpayers. claim the standard deduction, www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO BRIEF Figure 3 Income Tax Rates for 2016 Taxable Income Single Joint Head of Household Marginal Tax Rate $0 to $8,015 $0 to $16,030 $0 to $16,040 1.0% 8,015 to 19,001 16,030 to 38,002 16,040 to 38,003 2.0 19,001 to 29,989 38,002 to 59,978 38,003 to 48,990 4.0 29,989 to 41,629 59,978 to 83,258 48,990 to 60,630 6.0 41,629 to 52,612 83,258 to 105,224 60,630 to 71,615 8.0 52,612 to 268,750 105,224 to 537,500 71,615 to 365,499 9.3 268,750 to 322,499 537,500 to 644,998 365,499 to 438,599 10.3 322,499 to 537,498 644,998 to 1,074,996 438,599 to 730,997 11.3 537,498 and over 1,074,996 and over 730,997 and over 12.3 Note: These rates do not include the 1 percent tax on income over $1,000,000 that is deposited into the Mental Health Fund. rates is deposited into the state’s General Fund. observations deviate from the average annual While these rates are in effect only through 2030, compounded growth rate over a period of years. we include their impacts on volatility in this report. Figure 5 illustrates AD for California’s personal (There is an additional 1 percent tax rate on income income growth between 2011 and 2014. The over $1 million that goes into a special fund to pay compound annual growth rate over this four-year for mental health services. As this report focuses on period was 5.2 percent, as shown by the red line. the volatility of the General Fund, this 1 percent rate The growth rate in 2011 was 6.8 percent, which is is excluded from the discussion of tax rates.) 1.6 percentage points above the compound annual Credits. A credit is a provision that directly reduces Figure 4 a filer’s tax liability instead of Composition of $8 Billion in Credits reducing their taxable income the 2014 (In Billions) way a deduction does. As shown in Figure 4, the two credits that $5 reduce revenue the most are those credits for individuals and 4 dependents. In 2016, these credits were worth $111 for each filer 3 ($222 for a joint return) and $344 for each dependent. 2 Measuring Volatility 1 There are many ways to measure volatility. One such measure is average deviation Renter's Senior Enterprise Others Personal Dependent Credit Zone (AD), which was also used Note: Only about one-half of the amount of credits shown here reduced tax liabilities because the in our previous report. exemption credits are phased out for high-income taxpayers. AD summarizes how annual 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF growth rate, so the Figure 5 annual deviation California Personal Income Growth Annual Deviations, 2011-2014 for 2011 is 1.6. Because the sum of 8% positive and negative 7 Each Year’s Annual Growth deviations is usually approximately zero, 6 1.6 1.2 Average Annual Growth = 5.2% 1.0 the AD calculation 5 has to use the absolute 4 value (always a positive 3.9 3 number) of each annual deviation. 2 For example, in 1 2013 the growth rate was 1.3 percent, or 2011 2012 2013 2014 3.9 points below the Note: The average deviation of California personal income in the example above is 1.9, which is the absolute value 5.2 percent average of the average of the annual deviations from (absolute values) the 5.2 percent average annual compound growth rate over the period (1.6, 1.2, 3.9, and 1.0). annual growth rate, but the annual deviation is positive 3.9. The average year from 1990 to 2014 if the 2016 tax structure of all four annual deviations in Figure 2 (1.6, 1.2, 3.9, had been in place over the entire period.) In other and 1.0) is 1.9 percentage points, which produces an words, revenue from the PIT is more than five AD of 1.9. This means that if the pattern that held times as volatile as personal income itself. Below, from 2011 to 2014 continues into the future, personal we discuss the sources of the 9.9 AD difference income growth would deviate from its average growth between the 12.2 AD of the current PIT and the rate by an average of (plus or minus) 1.9 percentage 2.3 AD of personal income. points each year. The higher the AD of an income or Volatility From the PIT Base. In our previous tax, the more volatile it is—tending to move more up report on PIT volatility (Volatility of the Personal or down each year, compared to the average annual Income Tax Base), we found that the current PIT tax growth rate over time. base has an AD of 6.3. This means that the base is almost three times as volatile as personal income. The AD of PIT Tax Structure 4.0 difference in AD explains about 40 percent of the Comparing Personal Income Volatility to PIT 9.9 AD difference between personal income and PIT. Volatility. In our previous report, we calculated Volatility From the Graduated Rate Structure. the AD of personal income to be 2.3. To determine To estimate the volatility of the rate structure, we the causes of PIT volatility, we first estimate the calculate the AD of a hypothetical PIT with a single AD of the overall PIT and compare it to the AD rate. We estimate that a single tax rate of 6.23 percent of personal income. We calculate that the state’s with all deductions, adjustments, and credits kept current PIT has an AD of 12.2. (To control for the same as under current state law would have tax law changes, we estimated how much General raised as much revenue from 1990 to 2014 as the Fund revenue would have been collected in each actual 2016 tax structure would have. The estimated www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO BRIEF AD of the state PIT under this flat-rate scenario was seven times as volatile as income of lower-income 8.2, or 4.0 points less than the AD of the 2016 PIT filers. As Figure 6 shows, aggregate income below structure. From this we can conclude that imposing $150,000 is remarkably stable—the period from a graduated rate structure instead of a flat rate adds 1990 to 2014 included some very strong economic about 4 points to the AD of the tax. years and some very weak ones, yet the growth rate Volatility From Deductions and Credits. We of income below $150,000 was never higher than estimated a hypothetical PIT, with a graduated rate 6.2 percent or lower than minus 3.8 percent. structure proportional to the 2016 rates, but with How Do Graduated Rates Promote Volatility? no deductions, adjustments, or credits, that would As Figure 3 earlier showed, much of the first have raised as much revenue from 1990 to 2014 as $150,000 of a filer’s income is taxed at rates below the current PIT structure. This resulted in a rate 9.3 percent. In fact, in 2014 over 80 percent of filers of 0.685 percent on the current 1 percent bracket, below $150,000 would have had no income taxed a rate of 1.37 percent on the 2 percent bracket, and at the 9.3 percent rate even if the state’s tax code so on. The estimated AD of the state PIT under this had no deductions or credits. In contrast, most scenario was 10.1, or 2.1 points below the AD of the of the income of filers above $150,000 is taxed at current PIT structure. We estimate that roughly rates ranging from 9.3 percent to 12.3 percent. As three-quarters of this 2.1 point gap comes from aggregate income of filers above $150,000 is highly deductions, and the remainder from credits. volatile, the graduated rate structure causes PIT revenue to be more volatile than it would be under Understanding the a single rate. In other words, the rate structure Volatility of the PIT Structure Figure 6 Below, we explain why Higher-Income Filers Have Especially Volatile Incomes rates, deductions, and credits Annual Percent Change in Adjusted Gross Income increase PIT volatility. 40% Income Dynamics Differ Above, Below $150,000 a Year. Above $150,000 30 The year-to-year volatility in people’s incomes depends 20 where they are on the income spectrum. For instance, for 10 those earning above $150,000 (roughly the top 10 percent of filers in 2014), their aggregate Below $150,000 incomes over the past 25 years -10 had an AD of 14.2. By comparison, aggregate income -20 below $150,000 a year had an AD of 2.0. This means that the -30 aggregate income of higher- 1991 1996 2001 2006 2011 income filers is more than 6 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF amplifies the impact of the already volatile income 89 percent of personal, dependent, senior, and of higher-income taxpayers. blind ‘exemption’ credits—went to filers below How Do Deductions Increase Volatility? $150,000 in income. The state’s other credits that In theory, deductions can affect PIT volatility in are mostly available to filers with business income different ways, depending on how much they vary went primarily to upper-income filers, but these from year to year and whether they tend to move accounted for a small percentage of the total. in the same direction as AGI. In practice, however, Similar to deductions, credits disproportionately aggregate deductions increase volatility because they reduce incomes of lower-income taxpayers, disproportionately benefit lower- and middle-income thereby increasing overall volatility of the system filers as opposed to higher-income filers and because by making it more reliant on higher-income tax they are less volatile than AGI. (If deductions were payers. more volatile than AGI, they could reduce overall Conclusion volatility by reducing taxable income much more in years when AGI is high than in years when it is Summary of PIT Volatility. Figure 7 shows low.) Filers with incomes under $150,000 claimed the factors that make the PIT more volatile than 79 percent of total deductions in 2014. This reduces personal income. As mentioned above, personal the stable portion of the PIT base much more than income has an AD of 2.3 compared to 12.2 for the the volatile portion, and makes the remaining PIT PIT itself. Roughly 40 percent of this additional structure relatively more volatile. Of the six largest volatility comes from the differences between deductions, only the deduction for charitable personal income and the PIT base, another contributions primarily benefits upper-income people. 40 percent from the state’s progressive rate In contrast, filers below $150,000 a year claimed 75 percent of Figure 7 deductions for mortgage interest (the largest itemized deduction), Factors Contributing to PIT Volatility 93 percent for medical expenses, Average Deviation, 1990 to 2014 and 98 percent of standard 15 deductions. How Do Credits Increase 2.1 12.2 Volatility? By shrinking the 4.0 stable portion of the PIT base 10 more than the volatile portion, aggregate deductions increase 4.0 the volatility of the overall PIT. 5 Similar to deductions, credits increase volatility because they 2.3 primarily benefit lower- and middle-income filers and because they are less volatile Volatility of Definition of PIT Graduated Rate Credits and Volatility of PIT Personal Income Base Structure Deductions than AGI. In 2014, 75 percent PIT = personal income tax. of total credits—including www.lao.ca.gov Legislative Analyst’s Office 7 AN LAO B R I E F structure, and the final 20 percent from the state’s especially volatile. Deductions and credits also system of deductions and credits. increase estimated volatility. This is mainly because State PIT Base Much More Volatile Than they mostly benefit lower- and middle-income Personal Income. Why is the PIT base so much filers, and thereby reduce the relatively stable part more volatile than personal income? About half of the PIT base proportionately more than they of the difference comes from capital gains being reduce the relatively volatile piece of the PIT base. included in the PIT base but excluded from Legislature Could Reduce PIT Volatility . . . personal income. Capital gains have an AD of The state’s choices about what to include in (and 35.3—nearly three times the volatility of today’s exclude from) its tax base make the PIT tax base overall PIT. The other half of the difference arises more volatile than state personal income. Likewise, because some relatively stable income categories— the state’s adoption of a steeply progressive PIT including employer-paid benefits, transfer rate structure and various deductions and credits payments like Social Security and unemployment cause PIT revenue to be about twice as volatile insurance, and the excluded components of as the tax base itself. The Legislature has control dividends, interest, and rent—are excluded from over most aspects of the base and structure of the PIT. Moreover, transfer payments tend to rise PIT and could take any number of steps to reduce during recessions when other categories of income its volatility (in addition to the recent adoption decline, so they serve to smooth out aggregate of Proposition 2, which, as discussed in our prior income from one year to the next. report, aims to manage state budget volatility). In Why Do Graduated Rates and Other evaluating any proposed change, policymakers Provisions Make the PIT More Volatile? should also consider potential impacts on taxpayer California’s graduated rate structure that taxes behavior, on the incidence of the tax, and on ease higher-income filers more heavily than lower- of compliance and administration (especially if the income filers makes PIT revenue more volatile. state deviates from federal policy). This is the case because aggregate income reported . . . But More Stable PIT Would Likely Come by high-income filers has been much more volatile at Cost of Less Revenue Growth. We have discussed than aggregate income reported by low-income how the state PIT’s progressive rate structure filers. By taxing higher-income filers at higher increases volatility because the aggregate income of rates, the graduated rate structure amplifies the high-income people is especially volatile. It has also volatility of taxes paid by these filers. This pattern been the case that on average, the aggregate income of seems likely to continue barring a fundamental high-income people has grown much faster than the shift in the economy. Upper-income filers get a income of the whole population. If the PIT had been disproportionate amount of their income from less reliant on high-income filers, it would have been business profits and capital gains, which are less volatile but it also would have grown more slowly. LAO Publications This brief was prepared by Justin Garosi and reviewed by Ryan Miller. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This brief and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 8 Legislative Analyst’s Office www.lao.ca.gov