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The 2023 Income Tax Cut Proposal

As this year’s legislative session winds down, a new tax cut proposal is on the agenda of the state legislature this week. The proposal would reduce the top marginal tax rate from 4.9% to 4.7%. This essay considers some of the features of the proposal.

Arkansas has a unique multi-tier system of tax tables, first established in the context of tax cuts in 2015. Accordingly, the newly proposed legislation, Senate Bill 549, adjusts two tax tables separately. The Low Income tax tables are adjusted as shown in Table 1:

Table 1:

Tax cuts for income-earners in this range are affected primarily by adjusting the tax brackets; for example, by increasing the threshold for zero taxes from $5,000 to $5,100.  Toward the upper end of the scale, threshold incomes are increased and the top marginal tax rate is reduced from 4.9% to 4.7%.

The effects of these changes on average and marginal tax rates for incomes up to $84,500 are shown in Figure 1:

Figure 1:

The changes in tax-bracket thresholds results in lower taxes for all earners within the income range considered. The tax savings are fairly small: for example, for a taxable income of $32,000, the tax burden is lowered by $32.50—a reduction of 0.10%.  At the higher end of the scale, a taxpayer with an income of $84,500 would receive a tax cut of $137.50 (about 0.16%).

The high-income tax tables are adjusted as shown in Table 2. As in Table 1, the thresholds for the tax brackets are revised, along with a reduction in  the top marginal tax rate from 4.9% to 4.7%.  The breakdown of statutory marginal tax rates into income brackets in this case is completely fictional. The tax obligations in Table 2 could be equivalently stated as “$250 plus 4.9% of all income over $8,500” under existing law, or in the case of the proposed changes, “$260 plus 4.7% of all income over $8,800.”

Table 2:

But here’s where it gets complicated: Under either tax regime, existing or proposed, the two tax scheduled don’t align. Consider the proposed bill: for an income of $87,000 the tax burden from Table 1 is $3,509.  If we turn to Table 2 to calculate the tax obligation for an individual with an income of $87,001, it turns out to be $3,939, a tax increase of $430 for an income increase of $1. That’s an enormous effective marginal tax rate! This is an example of what is known as a “tax cliff.”

The legislative “fix” to this problem has been to append an adjustment ladder. In the proposed legislation, for example, an adjustment table reduces the tax burden for individuals with incomes in the range of $87,001 through $87,100 by $460. This assures a smoother transition at the $87,000 income threshold. The adjustment amount is reduced by $10 for every $100 until it reaches zero at an income level of $91,300. In effect, this turns one enormous tax cliff into 46 mini tax cliffs as shown in Figure 2, expressed in terms of average tax rates.

Figure 2:

At each one of these mini-cliffs, the marginal tax rate spikes: a $1 increase in income increases an individual’s tax burden by $10.047 (one dollar for the ladder-adjustment plus 4.7% for the one-dollar increment).

The standardized tax tables are set up in increments of $100, so if we use that as our basic unit, a $100 increase in income results in a $10 increase due to the ladder-adjustment plus $4.70 due to the marginal tax rate–a total marginal tax increase of 14.7%.  Figure 3 illustrates how this feature results in an effective marginal tax rate of 14.7% over the adjustment range, along with how the proposed 2023 tax cut affects marginal tax rates.

Figure 3:
*Marginal Tax Rate calculated in $100 increments.

So, although the proposed tax cut plan does reduce the maximum statutory marginal tax rate from 4.9% to 4.7%, the maximum effective marginal tax rate is 14.7% (down from 14.9%) through the adjustment-ladder income range (which itself is shifted by the proposal).

Economic theory and evidence tells us that the effective marginal tax rate is the relevant measure to consider when it comes to to evaluating economic incentives. The tax system introduces economic inefficiencies by discouraging the incentive to seek a higher income when marginal tax rates are high. By this measure, the 14.7% marginal tax rate over the income range of $87,000 to $92,000 is a clear disincentive.

The stated intent of income tax cuts is generally two-fold, to reduce the economic inefficiencies induced by taxation and to reduce the burden on individuals and households. The proposed tax-cut legislation leaves in place the oddity of a very high marginal tax rate over a specific income range, but how much does it satisfy the second objective: lowering taxpayers’ burden?

Figure 4 shows the tax savings under the proposed changes. For a net taxable income of $20,000, the tax cut would yield tax savings of $6.60.  The savings jumps to $17.70 for an income level of $23,600 and rises to $128.50 for incomes of approximately $80,000.

Figure 4:

For a range of incomes from $84,500 to $91,900 the tax cut represents more substantial savings, peaking at $385 for incomes just over $85,100. The magnitude of the tax cut drops to $170 at an income level of just over $91,450.

In dollar-value, the value of the tax cuts cannot be dismissed, but in terms of percent-of-income they are relatively small. Figure 5 converts the tax-cut savings into changes in average tax rates.  For incomes below $24,000 the tax cuts amount to about 0.05% of taxable income. The percentage rises to 0.16% for incomes above 80,000. At higher incomes (above $92,000), the percentage tax savings converge toward the 0.2% change in the statutory maximum marginal tax rate.

Figure 5:

Taxpayers with incomes in the range of $84,500 to $91,900 receive the largest tax reductions, both in absolute dollar terms and as a percent of income. For this segment of taxpayers, the incentive effects of tax cuts are most likely to have an impact. Those who face the highest marginal tax rates are those who benefit the most from tax-rate reductions.

The ongoing presence of an effective marginal tax rate of nearly 15% over a range of incomes is a significant potential source of economic distortions. Arkansas is the only state in the U.S. with this kind of two-tiered tax table—a remnant of past political compromise that has become a fixture of our tax system. Tax reform to increase the efficiency of our tax system should address this built-in artifact of our tax code as much as it addresses the issue of lowering the statutory marginal tax rate.

Arkansas’ New 15.5% Top Income Tax Rate

The Arkansas legislature adopted major income tax legislation this week, with the accomplished goal of lowering the marginal tax rate on high incomes from 5.9% in 2021 to 5.5% in 2022, with further reductions scheduled for subsequent years that would reduce the top marginal tax rate to 4.9% in 2025.

But one quirky feature of the Arkansas tax code results in an anomalous income bracket for which the effective marginal tax rate is actually 15.5%.  Moreover, over this particular income range, the tax code contains over 60 “tax cliffs” in which small increases in pre-tax income can result tax hikes that actually reduce after-tax income.

The reason for this anomaly is Arkansas’ dual tax table arrangement, where incomes up to a certain threshold are subject to one table, while there is a completely different tax table that applies to incomes above that threshold.

Typically, a progressive income tax increases the marginal tax rate (the tax on the next dollar), in uniformly increasing steps.  The result is a relatively smooth, increasing profile for average tax rates (taxes paid/taxable income).  An example is shown in Figure 1, which shows the marginal and average tax rates in the new legislation for incomes up to $84,500.

Figure 1:

But Arkansas’ dual tax-table system includes a more significant break, where the entire tax table changes for incomes above a certain threshold.  In the new legislation, this break-point is $84,500.

Nominally, the tax tables in the new tax code specify that for incomes above $84,500 the marginal tax rates are 2% on the first $4,300 of income, 4% on income between $4,301 and $8,500, and 5.5% for incomes above that.  But this is just silly.  If the tax table only applies to incomes above $84,500, it doesn’t matter what the marginal rates are below that threshold.  It would be more straightforward, and numerically equivalent, to say that the marginal tax rate is 5.247% on every dollar up to taxable income of $84,500 ($4,434) plus 5.5% above that level.

But however it is described, this presents a problem.  The tax for an income level of $84,501 turns out to be $620 higher than it would be if the lower income table was used. That would be an effective marginal tax rate of over 60000% for that 84,501st dollar of income.

That’s what is known as a “tax cliff.” When statutory thresholds become significant enough that people might change their economic behavior (or at last their tax-reporting behavior) to account for quirks in the tax system, then resources are likely being spent inefficiently.  Here at the Arkansas Economist, we pointed out the problem with tax cliffs when the multiple tax-table system was first introduced in 2015.

The Arkansas legislature’s solution to this problem in 2021 has been to introduce over 60 little tax cliffs to the mix.  The new system of “Bracket Adjustments” specifies that anyone with a taxable income of $84,501 to $84,600 is entitled to a tax-reduction of $620.  For each $100 beyond that, the bracket adjustment is reduced by $10, until it reaches zero for incomes above $90,600.

Figure 2 illustrates the multiple tax cliffs in the new legislation, showing the stair-step nature of the bracket adjustment effect on average tax rates.

Figure 2:

At each of these mini tax cliffs, the marginal tax rate approaches infinity as we narrow the definition of “marginal.”  A one dollar increase in income that raises tax burden by $10 can be described as a marginal tax rate of 1000%.  Decreasing the granularity of the calculation, an income increase of $100 over the bracket-adjustment range results in an increase in tax obligation of $10 plus the 5.5% statutory marginal tax rate—a total marginal tax rate of 15.5%.

Figure 3 puts the two tax tables and bracket adjustments together to show the average tax rates and effective marginal tax rates over income ranges from $0 to $120,000.  The marginal tax rate in Figure 3 is calculated as the increase in tax burden for each $100 increase in income.  The result is an effective marginal tax rate of 15.5% over the bracket adjustment range.

Figure 3:
*Marginal Tax Rate as calculated in $100 increments.

So, under the assumption that $100 increments are an appropriate measure of “marginal” that matters to taxpayers (at least those in the bracket-adjustment range), we might expect people to take measures to avoid the 15.5% marginal tax burden.  Those efforts represent the efficiency loss of the tax system’s complexity.

To further illustrate the point, let us consider a tax system that is roughly equivalent to the newly adopted regime, but one that eliminates the tax cliffs.  The calculations underlying Figure 3 provide guidance for how to construct such a system.  Taking the marginal tax rates from the lower-income tax table, extending the table to impose a 15.5% explicit marginal rate on incomes between $84,500 and $90,700, with a return to the 5.5% marginal rate for incomes above $90,700, we can reconstruct an average tax profile that is virtually indistinguishable from the one shown in Figure 3.

Zooming in on the bracket-adjustment range shows how this hypothetical unified tax table eliminates the stair-step nature of the tax cliffs while retaining the ramping-up of average tax rates—revealing the relevance of this near-observationally equivalent representation of the newly-adopted tax code.

Figure 4:

So, in a very real sense, the new tax code includes a 15.5% effective marginal rate over a specific range on incomes.

But does this all matter?  When it comes to a static analysis government revenue, the relevant measure is how the average tax rate schedule and the population income profile overlap. That is also true when it comes to the tax burden on individuals.  But when it comes to economic decision-making, marginal calculations matter  To the extent that the tax-cliffs and brackets with high effective marginal rates affect taxpayer behavior, a static revenue projection might be overstated relative to a dynamic analysis that takes tax-avoidance behavior into account.  Ultimately, whether the effect is quantitatively significant or not is an empirical question.

 

Sales Taxes Across the Nation

The Tax Foundation has released an updated list of state and local sales tax rates across the nation, accounting for changes in tax rates that took effect July 1 (the beginning of the fiscal year for most states).  Including both statewide and local sales taxes, Arkansas ranks near the top of the list for the highest rates in the nation.  Compared to the other 49 states plus the District of Columbia, the updated report shows Arkansas’ ranking dropping from #2 to #3 — not because of changes in Arkansas tax rates, but because a statewide tax increase in Louisiana catapulted that state from #3 to #1.

The statistics from the Tax Foundation are based on the sum of statewide tax rates plus a population-weighted measure of local tax rates.  In Arkansas, the state sales tax is 6.5% — tied for the 9th highest in the nation.*  The average local tax rate (weighted by population) is 2.8% — making the combined state/local tax rate 9.3%.  Only Louisiana (9.98%) and  Tennessee (9.45%) have higher combined sales tax rates.

Sales Taxes

The Tax Foundation figures do not incorporate exemptions for some categories of goods.  For example, in Arkansas and in other states the sales tax on groceries is lower than on other items.  The statistics also do not include additional sales taxes that are imposed on specific goods and services.  For example, several cities impose special taxes on prepared foods (the “hamburger tax”).  Moreover, the Tax Foundation statistics do not include excise taxes that are imposed at the wholesale level and therefore incorporated into retail prices.

Although the aggregate state/local sales tax rate for Arkansas did not change in the latest report from the Tax Foundation, tax rates in several local jurisdictions changed as of July 1.  The list of changes and resulting local tax rates is as follows:

  • Big Flat:  1.00%, newly enacted
  • Danville: 1.00%, decreased from 1.50%
  • Oak Grove Heights 1.00%, newly enacted
  • Ozark:  2.00%, increased from 1.00%
  • Rudy: 0.50%, newly enacted
  • Drew County:  2.25%, reduced from 2.50%
  • Marion County: 1.25%, increased from 1.00%

# # #

*Note:  The 6.5% statewide sales tax rate is actually an aggregate of 5 individual taxes.  The general sales tax rate is 4.5%, with additional taxes earmarked for special purposes:  Educational Adequacy 0.875%, Property Tax Relief 0.5%, Arkansas Highways 0.5%, and Conservation Tax 0.125%.

Collins vs. Brummett on State Income Taxes: A Comment

Over the past few weeks, columnist John Brummett and state Representative Charlie Collins have been engaging in a public debate about Collins’ suggestions for modifying the personal income tax structure in Arkansas.  Collins’ proposal is to eliminate the second-lowest 2.5% tax rate (lowering it to 1%), to eliminate the highest 7% tax rate (lowering it to 6%), and to raise the threshold at which the new highest rate would kick in.  The threshold would be raised in phases for “higher income levels (six-figure earners) … over time.”  (He has been cited as suggesting that the threshold increase by $20,000 per year.)

Collins argues that his proposal represents “a dramatic tax break for low-income workers (60 percent reduction from 2.5 percent to 1 percent), strong relief for middle-class working families (35 percent cut from 7 percent to 4.5 percent), and a modest drop for high-income workers and job creators (14 percent from 7 percent to 6 percent).”

In a recent column, Brummett called these calculations “superficial and misleading.”  He calculates that for a taxpayer making $7,800 in adjusted taxable income per year (after exclusions and deductions) the tax savings from Collins’ plan would be about $60, and for a taxpayer with $252,600 in taxable income per year the tax reduction would be $2,200.  He cites this comparison as being fundamentally “unfair,” and asks the rhetorical question: “What’s the percentage of the better deal the well-off guy gets with $2,200 than the poor guy gets with $60?”

So who is right?  Actually, that’s a complicated question.  Both Collins and Brummett are factually accurate, but neither tells the whole story.  Each picks particular comparisons to support his case, missing some of the more general and subtle implications of the proposed plan.  And more importantly, they are addressing somewhat different questions.   The Arkansas Economist decided to weigh-in on this debate in an effort to provide a common-denominator, in the hope of clarifying some of the issues that underlie the disagreement.

To begin with, there is an important distinction between marginal tax rates and average tax rates.  In a progressive income tax scheme, marginal tax rates increase in steps.  Under current Arkansas law (2011 tax year), the tax is 1% on the first $3,999 of income, 2.5% on the next $4,000, 3.5% on the next $3,900, 4.5% on the next $8,000, 6% on the next $13,300, and 7% for any adjusted taxable income above $33,200.   The average tax rate (taxes paid as a percentage of income) is therefore a composite of marginal tax rates paid on cumulative levels of income.

Figure 1, below, illustrates marginal and average tax rates for current law, and for three alternative scenarios corresponding to the components of Collins’ plan.  Panel A illustrates current Arkansas tax law, with marginal and average tax rates plotted against adjusted taxable income.  Because the higher levels of income are taxed at progressively higher rates, the average tax rate is lower than the marginal tax rate for all income levels above the lowest bracket.   Average tax rates increase with income in a fairly smooth relationship, converging gradually to the highest marginal rate.  Panel A shows that taxpayers with adjusted taxable income below $4,000 currently pay an average tax rate of 1% (the same as the marginal rate), while those with incomes of $250,000 pay an average tax rate of about 6.6%.

Source: Arkansas Department of Finance and Administration, and author’s calculations

Panel B shows the effect of eliminating the 2.5% and 7% marginal tax brackets, without adjusting the threshold levels of income.  This lowers average tax rates for all taxpayers with incomes over $4,000, reducing the “steepness” of the average tax rate curve. Taxpayers with incomes of $250,000 now pay an average tax of 5.75%.  Panel C shows an estimate of the first phase-in of Collins’ increase in the threshold at which the 6% rate kicks in — an increase from 19,899 to 39,999.  This change lowers average tax rates for all incomes above $19,899, particularly for those with incomes between $20,000 and $40,000.  The average tax rate for an income of $250,000 falls from 5.75% in Panel B to 5.63% in Panel C.  Similarly, Panel D — which shows an increase in the highest tax-bracket threshold to the “six-digit” figure of $100,000 — shows a further flattening of the average tax curve (particularly for adjusted taxable incomes between $40,000 and $100,000), with the average tax rate for $250,000 incomes declining to 5.27%.

Having made the distinction between marginal tax rates and average tax rates, which one matters?  Collins’ main argument is that lowering tax rates will boost economic growth, and in this regard his focus on marginal rates is appropriate.  Economists generally consider decisions are made on the margin:  when considering an action that would change a taxpayer’s income, the question is “how will taxes affect my net income from one additional dollar earned in gross income?”

But for comparing the magnitude of tax cuts for different income levels, the average tax rate is a more appropriate measure. Collins’ calculations using marginal tax rate changes amount to making comparisons at very specific points along the income distribution, with the changes in marginal tax rates serving as an approximation of the impact on taxes paid (since the total tax bill is actually a composite of marginal rates).

Brummett is even more explicit about comparing a limited number of cases.  In particular, he considers two extremes:  One taxpayer with income of $7,800 and another with an income of just over $250,000.  Figure 2, below, generalizes Brummett’s argument.  Figure 2 shows the total tax reduction (in dollars) as a function of taxable income.  At the lowest income levels, the tax reduction amounts to $60 (as Brummett calculates).  This figure applies to all incomes in a range from $8,000 up to $19,900, the current 3.5% and 4.5% marginal tax brackets.  These marginal tax rates are unchanged by Collins’ proposal, but the elimination of the 2.5% tax bracket lowers total (and average) taxes.  Brummett’s other extreme is a taxpayer making over $250,000 in adjusted taxable income.  After the elimination of the two tax brackets, a taxpayer with this income receives a tax cut of about $2,200.  Note that by ignoring the proposed increase in tax-rate thresholds, Brummett actually underestimates the savings for these taxpayers would enjoy under Collins’ complete plan.  After the threshold for the new highest rate has reached six figures, the total tax savings for a taxpayer with $250,000 in taxable income is about $3,400.

Source: Author’s calculations.

So does this mean that Brummett is correct about the innate unfairness of the plan?  No, not really.  His comparison of two extreme cases, generalized in Figure 2, amounts to nothing more than an observation that any across-the-board tax cut results in larger tax reductions (in absolute dollar terms) for those who pay the most taxes in the first place.

Typically, those who emphasize “fairness” in the tax structure are focusing on progressivity.  For example, no one expects that Warren Buffet has a lower total tax bill than his secretary, but the controversy about fairness focuses on whether or not he pays a lower average tax rate (there’s that average tax rate again!).  An across-the-board tax cut proposal like Collins’ could conceivably result in a universally more progressive tax structure, but it would still display the pattern shown in Figure 2.

Economists have no special insight on whether a tax structure is “fair” or not, but we can describe objectively whether one tax structure is more progressive than another.  To do so, we need to consider the pattern of tax reductions in percentage terms.  This is precisely equivalent to looking at the percentage change in average tax rates.  One tax regime is considered more progressive than another if larger proportionate tax cuts go to lower income tax payers and vice versa.

Figure 3 shows how these percentage changes work out under the Collins plan.  Under each of the modified scenarios, the largest tax cuts in percentage terms are for taxpayers with adjusted taxable incomes of around $8,000.  So, Brummet’s hypothetical low-income taxpayer with his $60 tax cut receives the largest proportionate reduction of any income category — around 42%.  Note that this is somewhat less than the 60% reduction calculated by Collins using changes in marginal tax rates.

Source: Author’s calculations.

Without any change in the threshold level for the highest marginal tax rate, the proportionate tax saving falls off sharply over the income range of $8,000 to $33,000.  The smallest tax cut, 4.2%,  goes to a taxpayer with adjusted taxable income of $33,200 (the current level at which the 7% rate kicks in).   From that point, the proportionate tax savings is increasing in income.

Over the range from $8000 to $33,200, we can state unambiguously that the elimination of the two tax brackets increases the progressivity of the tax structure.  More generally, one can select any two or three points along the income distribution to show that progressivity has increased or decreased.  The important point is that such comparisons are specific to the particular points chosen.  A tax reform plan is universally more (less) progressive if the percentage tax savings are decreasing (increasing) in income over all income ranges.

Note that increasing the threshold where the maximum tax rate takes effect introduces a much different pattern of progressivity over higher income levels.  With no change in the threshold, the tax cuts become proportionately larger for higher incomes.  But increasing the threshold leads to a boost for those with incomes between $19,900 and the new higher cut-off level.  Raising the threshold to $40,000 increases the percentage tax cut for someone at that level of income by 22.5%.  Raising it to $100,000 implies a tax cut of 31.6% for taxpayers with adjusted taxable income of $100,000.  In either case, the percentage change in taxes is decreasing for incomes above the new threshold.  That is, raising the threshold has the effect of introducing greater progressivity into the upper end of the tax structure.

Of course, the issue of fairness and progressivity reflects only one dimension of a complex issue.  Collins emphasizes the positive effect his proposal would have for economic growth.  Brummett points out that lower income tax revenues for the state have to be made up for by increasing other taxes or cutting government spending.  Both points are valid, but the key question in each case is “how much?”  In the end, these questions are arguably more important than the progressivity issue — but are beyond the scope of this brief comment on the recent debate.