Taxes and Tax Policy: Progressivity Isn't Everything

Vermont’s tax burden is again under scrutiny with the publication of the legislature’s tax study.

The two most serious problems with the report are that it ignores the property tax and that it only looks at 12 states. Both of these limitations are due to cost issues (the difficulty of looking at 23 case studies) and the complexity of Vermont’s property tax. These limitations are understandable, but they still significantly weaken the study.

 

More fundamental is that editorials and commentators looking at the study have focused only on one goal of tax policy, that of progressivity and fairness. 

In Vermont, this usually comes under the umbrella of tax equity, a concept that, to economists, encompasses more than progressivity.

The National Council of State Legislatures has a nice summary here, and the discussion that follows takes off from the NCSL framework.

Basically, a good tax system has a number of attributes. Certainly equity is one—those with a higher income should pay more in taxes -- and usually we think of this as a higher share of their income -- than lower income folks. But equity also means horizontal equity. Those with the same income should pay the same taxes. That’s usually not an issue in Vermont, but we do give preferential tax treatment to some even though their incomes are the same.

Vermonters often think that any discussion of tax policy should stop here, and that is what most commentators on the tax study have implicitly concluded when they note that it is a good thing that the study found that rich Vermonters pay more than lower income Vermonters.

But there are other goals as well. For example, the way taxes are levied and calculated should be easy for taxpayers to understand. Vermont’s property tax fails miserably on this count.

They should be easy to administer. Again, the property tax doesn’t fare too well here.  

Taxes should be balanced among a variety of tax sources. Vermont doesn’t do too well here, either. We have a heavy reliance on the income tax, and if we consider that for at least 2/3 of Vermont homeowners, the property tax is really an income tax, it’s even more skewed. Fortunately, Vermont has not had a serious economic downturn in more than 15 years. The income tax is the tax most sensitive to economic fluctuations so this will at some time in the future become a major problem for the state.

Finally, taxes should be as neutral as possible, meaning that they should not affect taxpayer behavior. Also, they should be sensitive and responsive to interstate competition. It is this point that Vermont’s tax policy, and the tax study, and most commentators on the study, ignore.

Vermont has, consciously or unconsciously, moved to a tax system that has significant competitive and behavioral impacts, especially among the highest income Vermonters. Some of these may be “captive” to the state, but most have choices as to where to live and earn their incomes. And most of these are the highest income Vermonters, including entrepreneurs who employ, or potentially could employ, hundreds, if not thousands of Vermont residents.

Take the tax study’s case 23, a Vermont family earning $1 million annually. Their taxes are “off the charts,” literally. The chart on page 22 is not high enough to show the Vermont family’s tax liability.

That’s just a graphing issue, though. Let’s look at some equivalent states. Vermont ranks only 6^th out of the 12 states in total tax liability for this family. Of course, there’s the problem that we may also rank 6^th highest of all 50 states, which makes Vermont look much worse. That’s one of the limitations of using only 12 states as the tax study does.

The states ranked just ahead of us are North Carolina and Minnesota. In all three states, the million dollar family pays between $72,000 and $77,000 in income taxes. That’s the bulk of the taxes they pay, according to the tax study. Remember that property taxes are ignored in the tax study.  In Vermont, if that family lived in a $600,000 house, they’d pay more than $10,000 in property taxes—far more than in the other states (it’s not totally relevant, but in Boulder, Colorado, a town I am familiar with, a house worth $450,000 is assessed $2,000 a year in property taxes).

In North Carolina, that $1 million family pays a marginal tax rate of 8.0%. But that marginal tax rate kicks in at an income level of $120,000. In Minnesota, the top marginal rate is 7.85%, and it kicks in at an income of $70,000. In Vermont, the top rate is 9.5%, but it doesn’t start until you reach a taxable income level of $350,000.

So in these other states, the middle class pays the top marginal tax rate to a greater extent than Vermont. That means that the consequences of spending decisions are borne by a larger group of taxpayers than in Vermont. The legislature, with the governor’s consent, has pushed income sensitivity for the state’s property tax up to almost $100,000, which insulates a large share of the middle class from the tax consequences of taxpayer and legislative decisions. And the legislature’s committee looking at an income tax alternative to the property tax would effectively insulate those making far more than $100,000 from its spending decisions.

This means that in Vermont, we have a situation where we have a tremendous appetite for government spending, yet are insulating most taxpayers from most of the tax consequences of those decisions. Half of all government spending in Vermont is for K-12 education, which is essentially a program that benefits the middle class. If the beneficiaries of that spending have little stake in its cost, you have a prescription for an ineffective program and a democracy that won’t work well.

That’s why Sunday’s Rutland Herald editorial, Faux Populism, gets it wrong. 

It’s not faux populism. Faux populism is meant to criticize Governor Douglas’s view that Vermont’s taxes are high. He’s right. They are high, just not for most Vermonters. It didn’t take a legislative study for anyone to know that. The governor is rightly concerned about the other goals of tax policy. Those goals are not all mutually consistent. They have to be balanced. And he’s concerned that our tax system is becoming less responsible to interstate and international competition and to the goal of having a tax policy that does not influence taxpayer behavior, such as deciding not to move to Vermont to start a business, or to move elsewhere to expand one.

No, it’s not faux populism. In fact there is real populism. I would say it’s emanating not from the governor, but from those who say there is no problem with Vermont’s tax policy and that we should continue on the path we are on.

The tax study never mentions the fact that Vermont’s overall tax burden is one of the highest in the nation, and someone must be paying those taxes. It loses sight of the forest for the trees. 

The Herald editorial concludes that

Lawmakers must continue to make decisions about new programs on their merits, and they must continue to weigh the cost to taxpayers.

At the same time, budget constraints imposed on the basis of a misconceived notion of the state's tax burden may prevent the state from addressing pressing needs.

But how can a legislature that is responsive to the will of the majority, a majority of which pays low taxes, be asked to objectively analyze “pressing needs?” Every person and family in Vermont has pressing needs. We weigh each of those needs against the others and against our ability to pay and, then, we prioritize. If someone else is paying, the list of our “pressing needs” grows larger and larger. But some day, the person who is paying won’t be there to open his wallet.