Testimony of E.J. McMahon before the Joint Fiscal Committees of the New York State Legislature

Among the many aspects of the state budget that will have an impact on the economy of New York, I’d like to focus today on an issue of overriding importance – the status of the state personal income tax.

Since 1997, the top rate of our state income tax has been set at 6.85 percent, which applies to New Yorkers with taxable incomes starting as low as $20,000. Legislation adopted with the budget two years ago temporarily added two brackets to this structure: a top rate of 7.7 percent on all filers with taxable incomes above $500,000, and a second rate of 7.5 percent for all taxpayers with incomes starting as low as $100,000 but not exceeding $500,000. The 7.5 percent rate has since been phased down to 7.25 percent, while the top rate remains at 7.7 percent. Both rates are scheduled to expire at the end of this year, and Governor Pataki has proposed legislation to accelerate the phase-outs by slightly reducing the temporary rates this year.

Once these higher tax rates had gained a statutory foothold, it was sadly predictable that we would hear calls in some quarters for making the tax hikes permanent. I am here to sound the warning that raising the personal income tax rate would be both economically destructive and fiscally irresponsible.

This would be New York’s first permanent income tax rate increase in more than 30 years. It would send a signal to investors and employers that the era of pro-growth tax reduction is over in the Empire State. Job creation and investment in the state would both suffer as a result. It would take years to undo the damage.

ECONOMIC CONSEQUENCES

As the late Walter Wriston observed, “Capital goes where it’s wanted and stays where it’s well treated.” In the 21 st century economy, investment capital is more mobile than ever. And high-income households have always been the most mobile of all taxpayers. States opting to impose steeply rising income tax rates can expect to lose some of their most industrious and talented citizens to jurisdictions with low (or no) income taxes. Highly skilled individuals remaining in the state make up for the larger tax bite by charging more for their labor and services, which further drives up the cost of living and doing business. Individuals affected by tax hikes earn less, save less and invest less in the state. Employers create fewer high-paid jobs and more low-paid jobs. In effect, the “soak-the-rich” approach ends up soaking everyone[1].

New York’s fiscal and economic history over the past half-century could serve as a case study in the hazards of over-the-top income taxation. During the Rockefeller era, the state’s top PIT rate was more than doubled, ultimately peaking at 15.375 percent. Not by accident, this was also the period of the state’s greatest economic decline, relative to the rest of the nation. By the mid 1970s, businesses and jobs were leaving New York in droves. And between 1960 and 1980, our share of the nation’s employment dropped 30 percent.

Over the past 45 years, New York State’s strongest relative economic performance has come when PIT rates were falling. And it’s worth noting that significant income tax rate reductions have taken place under both Democratic and Republican governors, with support from bipartisan majorities in both houses of the Legislature.

The state’s long march back toward a more sensible income tax policy started under Governor Carey, who in his second term reduced the top rate on wages and salary income from 15 percent to 10 percent. It continued under Governor Cuomo, who in his first term reduced the top income tax rate from 10 percent to 9 percent, and eliminated discriminatory taxation of capital gains and dividend income as part of the bargain. A further significant step came in 1987, when the state followed the federal government’s lead by adopting a five-year plan to combine lower marginal tax rates with a flatter, simpler tax structure.

Unfortunately, Governor Cuomo’s record on the income tax was decidedly mixed. Beginning in the late 1980s, he repeatedly postponed scheduled PIT reductions and reforms, and in 1991 he signed into law a significant increase in personal income taxes for New Yorkers earning more than $100,000 a year.

Progress in reducing taxes was renewed after Governor Pataki took office, with passage of a new round of income tax cuts in 1995. This law incorporated many of the changes originally approved in 1987, but went several steps further. Over a three-year period, the top rate was reduced a full percentage point, from 7.875 percent to 6.85 percent. The top bracket threshold for married couples was raised from $25,000 to $40,000, with corresponding changes for singles and heads of households. This was a major improvement for middle- and lower-income people. Standard deductions were expanded, the earned income credit for the working poor was increased, and some 500,000 low-income households were removed entirely from the tax rolls.

Unfortunately, the temporary tax hikes of 2003 have wiped out most of the post-1994 reductions for a key category of economic decision-makers -- along with thousands of taxpayers who, given the high cost of living in and around New York City, are “wealthy” only in the eyes of the tax collector. For example, this hit such rich people as firefighters and school teachers. This was not just a tax increase for individuals, because it also affected the corporate incomes of many thousands of small businesses and partnerships that are taxed through the PIT rather than the Article 9A corporate franchise tax.

Moreover, these increases have not been not as “modest” as portrayed. That’s because the 2003 law also expanded an obscure provision of the tax code that effectively converts the progressive income tax into a high flat tax on all income for many households. As a result, some households that would not be considered “wealthy” by downstate standards are effectively subject to a higher effective marginal state tax rate – that is, the tax on an added dollar of income -- than Donald Trump.

A full explanation of this bizarre feature of our state tax code would take more time than I have today.[2] Suffice to say, in the wake of the 2003 changes, New York’s PIT is more complex and less fair than ever.

Advocates of increasing the PIT like to note that our top income tax rate is not the highest in the country – although it is clearly among the highest in the country. But the top rate alone is an incomplete and misleading measure of the actual tax burden. Each state’s income tax bill is also determined by the bracket structure and by the definition of taxable income. When all these factors are taken into account, New York’s total tax burden is among the heaviest in the nation by any standard of comparison – even those favored by leading advocates of so-called “tax-the-rich” policies.[3]

New York’s state income taxes and tax rates on incomes below $500,000 are the highest among states with which it must compete most directly for jobs and business investment, as shown in the table attached to this testimony. For wealthier households, our top rate was recently surpassed for the first time by New Jersey’s, which has been set at 8.97 percent on incomes above $500,000. The Garden State has thereby handed us a potentially significant competitive advantage – if we are willing to seize it. However, it should be noted that even New Jersey’s newly increased tax is lower than both the temporary (12.15 percent) and permanent (10.5 percent) combined tax rates for New York City residents. This is not insignificant, given the geography of the region.

Another frequent justification for raising income taxes is that they are deductible on federal returns. But deductibility isn’t what it used to be. When New York State’s top rate was 15 percent, the top federal rate was 70 percent. This meant the effective tax bite on the highest-earning households was only 4.5 percent. Today, with the federal top rate set at 35 percent, the post-deductibility cost of a 7.7 percent state rate is 5 percent. (The effective cost of the permanent rate of 6.85 percent is about 4.5 percent.) In the end, what matters is how we compared to other states. And, any way you slice it, compared to other states, our income tax is still high.

In fact, for many of the taxpayers affected by the 2003 tax hikes, deductibility doesn’t even exist. Hundreds of thousands of NY households are subject to the alternative minimum tax, which does not allow for any state and local tax deductions. For many of the same taxpayers, all itemized deductions are capped at a fraction of their value, which increases with income. In other words, deductibility is worth the least to those who send the most to Albany.

Developments affecting New York’s estate tax provide yet another reason against raising the income tax rate.

For decades, New York’s exceptionally high estate tax gave wealthy and affluent households another reason to relocate to other states. Seven years ago, bipartisan majorities in the Legislature joined with Governor Pataki to address this problem by reducing our estate tax to the federal “pickup credit” level, essentially leveling the playing field with the rest of the country.

However, the scheduled phase-out of the federal estate tax, which is supposed to disappear by 2010, is – for complex reasons – leading to the automatic reappearance of the New York estate tax.

Several of our key competing states – including Florida and South Carolina -- have no estate tax at all. This is already being factored into the estate planning of many wealthy New York households, as any lawyer in the field will confirm.

THE FISCAL FOLLY OF HIGH PIT RATES

Even putting aside the economic considerations, there is a substantial fiscal reason to avoid further increases in tax rates for high-income households – and that is New York’s risky over-reliance on the income tax.

Ten years ago, personal income taxes constituted just over half of the state’s tax receipts. In fiscal 2005-06, the figure will be closer to 60 percent. New York is far more dependent on personal income taxes than any state except Oregon (which depends heavily on income taxes because it has no sales or use tax).[4]

Thanks to the 1995 income tax reduction program, which targeted a disproportionately large share of benefits to low- and middle-income filers, New York’s tax burden is more heavily skewed than ever before to the upper reaches of the income distribution.

In 2005, the Budget Division estimates, nearly half of the state’s personal income tax revenue will come from the 3.5 percent of tax filers earning adjusted gross incomes of $200,000 or more. To put it another way: with a total population of 19 million and the equivalent of the world’s eighth largest economy, the Empire State will derive nearly one-third of its total tax receipts from just 300,000 households – roughly the population of a single congressional district.

The downside of depending so heavily on such small number of taxpayers should be obvious. It means that when high-income households have a bad year, the entire state suffers inordinate fiscal stress. This is precisely what happened to New York between tax years 2000 and 2002. All of the decline in income tax revenues during that period was concentrated in households earning more than $200,000.

The goal of fiscal policy should be to develop a tax base that is both stable and sustainable. Further raising taxes on the wealthiest New Yorkers will do just the opposite. It will make the tax base more volatile, more vulnerable to shifts in the stock market and general economic downturns. This is an especially bad idea if the goal is to keep up with the skyrocketing growth of Medicaid, or financing a massive settlement in the CFE case.

In the short run, the best way to nurture New York State’s economic recovery is by restraining and reducing income tax and other tax rates. In the long run, keeping an eye on the outcome of federal tax reform efforts in Washington, you can make New York’s tax structure stronger and more competitive by shifting to a more consumption-based form of income tax – featuring a broader base and a flatter, simpler rate structure.

Above all, a state tax policy designed to foster economic growth and job creation should follow the Wriston rule: show capital it’s wanted, and treat it well.

TOP INCOME TAX RATES IN NY AND NEIGHBORING STATES
(Percentage Tax Rates Under Current Law)

	Taxable incomes over $500,000	Top Rate Below $500,000
New York City (combined)
Permanent	10.5	10.5
2005 Temporary	12.15	11.3
New York State
Permanent	6.85	6.85
2005 Temporary	7.7	7.25
Connecticut	5	5
Massachusetts	5.3	5.3
New Jersey	8.97	6.35
Pennsylvania (state)	3.07	3.07
Pennsylvania (Philadelphia)	7.4	7.4