State and Local Tax Policy: How do state and local income taxes work?
Forty-three states and the District of Columbia impose individual income taxes. The definition of taxable income varies by state (for example, New Hampshire and Tennessee tax only income from dividends and interest), but most states generally follow the federal definition, except that taxpayers may not deduct state income taxes paid. In addition, states often apply different rules than the Internal Revenue Service for other types of income and have differing tax rates. Nine states apply a single tax rate to all incomes, while the rest have multiple tax brackets and rates. Top marginal rates for state income tax in 2008 ranged from 3 percent in Illinois to 10.3 percent in California. Individual income taxes account for a relatively small share of state and local revenue: across all states, their contribution to general revenue rose from a low of 9.1 percent in 1972 to a peak of 13.7 percent in 2001 at the end of the 1990s boom, before falling back to 11.3 percent in 2003. Collections in 2006 totaled $269 billion, or 12.3 percent of general revenue.
- Fourteen states permit local governments to impose an income tax in addition to the state income tax. Local income taxes are currently imposed in specific localities in eleven of these states, but at significant levels in only three (Maryland, Ohio, and Pennsylvania). In most states, local income tax takes the form of a tax on wages; other states levy local income tax simply as a percentage of the state income tax.
- Most state income taxes are fairly flat, even in those states that apply graduated tax rates. In several states the top tax bracket begins at a very low level of taxable income; Alabama, for example, starts its top rate at $3,000. In other states the difference between the lowest and the highest tax rates is small: just 2 percentage points in Connecticut and Mississippi, for example.
- In the middle and late 1980s, most states followed the federal government’s lead in reducing the number of income tax brackets: nineteen states did so within three years of enactment of the federal Tax Reform Act of 1986. But that trend has reversed more recently. Some states have imposed new brackets for high-income taxpayers, often called "millionaire’s taxes." In 2005 California initiated a 1 percent additional tax on income over $1 million, and New Jersey enacted an additional tax bracket for income over $500,000. Most recently, Maryland expanded its effectively flat system to include an additional three marginal tax brackets, with the highest beginning at $500,000, effective in tax year 2008. But some states have gone in the opposite direction: New York added two high-income brackets in 2003, with the top bracket starting at $500,000, but reverted to a top bracket beginning at $20,000 in 2007.
- In 2005 fifteen states treated capital gains and losses the same as under federal law, taxing all capital gains and allowing the deduction of up to $3,000 in net capital losses. New Hampshire fully exempted all capital gains, and Tennessee taxed only capital gains from the sale of mutual fund shares. Massachusetts had its own system for taxing capital gains, applying a 12 percent rate to short-term gains (net of capital losses) and long-term gains from collectibles and pre-1996 installment sales, and a 5.3 percent rate to all other long-term gains. Hawaii had an alternative capital gains tax. The remaining twenty-four states that tax income and the District of Columbia generally followed federal treatment, with the exception of various state-specific exclusions and deductions.
- Income tax is generally imposed by the state in which the income is earned. However, various states have entered into reciprocity agreements with one or more other states that allow income earned in another state to be taxed in the state of residence. For example, Maryland’s reciprocity agreement with the District of Columbia allows Maryland to tax income earned in the District by a Maryland resident. As of 2004, sixteen states had adopted reciprocity agreements; typically these are states with employment centers close to a state border and large flows in both directions.
- State income tax rates appear to have little effect on rates in neighboring states. A 2003 study estimated that a 10 percent increase in personal income tax rates in neighboring states would actually induce a decrease of less than 1 percent in the home state’s tax rate. The author suggests that the relative immobility of the tax base explains the counterintuitive result: few workers move across state lines simply to reduce the income taxes they pay.
Federation of Tax Administrators, "State Individual Income Taxes, January 1, 2008" (Washington, 2008).
Tax Policy Center, State and Local Finance Data Query System.
American Council on Intergovermental Relations, Significant Features of Fiscal Federalism (Ocean Grove, N.J., various years).
Brunori, David, Local Tax Policy: A Federalist Perspective, 2nd ed. (Washington: Urban Institute Press, 2007).
_________, State Tax Policy: A Political Perspective, 2nd ed. (Washington: Urban Institute Press, 2005).
CCH Incorporated, 2004 State Tax Handbook (Chicago, 2003).
Rork, Jonathan C., "Coveting Thy Neighbors' Taxation," National Tax Journal 56 (December 2003): 775-87.
Wisconsin Legislative Fiscal Bureau, "Individual Income Tax Provisions in the States" (Madison, Wis.: January 2007).
Authors: Kim Rueben and Carol Rosenberg
Last Updated September 26, 2008