State and Local Tax Policy: How do state and local income taxes work?
Forty-three 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 who itemize in many states may not deduct state income taxes paid. In addition, states often apply different rules than the Internal Revenue Service (IRS) 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 2013 ranged from 3.1 percent in Pennsylvania to 13.3 percent in California (including a 1 percent surcharge on incomes over $1 million). 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 10.3 percent in 1977 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. Individual income taxes then rose steadily until 2008 to account for 12.6 percent of general state and local revenues before falling down to 10.4 percent in 2010 because of the Great Recession. Collections in 2010 totaled $260 billion.
- Local governments in 13 states impose an income tax in addition to the state income tax. Census of Government figures show that local income taxes make up more than 5 percent of local general revenue in six states, led by Maryland with 15.2 percent. The other five states are: Indiana, Kentucky, New York, 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: around 2 percentage points in Kansas 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." California approved a millionaire’s tax for 2013 that taxes incomes over $1 million an additional 1 percent Similarly, New York’s top rate of 8.82 percent kicks in above incomes of right around $1 million.
- In 2011 11 states and the District of Columbia 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. However, most charge the same rate as normal income, unlike the federal government, which has a preferential rate. New Hampshire fully exempted all capital gains, and Tennessee taxed only capital gains from the sale of mutual fund shares. Massachusettshad 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. Pennsylvania and Alabama only allow losses to be deducted in the year that they are incurred, while New Jersey does not allow losses to be deducted from ordinary income. The remaining 25 states that tax income 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 2010, 15 states and the District of Columbia had adopted reciprocity agreements; typically these are states with employment centers close to a state border and large flows in both directions. A 2010 study by Jonathan Rork and Gary Wagner suggests that income tax reciprocity agreements lead to more competition in other taxes.
- 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, 2013" (Washington, 2013).
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, 2012 State Tax Handbook (Chicago, 2012).
Rork, Jonathan C., "Coveting Thy Neighbors' Taxation," National Tax Journal 56 (December 2003): 775-87.
Rork, Jonathan C. and Gary A. Wagner, “Is there a Connection Between Reciprocity and Tax Competition?” Public Finance Review 40 (January 2012): 86-115.
Wisconsin Legislative Fiscal Bureau, "Individual Income Tax Provisions in the States" (Madison, Wis.: July 2012).
Authors: Kim Rueben and Yuri Shadunsky
Last Updated May 8, 2013