Mickey’s Musings, the policy blog of UCO Economics Professor Mickey Hepner, is consistently one of the best local sources for credible information and thoughtful opinion on economic and fiscal issues facing Oklahoma and the nation. One of Mickey’s favorite themes, which he revisits in this recent post, is that because of the interaction between federal and state tax laws, cutting the state income tax is of limited economic benefit to Oklahoma.
The reason is that state income tax cuts reductions are partially offset by an increase in federal tax liability. Here’s how it works:
Approximately one-half of Oklahoma’s married couples (and one-third of all Oklahoma taxpayers) itemize deductions on their federal income taxes. Among the deductions these taxpayers can claim is one for state income taxes paid. Consequently, when the state of Oklahoma cuts income taxes it is also reducing the amount of deductions these taxpayers can claim…resulting in an increase in federal tax liability.
For example, a $100 state income tax cut generates $100 less revenue for the state leading to a $100 reduction in state governmental services. Additionally, the $100 state income tax cut leads to a $100 reduction in deductions for those who itemize deductions on their federal returns. For taxpayers in the 25% marginal federal income tax bracket, this results in a $25 increase in federal income taxes. Thus, the state of Oklahoma loses $100 of government services but gains only $75 of disposable personal income. Essentially, we are giving up $100 in order to get $75 back…hardly the type of deal that would make our economy stronger.
Even in the midst of the deep and worsening budget shortfall, the Oklahoma Legislature is still looking at further cuts to the income tax. SB 315, which has passed the full Senate and a House subcommittee, would take the top personal income tax rate for 2010 down from 5.5 percent to 5.25 percent. The state revenue impact of that bill would be over $100 million, but as Mickey reminds us, some portion of the state tax savings would be captured by Washington in the form of higher federal taxes (In 2004, the Institute of Taxation and Economic Policy estimated the increased federal tax bill resulting from a cut to the state income tax at 11 percent). Yet 100 percent of the impact of the corresponding reduction in cuts to the state budget would be borne here in Oklahoma.
For what it’s worth, OK Policy’s proposal to increase the sales tax relief credit, in addition to having a much smaller fiscal impact than lowering the top tax rate, would be less subject to the federal deduction problem since the households eligible for the credit (up to a maximum of $60,000 for certain households under our proposal) are likelier to claim the standard deduction than to itemize their deductions (over 80 percent of OKlahomans earning under $50,000 in 2003 took the standard deduction).