Three reforms to modernize Oklahoma's income tax

At the first meeting of the legislature’s tax reform task force, both chairmen expressed support for making top-down cuts to Oklahoma’s income tax or eliminating it entirely. In a previous post, we explained why that’s a bad idea. In this post, we present three alternative reforms that would modernize the income tax and genuinely improve Oklahoma’s competitiveness and economy.

1. Update the Personal Exemption

Oklahoma’s personal exemption, which allows households to deduct a set amount from taxable income for each member, has not been changed since the early 1980s. The impact of inflation since that time means today the exemption is worth a just fraction of what it once was.

What we propose is similar to what Oklahoma has already done with the standard tax deduction. In 2006, it was tied to the federal standard deduction, which is adjusted every year based on inflation. If we also tied the personal exemption to the federal exemption, it would go up to $3,700 per person from the current $1,000. This change would make Oklahoma’s tax code better reflect the cost of living and help working families to make ends meet.

2. Modernize the Tax Brackets

Oklahoma’s tax brackets are outdated. Because the bracket structure does not change with inflation, every year an increasing proportion of Oklahomans must pay a higher rate. Today, the top rate affects 56 percent of Oklahoma households, which is far higher than most states, according to data by the Institute on Taxation and Economic Policy (ITEP). The chart below shows the percentage of Oklahoma households affected by each bracket:

Moving low- and middle-income people away from the highest tax brackets would create a tax structure more appropriate to the income levels in our state. Linking it to inflation would prevent the problem from happening again.

At the same time, we should add new tax brackets of 6 percent on income above $500,000 and 7 percent on income above $1 million. This would help preserve revenue needed to invest in schools, safe communities, good roads and transportation, and other building blocks of our economy while reducing taxes for the vast majority of Oklahomans.

3. Limit Itemized Deductions

Our current system of itemized deductions gives the biggest tax breaks to the wealthiest, who already pay a lower percentage of their income in state and local taxes than average working Oklahomans. Almost three of four Oklahoma households make less than $50,000, yet according to 2007 figures (the latest available), only one in eight of these low- and moderate-income households claimed itemized deductions (the rest claimed the standard deduction). By contrast, nearly half of itemized deductions were claimed by the 8 percent of Oklahoma households with income over $100,000 .

Many of these itemized deductions are purely wasteful and should be eliminated. For example, Oklahoma is one of only six states that allow taxpayers to deduct from their taxable income the amount of state income tax they owe, an unintended consequence of how federal and state taxes interact. This deduction has no rationale. Ending it  would raise $118 million  to help pay for vital services.

Itemized deductions are already disallowed in nine states [UPDATE: As of tax year 2011, they are prohibited in ten states]. Even if we don’t get rid of them entirely, Oklahoma should cap the total amount eligible for deducting or convert deductions to tax credits. Since deductions reduce taxable income before tax rates are applied, they provide a bigger break to wealthier taxpayers whose incomes are taxed at higher rates. Tax credits benefit all taxpayers equally, rather than doing more for those who need it less.

The Takeaway

These three reforms would do a lot to modernize Oklahoma’s tax code to benefit our  economy. They would ensure that we have the revenue to invest in education, transportation, public safety and other necessities that will keep Oklahoma competitive and create jobs. Alternatives, like eliminating the state income tax, would take Oklahoma backwards – damaging our economy and shifting costs of public services to those already struggling the most to get by. That’s not the way to build a prosperous future for Oklahoma.