How State Tax Policies Can Stop Increasing Inequality, Start Reducing It

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Tax Policy

The top 1 percent of households, in almost half the states, have received half of the income growth since the Great Recession. In this article, Elizabeth McNichol of the Center for Budget and Policy Priorities discusses the effect of income inequality and what state lawmakers can do through tax policy to reduce it.

Elizabeth McNichol

By Elizabeth McNichol

Elizabeth McNichol is a senior fellow at the Center on Budget and Policy Priorities.

Over the last three and one-half decades, income gains in the American economy have accrued largely to the richest households, while many middle- and lower-income Americans find their hard work hasn't paid off as they haven't shared in the nation's growing prosperity. See Figure 1 below.

Income gains since the 1970s have gone disproportionately to the wealthiest households not only nationally, but in each state as well. (See Table 1.) The top 1 percent's share of overall income rose in every state and the District of Columbia (and doubled nationally, from 10 percent to 20 percent) between 1979 and 2013, according to a recent analysis of IRS data. Income inequality abated somewhat due to the Great Recession, but wealth is again becoming more concentrated at the top during the recovery. In 24 states, the top 1 percent captured at least half of all income growth between 2009 (when the recession officially ended) and 2013 (the most recent year for which state data on the top 1 percent are available).

Across the country, the wealthiest residents have benefited most from the uneven growth in incomes. The average income of the top 5 percent of households is now at least ten times that of the bottom 20 percent in every state, according to 2015 American Community Survey data. Moreover, these figures understate income disparities because they omit capital gains income, which is heavily concentrated among the richest households. (Table 2 and Figure 3 below provide comparative income data by state.)

Growing inequality has reduced opportunities for working people striving to get ahead and weakened our overall economy. Though the growth in inequality reflects a host of long-standing national and global economic trends that are largely outside state policymakers' control (see box below), state policy choices can make matters worse or improve them.

For example, virtually all states collect more taxes from moderate- and lower-income families, as a share of their income, than high-income families (see Figure 1). This increases inequality by reducing after-tax incomes more deeply among low- and middle-income families than high-income families.

The mechanisms by which state tax systems ask less of the wealthy than of poor and middle-income families have developed over time, often through closed-door negotiations resulting in special tax breaks that benefit a relative few.

To reverse these trends, states should avoid actions — such as cutting income taxes or raising sales taxes — that worsen inequality by shifting taxes further to lower-income residents. Instead, they should ensure that high-income earners pay their share and lower-income earners don't face increased tax responsibility.

States can reverse these trends and use tax policy to reduce income inequality by taking the following actions.

Strengthen their income tax's inequality-reducing impact. Tax increases on high-income individuals — who are best able to afford the higher tax and least likely to spend substantially less as a result of the increase — can reduce inequality directly while raising revenue to invest in a more broadly prosperous future. Policymakers can raise taxes on high-income households by raising income tax rates at the top end and by capping itemized deductions and other tax breaks for high-income taxpayers.

For example, Rhode Island eliminated all itemized deductions in 2010. More recently, Vermont limited the amount of itemized deductions that high-income taxpayers can take to 2.5 times the standard deduction. ($15,500 for individuals and $31,000 for joint filers.) Maine and North Carolina have also recently capped itemized deductions.

Establish or expand taxes on inherited wealth, such as the estate tax. Only the very wealthiest taxpayers pay estate taxes — just 2.56 percent of estates, on average, in the states with the tax. Some 18 states plus Washington, D.C. have an estate or inheritance tax. States with an estate tax can avoid increasing inequality by resisting calls to reduce or eliminate the tax. States without an estate tax can reduce inequality by adopting one.

Eliminate costly and ineffective tax breaks for corporations. State corporate income taxes are declining; the share of tax revenue supplied by this tax in the 45 states that levy it fell from nearly 10 percent in the late 1970s, to only a little more than 5 percent today. Many profitable corporations pay nothing in state income taxes in some states where they do business. States can strengthen taxes on corporations by carefully examining and eliminating costly tax breaks. They can also establish strong minimum taxes — a floor on the amount of tax owed each year. In addition , states that have not already done so can adopt a reform known as combined reporting, which closes a loophole that enables corporations to artificially move profits out of the state in which they're earned and into states where they will be taxed at lower rates – or not at all.

For example, in 2015 Connecticut joined every other New England state in adopting combined reporting. It levels the playing field for small Connecticut businesses trying to compete with big corporations that use the loophole to cut their costs.

Evidence does not support the claim that these kinds of changes will drive large numbers of affluent people and businesses to other states.

Broaden the sales tax base. States can make their tax systems fairer by broadening the sales tax base to include more services that high-income families consume, such as investment counseling or country club memberships. While this would shift more of the responsibility for paying the sales tax to wealthier families, the effect would be relatively small; states should accompany such changes by other measures that go further to reduce inequality.

Enact state earned income tax credits. States can boost the incomes of low- and moderate-wage working families or offset the impact on these families of other tax changes by enacting or expanding a state earned income tax credit (EITC). Many states have created EITCs to build on the strengths of the federal EITC, which offsets low-wage workers' payroll taxes, supplements the earnings of low- and moderate-income families, and helps families move from welfare to work.

Over half of the states with an income tax and one state without an income tax — in all, 26 states plus the District of Columbia — have established EITCs. Several states strengthened their EITCs recently including the District of Columbia, Maryland, Minnesota, Rhode Island, and Ohio during the 2014 legislative session. In 2015, California adopted an EITC and Maine, Massachusetts, New Jersey, and Rhode Island expanded their credits.

Avoid costly tax shifts and tax cuts aimed at the wealthy. Public discussions about strengthening the economy often center on tax cuts, despite growing evidence that they don't create many jobs or promote broad prosperity. Maintaining and improving schools, transportation networks, and other public services shown to generate growth will require resources, both now and in the future.

As state revenues slowly recover from the Great Recession, some states, such as Louisiana and North Carolina, have considered extreme tax changes such as replacing the income tax with a higher, broader sales tax. That would sharply raise taxes for low- and middle-income households and threaten the state's ability to maintain many of the services necessary to assist families left behind in the current economy. Other states, such as Kansas, Mississippi, and North Carolina, have deeply cut income taxes for individuals and businesses without replacing the lost revenues, which over time will force drastic cuts in services like schools, transportation, and public safety.

Many states have enacted less extreme but still costly income tax cuts that benefit individuals at the top and profitable businesses but do little or nothing for low- and middle-income households and damage the state's ability to invest in more effective ways.

If these trends continue, they will tilt state tax systems even more against low- and middle-income households. States choosing to cut taxes as the economy grows can instead seek a better balance in multiple ways. States can reduce the impact of their taxes on low- and moderate-income families by enacting tax credits targeted to low-income taxpayers or by raising the personal exemption or standard deduction, rather than cutting top income tax rates or capital gains taxes.


The fact that the lion's share of income gains has gone to the wealthiest residents. contradicts the basic American belief that the people who contribute to the nation's economic growth should reap their share of the benefits of that growth. It also harms the health of those falling behind and diminishes educational opportunities for children growing up in less affluent areas. In short, such inequality blocks the way forward for Americans striving to provide for themselves and their families and drags down future economic growth. Reducing income inequality should be a high priority for state policymakers.

Incomes Grew Much Faster Among Richest 1 Percent of Households Than Rest of Households (Percent Growth Between 1979 and 2013)
Top 1 PercentBottom 99 Percent
New Hampshire145%30%
New Jersey190%20%
New Mexico55%-9%
New York272%5%
North Carolina100%12%
North Dakota261%44%
Rhode Island112%30%
South Carolina93%-3%
South Dakota201%29%
West Virginia41%0%
District of Columbia155%53%
United States141%4%
Source: EPI analysis of IRS data. Estelle Sommeiller, Mark Price, and Ellis Wazeter, “Income Inequality in the U.S. by state, metropolitan area, and county,” Economic Policy Institute, June 16, 2016
Richest 5 Percent of Households Have Dramatically Bigger Incomes Than Poorest Households (Figures exclude capital gains)
Ratio of Avg. Income for Richest 5% to Poorest 20% of HouseholdsRank
New York19.901
New Jersey15.617
New Mexico14.8912
North Carolina14.7114
South Carolina14.6217
Rhode Island14.5019
North Dakota12.8134
West Virginia12.7635
South Dakota11.3244
New Hampshire10.6148
District of Columbia28.24
United States14.81
Source: CBPP analysis of 2015 American Community Survey (ACS) dataNote: ACS income data do not include capital gains. Households were size-adjusted before being sorted into quintiles.

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