Talking Taxes: Progressive Income Tax Cuts in Alabama

On Thursday night, Alabama lawmakers sent an income tax cut bill, HB 292, to Governor Bob Riley for his signature. In a state that clearly needs progressive tax reform, this bill is an important first step in the right direction.

Alabama has been widely derided for its low personal exemptions and deductions, which tax the very poorest Alabama families further into poverty. As the Center on Budget and Policy Priorities' annual income tax threshold report shows, in 2005, Alabama families with two children owed income tax when their earnings reach just $4,600--lower than any other state.

HB 292 changes this deplorable situation in two ways:
1) the standard deduction, currently capped at $4,000, is increased to $7,500 for married couples with incomes under $20,000. For couples earning between $20,000 and $30,000, the benefits of this tax cut are gradually phased out-- so couples earning over $30,000 will get the same $4,000 standard deduction they always did, but get no new tax break from this bill. (For single Alabamans, the maximum deduction goes up from $2,000 to $2,500 with the same phaseout range; for single parents, the deduction goes from $2,000 to $4,700.)
2) The dependent exemption Alabama families can claim for each of their children, currently a rock-bottom $300 per kid, is increased to $1,000. The benefits of this tax cut are phased out too, but in a different way: with a "cliff."
Here's what it looks like:

Income Range      Per-Kid Exemption
Less than $20,000      < $1,000
$20-$100,000      < $500
Over $100,000      < $300

And that's the whole plan.
Just in case you lost track, these income limits don't mean anyone gets a tax hike--they just mean that when your income exceeds a certain amount, you don't get any new tax break. This approach to tax relief is a compromise between the goals of Governor Bob Riley, who wanted to cut taxes for people at all income levels, and the goals of progressives who wanted to pay for low-income tax cuts with income tax hikes on wealthier Alabamans.

So beyond the basic its-a-good-progressive-tax-cut observation, what's worth knowing about this bill? Two things stand out.

1) The use of phaseouts on the exemptions and deductions has pluses and minuses. The federal government and many states have provisions in their tax laws that make certain tax breaks available only below certain income levels. Anytime you do this, you need to either gradually phase out the tax benefits (as Alabama now does with its extra standard deduction) or have a "cliff" where one additional dollar of earned income results in a sudden tax hit (as Alabama now does with its extra dependent exemption).
The feds take the phaseout approach in a few prominent ways. The $1,000 per child credit phases out starting at $110,000 for married couples. Itemized deductions start to phase out at about $140,000 for marrieds, and exemptions start to phase out at a much higher $215,000 or so.

This practice has good points and bad points. The bad part is twofold: first, it's one more hoop that tax filers have to jump through, making tax forms marginally more complicated than they used to be. Second, anytime you impose income limits on a tax break, you're increasing the effective income tax rate on people whose earnings are in the phaseout range. (To see this, imagine a guy with two kids who earns $20,000. His new dependent exemption under HB292 is $1,000 per kid, for $2,000. But if he earns one more dollar, his dependent exemption is only $500 per kid for a total of $1,000. So that $1 of additional income increased his taxable income by $1,000; at a 5% tax rate, that's a $50 tax hike for one additional dollar of income. Hardly the end of the world, but not a very smart idea either.) High-income people are probably less sensitive to these little bumps in the effective tax rate, which is why the federal phaseouts cited above are so high in the income range. Putting these phaseouts much lower in the income distribution, as Alabama is doing, means that marginal tax rates are a little bit higher than they used to be for some working families (even though anyone facing these higher marginal rates is, without exception, paying less under HB292 than they were before).

There are two good things about this sort of phaseout: it saves money, and it makes the income tax more progressive. By starting the phaseout as low as they have, Alabama lawmakers made this tax cut much more targeted to low-income families, and much less expensive, than it otherwise would have been.

2) Alabama's income tax has several unusual flaws, and this bill helps fix exactly one of them. Flaw #1 (which HB292 does nothing to fix) the state's narrow tax brackets. Married couples with taxable income over $6,000 pay at the 5% top tax rate, much lower than most income taxes. (The top federal income tax rate only applies when a married couple's taxable income hits $326,000.) Flaw#2 is the state's deduction for federal income taxes, which few states allow and which disproportionately benefits the wealthiest Alabamans. Flaw #3, which this bill does take baby steps towards resolving, is the low "income tax threshold" above which families start to owe state income tax in Alabama. As a result of HB292, Alabama is no longer last in the nation by this measure-- they're fourth from last in the nation.

Kimble Forrister of Alabama Arise gets it just right in his characterization of this bill: