Utah: A Missed Opportunity for Income Tax Reform

Earlier this week, the Utah legislature became the latest deliberative body to confuse "tax reform" with "tax cuts." Lawmakers started out firmly in the reform camp over a year ago with refreshingly honest discussions of the value of broadening the tax base, simplifying tax rules, etc.-- and ended up with this mess in Tuesday's special session. The bill, passed by both houses on Tuesday and signed by Governor Huntsman yesterday, does two things:

1) it slightly expands the tax brackets in the state's regular income tax structure (a needed reform since about 70 percent of Utahns currently pay at the 7 percent top tax rate). Starting with the 2006 taxes Utahns will file next April, a married Utah couple can have taxable income of $11,000 (up from $8,800 or so) before they have to pay at the top rate. And the top rate itself goes down a bit, from 7 to 6.98 percent.
2) it creates an optional flat-rate tax of 5.35 percent that applies to a much broader, virtually loophole-free income tax base.

The first part of this plan is a nicely progressive, if miniscule, tax cut that reserves the biggest breaks for middle-income Utahns.

The second part is a neat idea that got implemented in a silly and counterproductive way-- and that accrues almost entirely to the best-off residents of the Beehive State. The wealthiest 1 percent of Utahns will enjoy 72 percent of the benefits from the optional flat tax, according to ITEP's estimates.

Bottom line: last week Utah had one income tax. This week it has two.

As the Utah Association of CPA's pointed out last week, turning the state's income tax into two income taxes will make a complicated income tax even more complex-- all the more dispiriting given that an initial goal of the legislature's reform efforts was simplifying the tax code.

The sad thing is that there were some very good income tax reform ideas floating around the legislature all year-- and that the ones that got incorporated into this week's bill were done in a way that's almost worst than the original law.

Rule #1 for income tax simplification is: get rid of tax loopholes. Look for unnecessary deductions and exemptions and repeal them. Then you can lower the tax rate on everyone without putting a big, unaffordable hole in your budget. Broader base= lower rate.

Tax writers in the legislature absolutely understood this, which is why throughout the year there was always a salient active bill that would have eliminated loopholes by making the state's income tax base equal to federal Adjusted Gross Income (a figure you can take from the first page of your federal income taxes).

A federal AGI-based tax could have knocked at least a page off of the Utah income tax forms, making life a lot easier for all Utahns.

Of course, a pure AGI tax includes no tax relief for low-income working families at all, so many working families would unavoidably get screwed by a switch to an AGI tax if the tax rates were anywhere near current law's rates. And the state's legislative leadership has said repeatedly that it didn't want tax reform to generate any "losers" at all. So to avoid imposing tax hikes on poor Utahns, earlier versions of this plan included a single tax credit designed to eliminate income tax liability for low-income families. For example, under one version every married couple would have gotten a $1000 tax credit, plus $100 for each kid. And the credit would phase out at higher income levels.

But the low-income credit costs money-- money that the Utah legislature was far more interested in doling out to upper-income families. So they found a second way to avoid generating "losers"-- making the new AGI-based tax optional.

So what will tax season look like for Utahns next year? For virtually all low- and middle-income families, it will look exactly like it did this year. They'll wade through the same array of forms and instructions they did this past April.

For upper-income Utahns, the story will be different. A bunch of them will want to see whether the flat-tax alternative is better for them, so they'll calculate their tax both ways. In the end, 3 or 4 percent of them will find that it's actually worthwhile. So a bunch of people will jump through a new hoop for nothing, and a tiny group of the wealthiest Utahns will get a windfall.

Tax simplification should make life easier for the low- and middle-income families who are most likely to be filling out their tax forms themselves. What Utah has done is to make things easier for a small group of folks who almost certainly weren't doing their own taxes to begin with-- and almost certainly won't be doing taxes themselves next year.

It's a disappointing outcome for those of us who thought the legislature was serious about "tax reform" rather than simply pushing through more tax cuts.