As its 2009-10 fiscal year draws to a close, New York is on track to collect roughly $500 million less than originally projected from last year’s temporary “millionaire tax,” which raised the marginal income tax rate by up to 31 percent on taxpayers with incomes as low as $200,000.  The state’s official bean-counters (you know who you are!) may be inclined to blame this entirely on “timing issues,” or the shift of banker bonuses to stock options, or capital loss carry-forwards.  Think twice, folks, and lower your sights for the long haul:  Impending federal tax increases will suppress the growth in New York’s income tax base for years to come, complicating efforts to dig out of a deepening budget hole.  An op-ed in yesterday’s Wall Street Journal explains why.

The author, Alan Reynolds of the Cato Institute, focuses on a concept of “elasticity of taxable income,” or ETI, summed up by the observation that “successful people are not docile sheep just waiting to be shorn.”  In other words, if you raise marginal rates on the incomes of high-income taxpayers, they will respond in ways that reduce their taxable income.   (Some, like this decidedly non-sheepish New Yorker, respond more publicly than others.)

Reynolds notes that Obama plans to finance $200 billion in new federal entitlements by “slapping a 3.8% ‘Medicare tax’ on interest and rental income, dividends and capital gains of couples earning more than $250,000, or singles with more than $200,000.”

“The president also hopes to raise $364 billion over 10 years from the same taxpayers by raising the top two tax rates to 36%-39.6% from 33%-35%, plus another $105 billion by raising the tax on dividends and capital gains to 20% from 15%, and another $500 billion by capping and phasing out exemptions and deductions.” he writes.

“Add it up and the government is counting on squeezing an extra $1.2 trillion over 10 years from a tiny sliver of taxpayers who already pay more than half of all individual taxes.”

And that’s where ETI comes in.

From past experience, these are just a few of the ways that taxpayers will react to the Obama administration’s tax plans:

• Professionals and companies who currently file under the individual income tax as partnerships, LLCs or Subchapter S corporations would form C-corporations to shelter income, because the corporate tax rate would then be lower with fewer arbitrary limits on deductions for costs of earning income.

• Investors who jumped into dividend-paying stocks after 2003 when the tax rate fell to 15% would dump many of those shares in favor of tax-free municipal bonds if the dividend tax went up to 23.8% as planned.

• Faced with a 23.8% capital gains tax, high-income investors would avoid realizing gains in taxable accounts unless they had offsetting losses.

• Faced with a rapid phase-out of deductions and exemptions for reported income above $250,000, any two-earner family in a high-tax state could keep their income below that pain threshold by increasing 401(k) contributions, switching investments into tax-free bond funds, and avoiding the realization of capital gains.

• Faced with numerous tax penalties on added income in general, many two-earner couples would become one-earner couples, early retirement would become far more popular, executives would substitute perks for taxable paychecks, physicians would play more golf, etc.

Reynolds cites a 2009 paper by Emmanuel Saez of the University of California at Berkeley, Joel Slemrod of the University of Michigan, and Seth Giertz of the University of Nebraska, who found that an ETI of just 0.5 would translate into a behavior-induced revenue loss of 43 percent.  That suggests Obama’s tax hikes will fall almost $600 billion short of their revenue target over the next decade.  But for high-income taxpayers–such as those targeted by Albany and by Obama — elasticity of response is probably larger.  Other research cited by Reynolds indicates the ETI can be as high as 1.2 for taxpayers with incomes above $500,000 — meaning a tax hike targeted at these payers will lose more revenue than it gains.

Since New York State shares its tax base with Washington, taxpayer behavior designed to minimize the impact of federal rate hikes will also reduce state revenues — as we noted in this 2008 Empire Center report analyzing the New York impact of the tax agendas of the presidential candidates.

Barring a miraculous turnaround of Washington’s runaway tax-and-spend train, here’s the bottom line: Regardless of what happens in the broader economy, New York State’s personal income tax receipts over the several years will consistently fall short of estimates.  As Josh Barro and I explain in this recent City Journal article, New York’s effective tax cost (net of federal deductibility) will soon reach an all-time high.  Albany’s tax receipts will be weaker still if the state extends or cancels the scheduled end-of-2011 sunset of the higher tax rates.

Don’t say you weren’t warned.

About the Author

E.J. McMahon

Edmund J. McMahon is Empire Center's founder and a senior fellow.

Read more by E.J. McMahon

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