In a bid to maximize the revenue generated by newly enacted state and city tax hikes, New York’s Legislature has expanded an obscure provision that effectively converts the progressive income tax into a higher flat tax on all income for some households.
As a result, affected New Yorkers (and workers commuting to jobs in the state) will pay hundreds or even thousands of dollars more than the Legislature’s deceptively “modest” rate increases might have led them to expect.
This memo documents the ins and outs of the new state and city tax laws—and some of their more perverse effects. For example:
- The effective marginal rate for many taxpayers in the second-highest tax bracket, which applies to incomes as low as $100,000, will be well above the highest rate imposed on the wealthiest New Yorkers.
- Many working couples will face a significant new marriage penalty for filing joint returns.
- The first dollar of income for New York City married couples in the second highest bracket will generate up to $610 in new state and city taxes, and first dollar in the highest bracket will trigger an additional $2,000 in state and city income taxes for all filers.
The basics on the rate increases
Like the federal government and most other states, New York has a progressive income tax system. In principle, at least, this means that there are a number of taxable income brackets, progressing upward from zero, each with a corresponding tax rate. Income in the lowest bracket is taxed at the lowest rate, income in the second-lowest bracket is subject to the second-lowest rate, and so on. The results are added up to compute the total tax owed.
On top of the state tax, New York City imposes its own income tax on city residents. From 1997 through 2002, the state had five tax brackets and the city had four tax brackets, featuring different rates kicking in at different income levels. Both taxes are computed and paid on the state income tax return.
When legislative leaders announced in May that they would override Governor George Pataki’s vetoes by imposing a “surcharge” on upper-income taxpayers, it sounded as if they were simply adding to the existing top rates in both the state and city tax codes.
In fact, as explained in this analysis, they were doing something more costly and complicated from a taxpayer’s standpoint.
The table below compares the newly enacted state and city tax rates with those under the prior law. The brackets shown here are for married couples filing joint returns; rates kick in at lower income levels for single taxpayers, married taxpayers filing separate returns, and heads of households.
New York State Personal Income Tax and New York City Resident Income Tax Rate Tables for Married/Joint Filers 2002 and 2003 Tax Years
As shown, the state and city each have added two income tax rate brackets. The highest bracket, set at 7.7 percent on the state income tax and 4.45 percent on the city tax, applies to taxable incomes above $500,000 for all filers. The second highest bracket of 7.5 percent on state taxes and 4.25 percent on city taxes applies to incomes above $150,000 for married filers (or $100,000 for singles and $125,000 for heads of households). This produces a combined top rate of 12.15 percent, compared to 10.5 percent under the prior law. The top rates remain in effect through 2005; the second-highest rates will be slightly reduced over the next two years.
If these rates were applied in a standard progressive fashion, the effects on many households just above the new income thresholds would be minimal. For example, the second highest state and city rate under the new law is a combined 1.25 percent higher than the 2002 rate, which equates to just $12.50 on the first $1,000 of added income for a city resident, or $6.50 taxpayers living outside the city.
However, simply adding a bracket or two to the existing tax structure would not have met the Legislature’s revenue target of $1.6 billion—unless the top state rate was boosted to more than 8 percent. This would have left New York with its highest state income tax rate since 1988, further highlighting its competitive disadvantage compared to neighboring states with much lower income taxes. It also would have resulted in a much larger tax increase for a much smaller number of taxpayers—the roughly 90,000 New Yorkers who earn more than $500,000 a year—giving them more of an incentive to move elsewhere or to take steps to shelter their New York income from higher taxes.
Instead, the Legislature found a way to minimize the apparent rate hike while aiming a larger tax hike at the roughly quarter-million New York State households earning taxable incomes between $150,000 and $500,000. This was accomplished by adapting to the new tax laws an existing tax provision that essentially converts the progressive income tax into a flat tax.
The original “bubble”
Although few are probably aware of it, New York state since 1991 has had an unusual bifurcated tax structure featuring progressive rates for taxpayers with adjusted gross incomes below $100,000, but a flat rate for all filers above $150,000.
The original “benefit recapture” provision of the state income tax, which remains in effect under the new law, applies to all taxpayers with adjusted gross incomes between $100,000 and $150,000. Depending on where their income stands within this “phase-out range,” taxpayers lose a portion of the benefits of having the lower tax rates applied on a progressive basis to their income below the top bracket. For married joint filers, that benefit totals $794, as shown below.
How the NYS Income Tax “Benefit Recapture” is Calculated
A couple with adjusted gross income of $125,000—at the exact midway point of the phase-out range—pays the 6.85 percent progressive tax rate that would normally apply to their income, plus exactly half of the rate table “benefit,” or $397. Through 2002, all married taxpayers with incomes of $150,000 or more paid an extra $794 as a result of this recapture provision.
Of course, $794 represents a much bigger tax bite to a family with income of $150,000 than to a much wealthier household. In fact, all middle-class families caught up in the first transitional income bubble created by the 1991 benefit recapture provision effectively are taxed at higher rates than the wealthiest New Yorkers. For example, a married couple living outside New York City with gross income of $150,000 pays an effective marginal rate of 7.7 percent—equal to the highest state rate under the new tax law, and nearly a point above the statutory maximum in effect from 1997 through 2002.
As a result of the 1991 provision, many married dual-earner couples filing a joint return owe higher tax payments than do couples who are unmarried or who file separate returns. As in the previous example, assuming the standard deduction is claimed, a childless married couple with gross income of $150,000 owes $9,274 including the benefit recapture. But two cohabiting single people with gross incomes of $75,000 each are not subject to the recapture provision; they owe a net $823 less in state taxes on their combined income than does a married couple with the same combined income.
New York City has different tax rates and brackets and, before the Legislature’s latest action, did not impose any benefit recapture provision.
In the new state and city tax laws, the Legislature retained the existing benefit recapture and created a second benefit recapture phase-out range between $150,000 and $200,000 of adjusted gross income for all classes of tax filer. The purpose of this change—included in both the state and city income tax laws—is to convert the second-highest rate into a flat tax on all income for taxpayers in the second-highest bracket. The maximum impact of this second recapture benefit is $975 on the state income tax and $1,115 on the city income tax, as shown below.
How the New State and City Income Tax “Benefit Recapture” is Calculated
Because the phase-out range for the first benefit recapture is well above the old top bracket of $40,000 for married couples, the original provision does not create any precipitous tax increases. The additional $794 is added on a steady, gradual basis until gross income reaches $150,000.
However, the phase-out range for the new benefit recapture provision effectively overlaps the $150,000 taxable income threshold at which married couples become subject to the second highest rate. Because their gross income always will exceed taxable income by at least $14,600 (the standard deduction for couples), this means all married joint filers will pay a state tax increase of at least $285 and a city tax increase of $326 once they earn more than $150,000 in taxable income. In fact, the added tax is $611 on the first dollar of income over that amount—$150,001. That’s equivalent to an effective marginal rate of 61,100 percent.
It also makes the existing marriage penalty for joint filers even larger, especially for New York City residents. On a joint return, a married couple with gross income of $200,000 using the standard deduction will owe $2,533 in new state and city taxes ($1,205 to the state and $1,328 to the city). But two cohabiting singles with gross incomes of $100,000 each won’t owe any additional state or city taxes.
The chart below illustrates the extent to which the state and city income taxes actually owed by New York households this year will exceed the statutory rate adopted by the Legislature.
The 200,000 percent tax
On top of the benefit recapture provision affecting the second-highest bracket, the Legislature added a flat tax on all incomes above $500,000. In this case, however, there is no transitional phase-out range. Instead, the higher flat tax applies to all income once a household moves into the over-$500,000 bracket.
This means a single dollar of income above $500,000 will require an additional state tax payment of $1,000, plus another $1,000 for city residents—an effective marginal rate of 200,000 percent on that first added dollar of income.
In actual practice, of course, taxpayers who find themselves within a few dollars of the top threshold are likely to do everything in their power to avoid triggering a higher tax liability. However, those with less room to maneuver will still find themselves paying effective marginal rates well in excess of the 12.15 percent set forth in the statutory rate table, as illustrated in the chart that follows.
New York’s New Income Tax Cliffs
Effective Marginal Rate* of State and City Income Tax for Married/Joint Filers, 2003
* The effective marginal rate is the rate at which income is taxed once it exceeds the threshold for the statutory tax bracket. In 2003, for example, the statutory rate table indicates that income in the second-highest bracket will be subject to a combined state and city rate of 11.75 percent. Income in the top bracket, which applies to incomes over $500,000 for all filers, will be subject to a combined rate of 12.15 percent. Applied to the first $50,000 of income above $500,000, this top rate would generate an added tax of $6,075. But because of the way the tax increase has been structured, including the impact of “benefit recapture” provisions, the actual tax owed on the first $50,000 above the top bracket threshold will be $8,075, which is 16.15 percent of $50,000. Thus, as the chart shows, while the statutory rate is 12.15 percent, the effective marginal rate is 16.15 percent.
Ironically, the effect of these distortions diminishes as income rises—the very opposite of progressivity—so the impact on the wealthiest households is minimal. For example, the combined $4,090 “benefit recapture” represents just a small fraction of the $165,000 in additional state and city taxes that will be owed by a New York City household with $10,000,000 in taxable income.
The labor effect
Economists have long noted that, when effective marginal tax rates rise high enough, it is rational for taxpayers to respond by working and earning less. For some New Yorkers who find themselves on or close to the brink of the two new state and city income tax brackets, the tax code for the next few years will pose some real disincentives to work.
Say, for example, that you are a free-lance writer living with your lawyer spouse in a Brooklyn brownstone apartment. Soon after Thanksgiving, you tally up your accounts and estimate that, after deductions, your family will end the calendar year with $150,000 in taxable income—just below the threshold of the state and city tax increase.
It’s been a good year, but living in the city is expensive, and you’d still like to scrape together a few hundred more dollars for holiday gifts for relatives. Now suppose an editor calls you with a small project for which he offers to pay $750. At last year’s tax rates, another $750 fee would have netted you $437 after federal, state and city income taxes, making it well worth your effort to accept the assignment. But in 2003, thanks to the peculiar structure of the new state and city tax law, you will owe at least $684 on the next $750 you earn—an effective tax rate of 91 percent—so this project will now net you just $66.
If you don’t care to effectively donate most of your next writing fee to the government, you could either contribute the fee to a tax-deductible charity or simply turn down the assignment. You could also ask the client not to pay you until after the next tax year starts on Jan. 1, in which case it could expose you to a similar problem in 2004 if your income is otherwise the same. The more you think about it, the less interested you are in accepting the project.
Using the same income and professional profile, let’s say you are offered a $2,500 fee for a somewhat more difficult and time-consuming end-of-year project—writing and laying out a holiday sales brochure for a local business. Under the old tax code, you would have accepted the assignment with the expectation of pocketing $1,455 after federal, state and city income taxes. This year, however, you will end up with just $983, or only 39 percent of your fee. For that amount, you might decide the job is simply not worth the added time and effort involved. In that case, a) you won’t be spending that extra cash in local stores, b) if the client can’t line up another free-lancer to complete his brochure, he’ll miss a chance to boost his profits, and c) the state and city will collect less in taxes than this activity would have generated under the old tax code.
The state and city income tax increases, along with sales tax hikes enacted by the Legislature this year, are supposed to expire after 2005.
However, with both the state and city facing sizeable budget gaps over the next two years, those statutory “sunsets” are likely to be postponed unless state and city officials find the political will to enact the sort of spending cuts they have resisted over the past two years. And in the meantime, as noted above, many New Yorkers who no doubt consider themselves middle class will be paying higher effective marginal rates than billionaires.
Originally Published: FISCALWATCH MEMO
- Following the same rate scheduled listed in the table for married/joint filers: State income tax brackets begin at taxable incomes of $8,000, $11,000, $13,000 and $20,000 for single filers, with new brackets added at $100,000 and $500,000; and at $11,0000, $15,000, $17,000 and $30,000 for heads of households, with new brackets added at $125,000 and $500,000. City income tax brackets are $12,000, $25,000 and $50,000 for single filers, with new brackets of $100,000 and $500,000; and $14,400, $30,000 and $60,000 for heads of households, with new brackets at $125,000 and $500,000.
- In 2004, the second highest state rate will be 7.375 percent and the second-highest city rate will be 4.175 percent. In 2005, those rates will be further reduced to 7.25 percent and 4.05 percent, respectively.
- Based on the distribution of tax filers by gross income class as last reported by the state in 1999, the state’s added benefit recapture payments will total at least $300 million in the current tax year, or $400 million during the 2003-04 state fiscal year. Raising the same amount through a progressive rate increase on taxpayers earning gross incomes over $500,000 would have required a top rate of 8.4 percent, based on the latest reported income and tax liability shares.
- Most middle-class couples rely on professional tax preparers or automated tax software programs and thus are probably unaware of the benefit recapture provision. For those who still do their taxes manually, the benefit recapture worksheet is probably one of the more annoying aspects of the state’s IT-201 tax form.
- The maximum tax benefit recapture is $397 for single filers and $563 for heads of households.
- This example assumes the couple is childless, and claims the standard deduction of $14,600. Including the benefit recapture of $794, the couple would owe taxes of $9,274 on taxable income of $135,400. This is what the same couple would pay if its income above $40,000—the old top bracket—was instead subject to a top rate of 7.68 percent.
- The benefit recapture is phased in at the rate of $15.88 per $1,000 of additional gross income between $100,000 and $150,000 for married/joint filers, and at correspondingly lesser rates for singles and heads of households.
- The adjusted gross income of married/joint filers with at least $150,001 must be at least $164,601 if they claim the standard deduction. They thus pay 29 percent (14,601/50,000) of both the city’s $1,115 benefit recapture and the state’s $975 benefit recapture.
- This is a greatly simplified example, of course. Because taxpayers must choose the same filing status for their state and federal returns, most married couples will need to go through the exercise of calculating all of their income taxes both ways, on joint and separate returns, to determine whether filing separate returns will yield the lowest overall tax bill.
- In 2002, a couple with income of $150,000 was subject to a 35 percent federal rate; as a result, the additional $750 would have been subject to a federal tax of $263 plus $50 in state and city income taxes, after adjusting for the deductibility of these taxes on the federal return.
- In 2003, the same couple is in a 33 percent federal bracket. Thus, $750 in added income would yield $248 in federal taxes plus $436 in state and city income taxes net of federal deductibility. This may actually understate the tax by a few dollars, since it does not reflect the impact of the limitation on itemized deductions, to which this hypothetical taxpayer is also subject. Assuming gross income of $175,000, the taxpayer effectively is allowed to deduct 95 percent of their state and city taxes.