Report :: If It Ain't Broke...New Jersey's Income Tax Makes Dollars and Sense by Mary E. Forsberg

Most people probably would agree that we need taxes at some level to pay for the things we want government to do. We could disagree on what to tax, how much and who-not to mention how best to use the money raised through taxes. But there is enough common ground for a reasoned discussion of such issues. There probably is little point in having an argument over whether taxes are "good" or "bad." Those who would oversimplify matters to that extent are unlikely to bring many more over to their side. The reality is that taxes are a tool; like any tool they need to be used wisely.

That said, New Jersey's tax structure is an unqualified mess. The state relies far too heavily on local property taxes, a levy based on the value of someone's home and land and often unrelated to actual ability to pay. Attempts over the years to put the system into better balance have sometimes made progress. But they also have foundered on political rocks and other times been reversed in favor of short-term fixes with unfortunate long-term consequences.

It's time to get serious. And maybe that is happening. As this was written, the Legislature was meeting in special session, having been directed by Gov. Jon S. Corzine to fundamentally reshape the ways New Jersey handles its finances. It is our hope that this report will become part of the debate, indeed that it will help to shape the debate so that progressive principles can guide the path to a new New Jersey when it comes to economic justice and investing in the future.

Simply put, the state income tax must continue to play an important role in New Jersey's overall tax system. It is a fair tax, and can be made more so. It is a productive tax, and can be made more so. But it also is a tax that often is misunderstood and misrepresented. There is much that needs to be explained and clarified about a levy that began 30 years ago and without which New Jersey would surely be in even worse shape than it is today.

Over its nine years of existence, New Jersey Policy Perspective has written extensively about taxes in New Jersey and how to devise a structure that works best for the most people while providing enough money for what needs to be done. Much of this work was done by Research Director Mary E. Forsberg, who came to NJPP five years ago after 14 years with the state Office of Legislative Services. Earlier this year, she wrote a report on the state sales tax to which this report on the state income tax serves as a companion. Together, along with other work over the years, they put New Jersey's revenue-raising system in what we believe is helpful perspective.

This report has a premise, which it explains and defends: progressive taxation makes sense. Long before there were income taxes, influential people advocated the underlying concept of progressivity. In 1776, the economist Adam Smith wrote in his classic book The Wealth of Nations:

"when the toll upon carriages of luxury...is made somewhat higher in proportion to their weight, than upon carriages of necessary use, such as carts, wagons, etc., the indolence and vanity of the rich is made to contribute in a very easy manner to the relief of the poor, by rendering cheaper the transportation of heavy goods to all different parts of the country."

"When he looked up he saw some wealthy people putting their offerings into the treasury and he noticed a poor widow putting in two small coins. He said, 'I tell you truly, this poor widow put in more than all the rest; for those others have all made offerings from their surplus wealth, but she, from her poverty, has offered her whole livelihood."

Those words mean as much today as they did back then. As New Jersey fashions a tax system that works for the future we would do well to follow them.

WHY AN INCOME TAX?

As society grew more complex in the early years of the 20th century, it became clear that an increasing variety of tasks were too big for individuals, businesses or local governments to accomplish separately. It was also recognized by many that in a market economy great disparity in citizens' wealth and income would arise.

The income tax emerged as a way to address both of those realities. Governments would do more to fund schools, create and maintain public infrastructure like roads, water supplies, sewers and parks and help minimize for people the risk of economic insecurity from unemployment and old age. And much of the money to do these things would come from a tax levied on people's income-often in accordance with their ability to pay. Fiscal theory compatible with public-welfare ideas in Europe and the United States held that, in industrialized societies where large differences in wealth exist, how much a citizen could afford to pay toward the common good-not the level of benefits received from government-was the fairest criterion of how much to contribute.

The federal income tax was enacted in 1913 soon after passage of the Sixteenth Amendment gave Congress the power to do so. The tax was one percent on all income over $3,000 for a single person and $4,000 for a married couple. No distinctions were made as to whether the income came from wages, rents, dividends, salaries, interest, entrepreneurial incomes or profits from the sale of assets. An additional surtax of 6 percent was levied on very high incomes, making the maximum rate 7 percent. Since the average personal income that year was only $621, only 2 percent of the U.S. population paid any income tax between 1913 and 1915.¹

Huge demand for revenue during World War I firmly established the income tax in the United States. Since then, rates have been raised and lowered. Different forms of income, such as capital gains, have been taxed at lower levels than wages. But the income tax has remained a crucial source of funds to run the federal government.

NEW JERSEY HISTORY

Today, 43 states and the District of Columbia have some sort of an income tax. New Jersey came fairly late to the income tax. When it adopted its broad-based tax on personal incomes in 1976 under Gov. Brendan T. Byrne, New Jersey became one of the last states to do so.

This was not New Jersey's first attempt to tax personal incomes. In 1961, New Jersey enacted the Emergency Transportation Tax Act, which taxed the income of workers who commuted between New York and New Jersey. Ten years later, in 1971, a similar tax was enacted on Pennsylvania and New Jersey commuters. These taxes addressed both the issue of ability to pay and who benefits. The rates were graduated-requiring those who made the most to pay the most. Taxing commuter incomes recognized that good mass transit, roads and bridges between the states benefited those who traveled those routes the most. Revenues from these taxes were deposited into the Transportation Fund and were used only for that purpose.

By the mid 1970s, concern over school funding surpassed transportation issues and led to enactment of the income tax in 1976 (the Legislature voted down an income tax in 1972). The Gross Income Tax Act was spurred by a succession of New Jersey Supreme Court rulings starting in 1973 that declared the state's school funding mechanism unconstitutional-because of its over-reliance on local property taxes-and ordered that another source of revenue be found. It mandated that all proceeds from the tax be put in a new fund dedicated solely to various forms of property tax relief.

The Legislature also passed a measure requiring that the income tax expire in 1978. In 1977, Byrne was resoundingly reelected after a campaign in which he repeatedly challenged his opponent to come up with a plausible plan for running the state without an income tax. A month after the election, the Legislature repealed the upcoming expiration; the income tax would be permanent.

It was, as income taxes go, modest. New Jerseyans would pay 2 percent on taxable income up to $20,000 and 2.5 percent on taxable income over $20,000, regardless of marital status. Until the special transportation taxes were eliminated on Pennsylvania commuters in 1977 and on New York commuters in 1983, taxpayers who were subject to the commuters' tax paid whichever was higher. If the amount of tax was greater under the commuters' tax, the difference was deposited in the Transportation Fund.

Legislation enacted in 1982 under Gov. Thomas Kean added a third tax bracket: 3.5 percent on income in excess of $50,000. In 1990, under Gov. Jim Florio, a new rate structure was imposed. For married households filing jointly, income between $70,000 and $80,000 was taxed at 5 percent; between $80,000 and $150,000 at 6.5 percent and over $150,000 at 7 percent.

Rates were lowered in three stages from 1994 to 1996 under Gov. Christie Whitman to where income under $20,000 was taxed at 1.4 percent; from $20,000 to $50,000 at 1.75 percent; $50,000 to $70,000 at 2.45 percent; $70,000 to $80,000 at 3.5 percent; $80,000 to $150,000 at 5.525 percent; and above $150,000 at 6.37 percent.

The next change came in 2004, under Gov. Jim McGreevey, when a new top rate was enacted: 8.97 percent on income over $500,000 (married or single).

THE INCOME - PROPERTY TAX LINK

The amount of money New Jersey takes in from the state income tax has grown from $656 million in Fiscal Year 1977 to an estimated $11.5 billion in Fiscal Year 2006. In all but three years (1988, 2002 and 2003), collections were greater than the year before, largely due to New Jersey's growing economy.

Local property taxes and state income taxes are two of the three taxes in New Jersey that bring in the most money for state and local use (the state sales tax is the third). Seeing the relationship among these three taxes is essential to understanding whether the overall revenue system is adequate. Two features are especially important: New Jersey's income tax is required under the state constitution to be used only for property tax relief; and, unlike in many other states, New Jersey's local governments collect no income or sales tax of their own. These two factors make New Jersey's state-levied income tax the main alternative to the property taxes that support schools and other local services.

Any discussion of income taxes must keep in mind this relationship. The more income tax collected, the more revenue available for schools and local government aid and direct property tax relief to taxpayers (much of which comes through various rebate programs).

Property taxes have increased on average by 7 percent a year during the past 40 years, and the jump has been as high as 15 percent. In only two years have property taxes increased by one percent or less (the year after the income tax was created and the year after the 1990 rate increases).

Income tax collections have increased most years at rates ranging from 1 percent to 29 percent. Of the three years when income tax collections declined, in only one year was it significant, (2002, in the wake of the economic downturn exacerbated by the Sept. 11, 2001 attacks on the World Trade Center) at 14 percent. Total state revenue collections have likewise increased in all but three years. On average, income tax revenue and total state revenue have increased by 10 percent annually.

Sources: Property tax data, Reock and Pfeiffer July 2006; other state data, Governors' budgets for various years.
Notes: Property taxes are based on calendar years; income and state revenues are based on fiscal years. Calendar year 2005 correlates with fiscal year 2005 (July 1, 2004 to June 30, 2995). State amounts represent actual collections through FY 2005. FY 2006 data are estimates from the Governor's FY 2007 budget; FY 2007 data are from the FY 2007 Appropriations Act.

Personal income and sales taxes together produce nearly 60 percent of state government's revenue. Income taxes over the years have fluctuated from 19 percent to 38 percent of all revenue collected by the state. In more recent years, income taxes have produced between 30 percent and 38 percent of all state revenues.

Sources: Governor's budgets various years.
Amounts represent actual collections through FY 2005.
FY 2006 data are estimates from the Governor's FY 2007 budget;
FY 2007 data are from the FY 2007 Appropriations Act.

STRUCTURE

New Jersey's income tax differs from the federal income tax and most other states in that it is levied on a much broader base. In other words, New Jersey allows for fewer deductions, exemptions and credits so that more of a household's income is taxed. For the most part, this enables rates to be lower than they might be otherwise. It also means that people with the same income, but from a different variety of sources, are treated more equally rather than rewarding or penalizing certain types of income or economic activity.

Many states closely follow the federal system, allowing similar deductions and credits and conforming to Internal Revenue Service standards and definitions. Some states levy their income tax simply as a percentage of federal taxable income (Colorado) or as a percentage of federal tax rates (Vermont and Rhode Island). When the federal government changes definitions and rates, these states either must accept the changes or take action to de-couple from them.

New Jersey's overall income tax structure is much as it was when enacted in 1976. In addition to the rate adjustments covered earlier, the table below details changes legislated over the past 30 years.

COMPARING STATES

All but seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) have income taxes. Two others-New Hampshire and Tennessee-levy taxes only on income from dividends and interest.

In five states with income taxes (Colorado, Illinois, Indiana, Michigan and Pennsylvania) there is only one tax rate, applied to all taxable income. This is known as a flat income tax. The rate ranges from 3 percent in Illinois to 4.63 percent in Colorado. In Massachusetts, wage income is taxed at 5.3 percent while dividends, interest and capital gains are taxed at 12 percent. Most states, like New Jersey, have a progressive-also called graduated-income tax where rates rise with income.

Often, state income taxes are compared to each other on the basis of the top rate-the highest percentage levied against income. But that can be a very misleading exercise; one that casts New Jersey's income tax-with the nation's seventh highest top rate-in an inappropriately negative light. That is why the information in the two columns on the right in the table that follows is so important.

To see why, consider a comparison between Maine and New Jersey. Maine's top rate is 8.5 percent and New Jersey's is 8.97 percent. If that is all one knows, one would assume all residents of the two states have similar tax liability. But, look again. Married taxpayers in Maine pay 8.5 percent on all taxable income above $36,500. In New Jersey the top rate applies only on income greater than $500,000, meaning that the vast majority of taxpayers in New Jersey pay a lower rate than in Maine.

Data as of August 2006
Sources: Tax Policy Center of the Urban Institute and the Brookings Institute, State Individual Income Taxes, Tax Rates for tax year 2006 as of January 1, 2006.
Note: (1) California imposes an additional 1% on taxable income over $1 million.
(2) Tax is 4.63% of federal taxable income.
(3) Tax is 3% of federal adjusted gross income with modifications.
(4) Tax is 3.4% of adjusted gross income.
(5) Massachusetts taxes interest, dividends and short term capital gains at 12.0% and all other income at 5.3%.
(6) Tax is 3.9% of taxable income.
(7) New Hampshire levies a 5% tax on interest and dividends.
(8) Oklahoma has two ways to calculate income taxes based on whether taxes are calculated before or after the federal tax deduction. Rates are for taxpayers not deducting federal income tax. Rates increase to 10% on $24,000 and over if federal income tax deducted.
(9) Tax is 3.07 of taxable income.
(10) Rhode Island is calculated at 25% of federal income tax rates in effect prior to 2001.
(11) Tennessee levies a 6% tax on interest and dividends.
(12) Vermont is calculated at 24% of federal income tax rates.

Accurate comparisons of income taxes from state to state must also take into account the fact that 12 states allow local governments to levy income taxes to support schools and municipal services. Local income taxes are widespread in six states (Indiana, Kentucky, Maryland, Michigan, Ohio and Pennsylvania). In the others, large cities or counties mainly levy them. Every state with a local income tax also levies a state income tax. Often the two are linked, using the same definitions for income and the same credits and deductions. Maryland's county taxes are the most closely linked since they are calculated as a percentage of state tax liability.

While local income taxes produce less than 2 percent of local revenues across the United States, in five states they produce more than 5 percent. Local income taxes produced nearly 16 percent of local revenue in Maryland, 9 percent in Kentucky, over 8 percent in Ohio, almost 7 percent in Pennsylvania and about 5 percent in New York in 2004.²

Sources: Judith Lohman, OLR Research Report, Connecticut General Assembly, November 17, 2005.
Tax Policy Center, Local Income Taxes, Select Municipalities, 2006,.
Pennsylvania Governor's Center for Local Government Services, Pennsylvania's Earned Income Tax Collection System:
An Analysis with Recommendations, Senate Finance Committee Informational Hearing, May 4, 2005.
David Baer, State Handbook of Economic, Demographic, and Fiscal Indicators 2006 AARP Public Policy Institute, May 2006.
Notes: Arkansas allows "first class cities" to levy a local income tax.
Georgia allows local governments to levy a 1% tax on Georgia income if they do not already levy a local general sales tax.

As the table below shows, the addition of local income taxes greatly affects relative tax liability from state to state. Of particular interest for New Jersey is the impact that New York City's and Philadelphia's levies have on narrowing differences among New Jersey, New York State and Pennsylvania.

* Rates are for Married Filing Jointly

Another way to assess the impact of taxes from state to state is on a per capita basis: dividing the amount of money a state collects by how many people live there. As the table below shows, New Jersey in 2004 ranked 14th in income tax per capita-at $852,when only state income taxes are counted, and 17th when state and local income taxes are counted.

Some more recent data are available, but they do not include local income taxes. Figures released in December 2005 by the U.S. Census ranked New Jersey 14th with a state income tax collection of $943 per person.

Source: U.S. Census, State and Local Government Finances by Level of Government and by State: 2003-04

TAXABLE INCOME

In addition to rates and where they are applied, it is necessary when comparing income taxes from state to state to consider what income is and is not taxed. Part of this involves the income tax threshold, an income level below which no income tax is owed. Thresholds are designed to eliminate income tax liability for the lowest income households. But there is considerable variation among states.

In New Jersey, a married couple filing a joint return does not pay income taxes until its income is over $20,000; a single person only if his or her income is over $10,000. As in other states, once the threshold is crossed income below that level also is taxed.

Only California begins to tax the income of a married couple filing a joint return above New Jersey's limit; and only Arizona, California and Connecticut have higher thresholds for a single taxpayer. Eight states have no threshold; all income is taxed.

However, exemptions that reduce taxable income can have a big impact on thresholds. The Center on Budget and Policy Priorities calculates that for a family of four with two children 22 states have higher thresholds than New Jersey. California's is highest, at $41,500.³

Personal exemptions and credits also lower a household's tax liability. They work in similar ways, but an exemption is deducted from income before taxes are calculated and a credit is figured after taxes are calculated. For the most part, they are designed to compensate for the cost of raising children or dealing with disabilities. In New Jersey, a husband, wife or single taxpayer each is permitted a $1,000 exemption. Additional exemptions of $1,000 each are available for being blind, disabled or over age 65 or having a dependent child attending college. A $1,500 exemption is provided for each dependent child not attending college. A married couple in New Jersey with two dependent children, one of whom is in college, would receive exemptions that lower by $4,500 the amount of income subject to tax.

In eight states, taxpayers get the same exemptions as on their federal return. New York allows exemptions only for dependents; Pennsylvania permits no exemptions or credits. Seven states allow taxpayers credits against taxes; two states allow both exemptions and credits.

Data as of August 2006. Source: NJPP, Various state tax departments.

(1) North Carolina and Ohio offer both credits and exemptions depending on income.
Source: Faith Russell, Individual Income Tax Provisions in the States, Wisconsin Legislative Fiscal Bureau, January 2005. Updated by NJPP.

Deductions-standard and itemized-further reduce taxable income in some states. Most states provide a standard deduction which is either a percentage of income up to a certain level or a flat amount. New Jersey is one of 10 states with no standard deductions. Nine other states accept the taxpayer's federal deduction.

Source: Faith Russell, Individual Income Tax Provisions in the States, Wisconsin Legislative Fiscal Bureau, January 2005.
Updated by NJPP.

New Jersey is among 27 states that fully exempt Social Security benefits from income tax. Five states exempt all retirement income from taxation. Many states exempt state, local and federal pension income but not private pension income. Some states, including New Jersey, exempt a portion of retirement income if the taxpayer's total income is not above a certain level. And in eight states retirement income is fully taxed as regular income.

Source: Faith Russell, Individual Income Tax Provisions in the States, Wisconsin Legislative Fiscal Bureau, January 2005. Updated by NJPP.
Current as of 2006 - Alabama, Arizona, Arkansas, California, Connecticut, District of Columbia, Georgia, Hawaii, Idaho, Illinois, Kentucky, Mississippi, Minnesota, Montana, Nebraska, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Tennessee, Utah, West Virginia. Current as of 2005 - Colorado, Delaware Illinois, Indiana, Iowa, Kansas, Louisiana, Maine, Maryland, Massachusetts, Michigan, Missouri, New Hampshire, New Mexico, Oklahoma, Oregon, Vermont, Virginia, Wisconsin. Current as of 2004 - North Dakota.

STATISTICS OF INCOME

Included in the Appendix of this report are the number of tax returns filed, net taxes paid and gross income for nine income levels over the 18-year period from 1986 to 2004. The trends provide important insight on what is happening to income in New Jersey.

In 2004, 2.6 million people in New Jersey paid more than $7 billion in income taxes on their $236 billion gross annual income. The majority, 64 percent, of New Jersey taxpaying households made between $20,000 and $100,000. Those making less than $150,000 were 91 percent of all filers. These households paid 37 percent of all the income tax collected and made 59 percent of the state's income.

The percentage of taxpayers who file returns showing less than $150,000 has declined slowly over time (91 percent in 2004 compared to 97 percent in 1994 and 98 percent in 1986) as incomes in New Jersey have risen and New Jersey raised the threshold below which incomes are not taxed. The share of income taxes paid by those making under $150,000 has also declined, from a high of 76 percent of the total to lows of 36 percent in 2000 and 37 percent in 2004. Their share declined because the share of income made by the state's highest earners increased.

The number of households with taxable income above $1 million tends to fluctuate from year to year, but on the whole has risen over time. In 2000, 12,365 households had taxable income greater than $1 million, as record stock market bonuses boosted their total gross income to $39.5 billion. In that year, they paid 29 percent of all income taxes collected in the state, at a top rate of 6.37 percent. Four years later, in 2004, 11,600 were in that highest income category. Their total gross income was $30.5 billion and, although their income was taxed at a top rate of 8.97 percent, they paid a slightly smaller share (27 percent) of all income taxes collected in the state than millionaires did in 2000.

NEW JERSEY & ITS NEIGHBORS: BOTTOM LINE

All of the factors that go into determining liability in each state add complexity to the task of comparisons among states. So, for the purpose of this report, NJPP used the TurboTax commercial software program to calculate how much tax four identical families would pay in New Jersey and some neighboring states.

The tax information is based on a family of four with two working parents and two school-age children. The family has no retirement income and takes the standard exemptions and deductions available in each location.

Local income taxes raise the tax cost for each of these families if they live in New York City or Philadelphia. For instance, the Smith family with a $550,000 income would pay $64,808 (12 percent of family income) in state and local income taxes combined if it lived in New York City; $41,134 (7 percent) if it lived in Philadelphia and $31,306 (6 percent) if it lived in New Jersey. The Jones family with an income of $28,000 would pay $734 (3 percent) if it lived in New York City compared to $1,204 (4 percent) in Philadelphia and $333 (1 percent) in New Jersey.

Taking state income taxes alone, at both income levels the family in New York State pays the most. Pennsylvania's tax is lowest for the upper two income families and the lowest income family-unless it lives in Philadelphia. But for the family making $80,000, New Jersey's income tax is the lowest.

PROGRESSIVITY & ITS "PERILS"

New Jersey's income tax is, by economic definition, progressive. The rate structure detailed earlier clearly requires those with higher taxable income to pay not just more of what they make to the state each year as income tax; it also requires them to pay a higher percentage of what they make. There is no formula to determine what is the proper amount of progessivity. It is a highly subjective matter that must also take into account economic and political consequences.

Source: Department of the Treasury, Division of Taxation, Statistics of Income for tax year 2004.

No discussion of New Jersey's income tax can ignore how income currently is distributed among the state's households:

Not surprisingly, then, the state's progressive income tax reflects the highly skewed distribution of income:

In the table below, average income, taxes and the tax rate are computed for each of the income categories based on 2004 data. The average gross income and tax are calculated based on the number of filers in each income bracket. The computed average tax rates that people actually pay range from 1.64 percent to 6.17 percent.

Source: Department of the Treasury, Division of Taxation, Statistics of Income for tax year 2004.
Calculations by NJPP.

These statistics suggest that New Jersey is doing a good job of basing its income tax on the ability to pay. Still, New Jersey's income tax has its critics. In all likelihood, the real objection of some is simply that they want to pay less, and even a 3 percent flat tax would be too much. But let's look at arguments raised against the tax because there are rational, convincing responses to be made.

The numbers don't lie: most of the tax revenue comes from a relatively small percentage of households. But it is equally clear that these are the households making the most money. And the income gap between them and the rest of New Jersey is widening.

Early in 2006, the Economic Policy Institute and Center on Budget and Policy Priorities⁴ updated income disparity data and found a disturbing trend. Over 20 years, the income of the lowest 20 percent of households in New Jersey rose by 24.4 percent, while that of the middle 20 percent went up by 78.7 percent and that of the top 5 percent rose by 132 percent-well above the U.S. average of 84.7 percent.

The data also showed New Jersey to be one of 10 states with the largest top-to-bottom disparities and one of 10 with the largest increase in the ratio of the income of the top 5 percent compared to the middle 20 percent over the past 10 years. New Jersey's income tax, then, relies for most of its revenue on the relatively small portion of New Jersey households who make the most money-and who have seen their income grow the most in recent years.

The "too few pay too much" argument also ignores a highly salient feature of New Jersey's overall state and local tax system. When the three major taxes paid by individuals-state income, state sales, local property-are taken together, the wealthiest households pay a much lower share of their yearly income than do middle-or low-income households.

In 2000, the lowest 20 percent of New Jersey households in terms of income-those making less than $19,000 a year-paid 12.4 percent of their income in the three major taxes.⁵ The middle 20 percent-those making $34,000 to $56,000-paid 9.8 percent of their income.

The top 20 percent broke down as follows: the top 1 percent-those making more than $571,000-paid 8.2 percent of their income; the next 4 percent-$193,000 to $570,000-paid 9.4 percent; and the next 15 percent-$94,000 to $193,000-paid 9.7% of their income in the three taxes.

For only the top 5 percent did the state income tax require them to pay a greater share of their income than did the sales or property tax. And, the ability to deduct state income tax and local property tax from a household's taxable federal income increases the disparity even further. The lowest 20 percent get no measurable cut from deductibility; the middle 20 percent see their rate drop to 9.3 percent from 9.4 percent; but the wealthiest 1 percent sees a drop of 2.5 points, down to 5.7 percent.

Since the study cited above was conducted New Jersey has raised its tax threshold and increased the rate paid on income greater than $500,000-so the disparities might have lessened to an extent. A new study is due early in 2007.

One more element must be considered: federal tax policy that in recent years has brought huge income tax cuts to the wealthiest households. Citizens for Tax Justice⁶ recently estimated that the wealthiest 1 percent of New Jerseyans-households with average income of $1,512,400-are paying $51,368 less in federal income taxes in 2006 than they would have without the tax cuts. So even with the state income tax increase enacted in 2004, they enjoy a net savings of, on average, $23,129.

The inescapable conclusion, then, is that New Jersey's progressive state income tax barely makes a dent in the overall regressive nature of the state and local tax system-and the skewed results of the federal income tax. Reducing the state income tax for the highest-income households, or increasing it only on low- and middle-income households, would make the relative tax share paid by each group more unfair.

This argument is made not so much on behalf of taxpayers but out of concern expressed about state finances. A tax that is subject to widely fluctuating revenues from year to year is less dependable. An unanticipated downturn results in less money and the possibility of having to cut services and programs or raise other taxes in order to meet the state constitution's requirement of a balanced budget. And, the argument goes, since most income tax revenue comes from high-income households and is more likely to come from investments than wages, stock market declines pose significant danger to the state.

It is true that income tax revenue is affected more than property tax revenue by economic conditions. And that does create uncertainty for state policymakers. But is the income tax's reputation for volatility earned?

Over the 40 years of the tax's existence, New Jersey state sales tax revenue has grown from year to year by an average of 10 percent. Five times it has grown by more than 20 percent; two times it has actually gone down.

The state income tax has been in effect for 30 years. During that time it has produced a revenue increase averaging 10 percent a year. Four times it has gone up by more than 20 percent; three times it has declined.

Revenue from local property taxes, meanwhile, has over the past 40 years grown by an average of 7 percent a year. The largest increase was 15 percent; property tax revenue has never declined over the period. Does this make the property tax better? And for whom? Stability in tax collections is good for the tax collector. But consider this: if your income declines in a given year, so does your income tax. But property tax is tied only to home value, not income. You could lose your job and you would still owe property tax. And the trend is that it will go up, not down.

The answer to this is not to rely less on the income tax. It is to make sure the overall tax system is balanced; that it blends fairness and stability and diversifies revenue sources like a well-thought-out investment portfolio. No tax system is immune from serious economic downturns; the key is to use resources cautiously in good times-not to reduce or abandon the tax based most closely on people's actual economic circumstances.

In 2004, the number of New Jersey state returns listing taxable income of $1 million or more was 11,600. That was fewer than in 2000, but more than in 2001, 2002 or 2003. A decline can be interpreted in various ways. Did people leave New Jersey? Or was their income simply subject to the vagaries of Wall Street? Still, anecdotes abound: so-and-so has a house in New Jersey and one in Florida and decided to call Florida his residence to avoid paying any state income tax (Florida has none). No one knows how often this happens.

But some things are known. According to data compiled over the past 20 years by the Internal Revenue Service, every year the average household income of those who move to New Jersey from other states is higher than that of households leaving New Jersey for other states. In 2004, the most recent year for which data are available, the median adjusted gross income for households moving into New Jersey from other states was $32,474. For those leaving New Jersey for other states it was $29,686.

What's also true is that the same three states account for the highest number of households moving into New Jersey from elsewhere in the U.S., and out of New Jersey.

Source: Internal Revenue Service State-to-State Migration Data, 2004 * Median adjusted gross income

As discussed earlier, income taxes in New York are higher than in New Jersey. In Pennsylvania, they are lower for some income levels and higher for others. There is no state income tax in Florida. All of this suggests that taxes might not be the only factor involved in state-to-state migration. IRS data analyzed by NJPP in 2003⁷ found no correlation between tax increases or cuts and movement into or out of New Jersey. It was not uncommon for the number of people coming to New Jersey the year after an income tax increase to exceed the number leaving, and for the number leaving the year after a tax cut to exceed the number coming in. Further, in most years it is the case that both the number coming and leaving rise or fall in tandem.

It is reasonable to infer a few other things from the data. Many people move to New Jersey during their peak earning years and then head south upon retirement (though a substantial number appears to be returning) or to Pennsylvania, which entirely exempts retirement income from taxation. And given that Pennsylvania's property tax burden per capita is less than half that of New Jersey's, it seems very possible that much of the movement from New Jersey to Pennsylvania is middle-income households seeking a reduction in a tax that affects them more than New Jersey's state income tax.

Tax policy should be made on the basis of revenue needs and fairness-not anecdotes or threats. What is needed is for New Jersey to conduct an analysis of high-income households that have stopped paying state income tax in recent years. To the extent that this reflects people who own homes in two states but no longer list New Jersey as their domicile under tax law, the state should release a count and also take aggressive action to make sure such people are complying with the law by actually living outside New Jersey for a majority of the year and taking such actions as registering to vote and becoming licensed to drive in the state they now call home.

RECOMMENDATIONS

New Jersey's personal income tax is better crafted than those in most states. Its progressive tax rate structure should be retained, with some changes that would make the tax fairer and more productive as a revenue source. The underlying premises are sound: Those who earn substantially more should continue to contribute more. The few exemptions and deductions allowed fit with standards of simplicity and fairness by permitting fewer ways to "game" the system.

The policy proposals that follow would increase revenue from the state income tax by at least $1 billion a year. That would be a promising start. New Jersey in the future should rely even more on the progressive income tax. The significant decrease in local property taxes would make the political battle worth it. But before that can happen, the state must move farther along with municipalities and school districts sharing services, consolidating and merging-so that taxpayers can be assured that property tax savings would not be eaten away by the inefficiency that today characterizes local service delivery.

Raising the tax threshold on households with incomes below $30,000 would eliminate the income tax burden for more than 400,000 New Jersey households. The Jones family of four with an annual household income of $28,000 would save $333. In a state with as high a cost of living as New Jersey's, it is appropriate not to tax the income of those who are most vulnerable.

The financial circumstances of households with annual incomes of $150,000 are sufficiently different from those making $500,000 that it is appropriate to tax them at different rates.

The few deductions and exclusions allowed by New Jersey's income tax code create a more equitable system because more income is taxed and special preferences are minimized. The state's treatment of retirement income is one of the few exceptions. Those making contributions to 401(k) retirement plans in New Jersey can exclude the amount from their taxable wages, but no deduction from taxable wages is allowed for contributions made to SEP IRAs, Simple IRAs, ROTH IRAs, Federal 457 plans, 403(b) plans, Traditional IRAs, Keoghs and 414(h) plans.

Equity in taxation requires that all taxpayers in similar circumstances be treated alike. Taxpayers would continue to get a federal deduction so there is still incentive to save for retirement.

Income taxes are constitutionally dedicated for property tax relief. But the Business Employment Incentive Program established in 1996 gives to many businesses that move to New Jersey cash grants that amount to between 10 and 80 percent of what the company withheld from its employees' pay for New Jersey Gross Income Tax. This has meant a net loss to the state treasury of more than $375 million in income tax for a program whose efficacy in attracting businesses to the state has yet to be proved. In 2006, the cost of this program is estimated to be more than $150 million.

Pennsylvania is an example of what New Jersey should not emulate. Its nearly 2,900 municipalities and school districts are permitted to levy wage and occupational privilege taxes. Many criticize them as hard to administer, expensive to collect and confusing to taxpayers.

It is significant that one of the four panels created for the special legislative session is the Joint Committee on Government Consolidation and Shared Services. Its duty is to suggest ways for all levels of government-but particularly local governments-to share operate more efficiently and collaboratively. Allowing cities, school districts or counties to levy their own local income taxes runs counter to this mandate. It would promote potentially detrimental competition, rather than cooperation. And since the ability and willingness to pay local income taxes would exacerbate the differences between wealthier and poorer municipalities, school districts and counties, such a course would be a step backward that would replicate the inequities of New Jersey's historical over-reliance on property taxation.

In its farsighted 1988 report, the bipartisan State and Local Expenditure and Revenue Policy Commission (SLERP) recommended that the state assume responsibility for the county court system and the county prosecutors' offices. Savings from the state assumption of county court costs have helped alleviate property tax pressures resulting from court costs; since 2005 four countries have received a total of $16 million to offset the costs of their county prosecutor.

More such actions should take place. What is called for is an unprecedented restructuring of how New Jersey provides services. The goal should be a streamlined system where the current scheme of rebates to property taxpayers is replaced by state-level service delivery and lower property taxes from the start: reform, not just relief.

A first step should be to move property tax collection and certain assessment functions now performed by municipalities to the state level. Property tax collection can be more efficiently done by the state. And, assessing certain properties by state assessors would improve consistency.

CONCLUSION

Over the past 30 years, New Jersey's income tax has earned its keep and more. It has produced billions of dollars in revenue and has made the overall state and local tax system at least somewhat less oppressive for middle- and low-income people. The fact that local property taxes continue to threaten the economic well-being of all but the wealthiest in New Jersey is less an indictment of the income tax as it is a reminder of how much worse things would have been if politically courageous lawmakers had not adopted the tax in 1976.

But that is not enough. The time has come for New Jersey to better balance its tax system by relying more on the one tax that is based on ability to pay. Progressivity is a virtue, not a vice.

Year after year, New Jersey is at or near the top of the nation in median household income, yet even as income grows more concentrated in the hands of a relative few households, the state clings to its property tax tradition. New Jersey's tax system should reflect reality, not flout it.

New Jersey Policy Perspective is a nonprofit, nonpartisan organization established in 1997 to conduct research and analysis on state issues. Earlier this year, NJPP released a companion report on taxes, You're 40; Now Get to Work: Making the State Sales Tax Pull its Weight. It is available on our website.