LD 1088: The Illusion of Tax Reform

Read the full report | LD 1088 (An Act to Modernize the Tax Laws and Provide over $75,000,000 to Residents of the State in Tax Relief) purports to eliminate the existing four tax brackets in Maine’s personal income tax by collapsing them into a single bracket with a flat 6.5 percent tax rate. Unfortunately, LD 1088 also sweeps away the standard/itemized deductions and exemptions in favor of new household tax credit. However, since the credit is both refundable for lower-income Mainers and eliminated for higher-income Mainers, the effective marginal tax rate (EMTR) is very different from the statutory 6.5 percent statutory tax rate.

Chart 1 and Table 1 plot the changes in the EMTR for incomes, as measured by adjusted gross income (AGI), between $0 and $250,000 for a married couple with two children under current law and LD 1088 for FY 2010 (when LD 1088 would take affect if enacted). The EMTR is measured by taking the change in tax liability divided by the change in income. For example, a change in tax liability of $80 over $1,000 in income yields an EMTR of 8 percent. EMTR is important because work effort and entrepreneurship are determined on the margin. Put simply, people work less if the EMTR becomes punitively high.

Overall, LD 1088 is more progressive than current law since it would create negative tax rates for lower income Mainers due to it being refundable if the household credit exceeds their tax liability. However, since the refund is capped at $75, the EMTR is –7.5 percent on the first dollar earned but 0 percent thereafter (since it is constant). Surprisingly, for Mainers in this profile earning between $34.000 and $42,000, they will actually face an EMTR that would be higher under LD 1088 than under current law. More disturbingly, since the credit phases-out for married filers with AGI over $93,900, the EMTR jumps to 8 percent— only 0.5 percentage points less than current law. And it stays at 8 percent until income exceeds $240,000!

As a result, the economic benefits of the lower statutory rate is almost completely eroded by the effects of the household credit. This is particularly devastating because, according to IRS data, married couples make-up 87 percent of all taxpayers earning more than $100,000. These folks are also Maine’s entrepreneurial class and LD 1088 does little to help them.