Assistant Professor Daniel Hemel on the Alaska governor’s plan for a state income tax:
Alaska Governor Bill Walker wants to institute a state income tax and reduce the dividend that state residents receive each year from the Alaska Permanent Fund. As the New York Times explains:
Mr. Walker’s recovery plan would take more from residents through the income tax and would give them less as well, by changing the formula under which the dividend is paid. The income tax would be 6 percent of the amount an Alaskan currently pays in federal taxes, so a person who owed $10,000 to the Internal Revenue Service would also need to write a $600 check to Alaska. Dividend payments would be tied directly to royalties that decrease or increase with oil production. Because oil production is down, next year’s payout would be cut by roughly half under the proposal, to about $1,000 a person.
On first glance, Walker’s plan seems like a rational response to the worldwide drop in petroleum prices, which has reduced revenues for the oil-dependent state. But when one considers the federal income tax consequences of Walker’s proposal, the logic becomes less clear.
Start with the way that federal tax law will treat the amount Alaska residents pay in state income tax. That amount is deductible from taxable income under section 164 of the Internal Revenue Code. Not all Alaska residents will benefit from the section 164 deduction though. Roughly two-thirds of taxpayers (primarily in the lower and middle income brackets) claim the standard deduction instead of itemizing; for them, the section 164 deduction is worthless. Some higher-income taxpayers are subject to the alternative minimum tax (AMT); those taxpayers also don’t benefit from section 164 because state taxes aren’t deductible from AMT income. And even for taxpayers who itemize and who aren’t hit by the AMT, the value of the deduction may be limited by various other features of tax law. For example, state taxes are included in adjusted gross income for purposes of the 2% floor on miscellaneous itemized deductions, the Pease limitation, and the personal exemption phaseout (PEP). The section 164 deduction is not one of the miscellaneous itemized deductions limited by the 2% floor, but the value of the deduction is reduced by the Pease provision for some taxpayers.
Next, consider the fact that dividends from the Permanent Fund are treated as ordinary income for federal tax purposes. This means that many Alaska residents will pay federal income tax on their $1,000 dividend but won’t be able to deduct the amount they pay in state income tax. So say that an Alaskan resident in the 25% federal income tax bracket claims the standard deduction and pays $16,667 in federal income tax. She will then owe $1,000 in state income tax (6% of $16,667) and will receive a $1,000 dividend from the Permanent Fund. She won’t benefit from the section 164 deduction for the $1,000 she pays in state income tax, but she will be liable for $250 in federal income tax due to the dividend she receives from the Permanent Fund. In other words, even though her tax payment to the state exactly equals the dividend she receives from the state, she is $250 worse off after factoring in the federal income tax consequences.
What is especially curious about this result is how easily Alaska can avoid it. Consider an alternative in which Alaska imposes a state income tax on residents equal to 6% of federal income tax due, while also eliminating the Permanent Fund dividend and replacing it with a $1,000 refundable tax credit. Thus, an Alaska resident who owes nothing in federal income tax would receive a $1,000 check from the state; a resident who owes $16,667 in federal income tax would receive nothing from the state and would owe nothing to the state; and an Alaska resident who owes $200,000 in federal income tax would have her $12,000 state income tax bill reduced to $11,000 by virtue of the $1,000 tax credit.
On a pre-federal tax basis, this alternative arrangement is identical to Governor Walker’s plan. Factoring in federal taxes, however, the alternative would seem to be much better from the perspective of Alaska residents. A U.S. Tax Court decision this spring, Maines v. Commissioner, addressed the federal tax treatment of refundable state tax credits. A state tax refund is taxable income for federal tax purposes under certain circumstances; however, “the amount of a state-tax credit that reduces a tax liability is not an accession to wealth under section 61,” and is thus not included in taxable income. So an Alaska resident who pays zero federal income tax and receives a $1,000 refund under my alternative would be no better off than under the Walker plan—but no worse off either. And most other Alaska residents would be better off under my alternative than under the Walker proposal.
To get a sense of just how much better off Alaska residents would be under my alternative, consider a few hypothetical cases. I’ve already discussed the example of an Alaska resident in the 25% bracket who claims the standard deduction and owes $16,667 in federal income tax. She is $250 better off under my alternative than under the Walker plan, because her $1,000 credit would not be federal taxable income but her $1,000 dividend would be. Next, consider an Alaska resident subject to the federal AMT and in the 28% AMT bracket who pays more than $16,667 in federal income tax (i.e., more than $1,000 in state income tax under the Walker plan). She is $280 better off under my alternative—again because the tax credit is excluded from AMT income. Finally, consider an itemizing couple in the 33% bracket whose income is above the Pease limitation and within the personal exemption phaseout range. Under the Walker plan, the $2,000 dividend ($1,000 for each member of the couple) decreases the couple's itemized deductions by $60 because of Pease, reduces their personal exemption by roughly $128 because of PEP, and raises the floor on their miscellaneous itemized deductions by $40. While they can claim the section 164 deduction for state tax, their taxable income is still $228 higher (and they pay roughly $75 more) under the Walker plan than under my alternative.
My point is not to criticize Walker for putting forward his plan rather than mine. Those of us outside Alaska should be quite pleased that Governor Walker structured his plan in a way that results in Alaska residents paying more in federal income taxes. As compared to my alternative, Walker’s plan effectively amounts to a transfer of wealth from Alaskans to the rest of us. So on behalf of everyone in the other 49 states: Thank you.
The puzzle is why Governor Walker opted for this path. In other words: Why would Walker choose the combination of a state income tax and a Permanent Fund dividend when an otherwise equivalent approach, involving a state income tax and a refundable credit, would lead to lower federal income taxes for many Alaska residents without resulting in higher federal income taxes for any Alaska residents? I see no easy answer. Perhaps Walker thinks that from a political perspective, it’s easier to sell a plan that reduces the Permanent Fund dividend than to sell a plan that eliminates the Permanent Fund dividend and replaces it with a refundable tax credit. This strikes me as a questionable strategy. Walker is up for reelection next in November 2018, by which point Alaska residents will have two tax seasons of experience under his plan. By then, at least some voters will have come to recognize the disadvantage of the dividend-plus-state-income-tax combination. And Walker’s Republican and Democratic challengers (Walker is an independent) will have an incentive to point out that the governor’s plan has cost the state millions of dollars. (According to the IRS, nearly 358,000 Alaskans filed individual income tax returns in 2014. If the average Alaska taxpayer would be $100 better off under my alternative than under the Walker plan, that amounts to $35.8 million flowing out of Alaska each year.)
Alaska is unique insofar as it has a Permanent Fund that pays a dividend to state residents. But the mystery of the Walker plan has analogs in other tax puzzles. Most states have state income taxes and state sales taxes, even though section 164 only allows taxpayers to deduct one or the other. One would think that itemizing taxpayers in dual-tax states would be better off from a federal tax perspective if the state imposed only an income tax or only a sales tax (in which case all state taxes would be deductible under section 164). Nonetheless, 39 states have opted for a dual income-plus-sales tax structure, despite the federal tax drawback. Meanwhile, the vast majority of S&P 500 companies (424 of 500) pay dividends, even though share buybacks are a more efficient way to return profits to shareholders from a federal tax perspective. In this respect, Governor Walker’s plan resembles the payout policies of the largest publicly traded companies; although tax-sensitive investors would be better off if these payments did not take the form of dividends, the prevalence of dividends persists.
In sum, Governor Walker’s plan presents a puzzle, but it’s a puzzle not limited to the Last Frontier. Like other states, Alaska is structuring its tax and transfer system in a way that fails to minimize its residents’ federal tax liabilities. And like other dividend payers, the Alaska Permanent Fund is returning profits to stakeholders in a tax-inefficient manner. The Walker plan might seem illogical in this respect, but the illogic is widely shared.