Study: Oregon's income tax is regressive thanks to an obscure tax break

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By allowing Oregonians to subtract the federal tax they owe from their state taxable income, the state's tax brackets get knocked out of whack, according to new research from Yale Law School. (AP Photo/Jacquelyn Martin)
Christian Gaston | By Christian Gaston | The Oregonian
on March 26, 2014 at 6:00 AM, updated March 26, 2014 at 10:10 AM

New research suggests that allowing Oregonians to subtract what they pay in federal tax from their state taxable income results in regressive effective tax rates.

The tax break, which is available to most tax filers, reduces the Oregon tax base and results in odd interactions that disrupt Oregon’s progressive income tax brackets.

Oregon is among six states that allow residents to subtract federal taxes from their state taxable income. Yale Law School Professor Yair Listokin and his student Erik Stegemiller developed a formula to translate the effective rates in those states into rates comparable to states that don’t allow for the subtraction.

The results are surprising. In Oregon, income between $8,150 and $125,000 has a stated tax rate of 9 percent. But because of the federal subtraction, Listokin and Stegemiller found that income between $7,945 and $15,025 is taxed at effective rates between 7.65 and 8.1 percent, while income between $42,350 and $46,785 is taxed an effective rate of 6.75 percent.

That means some “middle” income is being taxed at a lower effective rate than the 7 percent tax rate on income between $3,250 and $8,150.

“It’s unusual for states to present the rate that makes them look bad,” Listokin said, referring to the hidden tax break that some Oregon taxpayers get. “You’re stating that they’re getting taxed at 9 percent when really they could be in the sevens or the sixes even.”

Alabama, Iowa and Louisiana, which allow taxpayers to subtract an any amount of federal tax from their state tax liability, wind up with significantly lower top marginal tax rates. But Montana, Missouri and Oregon cap the subtraction, leaving the top rates (including Oregon’s 9.9 percent rate) intact.

The distortion in Oregon’s tax rates is also limited because the $6,100 cap is lower for certain high earners. Single filers with taxable incomes greater than $145,000 and joint filers with incomes greater than $290,000 can’t claim the tax break at all.

According to the Oregon Department of Revenue, 944,790 full-year filers benefitted from the tax break in 2010, and half of the $275.6 million in tax relief went to filers with $77,000 or more in taxable income. The tax break is projected to reduce state income tax revenue by $863,700 in the 2013-15 budget cycle.

“It’s not a small amount of money,” Listokin said.

Tax activist Bill Sizemore has tried to eliminate the state’s cap on federal deductions with multiple ballot measures, but voters have shot them all down. The main goal? Eliminating “double taxation.”

But Listokin said the argument doesn’t work mathematically.

“You can call it double taxation, but it’s really just a different rate on a different base,” Listokin said.

He compared the tax bases in the six states that allow the federal tax subtraction to the metric system, while the tax bases in the other states are akin to the standard English measuring system -- the U.S. standard.

Oregon, in effect, is posting a speed limit of 55 kilometers-per-hour when it really intends to post a 55 mile-per-hour speed limit in equivalent kilometers (roughly 88).

Since most policy makers -- and taxpayers -- don’t apply that kind of lens to a state’s tax brackets he says Oregon should drop the subtraction in order to reduce confusion about effective tax rates.

“If something’s mathematically equivalent you can’t really say that it’s more or less fair than the alternative,” Listokin said. “It’s kind of like saying that the metric system is unfair.”

-- Christian Gaston