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Connecticut Payroll Tax Proposal Raises Difficult Questions

With less than a month remaining in the legislative session, some Connecticut lawmakers want to go bold, eliminating the income tax for many taxpayers and replacing it with a new payroll tax. And while it has the support of some key legislators, many important details have yet to be worked out. The proposal seems straightforward […]

With less than a month remaining in the legislative session, some Connecticut lawmakers want to go bold, eliminating the income tax for many taxpayers and replacing it with a new payroll tax. And while it has the support of some key legislators, many important details have yet to be worked out.

The proposal seems straightforward enough at first glance: the state’s graduated-rate income tax would be largely replaced by a 5 percent payroll tax, plus an additional 2 percent tax on income above $200,000, which would raise more money than the current income tax. The state’s Earned Income Tax Credit (EITC) would be increased to offset the higher tax liability for low-income earners, and because the payroll tax is a deductible expense for businesses, taxpayers subject to the $10,000 state and local tax (SALT) deduction cap would get a federal tax cut even as the state generates more money. It’s an intriguing idea, but also a potentially very complex one. As they consider this new proposal, here are a few questions policymakers might consider asking:

1. What will this do to state employment?

In theory, employees are no worse off—and in some cases better off—if their company takes on this payroll tax burden on their behalf, in lieu of personal income tax liability. Proponents suggest that businesses should cut wages by about 5 percent to account for the shift in tax liability from employee to employer. However, this may work better on paper than in the real world, where wages are sticky.

Employment contracts, labor agreements, prevailing wage and minimum wage laws, and the simple fact that many employees might be inclined to resist a pay cut even if it doesn’t reduce after-tax income, will all interfere with businesses’ ability to reduce wages in proportion to their increased liability. If employers can’t cut compensation, they might resort to the other available option for keeping labor costs from rising: layoffs.

The Connecticut School Finance Project, which issued a position paper recommending a payroll tax, suggested phasing the payroll tax in at the rate of cost-of-living adjustments to ameliorate this concern, meaning that employees simply wouldn’t receive cost-of-living raises for two or three years. In some cases, however, annual increases are written into contracts, complicating matters.

2. How does a progressive payroll tax work?

Preliminary proposals envision a graduated-rate payroll tax, with a standard rate of 5 percent and a 7 percent rate on income above $200,000. What happens, though, if a wage earner receives compensation from two employers, or has a mix of wage and self-employment income, which exceeds $200,000 in aggregate? Would the individual be liable for the difference under a separate tax, under a self-employment payroll tax, or through some other arrangement?

3. How will the tax affect people who also owe taxes to other states?

If a Connecticut resident sometimes travels to New York (or some other state) for business, they may owe income tax to New York for those days, but they receive a credit against their Connecticut income tax liability for tax paid to other states, to limit double taxation. If, however, Connecticut replaces its income tax with a payroll tax, there is no obvious mechanism by which to reduce Connecticut liability. They would pay the additional income tax to New York, but unless separate provision is somehow made, there would be no way to make a corresponding reduction in Connecticut tax liability.

Moreover, even if Connecticut lawmakers found a way to solve this problem for Connecticut residents—perhaps by offering a direct refund to affected taxpayers—it would penalize any nonresidents who choose to work in Connecticut, since they would not be able to claim their taxes paid to Connecticut as a credit against their own states’ liability. This state of affairs could make Connecticut less economically attractive overall.

4. How can the Earned Income Tax Credit (EITC) increase hold lower-income workers harmless?

The payroll tax would increase liability for low-income workers, since unlike the current state income tax, it lacks a standard deduction or a lower rate on the first $10,000 of income (all income above $10,000 is currently taxed at 5 percent or higher). There are two possible ways to address this: an exemption for a certain amount of payroll income, which gets complex if a person draws two or more paychecks, and is potentially gameable for tax avoidance purposes, or an enhancement of the EITC to make up the difference. Lawmakers appear to be inclined toward the EITC as a solution.

Outside of an across-the-board tax cut, it is incredibly difficult to hold all taxpayers harmless, and some reforms are worth doing even if they cannot provide such assurances. However, it appears to be lawmakers’ intention to avoid a tax increase on lower-income workers, and the mechanism chosen is imperfectly suited to that task. Increased liability under the payroll tax is entirely a matter of income, while the EITC takes into account additional factors like family size. This means that the amount of money necessary to hold low-income taxpayers harmless in aggregate cannot hold all taxpayers harmless. There will be winners and losers unless the EITC expansion is significantly larger than the overall tax increase on low earners.

5. How will nonwage income be taxed?

Payroll taxes, by definition, tax payroll—which is to say, wage income. Connecticut proposes to extend the tax to non-employer income, similar to how self-employed individuals are required to remit both the employer and employee side of the federal payroll tax (FICA). This would not, however, include other forms of taxable income, like investment income (interest, dividend, and capital gains income), alimony, certain court awards, any taxable share of Social Security income, and other forms of nonwage taxable income. If the state still wishes to tax these forms of income—and presumably it does—it would likely have to retain the income tax for nonwage income.

The Connecticut School Finance Project recommended keeping the state income tax in place, running in parallel with the new payroll tax, with a $50,000 zero bracket and a top rate of 2.99 percent. Combined with a 5 percent payroll tax, this yields a top marginal rate of 7.99 percent, a percentage point higher than the current top rate of 6.99 percent. Proponents argue that this is still a good deal for high earners given the benefits of functionally uncapping the SALT deduction, but this effort to game the federal tax code could be undone if the IRS disallows the strategy, or if the SALT deduction cap is ever repealed.

It is not clear at this time whether retaining the individual income tax, layered with the payroll tax, is part of legislative proposals, or if income taxes would be limited to nonwage income.

6. What happens if the IRS disallows the deduction?

The whole proposal is built around the assumption that the IRS will treat the tax as one paid by businesses, not individuals, making it deductible at the entity level and thus circumventing the new $10,000 cap on state and local tax deductions. The idea is that, at least for high earners, this enables a state tax hike, increasing Connecticut revenues, without forcing Connecticut residents to pay more in taxes overall, since recharacterizing the tax would enable them to lower their federal tax liability.

It is possible that the IRS could reject this strategy outright, concluding that, name notwithstanding, the tax still functions like an income tax and should be treated as such. In this case, businesses might be viewed as remitting the income tax on behalf of their employees, which is itself a taxable event, creating more complexity and resulting in a net tax increase.

Even if the IRS permits the SALT cap workaround for employer-paid taxes, moreover, it might come to a different conclusion for self-employment taxes. And even if permitted, self-employed individuals might need to clear additional hurdles and file additional paperwork to be able to claim the tax payment as business deduction (since they might not currently be organized in a way to permit that). If for some reason a self-employed individual was unable to do so, they might be really out of luck, since payroll taxes for individuals are not a deductible state and local tax, meaning that they could lose all benefit of the SALT deduction on those taxes paid—not just the amount over $10,000.

7. What happens if the SALT deduction cap is repealed?

Like many provisions of the Tax Cuts and Jobs Act, the SALT deduction cap is set to expire at the end of 2025 unless extended or made permanent by Congress. The cap is also the subject of repeal efforts championed by lawmakers from a number of states including Connecticut. Absent the ability to work around the SALT deduction cap, this proposal would represent a substantial net tax increase for Connecticut residents. Do policymakers intend to make these higher taxes contingent on the continuation of the SALT deduction cap, or would the new system—and significantly higher resulting tax liability—remain in place even if the SALT deduction cap expired or was repealed?

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