Mitt Romney, a leading Republican candidate for President wants to end federal income taxation of interest, dividends and capital gains for most Americans. Should he get the chance to implement that proposal the details of how this is phrased in the tax code, could either have no impact on Colorado state revenues at all, or could reduce to Colorado’s tax revenues more than Douglas Bruce ever did with TABOR.The issue is a signature issue for Romney, designed to distance himself from his home state of Massachusetts, which has historically taxed investment income at a higher rather than ordinary income.
Colorado’s income tax is based upon Congressionally defined federal taxable income. Every time Congress narrows the federal taxable income tax base, Colorado income tax revenues go down. Every time Congress broadens the federal taxable income tax base, Colorado income tax revenues go up, subject to state revenue restrictions (currently suspended on a temporary basis) in Colorado’s constitution. These changes happen automatically without any action on the part of the state legislature or the Governor.
While Colorado uses the federal definition of taxable income, with only slight modifications, however, it sets its own flat tax rate, currently 4.63%. Unlike the federal system, Colorado’s income tax makes no distinction between ordinary income and income from dividends or capital gains.
This scheme has the benefit of making it very easy to complete a Colorado income tax return. But, it has the downside of making the state’s revenue stream highly dependent upon the nuances of how changes in federal tax law are worded, even when choices between describing a tax break as an exclusion from income, a deduction, a tax credit or a tax rate change are almost completely equivalent to taxpayers outside of Colorado.
Romney’s proposal is targeted at families making $200,000 or less. If it is implemented as a separate tax rate, like the current low tax rates on dividends and capital gains at the federal level, it would have no impact on Colorado revenues at all. It would also have no impact on Colorado revenues if it were implemented in the form of a tax credit that was phased out for high income families, like the tax credits for educational expenses or the earned income tax credit.
But, if it were instead implemented as an exclusion from income, like the one that applies to employer provided health insurance and “non-qualified deferred compensation” for executives, or an income tax deduction that phases out for high income families, like the IRA contribution deduction, the impact on Colorado’s revenue stream could be dramatic.
Indeed, on a percentage basis, Colorado’s revenue streams would be more heavily impacted than federal revenues by an exclusion or deduction approach. This is because Colorado taxes interest, dividend and capital gain income at the same rates as ordinary income, while the federal government already taxes dividend and capital gain income at reduced rates.
About 9.7% of Colorado’s income taxes come from taxation of interest, dividends and capital gains. Romney’s proposals, if implemented with a deduction or exclusion from income, would reduce Colorado’s individual income tax revenues by roughly 3.5%, removing roughly $100 million a year from Colorado’s general fund budget.
Under TABOR, a Congressionally approved income tax revenue change does not count as a tax increase, but an increase in state taxes through a statutory change does and thus requires voter approval. Thus, any state response to increase income tax revenues (even simply to restore the status quo state tax treatment of interest, dividends and capital gains) in response to to federal law removing interest, dividends and capital gains from the federal tax base would require a statewide vote. This would insure both a delayed response and a heated political fight with an uncertain outcome.
Romney’s proposal is currently described in his press releases as a tax rate change, which would not impact Colorado. But, it is not uncommon for the details of how a tax change is implemented to be adjusted by political staff level in consultations with tax experts, in the process of turning campaign slogans into law. For example, banks and investment companies might push to have the change described as an exclusion from income rather than as a tax rate change to reduce their 1099 information return burden.
Ironically, Colorado actually enacted a version of Romney’s proposal, excluding the first $2,400 of interest, dividend and capital gain income in 2000 and the first $3,000 of such income in 2001, but that proposal was contingent upon the state having revenue surpluses that would otherwise have required TABOR refunds. The potential TABOR refunds are gone for now and so is the tax break.