Abolishing Colorado's State Income Tax Is A Horrible Idea

Democratic Governor Polis floated an idea on Monday to abolish Colorado's state income tax, as nine other states have done. This is a horrible idea which almost all Democrats in the Colorado General Assembly, where they hold a majority in the state house and state senate, oppose.

Here are some basic background facts.

Colorado imposes a 4.55% flat tax rate on personal and corporate federal taxable income (including capital gains, qualified dividend income, and other investment and self-employment income) with some minor modifications and some additional tax credits. The instructions for Form 104, the Colorado equivalent to IRS Form 1040, disclose the status quo in terms of revenues, expenditures and income incidents by type of tax (as of 2017 due to a data gathering lag):

Unlike the federal government, Colorado must have a balanced budget each year and is limited in its legally authorized ability to incur debt. Any drop in revenue means a dollar for dollar drop in state government spending. Higher education usually bears the deepest brunt of cuts, but state spending cuts can effect almost everything. 

Colorado's state constitution also requires popular referendums on all tax increases and all significant revenue increases that are not refunded to taxpayers (called TABOR for the taxpayer bill of rights), imposes a minimum level of state K-12 education spending, and has a number of other quirks, although the Gallagher Amendment (which imposes differential property tax assessment rates on residential and non-residential real estate with significant state level impacts as well) was significantly reformed by a 2020 ballot measure. Federal Medicaid mandates and other federal programs and state and federal constitutional mandates impose additional involuntary spending requirements on state government. 

Every alternative form of revenue to replace a state income tax is more regressive, i.e. it disproportionately favors people with higher incomes. Alternatives like funding schools with property taxes (which Colorado does partially now) also create regional disparities in school funding that violate the state constitution.

The standard deduction means that single people with incomes of less than $12,550, heads of households with incomes of less than $18,800, and married couples with incomes of less than $25,100 a year pay zero state income tax. In many cases, additional above the line and itemized deductions, and tax credits further reduce their state income tax burden. State income taxation only begins above this threshold. So, for example, a married couple with a $30,000 adjusted gross income that takes the standard deduction and receives no state tax credits would pay $223 in state income tax for the year.

Colorado's state sales tax rate is 2.9%. Local sales taxes from multiple levels of local government range from 0% to 8.3% and averages 4.6%, for a combined sales tax rate, on average, of 7.5%. The sales subject to sales tax are not exactly identical between state and local sales taxes, but they are very similar.

Colorado's state government (excluding local government) gets 70.6% of its tax revenues from income taxes, 18.9% from regular sales and use taxes, and 10.5% from other taxes such as gas taxes, alcohol taxes, tobacco taxes and car registration fees.

In Colorado, 36.7% of all state and local tax revenues come from the state income tax, 32.1% from property taxes, 25.0% from regular sales and use taxes, and 6.2% from other taxes such as gas taxes, alcohol taxes, tobacco taxes, car registration fees, and occupational licensing fees.

Each one percentage point of state sale tax rates generates 6.4% of the state's tax revenues.

Each one percentage point of state income taxes generates 15.2% of the state's tax revenues.

A 2.375% state sales tax rate generates the same income as a 1% state income tax rate.

To replace Colorado's state income tax on a revenue neutral basis with a state sales tax would require a state sales tax rate of 13.7% in addition to an average 4.6% local sales tax rate, would result in a combined sales tax rate of 18.3%. The top combined state and local sales tax rate would be 22%.

Conversely, Colorado could abolish its state sales tax entirely by increasing its state income tax rate to 5.77%. This would reduce the average combined local sales tax in Colorado from 7.5% to 4.6%.

Sales taxes in Colorado, and in most states, exempt rent, real estate purchases, groceries, and services like medical care charges. Most non-U.S. value added taxes have a much broader tax base that includes these things, but still effectively exempts unearned income from taxation.

Many states without a state income tax impose a back door tax on business income with no deduction for wages paid, which is effectively a 0% tax rate for investment income and a similar tax rate, imposed indirectly, on business income and wage and salary income. 

States without a state income tax are also sometimes supported by natural resource taxes (like Alaska), taxes on gambling (Nevada), or state property taxes. Colorado has no dominant driver of the economy that can be taxed in this manner, but could impose state property taxes in lieu of state income taxes. Property taxes would have to increase by 215% across the board if state property taxes replaced state income taxes.

States with no state income tax tend to have the most regressive tax systems overall (the chart is as of 2017; Colorado is the second from the right yellow bar in the chart the the most rightward yellow bar being Utah, Alaska is the further right blue bar, the other blue bar is New Hampshire; the green bars are Montana, Oregon and Delaware).