CONNECTICUT GENERAL ASSEMBLY

LEGISLATIVE PROGRAM REVIEW AND INVESTIGATIONS COMMITTEE

The Legislative Program Review and Investigations Committee is a joint, bipartisan, statutory committee of the Connecticut General Assembly. It was established in 1972 to evaluate the efficiency, effectiveness, and statutory compliance of selected state agencies and programs, recommending remedies where needed. In 1975, the General Assembly expanded the committee's function to include investigations, and during the 1977 session added responsibility for "sunset" (automatic program termination) performance reviews. The committee was given authority to raise and report bills in 1985.

The program review committee is composed of 12 members. The president pro tempore of the Senate, the Senate minority leader, the speaker of the house, and the House minority leader each appoint three members.

2005-2006 Committee Members

Senate

Catherine W. Cook

Co-Chair

Joseph J. Crisco

Leonard A. Fasano

John W. Fonfara

Anthony Guglielmo

Gary D. LeBeau

 

House

J. Brendan Sharkey

Co-Chair

Mary Ann Carson

John W. Hetherington

Michael P. Lawlor

Vickie Orsini Nardello

Kevin D. Witkos

     

Committee Staff

Carrie Vibert, Director

Catherine M. Conlin, Chief Analyst

Brian R. Beisel, Principal Analyst

Michelle Castillo, Principal Analyst

Maryellen Duffy, Principal Analyst

Jill E. Jensen, Principal Analyst

Miriam P. Kluger, Principal Analyst

Anne E. McAloon, Principal Analyst

Renee La Mark Muir, Principal Analyst

Scott M. Simoneau, Principal Analyst

Carrie O. Evangelinos, Legislative Analyst II

Bonnine T. Labbadia, Executive Secretary

Project Staff

Catherine Conlin, Carrie Evangelinos, Jill Jensen, and Scott Simoneau

STATE CAPITOL ROOM 506

HARTFORD, CT 06106

(860) 240-0300

Email: pri@cga.ct.gov

 

www.cga.ct.gov/pri

Legislative Program Review

& Investigations Committee

Connecticut’s Tax System

January 2006

Table of Contents

Executive Summary i

Introduction 1

I. Assessing Connecticut’s Tax System

Tax System Overview 5

Assessment: NCSL Principles 9

II. Profiles of Connecticut’s Major Component Taxes

Sales and Use Tax 31

Excise Taxes 42

Personal Income Tax 48

Local Property Tax 63

Corporate Income Tax 88

Estate and Gift Tax 103

III. Administration of Connecticut’s Tax System

Department of Revenue Services: Organization and Structure 109

Major Programs and Functions 110

Agency Resources 112

Limitation in Assessment 114

Overall Performance Measures 115

Operations and Taxpayer Services 119

Compliance and Enforcement 123

Collections and Enforcement 132

Automated Systems 132

Selected Management Practices 134

IV. Other States’ Experience

Tax and Expenditure Limitations 139

California… 142

Massachusetts 144

New Jersey 147

New Hampshire 148

Colorado 150

Michigan 153

V. Findings, Policy Options and Recommendations

Complementary 157

Balanced 162

Reliable 169

Equitable 179

Economically Competitive 190

Neutral 201

Promotes Compliance 211

Accountable 217

Fairly and Efficiently Administered 223

APPENDICES

A. Agency Responses

B. PRI Tax Forum Agenda

C. Connecticut Sales Tax: Taxable and Tax Exempt Items

D. Tax Profiles: Alcohol, Cigarette, and Motor Fuel Excise Taxes

E. Personal Income Tax: State Comparison of Rates and Income Groups

F. Connecticut Local Property Tax Exemptions

G. Major State Grants to Municipalities

H. Summary DRS ITAS Project

I. Tax Rate Changes After Revaluation

J. Options for Redistributing the Sales Tax

K. Supporting Data Regarding Reliable Principle

L. Tax Burden Comparison Among the Northeastern States

M. Motor Vehicle Property Tax

N. Taxation of Services

O. Minnesota Property Tax Comparison

P. Corporate Credit Usage by Industry

Q. Sources Consulted

Introduction

Connecticut’s State and Local Tax System

The Legislative Program Review and Investigations Committee initiated a study of Connecticut’s state and local tax system, incorporating an examination of all major state taxes as well as the local property tax, in March 2005. The study’s chief purpose was to assess the overall performance of Connecticut’s system relative to other states and in relation to nationally recognized criteria. After an extensive literature review, the principles of a high-quality state revenue system developed through a National Conference of State Legislatures (NCSL) project were selected as the committee’s primary evaluation framework.1

The program review committee study was conducted in two phases. The first focused on evaluating the state and local tax system as a whole and the main tax components based on the nine NCSL principles: complementary, balanced, reliable, equitable, economically competitive neutral, promotes compliance, accountable, and fairly and efficiently administered. The study’s second phase was aimed at identifying ways to address major shortcomings the legislature could consider that would improve the system’s performance in terms of one or more principles and, at the same time, be revenue neutral.

Methods

The program review committee and its staff relied on many information sources and a variety of research methods to carry out this study. Key staff and officials of the Department of Revenue Services (DRS), the Office of Policy and Management (OPM), and the Office of the State Comptroller (OSC) were interviewed about the state and local tax structure, and statutes and reports on Connecticut’s system were reviewed. Dozens of reports on other state tax systems, in terms of reforms and key principles, tax incidence, and tax compliance and administration, were also reviewed. Policy reports authored by a wide range of organizations -- business, taxpayer, and public finance, tax administration, and other professional groups, as well as “think tanks” representing a variety of viewpoints – were examined by committee staff.

Local and national experts were interviewed and provided considerable assistance in identifying well-accepted tax system measures and research methods. As part of its study, the program review committee sponsored an informational forum for legislators, staff, and the public on state and local tax policy on October 26, 2005. At the forum, a panel of invited national and state experts discussed guiding principles for revenue systems, trends in state and local tax policies and systems, and actual tax reform experiences in selected states. The panelists also participated in a moderated question and answer session. (A copy of the forum agenda is provided in Appendix B.)

The committee also conducted a series of public hearings to obtain information and views regarding Connecticut’s tax system from interested individuals and organizations around the

state. A total of five program review committee hearings were held at various locations (Hartford, Hamden, Groton, Danbury, and Stamford) during November and December 2005.

The study presented a number of data challenges. The best comparative information on state and local finances is compiled by the U.S. Census. The most recent data on tax revenues and expenditures for both the state and local levels of government, however, are from 2002. Detailed data on Connecticut local government budgets are not centrally collected and information on local property tax collections, due to the nature of the tax, lags state level data (i.e., the most recent local totals are for FY 03).

Problems with state information systems also complicated data collection efforts throughout the committee study. Finalized state fiscal information for either FY 04 or FY 05 was not available from the Comptroller before the study concluded due to technical troubles with CORE-CT, the recently implemented statewide automated accounting system. Conversion to a new automated information system within the Department of Revenue Services significantly impeded compilation of data on state tax programs and department administrative activities by the program review staff.

Unresolved confidentiality issues related to tax information also hindered committee research efforts and prevented several key aspects of analysis. One area particularly hampered by data limitations was the study’s analysis of equity issues including the distribution of state and local tax burden on individual taxpayers in Connecticut. Committee staff had to rely on tax incidence work conducted by a national research organization, the Institute on Taxation and Policy, which uses sample data from each state instead of Connecticut-specific information.2

In general, for a variety of reasons, the committee was unable to obtain the detailed and up-to-date data on tax revenues and taxpayers required for a comprehensive evaluation of Connecticut’s state and local system in terms of every aspect of every principle within the study timeframe. Further, although committee staff was able to spend many hours talking to DRS staff about areas pertinent to the study, the objectivity of the research process was impaired by the DRS commissioner’s requirement that her representative be present at all DRS interviews. It is program review office practice to interview individuals about study topics without the presence of their supervisors or agency heads whenever possible, a practice intended to prevent any influence that may be exerted, intentionally or unintentionally, by management officials.

Report Organization

The program review committee report on Connecticut’s tax system contains five chapters. Chapter I summarizes the results of the committee’s assessment of Connecticut’s overall state and local system using the nine NCSL guiding principles. Chapter II provides a profile and assessment of each major component tax, specifically: the state sales and use tax; the three major state excise taxes; the state personal income tax; the local property tax; the state corporate income tax; and the state estate tax. A profile of the general organization, key resources, and main activities of Connecticut’s primary tax administration agency, the Department of Revenue Services (DRS), is provided in Chapter III.

National tax policy trends, with an emphasis on state tax and spending limitations, are highlighted in Chapter IV. The chapter also contains case studies of the experiences of several states, including California, Colorado, and Massachusetts, that enacted major reforms of their tax systems in recent years. The last chapter of the report, Chapter V, presents the program review committee’s findings about the performance of Connecticut’s overall tax system and some broad options for tax policy changes along with possible implications if they were implemented. Committee recommendations for specific operational changes to improve tax administration and accountability are also presented in Chapter V.

It is the policy of the Legislative Program Review and Investigations Committee to provide agencies included in the scope of a review with the opportunity to comment on the committee findings and recommendations prior to the publication of a study report in final form. The responses received from the Department of Revenue Services and the Office of Policy and Management are contained in Appendix A.

THIS PAGE INTENTIONALLY BLANK

Chapter I

Assessing Connecticut’s Tax System

The ideal tax system is reliable, fair, and efficient. In theory, state tax policies should be designed to achieve these goals, resulting in a structure that produces a revenue stream adequate for providing services the public expects, without disruption, frequent rate or base changes, or placing undue burden on any taxpayer group. In practice, decisions on tax policy are usually made incrementally, often in response to a fiscal crisis or constituent demands, or to promote any number of other policy goals from job creation to environmental protection.

In general, legislators do not have the time or the information to assess current tax policies and determine whether fundamental restructuring, selected fine-tuning, or no action is needed to improve system performance. The main purpose of this program review committee study is to provide an assessment of Connecticut’s existing state and local tax system based on well-established evaluation criteria. The primary evaluation criteria used in the study are nine principles of a high quality revenue system developed under the auspices of NCSL. This chapter contains a brief overview of Connecticut’s state and local tax system, highlighting its composition, trends in collection, and broad comparisons with other states.

Results from the committee analysis of the NCSL principles for a high quality state revenue system as applied to Connecticut’s overall tax structure are discussed below. A table summarizing these results is presented at the end of this chapter. Detailed profiles and assessments of each major component tax are contained in Chapter II.

Tax System Overview

The Connecticut state and local tax system, for the purposes of the program review committee study, is comprised of the local property tax, the only significant municipal level tax, and all state taxes. Altogether there are more than 40 different types of state taxes. The five major state tax components that fall under the committee’s scope of study are: the personal income tax (PIT); the corporate income tax (CIT); the general sales and use tax; several selected sales or excise taxes; and inheritance and estate taxes.

The main components of the system and their relative contribution to total revenues as of FY 03 are illustrated in Figure I-1. (FY 03 is the most recent year for which both state and local tax collections data are available.)

Taxes are the primary revenue source for both state and local governments in Connecticut. As of FY 04, receipts from all state taxes represented 74 percent of all state revenues. At the local level, towns rely very heavily on the property tax to fund services. The most recent available data (FY 03) show that the property tax accounts for 98 percent of all municipal tax collections. Those property tax revenues make up two-thirds (68 percent) of all revenues the towns receive, with less than one-third (32 percent) coming from state aid and intergovernmental transfers like federal grants.

Total state tax and local property tax collections in Connecticut since FY 90 are shown in Figure I-2. It is important to note this time period includes one fiscal year before the state’s personal income tax was enacted in 1991 and the two years it was phased in before being fully implemented in FY 93. Between FY 90 and FY 03, actual state and local tax revenues together rose from $8.6 billion to nearly $15.8 billion, increasing on average 4.8 percent per year. Local property tax collections grew steadily over this time period, while state and total revenues dipped one year during the most recent economic recession (FY 02). (Also, state revenues had dropped during the previous recession in FY 91, a primary reason for enacting the state income tax.)

Growth in state and local tax revenues over this period adjusted for inflation is shown in Figure I-3. Also shown is inflation-adjusted growth in the state economy, as measured by annual change in Connecticut personal income3. Between FY 91 and FY 03, real growth in tax revenues averaged 2.1 percent per year, exceeding the average annual growth in inflation-adjusted personal income, which was 1.6 percent.

Connecticut’s tax system, in terms of state share of total state and local tax revenues and two commonly used measures of relative tax burden, is compared with other Northeastern states and the U.S. average in Table I-1. Data are for 2002, the most recent available for state and local revenues for all states. The per capita tax burden measure, which controls for differences in population, and the per $100 of personal income measure, which controls for differences in state income, are both based on total collections from all state and local taxes. The rankings are for all 50 states and the District of Columbia.

Table I-1. State and Local Taxes 2002: Connecticut and Other Northeastern States

 

State Share

Per Capita

Per $100 Personal Income

 

Percent

$

Rank

$

Rank

Connecticut

59.7

$4,440.7

3

$10.2

21

Maine

57.8

$3,561.7

9

$12.5

2

Massachusetts

62.0

$3,763.7

5

$9.6

39

New Hampshire

52.7

$2,911.7

28

$8.3

50

New Jersey

52.9

$4,115.6

4

$10.2

20

New York

48.7

$4,683.7

2

$13.1

1

Rhode Island

58.7

$3,456.3

13

$10.9

8

Vermont

77.3

$3,226.8

19

$10.8

10

U.S. Total

59.1

$3,215.7

-

$10.2

-

Sources of Data: Governing Sourcebook 2005 and NCSL (Feb. 2005), both based on U.S. Census 2002

Connecticut is nearly the same as the U.S. average for state share of total state and local revenues, and for state and local tax burden when measured against personal income. On a per capita basis, Connecticut’s tax burden is higher than average and ranks third highest in the country. On both measures, New York has the highest burden of all states in the region and ranks one and two nationwide. New Hampshire has the lowest state and local tax burden in the region using either measure and is 50th in the country in terms of taxes per $100 of personal income.

Assessment: NCSL Principles

In the early 1990s, the National Conference of State Legislatures convened a group of policymakers, legislators, legislative and executive staff, and academics to identify elements of sound state fiscal policy. Out of that effort, a document called “Principles of a High-Quality State Revenue System” was created and subsequently updated. The report identifies nine principles on which to evaluate a tax system: 1) complementary; 2) reliability, including stability and sufficiency; 3) balanced; 4) equity; 5) facilitates compliance; 6) fairly administered; 7) economically competitive; 8) neutral; and 9) accountable. Each of the principles is discussed below in the context of assessing Connecticut’s tax system.4

Complementary

The elements of a tax system that state and local government rely on to raise revenues should be complementary, meaning tax bases are not in competition, tax policies are not contradictory, and revenue-raising authority matches with financial responsibilities. In Connecticut, there is little overlap in taxing authority between the state and municipalities. Local government in this state is limited to raising revenue through a property tax, unlike many other states where counties and sometimes municipalities can also levy a local tax on sales or, more rarely, a tax on income.

Limiting the local revenue base to the property tax avoids taxpayer confusion and concerns over “double” taxation. At the same time, it restricts municipal capability and flexibility for funding what has become a wide array of expected local services. In recognition of this constraint, state policymakers need to be cautious about introducing new unfunded mandates on towns and must honor previous municipal funding commitments, particularly in the area of education, the largest mandated expense for most Connecticut communities.

Complementary tax systems can be especially difficult to achieve when state or local governments adopt constitutional or statutory tax and expenditure limitations (TELs). Measures put in place to provide tax relief and control public budgets can have intended and unintended consequences in terms of the breadth and quality of services provided, as well as raise taxpayer fairness issues. Connecticut has a constitutional cap on state spending and a balanced budget requirement, which were put in place as part of a fiscal reform package adopted at the same time as the state personal income tax; however, no formal constraints have been placed on state taxing authority. To date, Connecticut has not instituted any statutory limits on local taxing authority (e.g., caps on local property assessments), although various proposals to do so have been introduced in recent legislative sessions. The potential benefits and risks of TELs, along with a description of the actual experiences of several states that adopted caps on state and local taxes and/or spending are discussed in more detail in Chapter IV.

Reliable

High quality tax systems produce revenues in a reliable manner, which involves three factors: stability, certainty, and sufficiency. Each factor is discussed separately below.

Stability. A stable tax system produces revenues that are predictable and relatively constant over time. Revenue stability is important to budgetary planning, and helping governments avoid fiscal crises and erratic funding of public programs. Some revenue variability is inevitable. Tax collections will change with demographic shifts and changes in the structure of the economy, as well as from the impact of natural disasters, wars, and other events that no one can forecast.

Tax system volatility can be reduced, however, by incorporating a mix of tax types that respond to the economy in different ways. This allows the system to weather economic downturns by relying on revenues from one source during boom periods, and another during slumps. For example, in good times income tax revenues usually outpace growth in the economy, measured either by personal income or gross state product5, but they also fall off more deeply during recessions. While sales tax revenues also fluctuate with business cycles, their volatility is less dramatic, and local property taxes, which do not grow as quickly as other revenue sources, are the most reliable.

Program review committee staff examined the revenue volatility of state and local taxes by analyzing long-term growth trends and the amount and frequency of year-to-year fluctuations in revenues for total state taxes, for each of the three major state taxes (personal income, general sales and use, and corporate income), and for the local property tax. The results of this analysis are summarized in Table 1-2.

In each case, the state tax revenues included in Table I-2 were adjusted to remove the effects of year-to-year legislative changes on collections,6 (e.g., revisions in the rate, base, and exemptions) so tax system volatility due to economic conditions could be isolated. Since volatility can vary with business cycles, a 30-year period that encompasses several recessionary and expansionary cycles was examined. Longer-term trend analysis in Connecticut is complicated by the fact the state’s personal income tax, now the major source of state revenues, was not established until 1991 and did not go into effect fully until FY 93. For that reason, the table includes information for the full period and for a sub-period following implementation of the personal income tax (FY 93 – FY 04).

The table includes two calculations: long-term average annual growth, a gross measure of revenue volatility; and standard deviation, a statistic that indicates the range in variation around the long-term trend rate. The greater the standard deviation, the more volatility there is in tax revenue performance. For example, Table 1-2 shows total tax revenues grew, on average, almost 6 percent a year between FY 75 and FY 04. The standard deviation of 6.2 means most of the time annual growth rates will be between roughly 12 percent and 0 percent, or fairly volatile. The corporate tax is by far the most volatile component tax with annual growth rates that could range from a decline of 9 percent to an increase of 18 percent, while the general sales tax is the most stable state tax source, with annual average growth rates between 2 and 12 percent over the full period. The volatility of the tax system has been less in the sub-period, with a standard deviation for the entire system of 4.1 in the FY 93 – FY 04 period. This could be partially due to the income tax absorbing some of the previous volatility in the other component taxes, thus making for a less volatile tax system overall.

Table 1-2. Average Annual Growth and Standard Deviation of

Connecticut State Tax Revenues: FY 75 – FY 04 and

Local Property Tax Revenues FY 93 – FY 03

 

Full Period:

FY 75 – FY 04

Sub-Period:

FY 93 – FY 04

Total State Tax Revenues

   

Average Annual Growth

5.8%

5.2%

Standard Deviation

6.2

4.1

Sales and Use Tax

   

Average Annual Growth

7.0%

5.5%

Standard Deviation

5.1

2.3

Corporate Income Tax

   

Average Annual Growth

4.4%

3.0%

Standard Deviation

13.7

10.3

Personal Income Tax

   

Average Annual Growth

n/a

7.7%

Standard Deviation

n/a

7.5

Local Property Tax

 

Sub-Period:

FY 93 – FY 03

Average Annual Growth

 

3.9%

Standard Deviation

 

1.6

Source: PRI

Measures of volatility of the local property tax are also presented in the table, but for a different time period (FY 93 through FY 03), due in part to data availability. During the period, local property tax revenues grew 3.9 percent each year on average, with a relatively low standard deviation of 1.6, as shown at the bottom of the table.

Looking at the volatility of all state taxes and the local property tax together between FY 93 and FY 03 shows the long-term average annual growth is 4.2 percent, slightly less than the rate just for state taxes. Stability for the overall system, however, is greater, with a standard deviation value of 2.8. Thus, by these measures, the property tax is certainly less volatile than the major state taxes, and in fact has an important stabilizing effect on the state and local tax system as a whole.

Year-to-year volatility differences between the local and state-level taxes are more apparent in Figure I-4. Annual percent changes in local property taxes are far less dramatic than annual changes in state tax collections, as Figure1-4 illustrates.

On the whole, the volatility of Connecticut’s state tax revenues exceeds that of the state’s economy and is greater than the national average for state tax revenues. Figure I-5 shows, since FY 93, the first year the state’s personal income tax was fully implemented, total state tax revenues (adjusted to remove the impact of year-to-year legislative changes in tax rates or base) have fluctuated more than Connecticut’s total personal income.

Figure I-6 compares annual growth in Connecticut state tax revenues with the year-to-year change for all states since FY 93.7 Throughout this time, the volatility – or degree of change from year to year – of Connecticut’s state tax revenues was greater than the national average.

In general, Connecticut’s economy, as measured by personal income growth, is less stable than the U.S. economy on average (see Figure I-6). (Data are not easily available to allow any nationwide comparisons of volatility in revenues for combined state and local tax systems. Based on earlier analysis, however, it is likely the volatility of Connecticut’s tax system would be less if local property taxes were included and might compare more favorably to a national average.)

Chapter II provides more detailed analysis on the volatility of each component tax of Connecticut’s system. Based on that analysis, it appears much of the volatility of the overall system is related to the state’s personal income tax (PIT). While the corporate income tax is the most volatile of all the system’s component taxes, its contribution to total revenues has been decreasing sharply both in actual dollars and as a percentage, which lessens its impact on the stability of the state’s tax system. The high variability in Connecticut PIT revenues is due largely to the high incomes of taxpayers in the top bracket, the percentages of total taxes they pay, and the variability in both (rather than due to the PIT rate structure). As the state becomes more reliant on the personal income tax, its volatility makes the whole tax system more susceptible to dramatic upswings and downturns.

Certainty. A reliable tax system achieves certainty by keeping the number and types of tax changes to a minimum. Frequent revisions impede long-term planning by taxpayers and government agencies as well as add administrative and compliance costs.

The component tax profiles contained in Chapter II include a discussion of major legislative changes to each tax since the early 1990s. All the state taxes have undergone modifications, with corporate taxes being the most prone to rate and base changes, including several rate reductions and the addition of various business tax credits. On the whole, the personal income tax has been immune from broad revisions; the top rate changed once while the value of the property tax credit on the income tax has fluctuated a few times. The current sales tax rate of 6 percent has not changed since it went into effect in 1992, but the number of exemptions has steadily increased each year. The state has also opted to offer sales tax “holidays” and rebates from time to time, a policy that reduces revenue certainty.

It is difficult to assess at what point the number and scope of changes in a tax system result in more harm, in terms of uncertainty, than good, in terms of improved efficiency, fairness, or just increased revenues. In most states including Connecticut, recessions have tended to bring about increases in tax rates, new additions to tax bases, or elimination of some exemptions or credits; when the economy improves, the reverse occurs. However, based on the most recent economic cycle, states appear to be making more use of temporary revenue adjustments, such as one-time surcharges to increase collections and rebates or refunds, rather than rate or base reductions to provide tax relief. Such practices help preserve tax system reliability.

In 2003, for example, Connecticut made some modifications to the tax system – increasing the top rate of the income tax to five percent, raising the cigarette tax, and expanding the base for the sales tax. However, the state has also increasingly used one-time surcharges, especially to the corporate income tax, to raise revenues. This provides more certainty to the tax structure itself, although the financial impact on the taxpayers affected may be as great as if the structure changed, especially if the surcharge is imposed year after year.

Sufficiency or adequacy. A reliable tax system raises funds adequate to pay for the level of services the public, directly or through elected representatives, chooses to provide. Sufficiency, therefore, requires the system to produce enough revenue to balance the budget each year and adapt to desired spending changes. This element of a tax system is especially difficult to assess since the debate over appropriate funding and spending levels is the crux of the legislative process each year. Adequacy is essentially a value judgment; one legislator’s view of adequate funding for needed public services could be another’s idea of profligate government spending.

One broad indicator of tax system adequacy is whether revenue growth keeps pace with spending and growth in the economy over the long term. Program review compared increases in state and local tax collections between FY 91 and FY 03 with several measures of economic growth as well at trends in state and local expenditures. Results are summarized in Table I-3.

Table I-3. Connecticut Fiscal Growth over Time
 

Total Percent Change

FY 91-FY 03

Revenue Growth

 

State and local taxes

62.9

State taxes

66.6

Local property taxes

59.8

Expenditure Growth

 

State and local expenditures

59.9

State expenditures

64.7

Local expenditures

53.7

Economic Growth

 

Total percent growth Connecticut Personal Income

55.7

Total percent growth Connecticut Gross State Product

52.8*

Total percent growth inflation

(Consumer Price Index-urban)

32.5

*FY 93-03 period

Source: PRI analysis

Based on Table I-3, it appears Connecticut’s tax system produced sufficient revenues over this 13-year period. Total growth in state and local tax revenues, separately and combined, have more than kept up with personal income growth and is well above the cumulative inflation rate for this period. The overall increases in tax collections, combined and at the state and local levels, have also exceeded the growth in their respective expenditures.

To assess adequacy another way, the study examined General Fund budget balances over the past 20 years. In Connecticut and all other states except Vermont, a balanced budget is required by law. Unlike the federal government, states are precluded from deficit spending; their tax systems must produce revenue sufficient to meet approved expenses. In most cases, states including Connecticut, balance their budgets every year; however, deficits sometimes occur or are avoided through fiscally questionable means (such as issuing short-term bonds to pay off the revenue shortfall).

Figure I-8 shows Connecticut has experienced budget deficits several times over the last 20 years. Four consecutive years of deficits, including the nearly $1 billion shortfall at the end of FY 91, precipitated adoption of Connecticut’s currently configured revenue system that relies heavily on a personal income tax, as well as a number of fiscal reforms intended to improve the system’s reliability (e.g., the balanced budget requirement, state spending cap, and a more realistic “rainy day fund.”).

This was followed by an unprecedented 10-year cycle of surpluses, some of which reached more than $500 million, and was due in large part to a similarly unprecedented period of robust economic growth. However, a recessionary period compounded by the impact of the September 11th terrorist attacks and war in Iraq contributed to another massive deficit in FY 02 and a smaller shortfall in FY 03. The already significant volatility of Connecticut’s state revenue system was exacerbated by this unusually severe economic downturn.

An analysis carried out recently by the Federal Reserve Bank of Boston (FRBB) offers another way to assess state tax system adequacy using a measure called fiscal comfort. The FRBB used a method called the representative tax system to measure the ability of states to generate revenues (fiscal capacity) and the extent to which states use their tax bases (tax effort) for FY 1999.8 Another methodology computes fiscal need through the development of a representative expenditure system, which is a common bundle of state and local functions. The final measure calculated in the analysis is fiscal comfort, a state’s fiscal capacity relative to its fiscal need.

Using these measures to evaluate Connecticut’s system, the FRBB analysis found:

• Connecticut’s 1999 fiscal capacity to raise revenues was 27 percent above the national average, ranking second among the 50 states. Massachusetts and New Hampshire were also above average, ranking in the top 10.

• From 1987 through 1999, Connecticut consistently ranked among the top five states.

• Connecticut’s tax effort (or burden) was 19 percent above the national average and third highest in the nation. All the New England states, except New Hampshire, showed a high tax effort and were above the national average.

• Connecticut’s fiscal need was 2 percent below the national average and ranked 26th in the nation.

• Connecticut’s fiscal comfort was 29 percent above the national average, ranking it second highest in the nation. All New England states, except New Hampshire, were above the national average.

The FRBB analysis suggests that, all other things being equal, the ideal situation for a state is to have high fiscal capacity with: 1) low tax effort; and 2) low fiscal need (or at least a positive differential between capacity and effort/need). Connecticut’s tax system provides that situation, having a +10 differential between fiscal capacity and effort, and a +31 differential between fiscal capacity and need.

Balanced

High quality revenue systems rely on a balanced mix of a variety of taxes. While not a strict rule, system balance is often measured against a “three-legged stool” framework, with each major tax – personal income, sales, and property – contributing roughly equal portions of revenue, and other sources contributing a lesser share.

A major benefit of a system with a balanced blend of diverse taxes is its ability to provide for a broad base and low rates within each component. Balance also contributes to a system’s ability to meet other principles by: avoiding too much reliance on any one tax type; helping maintain economic competitiveness through lower tax rates and/or broad component tax bases; and promoting a sense of system fairness in that tax burden is shared among many segments of taxpayers.

Like most other states, Connecticut’s revenue system incorporates both wealth and consumption taxes and relies on three primary components: income taxes, both individual and corporate; sales taxes, general and selected; and property taxes. Connecticut has a balanced system in the sense it incorporates the whole range of major tax components to raise revenue and support public services.

Connecticut’s reliance on each major source of tax revenues over time is shown in Figure I-9. In FY 03, the year with the most recent available data, Connecticut relied on two major taxes – the local property tax and the personal income tax – for more than two-thirds of its total state and local tax revenues in FY 03. The state’s general sales tax accounts for about 19 to 20 percent and has remained at about that level since FY 92.

Based on 2002 census data, the most recent available, Connecticut is more reliant on the property tax than 42 other states (and of the eight that are more reliant, three do not have a broad-based income tax). As Table 1-4 shows, in Connecticut like nearly all the states in the Northeast region, property taxes account for a higher portion of total state and local tax revenues than the national average of 30.8 percent. (The percentages in Figure I-9 and Table I-4 vary somewhat because the Connecticut-only figures are based on Comptroller and OPM data, while the state comparison information uses U.S. Census data.)

Table I-4. State and Local Tax Collections by Source: Percentage of Total Taxes, 2002
 

Property

Sales

Indiv. Income

Corporate

Other

U.S. Total

30.8

24.6

22.4

3.1

19.0

Connecticut

39.6

20.1

24.4

1.0

14.8

Northeast Region

         

Maine

42.1

18.4

23.6

1.7

14.1

Massachusetts

36.5

15.5

33.1

3.4

11.5

New Hampshire

60.3

Na

2.0

10.5

27.2

New Jersey

46.3

17.3

19.8

3.2

13.3

New York

30.2

18.7

34.0

5.7

11.4

Rhode Island

40.4

20.2

22.7

0.8

16.0

Vermont

41.9

10.9

20.8

1.9

24.5

Selected Other States

         

California

25.1

26.0

27.4

4.4

17.0

Colorado

29.9

29.7

25.0

1.5

13.8

Michigan

32.0

25.4

21.5

6.7

14.4

Source of Data: Federation of Tax Administrators (based on U.S. Census, 2002)

In addition, Connecticut’s recent growing reliance on property tax revenue is in the reverse direction of the trend in most other states. Nationwide, the property tax accounted for 31 percent of all state and local tax collections in FY 92; in Connecticut it was more than 41 percent. By FY 02, reliance on property tax nationally was down to 29 percent but in Connecticut property tax revenues (after dropping somewhat through the 1990s) had climbed back up to almost 40 percent of the state and local total revenues.

Shifts in Connecticut’s tax system balance over time are likely due to a combination of many factors. One contributor, discussed in more detail in Chapter II, is the reduction in reliance on the corporate income tax as a source of state and local revenue. While never a major revenue source even before enactment of the broad-based state personal income tax, it did make up just over 9 percent of state and local tax collections in FY 90. Since full implementation of the personal income tax in FY 93, the CIT share has dropped from just over 6 percent as little as 2.6 percent in FY 02 and just over 3 percent in FY 03. Another contributor is the lower reliance on the sales and use tax to produce substantial revenue. A third factor is that state aid to local towns has declined in the recent economic downturn and municipalities have had to rely more heavily on the sole local tax, the property tax, to raise revenues for local services.

Equitable

A good tax system is fair and achieves equity in two main ways: 1) the system distributes tax burden according to ability to pay (vertical equity); and 2) the system treats taxpayers of comparable circumstances similarly (horizontal equity). Like many of the other principles discussed in this chapter, fairness is difficult to define, let alone measure. Equity, like adequacy, is a value judgment. However, there is general agreement that a fair tax system minimizes regressivity, placing less tax burden on lower-income taxpayers compared to higher income taxpayers.

One commonly used gross measure of tax burden is the percent of personal income total state and local taxes represents. This measure is used to compare total tax burden over time as well as to make comparisons with other states. Results of program review analysis of the overall tax burden of Connecticut’s system since FY 90 are summarized in Figure I-9.

Figure I-10 shows that all state and local taxes as a percentage of state personal income (the top line) grew from slightly less than 10 percent at the beginning of the 1990s to almost 11.5 percent in the mid-1990s, before declining to a low of 10.1 percent in FY 02 and then increasing slightly to 10.5 percent in FY 03.

Based on the most recent available comparative data, Connecticut’s overall tax burden is similar to the national average. In 2002, state and local taxes represented 10.2 percent of personal income in Connecticut and for the U.S. in total, which placed Connecticut 21st among all the states.

As shown earlier in Table I-1, Connecticut along with New Jersey ranks 5th highest among the states in the Northeast in terms of state and local taxes per $100 of personal income ($10.2). Massachusetts ($9.6) and New Hampshire ($8.3) are lower, while New York ($13.1), Maine ($12.5), Rhode Island ($10.9) and Vermont ($10.8) are higher.

However, examining tax burden as a share of personal income or even on a per capita basis does not gauge the impact on individual taxpayers. Vertical equity raises issues about how much more (if any) people at higher income levels should pay in taxes. Taxes that are based on income, like the personal income tax – especially those placing higher rates on higher income individuals – are more progressive, since they place a higher proportional burden on higher income groups. Other taxes, like sales, excise, or other consumption taxes, are considered highly regressive, since they place more proportional burden on lower income groups.

While the equity of each component tax is discussed in detail in Chapter II; it is even more important, as most tax policy experts point out, to examine the progressivity/regressivity of an entire tax system working together in order to understand the distribution of tax burden among all taxpayers. To assess the burden the tax system places on different taxpayers, program review relied on recent work carried out by the Institute on Taxation and Economic Policy (ITEP) that assesses tax distribution and ability to pay within all 50 states and the District of Columbia. A nationally recognized research organization funded by a number of philanthropic organizations and individual donations, ITEP’s stated mission is to better inform policymakers and others on government tax and spending policy issues.

The most recent research undertaken by ITEP is presented in its 2003 report on state and local tax fairness entitled Who Pays? A Distributional Analysis of the Tax Systems in All 50 States. The analysis, which uses 2002 data, is based on a sample of the population under age 65 in each jurisdiction that is divided into five income groups or quintiles, with the top quintile further separated into 15 percent, 4 percent and top 1 percent groupings for each of the 51 jurisdictions. Results are summarized in Figure I-11, showing the amount of state and local taxes paid by the different income groups in terms of a percentage of their income. Greater burden on lower-income groups is evidence of a more regressive state tax system, and the greater the burden a state tax system places on the top income groups the more progressive the system is considered.

Overall, the 2003 ITEP study found most state and local tax systems take a much greater share of income from the middle- and low-income groups than from the wealthy. In other words their tax systems are regressive. The ITEP study indicates that only four states require their wealthier residents to pay as much of their income in taxes as middle income groups, and only eight states tax the top income groups at effective tax rates as high as those levied on the lowest income groups. ITEP study results for Connecticut are compared with those for the U.S. on average in Figure I-11.

In Figure 1-11, each of the four bars on the left for the U.S. and for Connecticut represents an income quintile – starting on the left with the lowest 20 percent and continuing to the right – and the last three bars together comprise the top 20 percent, with each representing the top 15, 4, and 1 percent groups. The results show that overall the average of all states’ (U.S) systems tends to be more regressive, with the trend in each income group paying less as income rises very apparent in the graph.

For Connecticut’s system, the trend in distribution of tax burden is less clear-cut. The three bottom income groups pay a very similar percentage of their income (about 10.3 percent) and the fourth quintile pays the highest effective tax rate (10.7 percent). At that point the effective tax rates for the top income earners fall sharply; the top 1 percent group pays an effective tax rate of 6.4 percent. It should be noted these are effective tax rates before any offset for deductions of federal income tax payments. If those were included, effective tax rates for the higher income groups would be less.

The figure also illustrates the greater portion of income the property tax represents for middle-income earners in Connecticut than similar income groups nationwide. Excise and sales taxes appear to take a smaller share of taxes paid by Connecticut lower- and middle-income groups than is the case nationwide. From the chart it appears Connecticut’s income tax is more progressive than either the sales or property taxes, but its impact is not enough to make the entire system a progressive one. Based on the ITEP analysis, Connecticut’s system seems to be a more proportional system, exhibiting similar effective tax rates for lower- and middle-income groups, but because it clearly has lower effective tax rates for top-income individuals, the tax system clearly becomes sharply regressive.

Simple/Promotes Compliance

Good tax systems promote compliance in part by being simple to understand and implement. More complicated systems, with numerous tax types, rates, exemptions, deductions, and credits, all with related paperwork and filing requirements, increase taxpayer compliance costs and provide an incentive for avoidance. Complex systems also require more state and local resources for effective administration and enforcement.

Of course, a tax system is only as straightforward as its component parts. Chapter II describes each of the major taxes in Connecticut, including how each is calculated, available exemptions and credits, and other structural aspects that contribute to making compliance simple or difficult.

Overall, Connecticut’s personal income is relatively simple compared to other states. It has only two brackets, and other than basic threshold-income exemptions, very few types of income are exempt from tax. Further, the state’s personal income tax offers only two credits, for payment of income tax to other states and cities, and the property tax credit. Connecticut policymakers have resisted what other states have done in exempting a variety of income and pensions from taxable income, and offering credits to promote certain activity or compensate for certain expenses. While these strategies may appear positive in the short-term, they reduce the taxable base, make the tax more complicated, and allow certain taxpayers to benefit from the exemptions or credits, while others must pay for that benefit, or revenues are reduced.

In contrast, the state’s corporate income tax is complex. The variations in who pays and how the tax is calculated, what is considered income, the apportionment formula, and what factors apply to which businesses, and the increasing number of years when businesses can claim losses from their income all make for a complicated tax. The tax literature indicates the more complicated the tax, the easier it is to find “loopholes,” and avoid the tax. While declining rates through the 1990s certainly have contributed to the decline in corporate tax revenues, the complexity of the tax and the increasing number and use of business tax credits also played a role. In 2001, the last income year that state statistics are available for corporations, businesses were able to reduce their tax liability by one-third through tax credits. Indeed, two-thirds of corporate filers paid only the minimum tax of $250.

The Connecticut general sales tax is also a relatively simple tax from the direct taxpaying consumer’s standpoint since it is paid at the time of purchase; paperwork is only required from the retailers. The state excise or selected sales taxes are even simpler as they are levied at the wholesale level and unlike some other jurisdictions, Connecticut has rarely authorized any type of local excise tax. Also, unlike many other states, the state general sales tax, with several very minor exceptions, is the only sales tax in place in Connecticut, and there is just one tax rate (6 percent). However, Connecticut has added many exemptions to the general sales tax over the years, which can impact compliance. In addition, in all states, e-commerce (internet sales) and mail order catalogue operations have made it much easier to evade state general and selected sales taxes. As Chapter II discusses, Connecticut is participating in several interstate efforts to improve compliance with both the general and certain selected sales taxes.

In Connecticut, the property tax is only levied at the local level and it is the only tax towns are authorized to impose. While municipalities conduct their own assessments of local property values and establish their own rates, some uniformity is promoted by a state statutory requirement for a uniform rate (70 percent of true and actual value percent of fair of fair market) and local revaluation at least once every five years.

The property tax is the only tax where the payer gets a tax bill, which may make it relatively easier in that the taxpayer has no forms to complete, no return to file, or tax to calculate. However, despite its simplicity, it is probably the most grumbled-about tax; because the tax is “lumpy”, the taxpayer sees the total amount all at once. Of all the taxes, the property tax has the highest collection rate, and while there are no firm statistics, indications are that the increased prevalence of property taxes being paid through escrow accounts by banks and other mortgage holders contributes to that high rate.

Fairly and Efficiently Administered

A good tax system must be fairly and efficiently administered, giving taxpayers confidence that its provisions are uniformly applied. Administrative fairness is related to the simplicity of the system, and also depends on the resources available for collection and enforcement. Administration of Connecticut’s state tax system by the Department of Revenue Services (DRS) is discussed in more detail in Chapter III, while administrative issues related to the local property tax are highlighted in the profile of that tax in Chapter II.

The corporation income tax is particularly difficult to administer for a number of reasons. The tax itself, with its many steps in calculating the taxes owed, is complex. Also, Connecticut does not require uniform filing, which makes it easier for multi-state corporations to maneuver income, business activity, and credit use to states where it is most advantageous for the companies’ tax purposes. Because there are so many factors, and the tax is often subject to legal and accounting interpretation rather than clear statutory and regulatory standards, many corporate tax cases are subject to negotiation.

DRS staff also express frustration at what is perceived as a practice of tax minimization and avoidance that has become commonplace in the corporate tax area. For example, the use of abusive tax shelters has become an increasing area of concern in overseeing the corporation tax (as well as the income tax). While no firm statistics are available at the state level, the federal Department of Treasury and the Internal Revenue Service indicate the use of abusive tax shelters total billions of dollars in lost revenue nationally. 9

During the 2005 session, the Connecticut General Assembly passed legislation allowing DRS to assess penalties against promoters who make false statements in connection with such transactions and against taxpayers who fail to report a “listed” transaction (i.e., one of the types the IRS has determined to be a tax avoidance transaction) on their federal return. The law became effective on January 1, 2006, but DRS offered an amnesty period, with reduced penalties, for persons who declared before that date.

Administration of the sales tax also can pose problems, with lost revenues from Internet, catalog, and other purchases made out-of-state, as mentioned above. Interpretations of what is taxable or exempt, and nonpayment of the sales tax, especially in cash businesses like restaurants, bars, and individual trade contractors, are day-to-day issues according to DRS auditors. According to audit statistics provided by DRS, the three-year average of assessments for unpaid sales and use taxes totaled about $117 million, almost one-third of the total $356 million assessed from audits of all taxes DRS administers.

As will be discussed in Chapter III, since FY 00, DRS staff has been reduced and its budget has been stagnant. It is almost impossible to determine whether Connecticut’s tax system is better administered or more efficiently operated than other states since few benchmarks on administration exist. The Federation of Tax Administrators – an association made up of the principal tax collection agencies in all 50 states and D.C. whose objective is to improve the quality of tax administration – has formed a working group to examine such workload, efficiency, and performance measures. However, the measures are still being developed, and serve as guides, not standards, and Connecticut’s role in the project is minimal.

Competitive

A state must recognize that its tax system is integral to economic competitiveness. It should neither impede a state’s economic growth nor put resident businesses at a disadvantage with higher rates or compliance costs than other jurisdictions.

Some believe tax policy should promote economic development although it is not always clear what policies best achieve that goal. Other experts minimize the effect taxes and “business climate” have on economic growth, suggesting instead that tax cuts and tax incentives that state and local governments offer may undermine their ability to retain businesses and create jobs. Such research highlights that state and local taxes are only a small burden on business, and that financial incentives to reduce that burden is an inefficient use of tax revenues, because the money lost in tax revenue surpasses what the firms (and the state) gain in additional income.10

This research also suggests that cooperation among states is better than competition, and that attention to needed public services like good transportation infrastructure, and a well-educated population, may actually aid in faster growth and more jobs. States may also need to reexamine their economic development and tax policies in light of a pending U.S. Supreme Court ruling on the constitutionality of an Ohio business tax credit program. Last year, the U.S. Court of Appeals for the Sixth Circuit ruled in the case of Cuno v. Daimler-Chrysler that Ohio’s tax credits for investment in new machinery and equipment violated the federal Commerce Clause. The outcome of this case has implications for tax credit laws in all states.

A number of organizations rate and rank states on their “business climate” or “competitive environment.” Generally, they produce widely different rankings so it is not clear whether their results are reliable or accurate measures of a state’s capacity or potential for economic growth. However, they are often cited and sometimes used as rationale for changing state tax policies. One of the most well known is published by the Tax Foundation, a private, non-profit research organization with a primary focus on taxes and the impact of tax expansion on private sector growth.

The foundation defines the most competitive states as those that raise sufficient taxes without at least one of the three major state taxes in its structure – personal income, corporate, or sales. In contrast, the states at the bottom of the foundation’s ranking have multiple-rate corporate and income taxes, above average sales tax rates that exempt few business-to-business purchases, and few taxing or spending limits. In its most recent report, the Tax Foundation ranks Connecticut 37th using this criteria, neither in its top-10 most competitive nor among the 10 states ranked least competitive.

Connecticut’s tax system was significantly modified throughout the 1990s to improve its business climate. As discussed in more detail in Chapter II, corporate income tax rates were lowered (from 11.5 percent to 7.5 percent), certain businesses (pass-through entities like limited liability corporations) were exempted from the corporate tax, and the numbers and types of business tax credits were expanded. At one time Connecticut’s corporate tax ranked high among the states in terms of corporate burden, but it now compares well with other states. In 2003, Connecticut ranked 24th in terms of the corporate income tax as a percent of gross state product. Further, between 1998 and 2003, Connecticut corporate tax revenues as a percent of gross state product dropped 77 percent, the second greatest decline in the nation.

The importance of business taxes and credit use in creating an advantageous economic climate is subject to debate. Tax burden is only one factor in affecting the economic climate in a state and its importance in business location decisions is also the subject of considerable research and discussion. While lowering tax rates and expanding business credits have reduced corporate tax revenue and business tax liability, it is unclear whether these measures have increased the state’s economic competitiveness.

The state’s personal income has grown since the early 1990s, and Connecticut remains the state with the highest per capita income in the country. However, the increase in personal income over the period 1993-2003 is less than the rise in U.S. personal income, and Connecticut’s job growth lags behind almost all other states in the creation of jobs as the Federal Deposit Insurance Corporation reported in June of this year. Further, Connecticut ranks behind 33 other states in the growth of its gross state product from 1999 to 2003.

When Connecticut introduced the personal income tax there were predictions it would make the state less competitive as wealthy individuals, such as business owners and highly paid employees of local companies, might leave or decide not to locate in the state. These negative pronouncements did not materialize – while Connecticut’s overall population has increased only slightly (3.6 percent) from the 1990 to 2000 census – it has not appeared to prompt wealthier individuals to relocate.

As outlined in the Chapter II personal income tax profile, using 2002 IRS data, the average federal AGI income for all filers in Connecticut is $64,724 – 40 percent higher than the U.S. average ($45,974), and 9 percent higher than the second-highest state, New Jersey ($59,159). Further, Connecticut’s income tax rate structure, highlighted in Table 1-5 below, appears competitive with neighboring states and may even be attractive to high-income earners whose employment might limit their residence choice to one of the states in the tri-state area.

Table I-5. Comparison of Upper-Income Tax Rates for Joint Filers in New York, New Jersey, and Connecticut

State

Rate

Taxable Income Level

New York

7.25%

7.7%

$150,001 -$500,000

over $500,000

New Jersey

6.37%

8.97%

$150,001 -$500,000

over $500,000

Connecticut

5%

Over $20,000

Neutral

Another aspect of a good state tax system is that it be neutral, and that tax policy not be used to influence market decisions or economic behavior. Mainly states use revenue systems to influence budgets through tax deductions, exemptions, and credits, and through earmarking or dedicating funds for specific activities. These types of policy strategies shift tax burden from a set of taxpayers selected for favorable treatment to others who pay to make up the lost revenue. Selected sales taxes like the excise taxes on alcohol and tobacco are not neutral intentionally; they are aimed at certain taxpayer groups or activities, and many are designed to influence behavior.

As discussed earlier in this chapter, Connecticut policymakers have resisted, for the most part, using the personal income tax for selected exemptions, credits and the like, and generally filers at certain income levels will be paying the same amount of Connecticut state income tax. The same cannot be said of the corporate income tax. As Chapter II points out, the corporate income tax has been altered many times – through exemptions and credits and the apportionment formula – to benefit certain types of businesses.

Connecticut’s tax system has also for the most part avoided the practice of earmarking funds. The state’s Special Transportation Fund, funded with motor vehicle related taxes and fees, is a major exception. Unlike some other states, especially those that have strict tax and expenditure limitations in place, Connecticut has not turned to raising very specific types of revenues and designating them for special services or capital projects.

Accountable

A high quality revenue system is accountable, with tax policies that are open and transparent. It should be clear and explicit to taxpayers how all revenues are raised. Taxpayers should be notified of impending changes, and proposed changes should be well publicized so they can be debated before being enacted.

The local property tax has always been considered the most accountable to taxpayers since the taxpayer sees the bill and is often keenly aware of what local services the tax pays for. Further, as the property tax discussion in Chapter II points out, many towns are not allowed to pass a budget without approval through a town meeting or referendum and often, local budgets take more than one vote to be approved. While these measures may procedurally hold up budget adoption, town officials are held accountable to local voters for their fiscal decisions, including making difficult spending cuts if necessary.

At the state level, a major feature of accountability in Connecticut’s tax system was built in with the 1991 income tax and budget reform legislation. Since that time, a spending cap limits the annual growth in budget expenditures to the greater of: 1) the five-year average growth in personal income; or 2) the 12-month rate of inflation as measured by the consumer price index. During the period of economic growth in the late 1990s, the spending cap was instrumental in curbing new spending and adding surplus revenues to the state’s Budget Reserve (“rainy day”) Fund. This type of accountability helps save taxpayers from facing increased taxes when the state faces bad economic times.

Accountability for state tax policies is also provided through the statutorily mandated tax expenditure report. The legislature’s Office of Fiscal Analysis is required to produce a report every two years listing state tax credits and exemptions and the amount of lost revenue each represents. The report also shows the number of persons or businesses that benefit from each of these tax expenditures.

Some experts argue that this type of report does not go far enough. First, the tax expenditure report does not receive the same scrutiny or level of discussion in the legislature as the budget does, even though the total state tax expenditures amount to billions of dollars in forgone revenue. Second, those who benefit from tax expenditures, especially those involving business tax credits, are anonymous, identified only by total numbers of filers. Those who call for improved transparency suggest that businesses that claim these credits should be identified, and required to annually advocate for their continued use. Even absent that level of accountability, the legislature to date has not analyzed or evaluated the use of corporate tax credits to ensure they are proving successful and are worth continuing.

Two actions taken during the 2005 legislative session should improve the transparency of state businesses taxes and generally strengthen accountability for the tax system. Public Act 05-215, the budget implementation bill, created a new group, the Business Tax Credit and Tax Policy Review Committee, to oversee business tax expenditures. The committee comprises 14 members including: the chairs and ranking members of the Finance, Revenue and Bonding Committee, one member appointed by the governor and one by each of the legislative leaders, and the commissioners of revenue services, economic development, and labor or their designees. The committee is charged with studying and evaluating existing credits and their benefits, and is authorized to request certain information from DRS on the particular business taking the credit, although not identification by name and/or address.

Another act, P.A. 05-262, requires the legislature’s two fiscal committees to meet annually in November to consult and receive information on the state’s fiscal condition and outlook including: estimates of revenue; spending and ending balances by fund for the current biennium and for the three years after; the tax credits projected for the same period; estimated deficiencies, and projected budget reserve balances; and bond authorizations and issuances and their effect on debt service. The increased information made available through this act and the tax policy committee should strengthen planning, evaluation, and oversight capabilities of the finance committee and the legislature as whole.

THIS PAGE INTENTIONALLY BLANK

Chapter II

Profile of Connecticut’s Major Component Taxes

Connecticut relies on six major taxes to support its public services at the state and local level. While revenues from gaming and those raised from fees are an important source of financing services, they are not considered taxes and are not part of the scope of study. The six major taxes profiled in this chapter are the:

• general sales and use tax;

• excise taxes – motor fuel, alcohol, and tobacco;

• personal income tax;

• local property tax;

• corporate income tax; and

• estate and gift taxes.

Each of these taxes has been introduced at different periods in the state’s history, and each has gone through major changes -- in terms of its construction, the rates and base, and the revenues raised -- since first being implemented. This chapter profiles each of the component taxes by: identifying when the tax was first initiated and any major changes or modifications to the tax; describing who pays the tax, how it is calculated, what the rate is, and what the tax applies to; who or what is exempt from the tax; how the tax is collected; revenue trends; and comparing the major features of each component tax with those in other states.

Profile of the Sales and Use Tax

Background

During the Great Depression, income generated from the states’ primary source of revenue, the property tax, fell by 40 percent. The sales tax was developed at that time to provide the states with an alternative revenue source. Between 1932 and 1938, 29 states implemented the tax (although five allowed it to expire after a year or two). Later, the post-World War II economic climate again negatively affected state revenues and created a great need for public services. In response to continually increasing demands on state revenue, another 16 states implemented a sales tax. There are currently 45 states with a sales tax in place.

The use tax was developed in 1937 to supplement the sales tax by capturing some of the revenue lost from out-of-state purchases. The use tax is meant to help in-state merchants remain competitive with merchants located in lower-tax jurisdictions or those not required to collect a sales tax. The state of Connecticut adopted the sales and use tax in 1947.

Taxable Items

The sales tax is imposed on tangible personal property,11 which can be broken down into three main categories:

• consumer goods or household purchases;

• business purchases; and

• services.

The use tax is applied to the same goods when they are purchased outside the state and are then brought into Connecticut for use. Like other states, Connecticut exempts certain items from its sales tax to make the tax less regressive. Currently, there are over 115 exemptions. Examples of taxable items and exemptions are detailed in Appendix C.

Payment

In Connecticut, as elsewhere, both individual consumers and businesses pay sales and use taxes. In FY 03, consumers paid 51 percent and businesses paid 49 percent of the state’s total revenue from the sales tax.

These figures, issued in a report by the Council on State Taxation (COST),12 are based on estimates using the Ernst & Young 50-state sales tax model -- which computes state-specific, industry-specific flows of business inputs and investment purchases and compares those to estimates of household purchases by category of spending -- to develop a separate sales tax matrix for each state. The matrix incorporates state sales tax laws and is applied to levels of transactions to produce estimates of total sales and use taxes on business inputs, business investment purchases, and consumer expenditures.

Using these estimates, Figure II-1 compares the distribution of the sales tax burden between businesses and consumers in Connecticut with that in neighboring states. The comparison shows that businesses and consumers pay about an equal share of the sales tax in Connecticut and New York, while consumers pay a greater share in Massachusetts and New Jersey. This indicates that more business inputs and investments are subject to the sales tax in Connecticut and New York than in surrounding states.

Tax Collection

Consumer. Figure II-2 illustrates the process by which sales and use tax revenues are collected. Consumers pay the sales tax to the retailer or vendor at the time of the purchase or transfer of goods or services.

Retailers and vendors. Retailers or vendors must file a Sales and Use Tax Return (form OS-114) with the commissioner of revenue services monthly (on or before the last day of the month). If their total tax liability for a year is less than $4,000, retailers must remit the tax quarterly (CGS 12-414). In cases where the use tax is not paid upon the exchange, the consumer must file a return once during the calendar year. The use tax is declared either on the Connecticut Income Tax forms CT-1040 and CT-1040EZ or separately on the Connecticut Individual Use Tax Return (form OP-186).

The state of Connecticut requires all vendors engaging in sales transactions or with a physical presence within the state to obtain a permit from the Department of Revenue Services. The permit fee is $50. Permits issued on or after July 1, 1985, but prior to October 1, 2003, expire biennially on the anniversary date of issuance, while permits issued on or after October 1, 2003, expire on the fifth anniversary date of the issuance of the permit. In FY 03, there were 172,830 permitted sales tax vendors (of which 25,290 vendors filed monthly, 63,015 filed quarterly, and 84,525 filed annually).

Direct payment permits. The Department of Revenue Services also offers anyone who makes a high volume of taxable purchases the opportunity to apply for a direct payment permit for a $20 fee. This type of permit can reduce the cost and time of administering the tax for both the business and for DRS. The permit functions like the direct deposit option offered by most employers. DRS and the permittee establish an effective sales and use tax rate and a forecast of volume to establish an agreed-upon base for which the permittee will pay taxes. DRS staff regularly audit these permittees and perform audit tests that would demonstrate any changes to the base over time that might affect the amount of tax they must report.

Calculation

With three exceptions, Connecticut has one statewide sales and use tax rate of 6 percent on gross receipts of retailers from sales, rental or leasing, and on certain business services. Unlike many other states, there are no additional local sales and use taxes in Connecticut.

The exceptions to the six percent rate are:

• 4.5 percent on the sale of a motor vehicle to a nonresident member of the U.S. military serving on active duty in Connecticut or his/her spouse;

• 1 percent on computer data processing services; and

• 12 percent on lodging (e.g., hotel rooms).

Revenue

In FY 03, Connecticut’s sales and use tax brought in $3.03 billion in revenue, or 19.2 percent of the total state and local tax revenues. In FY 04, the amount increased 3.6 percent to $3.13 billion. Figure II-3 illustrates the trends in sales and use tax revenue in actual dollars and in inflation-adjusted dollars from FY 90 to FY 04.

Connecticut experienced a sharp decrease in sales and use tax revenue between FY 90 and FY 92. The drop likely occurred for three reasons: 1) the sales tax rate was reduced 25 percent -- from 8 to 6 percent; 2) the personal income tax was introduced, leaving taxpayers with less disposable income for purchases; and 3) the state was still in the economic recession of the early 1990s. Revenues steadily increased between FY 93 and FY 01, before slumping in FY 02 and FY 03, and then recovered in FY 04. However, over the long term, FY 90-FY 04, sales tax revenues have declined in real terms due to inflation, as the figure shows. If sales and use tax revenues are measured in 2004 dollars, there is a decline of about $400 million from FY 90. The decline in revenue is likely the result of an increasing number of exemptions, a shift away from consumption of taxable tangible goods toward tax-exempt services, and the increased consumer preference for purchasing goods online.

The bulk of the revenue from the sales and use tax is deposited into the General Fund. However, since 1998, a portion of the sales tax collected by the Department of Motor Vehicles on motor vehicle sales between individuals (not dealers) is transferred from the General Fund to the Special Transportation Fund in the following dollar amounts:

• $10 million in FY 00;

• $20 million in FY 01;

• $30 million in FY 02; and

• $40 million in FY 03 and thereafter.

Figure II-4 illustrates the actual percent change in sales and use tax revenue from year to year since FY 89. (For FY 00 – FY 04, the changes in gross collections are before transfers to the transportation fund.) The figure also shows the percent changes reflecting adjustments for the impact of legislative modifications to the rate and base, such as adding or eliminating exemptions.

Trends in Revenue and Rates

The revenue collected from the sales and use tax makes up about 20 percent of total state and local revenue. (See Figure II-5). The percentage the sales tax contributes to overall revenues has been decreasing over time. In FY 89, the ratio was almost 30 percent; by FY 03, it had fallen to slightly less than 20 percent.

Of course, the personal income tax, introduced in 1991, has resulted in a major shift in the portion each component tax comprises of the overall tax collected, as discussed in Chapter I.

The sales and use tax rate is currently 6 percent. The rate was initially set at 3 percent when the taxes were implemented in 1947. It peaked at 8 percent in 1990 and was then adjusted to 6 percent in 1992, after the implementation of the state income tax.

Connecticut Compared to Other States

Rates. A total of 45 states have implemented a sales tax. (Alaska, Delaware, Montana, New Hampshire, and Oregon do not levy a sales tax.) Figure II-6 presents the current statewide sales tax rates across the country. Connecticut is one of 12 states that impose a 6 percent rate. Thirty-one states also permit local sales taxes; of those, 21 states have a lower statewide sales tax rate than Connecticut. However, the total sales tax rate in those states may not be less, because the figure does not include the local sales tax rates.

Base. Some states including New Mexico, Iowa, Hawaii, and South Dakota tax a broad number of goods and services, with few exemptions. For example, Hawaii and New Mexico tax nearly all services (of which there are over 150) allowing the states to set a lower sales tax rate. These states have what economists consider a broad base.

Revenue. Table II-1 demonstrates where Connecticut ranks among states that collect a sales tax. The rankings are based on sales tax revenues as a percent of “state and local” or “state only” collections. The first column shows that Connecticut -- collecting only 20 percent of its total revenue from sales tax -- ranks 35 out of the 46 states (and the District of Columbia) that collect sales tax.13 The second column shows that Connecticut (at 30.4 percent of state-only taxes) ranks 30th out of the 45 states that collect sales tax.

Table II-1: State Rankings Based on Sales Tax Collections

2002 State & Local Collections

2004 State-Only Collections

Percent of Total Revenue

Rank

Percent of State Revenue

Rank

Top Five States

Top Five States

Washington

47.3%

1

Tennessee

61.3%

1

Tennessee

45%

2

Washington

60.6%

2

Arizona

40.1%

3

Florida

56.4%

3

Louisiana

39.7%

4

South Dakota

55.2%

4

Arkansas

39.3%

5

Texas

50.3%

5

U.S.

24.6%

 

U.S.

33.4%

 

Bottom Five States

Bottom Five States

Connecticut

20.1%

35

Connecticut

30.4%

30

Virginia

16.2%

42

Maryland

23.9%

41

Massachusetts

15.5%

43

Massachusetts

22.4%

42

Maryland

13.5%

44

New York

21.9%

43

Vermont

10.9%

45

Virginia

20.9%

44

Alaska

5.9%

46

Vermont

14.5%

45

Source: Federation of Tax Administrators

Major exemptions. Below is a breakdown of the number of states (including Connecticut) exempting these main categories from their state sales tax.

• Food: 28 states (Illinois, Missouri, and Tennessee tax food at a reduced rate while Kansas allows for the disabled, elderly, and low-income households to receive refunds)

• Prescription Drugs: 44 states (Illinois taxes them at a reduced rate)

• Motor Fuels: 31 states (Georgia taxes this at a reduced rate)

• Services: 25 states (Connecticut taxes certain services, including services to businesses)

• Clothes: 7 states (Connecticut exempts clothes up to $50 per item, Massachusetts exempts clothes up to $175 per item, and Vermont exempts clothes up to $110 per item)

• Sales Tax Holidays: 12 states have them; they range in duration from two to nine days.

• Cigarettes: all 45 states tax cigarettes (Connecticut applies a separate excise tax to this product in place of the sales and use tax)

• Computer Software (Canned): 43 states

• Computer Software (Custom): 31 states (Louisiana established that for FY 04, 50 percent would be subject to tax, in FY 05, 25 percent, and from FY 06 and into the future this category would be exempt)

Assessment: NCSL Principles

Adequacy. Figure II-7 illustrates how the sales and use tax has generally mirrored the economy by comparing the sales and use tax revenue to the state’s personal income growth over time and adjusting for legislative changes. It shows a deep drop in the early 1990s followed by a significant increase from FY 93 to FY 95. Some of the increase may be explained by pent-up consumer demand after coming out of the economic recession of the early 1990s.

Over the long term, however, Connecticut’s sales and use tax revenues have not kept pace with growth in the economy (personal income). From FY 90 to FY 04, the cumulative growth in the state’s personal income was 61.8 percent, while the sales and use revenue in actual terms (without legislative adjustments) grew by 42.4 percent, and inflation was 43.7 percent. The substantial lag in sales and use tax revenue growth behind personal income in that recent 15-year period is reflecting what appears to be happening nationwide.

According to the National Conference of State Legislatures, the amount of personal income spent on taxable goods has decreased nationwide. In 1945, consumption of goods comprised 67 percent of personal income and consumption of services was approximately 33 percent. In 1983, acquisition of goods and services were equal at 50 percent of personal income. By 2002, the shift in consumer behavior became evident as 41 percent of personal income was spent on goods and almost 60 percent on services. Losses from Internet purchases alone (not including interstate catalog sales) for state and local government were estimated at $13.3 billion for 2001 and predicted to increase to $44.2 billion by 2005.

Reliability/Volatility. In Connecticut, the revenue stream provided by the sales and use tax is fairly steady, contributing roughly 20 percent of total state and local revenue. Program review staff measured the sales tax volatility over the long-term and for the more recent FY 93 – FY 04 (post-income tax) period. Adjusting for legislative modifications, the year-to-year long-term average annual growth rate in sales tax revenues from FY 75 to FY 04 was 7.0 percent, and the standard deviation (the average difference around the trend rate) was 5.1 -- meaning that the sales and use tax is only somewhat volatile. For the post-income tax period, the average annual change was 5.5 percent, and the standard deviation was only 2.3. Thus, while the sales tax has had a somewhat lower average annual growth rate in recent years, it has become less volatile and more predictable.

Equitable. The sales and use tax is highly regressive, meaning low-income individuals typically spend a larger share of their income on sales tax than individuals with higher incomes. To combat the regressivity, Connecticut exempts many items considered necessities including: food, health care services and medicine, utilities used in residences, and clothing and footwear under $50. In addition, during “tax free” week, all apparel under $300 an item is not taxed. As a result of these efforts, Connecticut’s sales and use tax appears less regressive than other states.

Using the ITEP data on tax burden discussed in Chapter I, Figure I-11 on page 22 shows that sales and use taxes take considerably less from Connecticut’s lower- and middle-income groups than is the case nationally. (The ITEP data includes excise tax burden as well.) For example, the lowest quintile in Connecticut pays 6.3 percent of its income in sales and use taxes; the same group nationwide pays 7.8 percent. The middle quintile in Connecticut spends 3.7 percent, while that group nationwide spends 5.1 percent on sales and use and excise taxes.

Promotes compliance. For consumers the sales tax is fairly simple, since they pay the tax on the items at the time of purchase. The forms, filing process, and availability of taxpayer support services to both consumers and vendors help to promote compliance. However, the number of exemptions and exclusions, lack of specificity in statutory language, and short time period between enacted legislative changes and implementation dates can complicate the tax for consumers, businesses, retailers, and DRS tax administration and auditing staff.

Economic competitiveness. Connecticut imposes a slightly higher sales tax rate than some of its neighbors and it makes fewer exemptions for businesses. Table II-2 provides comparison data on the number of services by category that is taxed by Connecticut and its neighboring states. Of particular note is the high number of taxable services in Connecticut compared to neighboring states like Rhode Island and Massachusetts.

Table II-2: Number of Taxed Services by Category in Connecticut and Selected States

State

Utilities

Personal Services

Business Services

Computer Services

Admissions/ Amusements

Professional Services

Fabrication, Repair & Installation

Other

Total

CT

10

9

20

6

10

0

11

14

80

DE

9

20

33

6

10

9

19

37

143

MA

9

1

4

0

1

0

2

2

19

NH

6

1

0

2

0

0

0

2

11

NY

4

4

13

1

5

0

14

15

56

RI

10

1

6

3

4

0

3

2

29

Source: Federation of Tax Administrators, Tax Administrators News, 2004 Survey on State Taxation of Services, (May 2005).

There are differing views on who should pay the sales tax, and whether who actually pays affects economic competition or not. One opinion is that the tax should only apply to “final consumption” by consumers and not apply to business inputs. “Final consumption” means the “final sale in the production and distribution of goods and services.” Opponents of sales taxes for business argue that imposing a sales tax on business inputs causes “pyramiding” or “cascading”, meaning the tax is applied to each item used in the production and distribution of a good, which increases the cost of conducting business. In response, businesses either decide to pass the additional cost on to the consumer by raising prices or decide to move the business or its activities out of the state. Proponents of sales taxes for business favor broadening the sales tax base by removing existing exemptions and lowering the tax rate. Four states broadly tax goods and services for both businesses and individuals: New Mexico, Iowa, Hawaii, and South Dakota.

Simplicity. Unlike the 31 states that permit sales taxes at county or town levels, Connecticut levies only a state-level sales tax, which, for the most part, is at a single rate. The single tax helps ensure that all consumers know what the sales tax is, and the rate. Again, what detracts from the simplicity is the number of exemptions and whether an item is taxable or not.

At present there is a national movement toward simplifying the design of state sales taxes even further under the Streamlined Sales Tax Project. The goal of the project is to demonstrate uniformity among the various states’ sales taxes to Congress to achieve legislation that permits the states to collect sales tax on interstate commerce such as Internet and catalog purchases, and lessen the complications associated with doing business in multiple states. It requires using standardized definitions for terms (e.g., clothing, food, and computer software) and eliminating thresholds (taxing items at different rates) as Connecticut does for clothing. Of the 45 states that levy a sales tax, 40 are involved in the project at various levels. Per executive order from then-Governor John Rowland, Connecticut became involved in the project as a “participating state”, meaning Connecticut is involved in the project but has not implemented the required statutory changes. The categories of more active participation are:

Full Member States – fully in compliance (IN, IA, KS, KY, MI, NE, NC, OK, SD, WV, MN)

Associate Member States – generally in compliance but have a delayed effective date (NJ, ND, UT, TN, OH, AR, WY)

States that Enacted Compliance Legislation – not yet certified or fully compliant (NV and VT)

Profile of Excise Taxes

Background

Excise taxes, which are also known as selected sales taxes, are levies applied to specific consumer items, often in addition to a state’s general sales and use tax. In comparison to income and general sales taxes, selective sales taxes are not a major revenue source for most states. Table II-3 shows all selected sales tax collections nationwide averaged about 16 percent of total state tax revenues in 2004. It is important to note these revenue figures, which are the best available comparative data for excise taxes only reflect state level tax collections and do not include any local taxes.

State reliance on selected sales tax revenues ranged from a high of almost 34 percent in New Hampshire, a state with neither a statewide general sales tax nor a personal income tax, to a low of 7.4 percent in Wyoming. Connecticut, at 17.2 percent, is similar to the national average in its reliance on all selected sales tax revenues and ranked 21st among all states in such tax collections in 2004.

Table II-3. State Reliance on All Selective Sales Taxes: 2004

Rank

State

Percent of Total State Tax Collections

1

New Hampshire

33.6

2

Nevada

32.9

3

Texas

29.8

4

West Virginia

28.6

5

Montana

26.9

21

Connecticut

17.2

46

Oklahoma

11.6

47

Georgia

10.6

48

Massachusetts

10.3

49

California

8.7

50

Wyoming

7.4

 

U.S. Total

16.1

Source of Data: Federation of Tax Administrators

States impose many different types of selected sales taxes but the most common ones are excise taxes on alcoholic beverages (liquor, beer, and wine), tobacco products (cigarettes, cigars, snuff, and pipe and chewing tobacco), and motor fuels (gasoline, diesel, and other motor vehicle fuels). These three types of excise taxes are in place in some form in all states including Connecticut. Nationally, alcohol, tobacco, and motor fuel excise taxes, which account for about half of the revenues generated by all state selected sales taxes, make up about 8.5 percent of the total state tax collections.

The key features of Connecticut’s alcoholic beverage tax, cigarette and tobacco products tax, and motor fuels taxes are summarized below. A summary of the committee assessment of the three state excise taxes in terms of NCSL principles is also presented. Detailed, individual profiles of each major excise tax are provided in Appendix D.

Calculation and Payment

Like nearly all excise taxes, Connecticut alcohol, cigarette, and motor fuels excise taxes are calculated on a per-unit basis; liquor, wine, and beer as well as gasoline and other motor vehicle fuels are taxed per gallon while cigarettes are taxed per pack. In contrast, nearly all tobacco products other than cigarettes are taxed as a percentage of the wholesale price. With the exception of the motor fuel tax program that applies to interstate motor carriers (which is handled through quarterly returns filed by vehicle owners), all three types of excise taxes are paid monthly at the wholesaler/distributor level and included in the product purchase price.

Revenues Produced

The state’s three major excise taxes are very small revenue components of the total state and local tax system. In FY 03, collections from the alcohol, tobacco, and motor fuels taxes together accounted for less than 5 percent of total state and local tax revenues. The three taxes are more significant within the state budget, producing $788 million in revenues in FY 04. This represented 7.6 percent of that year’s total state level tax collections. The portion of tax revenues contributed to the state budget by these three selected sales taxes, however, has dropped from and has remained well under l0 percent following enactment of Connecticut’s personal income tax in 1991.

Of the three, the motor fuels tax consistently contributes the largest amount of revenue, providing nearly 60 to over 75 percent of total excise tax collections each year. In FY 04:

revenues from the state’s alcoholic beverage tax totaled about $44 million, or less than 1 percent of all state level tax revenues;

the state’s cigarette and tobacco product taxes raised almost $280 million, which represents less than 3 percent of total state level tax revenues for that year; and

the state’s motor fuel taxes produced nearly $465 million, which represents 4.5 percent of total state level tax revenues for that year. While relatively small in terms of dollars collected, Connecticut motor fuel taxes are the state’s fourth largest single tax revenue source.

Major Changes

Increases in the state cigarette tax rate have been frequent over the past 15 years and usually were made in response to a fiscal crisis. Most recently, the cigarette tax was more than doubled through two substantial per pack rate hikes enacted in 2002 and 2003 to help address state budget shortfalls. In contrast, tax rates on liquor, wine, and beer have been in place since the 1970s, were raised significantly in 1984 and 1989, but have not changed since. Motor fuel tax rates were raised five cents in one-cent increments during the mid-1990s. A series of rate cuts put into effect between 1998 and 2001 subsequently reduced the motor fuel tax from $0.39 to $0.25 per gallon, the current rate.

Connecticut Compared to Other States

Alcoholic Beverage Tax

Connecticut is one of 32 “license” states that regulate private wholesale and retail sellers of liquor, wine, and beer (alcoholic beverages) and impose excise taxes on distributors of these products. (The other 18 states operate monopoly systems and control and tax alcohol sales through government agencies and stores.)

Connecticut’s excise tax on liquor ($4.50 per gallon) is among the higher rates in the country, while its wine and beer rates ($0.60 per gallon and $0.19 per gallon, respectively) are close to the national median rates.

Within the Northeast region (New England plus New York and New Jersey), Connecticut’s liquor tax is 2nd highest, its beer tax is the 3rd highest, and its wine tax is about in the middle (the same or lower than four states and higher than three).

Cigarette and Tobacco Products Taxes

Like all other states, Connecticut imposes an excise tax on cigarettes as well as other tobacco products such as cigars, snuff, and pipe and chewing tobacco.

As of January 2005, Connecticut’s cigarette tax of $1.51 per pack was, with Massachusetts’s, the sixth highest in the U.S. and significantly higher than the national median of $0.70. Many believe this high rate makes the state’s tobacco tax revenues vulnerable to erosion from smuggling and Internet sales.

Within the Northeast region, Connecticut’s cigarette tax rate is higher than four of the seven other states; its tax on other tobacco products is among the lowest.

Motor Fuels Taxes

Connecticut, like all other states, imposes an excise tax on motor fuels through two similar but separate programs: a motor fuels tax, a per-gallon levy included in the price paid at the pump; and a motor carrier road tax that applies, at the same per-gallon rate, to certain vehicles generally engaged in interstate commerce and is based on their reported mileage and fuel purchases.

As of January 2005, Connecticut’s per-gallon gasoline tax rate of $0.25 was the 10th highest in the country.

Connecticut has the fourth highest gasoline tax and third highest diesel and gasohol taxes in the Northeast region.

Assessment: NCSL Principles

Neutral

In theory, selected sales taxes are one way to charge consumers directly for the benefits of a government service. For example, the excise tax on gasoline can be viewed as a user charge for public roads if revenues are earmarked for highway construction and maintenance. In some cases, selected sales taxes are imposed on specific activities or products to discourage negative behaviors like smoking or drinking and to help offset their social costs (“sin taxes”). Excise taxes like the ones applied to alcoholic beverages and tobacco products, therefore, are not intended to be neutral, in contrast to the guiding principles for high quality revenue systems.

Equitable and Reliable

Excise taxes are regressive and tend to grow more slowly than the economy. This is because they usually are applied on a per-unit basis (e.g., cents per pack or per gallon) rather than as a percentage of price. Consumers pay the same rate regardless of their income and, unlike the ad valorum general sales tax, the amount of tax paid is unrelated to the value of the item.

Per-unit excise tax collections only grow if consumption or rates increase. Nationwide, consumption of alcohol and tobacco products is declining or flat; sales of motor fuels have been affected by increasing fuel efficiency of new vehicles. The lack of sales growth or a rate hike means excise tax revenues will be eroded just by inflation. Figure II-7 shows revenue growth, adjusted for inflation, over time for Connecticut’s three main excise taxes, all of which have unit-based rates, and illustrates this situation.

Given the trends shown in the figure, Connecticut excise taxes are not reliable or adequate as revenue sources for public programs with steadily increasing costs. To sum up:

Alcoholic beverage tax revenues, when adjusted for inflation, are, like alcohol sales nationwide, declining over time. Connecticut’s alcoholic beverage tax, which has experienced no significant changes in either its rate or base since FY 90, has had virtually no growth in revenues over the same time period shown in the chart. Actions to preserve the reliability and adequacy of this revenue source (e.g., rate increases) have not been taken since 1989.

Cigarette and tobacco product tax collections, when adjusted for inflation, show negative growth during this timeframe except when the cigarette tax rate was doubled during FY 02 and FY 03. Revenue growth when adjusted to remove the impact of the legislated rate increases has been negative in 11 of the past 15 years. Therefore, Connecticut’s cigarette tax is neither a very reliable nor adequate revenue source.

Motor fuel tax revenues are not keeping pace with the state economy measured by personal income and real growth has been negative every year since FY 98 when a series of rate reductions was first enacted. A steep drop in real motor fuel tax collections in FY 01 reflects a cut of seven cents in the per-gallon rate (22 percent) as well as the effects of a poor economy. Year-to-year fluctuations in tax collections are considerable even taking into account legislated rate changes. Adequate and reliable revenue growth is further compounded by the fact motor vehicles are becoming more fuel efficient, meaning consumption, the current base for motor fuel taxes, will decline over time.

Simple/Promotes Compliance

Administration of excise taxes tends to be easier than for other sales or income taxes. In general, taxes are collected at the wholesaler/distributor level, making the number of taxpayers relatively small. Also, since the 1990s, there has been an international cooperative agreement in effect that simplifies the reporting and collection of fuel taxes from interstate motor carriers and another national project to promote uniformity in state motor fuel tax programs is underway. Connecticut is a participant in both efforts.

However, frequent changes to the rate and base of excise taxes complicate agency administration and taxpayer compliance, in addition to reducing tax revenue certainty. In general, when states need to raise revenues there tends to be less resistance to higher excise taxes than to any increase in broader based and more visible general sales and income taxes. Increases in state cigarette and other “sin taxes” were common in the most recent national economic downturn. As noted earlier, Connecticut has increased its cigarette tax six times since FY 90, and during 2002 and 2003, changes enacted to help address the state’s budget shortfalls more than doubled the per-pack tax rate. The state’s motor fuel taxes have also been subject to both increases and reductions almost every year over the past decade; additions and modifications of tax exemptions have occurred as well.

If excise tax rates become too high, tax avoidance including black-market sales and smuggling can become a serious problem requiring expensive, labor intensive enforcement efforts. Enforcement of all types of sales taxes is becoming more complicated as electronic commerce becomes more prevalent. State tax agencies, including Connecticut’s Department of Revenue Services, now find it necessary to monitor Internet sales, particularly of high excise tax items like cigarettes and alcoholic beverages, to achieve taxpayer compliance.

Economic Competition

As discussed earlier, Connecticut’s excise tax rates tend to be among the higher ones in the country although most are comparable to those of neighboring states. High rates are a concern for local businesses selling the products subject to the state’s alcohol, tobacco, and motor fuel taxes, particularly those located near borders. Whether further increases would put Connecticut businesses at a competitive disadvantage is an important consideration for policymakers.

Accountable

Excise taxes, because they are applied at the wholesale level and included in the purchase price, are not easily identified by consumers. Less visible taxes like the alcohol, tobacco, and motor fuels taxes have less taxpayer accountability.

Profile of the Personal Income Tax

Background

Forty-one states and the District of Columbia have imposed a broad-based personal income tax. The personal income tax (PIT) plays an increasingly pivotal role in raising revenues for state government. In the 1950s, when states first began enacting taxes on personal income, the tax accounted for less than 10 percent of total state tax revenues. By 1998, the state personal income tax was contributing about 34 percent of total state tax revenue, and had become the single largest source of revenue for the states.

Connecticut did not enact its comprehensive income tax until 1991. The General Assembly had passed an income tax in 1971, but there was such a public outcry that it was repealed within 24 hours. However, facing a $1 billion budget deficit in 1991, the legislature narrowly passed the tax on personal income in Connecticut. The first two years were years of adjustment; thus most analysis conducted in this profile and assessment begins with FY 93. The statutory provisions for Connecticut’s personal income tax are contained in chapter 229 of the Connecticut General Statutes.

Features of Connecticut’s Personal Income Tax

Who it covers: Full-time residents (including estates and trusts) who have earned and/or unearned income and part-time residents and non-residents with Connecticut-source income.

What it covers: All income -- both earned (i.e., wages and salaries), and unearned (i.e., capital gains, interest and dividends) – is taxable. Prior to 1991, Connecticut taxed only unearned income.

Persons must file if they:

• had Connecticut income tax withheld from their wages;

• made estimated Connecticut income tax payments;

• were required to pay the federal alternative minimum tax; or

• meet Connecticut’s gross income test, which in 2004 was:

- $24,000 for married persons, filing jointly;

- $19,000 for heads of household;

- $12,000 for married persons filing separately; and

- $12,625 for single filers.

How the Tax is Calculated

Connecticut’s income tax is linked to the amount of federal Adjusted Gross Income (AGI) on a filer’s federal income tax return. This figure is the starting point for calculating Connecticut income tax and, therefore, all the definitions for federal adjusted gross income apply first to arrive at that amount. Then, several additions or subtractions to federal AGI (like loss or gain on the sale of Connecticut state or local bonds) are applied to arrive at Connecticut AGI.

To compute Connecticut taxable income, the filer subtracts the personal exemption (i.e., the gross income limits listed above) for the filer’s filing category from the filer’s Connecticut AGI. If the result is zero or less, no taxes are owed.14 If the amount is a positive number, the state uses two tax rates that apply to different income brackets as shown in Table II-4.

Table II-4. Connecticut’s Personal Income Tax: Filer Categories, Income Categories and Rates

Category of Filer

Connecticut Taxable Income

Tax Rate

Single or married filing separately

Up to $10,000

3%

Over $10,000

$300 flat amount plus 5% of taxable income more than $10,000

Head of household

Up to $16,000

3%

Over $16,000

$480 flat amount plus 5% of taxable income more than $16,000

Married filing jointly

Up to $20,000

3%

Over $20,000

$600 flat amount plus 5% on taxable income more than $20,000

However, the amount of tax a person actually pays may be offset by statutorily specified “credits” based on a sliding scale. Under C.G.S. Sec. 12-703, a personal tax credit ranging from 1 percent to 75 percent is available to all categories of filers up to certain income levels. This credit is deducted from the tax liability. The range of credits in 2004 by category of filer is shown in Table II-5. Consequently, these exemptions mean that taxpayers are not charged the full rates until their incomes exceed the “no credit” amount shown in Table II-5.

Table II-5. Personal Credits by Filer Category

Category of Filer

Maximum Credit (75%)

Minimum Credit (1%)

No credit

Single or married filing separately

If AGI > $12,625 but

< $15,570

If AGI > $54,000 but < $55,000

AGI > $55,000

Head of household

If AGI >$19,000 but

< $24,000

If AGI > $78,000 but

< $78,500

AGI > $78,500

Married filing jointly

If AGI > $24,000 but

< $30,000

If AGI > $100,000 but

< $100,500

AGI >$100,500

Exemptions and Credits

Threshold/base exemptions. As discussed above, persons with incomes below specified thresholds are exempt from filing, while others are eligible to have their taxable income and tax liability reduced through personal exemptions. Annually, over the next few years (until 2010) the exemption amounts will decrease by $1,000 for each additional $1,000 of AGI filers have, until the exemption is removed at a certain AGI. Table II-6 summarizes the reduction for each category of filer and lists the AGI level above which the exemption is no longer available.

Table II- 6. Personal Exemption Reductions

Category of Filer

Reduction in Allowable Personal Exemption

AGI where Exemption Eliminated

Unmarried individual

$1,000 for each $1,000 over $12,750 AGI

$36,000

Married filing separately

$1,000 for each $1,000 over $24,000 AGI

$35,000

Head of Household

$1,000 for each $1,000 over $38,000 AGI

$56,000

Married, filing jointly

$1,000 for each $1,000 over $48,000 AGI

$71,000

Source: C.G.S. Sec. 12-702

Other income exemptions. Income from social security is exempt for single filers or married persons filing separately whose federal AGI is less than $50,000, as well as for heads of household or married couples filing jointly, if their Connecticut AGI is less than $60,000. If Connecticut AGI is higher, social security income is partially exempt. Fifty percent of military retirement income will be exempt beginning in 2008.

Credits

Other income tax payments. All income tax paid to other jurisdictions (i.e., other states and cities), but not federal income tax or tax paid in a foreign country, is subtracted from income tax liability in Connecticut.

Property tax credit. Any Connecticut filer who is required to pay state income tax and has also paid property tax on an automobile or primary residence in Connecticut is eligible for a credit against the filer’s actual tax liability. The amount of the credit depends on property tax paid and the filer’s adjusted gross income. The percent of property tax paid that can be taken as a credit declines as income increases -- maximum credit was $350 for tax year 2004. (The state budget adopted during the 2005 session sets the maximum at $400.)

Alternative Minimum Tax (AMT): If a Connecticut filer has paid the federal alternative minimum tax, the Connecticut income tax owed is also calculated using that as a base. In addition to the regular state income tax liability, the taxpayer must also pay the Connecticut AMT, which is the lesser of:

• 19 percent of adjusted federal alternative minimum tax; or

• 5.5 percent of adjusted federal alternative taxable income.

While it is not possible to determine the number of filers that pay the AMT from state DRS data, IRS federal return data for 2003 indicate the percentage of Connecticut filers paying the AMT was about 3.8 percent.

How the Tax is Paid

Tax returns must be filed annually by April 15th with the Department of Revenue Services. Generally, for wage earners a certain amount of tax liability is withheld in payroll taxes throughout the year, which employers then submit to DRS. Upon submitting the return, filers either get a refund if they have already paid more than what they owed in taxes, or they pay any remaining portion of tax liability not covered by withholding.

Certain taxpayers must make quarterly estimated payments if their income tax liability (after credits) is more than $1,000 and the filers expect the withholding amounts will be less than their required annual payments. The state requires filers to pay the lesser of 90 percent of the income tax due on their current return, or 100 percent of the income tax due on the previous year’s return.

Number of Taxpayers: FY 04 --1.39 million filers (for income year 2003)

Revenue Collected: FY 04 -- $4,943,298,949 (for income year 2003)

As Figure II-8 shows, personal income tax revenue has grown dramatically in the 13 years depicted. In FY 93, the tax generated about $2.3 billion; by FY 05 that had more than doubled – to $5.1 billion. Aside from FY 02 –when the revenues from the personal income tax seriously dropped from the previous year and FY 03, which was basically the same as FY 02 – the yearly increases have been steady and substantial.

Major Changes in Income Tax.

• 1993 – established an alternative minimum tax = 23 percent of federal AMT

• 1994 – changed the alternative minimum tax to 19 percent of federal AMT or 5 percent of federal adjusted alternative minimum taxable income

• 2003 -- made several changes including the rate increase from 4.5 percent to 5 percent and reduction of exemptions

Rate Changes

Since the income tax was first established, many of the changes have been to the income brackets subjected to the two different rates, as outlined in Table II-7.

Table II-7. Changes to PIT Rates and Income Categories

Year

Rate

$ Taxable Income by Filer Type

   

Single

Head of household

Joint

1991

1.5%

   

1992

4.5%

     

1995 (effective 1996)

Establishes 2 rates – 3% on certain income 4.5% on rest

3% on first $4,500

3% on first $7,500

3% on first $9,000

1997

Increases income levels for the 3% over 3-year period

4.5% on rest

3% on first $6,250

3% on first $10,000

3% on first $12,500

1998

4.5% top rate

3% on first $7,500

3% on first $12,000

3% on first $15,000

1999

4.5% top rate

3% on first $10,000

3% on first $16,000

3% on first $20,000

2003

Top rate increased to 5%

Over $10,000

Over $16,000

Over

$20,000

Changes in Exemptions:

• 1997 --One-half of taxable Social Security becomes exempt in 1998

• 1999 -- 100% of taxable Social Security is exempt for taxpayers with Connecticut AGI under $60,000 for joint filers and $50,000 for singles

• 1999 – Phase-in of standard deduction increases before reaching taxable income to occur between 1/1/00 to 1/1/07

• 2002 -- Phase-in delayed two years – to be completed in 2009

• 2003 – Phase-in to be completed by 2010

• 2005 exempts half of military retirement income from the income tax, and delays by two years scheduled income tax reductions for single filers

Connecticut Compared to Other States

Forty-one states and the District of Columbia have a broad-based state income tax. Seven states – Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming -- have no income tax and two states—New Hampshire and Tennessee -- tax only unearned income. States structure their personal income tax in many different ways. Appendix E provides a state-to-state comparison of some of the major features of the income tax. Some of those features and variations are summarized below.

Filing thresholds. Twenty-seven states use the federal adjusted gross income as the base, or starting point, for their income tax, while 10 states use the federal taxable income as the base. In most states, people may have a certain amount of income before they are required to file a return and/or pay a tax on their income. Many states use the same thresholds as the federal government for filing. (For filers under age 65, the 2004 thresholds are: $7,950 for single filers; $11,450 for head of household; and $15,900 for married filing jointly.) Connecticut has much higher filing thresholds.

Brackets. One of the primary ways a state income tax structure differs is the number of income brackets. As shown in the table below, the number of these brackets varies from one rate (flat tax) which six states have, to 10 rate brackets in Missouri. Table II-8 below shows the number of states using different rates. Connecticut is the only state to use two rates. For a full listing of state’s rates and income brackets, see Appendix E.

Table II-8. A State Comparison of Rates and Brackets

Number of Rates/Brackets

Number of states

Lowest %

Highest % bracket

1 (Flat Rate)

6

3%

5.3%

2

1—CT

3%

5%

3

7

2%

9%

4

7

2%

8.5%

5

6

2%

9.9%

6

7

1%

8.97%

7

2

2%

7.7%

8

2

0.5%

7.8%

9

3

0.36%

8.98%

10

1

1.5%

6%

Source: Federation of Tax Administrators, January 2005 and Wisconsin legislative Fiscal Bureau, January 2005

Exemptions and credits. Other than base threshold and personal exemptions built into the income tax structure, Connecticut does not offer many exemptions for types of income. As mentioned previously, Social Security is exempt, but only if a filer’s total income falls below a certain level. Refunds on state and local taxes are exempt for all filers (and in the future, only half of military retirement pensions will be taxable). Many other states treat certain types of income (e.g., retirement, private and public pensions) differently from wage income.

Connecticut’s income tax offers only two credits – income tax payments to other states and localities, which are not capped, and payments for local property tax, which are capped at $350 per filer, with a percentage of that $350 reduced at higher income levels. The number and types of credits given in other states vary widely, but all have more than Connecticut. The table below summarizes the number of credits by category and the states that fall in those categories.

Table II-9. Comparison of Credits in the Personal Income Tax

Number of Credits

States

Less than 5

CT

5-10

AL, DE, DC, KY, MD, MI, MN, NE, NJ, PA, WV

11-15

CO, ID, IL, IN, MA, NM, ND, OH, VA, WI

More than 15

AZ, AR, CA, GA, HI, IA, KS, LA, ME, MS, MO, MT, NY, NC, OK, OR, RI, SC, UT, VT,

Source of Data: Wisconsin Legislative Fiscal Bureau, Individual Income Tax Provisions, January 2005

The greater the number of exemptions, the more the tax base is reduced, and the greater the value of credits, the less that is collected in taxes. In 2002, for example, the exemptions for Social Security reduced Connecticut’s taxable income by approximately $1.2 billion, and the property tax credits in 2003 reduced revenues collected by about $272 million.

Profile of Connecticut Income Tax Filers

Based on IRS data for all states for income year 2002, program review staff profiled Connecticut compared to other states using a variety of factors to assess income and filing status.

Federal adjusted gross income. Connecticut ranked highest in terms of adjusted gross income, with $64,724 -- 9.4 percent higher than the next-highest state, New Jersey, and about 40 percent higher than the national average AGI.

Table II-10. Lowest and Highest States by Avg. Federal AGI (total AGI in $millions)

 

# Filers

Tot. AGI

Avg. AGI

MISSISSIPPI

1,163,632

$39,276,788

$33,754

MONTANA

429,570

$14,508,848

$33,775

WEST VIRGINIA

748,020

$26,136,779

$34,941

ARKANSAS

1,119,779

$39,715,629

$35,467

NORTH DAKOTA

301,040

$10,733,301

$35,654

UNITED STATES

130,836,098

$6,015,047,033

$45,974

NEW YORK

8,613,811

$454,581,808

$52,774

MARYLAND

2,589,664

$139,952,530

$54,043

DISTRICT OF COLUMBIA

278,412

$15,294,026

$54,933

MASSACHUSETTS

3,075,666

$174,588,374

$56,764

NEW JERSEY

4,072,512

$240,924,251

$59,159

CONNECTICUT

1,663,015

$107,637,662

$64,724

Connecticut ranked third highest in terms of the percentage of filers who claim deductions, (44 percent). Connecticut had a substantially greater percentage than the national average (35 percent), but below Maryland and New Jersey.

Table II-11. Highest and Lowest States by Percentage of Filers Taking Deductions

MARYLAND

49%

NEW JERSEY

45%

CONNECTICUT

44%

MINNESOTA

42%

COLORADO

42%

OREGON

42%

UTAH

42%

UNITED STATES

35%

LOUISIANA

22%

WYOMING

21%

NORTH DAKOTA

20%

WEST VIRGINIA

19%

SOUTH DAKOTA

18%

Comparing Connecticut to other states using percent of adjusted gross income that comes from unearned income like dividends, interest, and capital gains, Connecticut ranks sixth, at 9.4 percent, which is considerably higher than the national average of 7.9 percent.

Table II-12. Highest and Lowest States: Percent of AGI is Unearned Income

WYOMING

15.5

NEVADA

12.5

FLORIDA

12.1

MONTANA

11.0

DISTRICT OF COLUMBIA

9.5

VERMONT

9.5

CONNECTICUT

9.4

UNITED STATES

7.9

MICHIGAN

5.9

LOUISIANA

5.8

MISSISSIPPI

5.7

WEST VIRGINIA

5.5

ALASKA

5.0

Finally, Connecticut ranked highest among all the states in terms of the percentage of filers with high incomes. Fully 34 percent of filers had federal AGI of more than $200,000; the national average was 21 percent.

Table II-13. Lowest and Highest States with Percent of

AGI over 200K

WEST VIRGINIA

9

NORTH DAKOTA

11

IOWA

12

NEW MEXICO

12

MISSISSIPPI

12

UNITED STATES

21

MASSACHUSETTS

26

NEW JERSEY

27

NEW YORK

30

DISTRICT OF COLUMBIA

32

CONNECTICUT

34

Assessment: NCSL Principles

Volatility. The Connecticut income tax is based on all personal income, and that income can be from many sources. A booming stock market, a robust real estate market, and wage increases in a thriving job market can all signal great growth in the personal income tax. But busts in any of those segments of the economy can also spell deep troughs in the revenues collected, making the personal income tax one of the more volatile taxes.

As shown in Table II-14, program review measured the annual percent change in the PIT between 1993 and 2005 and compared that to the standard deviation (or how much variation there is from the average or mean). (Although the PIT began in 1991, it took some time for the administration and collection of the tax to become well established. Therefore, 1991 and 1992 are not included in the measurement.) This analysis uses OFA legislative adjustments to the PIT; thus the changes being measured are those responding to the economy. Twelve years is not a long period to measure volatility, and people will caution that it may not include more than one economic cycle, but since the PIT was begun in 1991, it is the only period that can be captured.

Table II-14. Personal Income Tax: Average Annual Growth Rate and Standard Deviation FY 93- FY 05

Total Percent Growth for Period

89%

Average Annual Percent Change

6.85%

Standard Deviation

7.7

Range

26

The statistics in the table indicate there is considerable volatility in the PIT revenue stream in Connecticut. While the average annual growth was 6.85 percent, the standard deviation was almost 8, which means that two-thirds of the time the annual growth rate fell between –1 percent and +14 percent. The other third of the time it was outside that range. The greater the standard deviation, the less stable the revenue source and the more difficult to accurately forecast the total revenues from the tax.

The volatility in the personal income tax is more readily seen in Figure II-9, which tracks the changes in personal income tax revenues, compared to the state’s economy, using personal income in Connecticut as the measure. While PIT revenue generally trends similarly to the state’s personal income, the changes are much more dramatic – the increases higher and the declines deeper.

Analysis later in this chapter will show that Connecticut’s PIT is heavily reliant on top income filers for paying the bulk of the tax. Thus, Connecticut’s income tax is more volatile than most states’ income taxes due to the characteristics of our distribution of income and filers compared to other states. For example, Connecticut is:

• the state with the highest federal AGI,

• the state with the highest percentage of filers with AGI above $200K, and

• one of the highest states in terms of percentage of AGI from “unearned income” (i.e., capital gains, taxable interest, and dividends).

Adequacy

Figure II-9 above illustrates the volatility of Connecticut’s income tax compared to the economy (personal income). The figure also demonstrates that the income tax is adequate – it has been growing faster than the economy, and it has far outpaced inflation (i.e., consumer price index for the Northeast) by a wide margin. Table II-15 shows the comparative aggregate percentage growth in the three indicators over the last 12 years.

Table II-15. Total Percent Growth – 1993 -2004

Connecticut Personal Income Tax Revenues

91.9%

State Personal Income

54.5%

Inflation (CPI-U Northeast)

29.8%

Simplicity

Based on federal return. Connecticut’s income tax is a relatively simple one. First, Connecticut, like the vast majority of states, ties its PIT to the tax filer’s federal return. Connecticut uses federal adjusted gross income as its starting point. Thus once a Connecticut filer has completed his or her federal return, the federal AGI is used on the first line on the state tax return, and income does not need to be calculated twice. This also makes the tax easier to administer since the income can be easily verified with federal return information.

Few exemptions and credits. Connecticut’s tax is also simple in that it has few credits or exemptions. There are the basic income thresholds and standard deductions described earlier in the income tax profile. Those exemptions and deductions are built into the tax tables prepared by the Department of Revenue Services and displayed on the DRS website, making it easy for filers to calculate the taxes they owe.

Two rate brackets. Connecticut’s income tax has only two rates -- 3 percent and 5 percent -- applied to different income brackets by filer type. Having only two rates adds to the simplicity of the tax.

Withholding. Because the income tax is often withheld in employees’ paychecks, and employers submit that to the DRS, payment of the tax is relatively easy to comply with. In Connecticut, about 80 percent of the tax is collected through withholding and 20 percent through estimated payments.

Balance

Because the growth in the personal income tax has been so significant, it is contributing an ever-greater share of the state’s revenue stream. As Figure II-10 illustrates, the reliance on the income tax as a percentage of all state and local revenue has increased from about 23 percent in FY 93 to slightly more than 30 percent in FY 01, before declining to about 28 percent in FY 03. Revenues from the PIT make up an even greater share of state General Fund revenues – from a low of 30 percent in FY 95 to about 40 percent in FY 01 and FY 02.

While income tax revenues have more than kept pace with the economy, the tax revenues as a portion of the state’s personal income has been relatively stable. As shown in Figure II-11, the ratio has increased from about 2.5 percent in FY 93 to slightly more than 3 percent in FY 04; thus as a burden on the economy, the PIT is about the same.

Table II-16. Connecticut’s Personal Income Tax Revenue as a Percent of Personal Income

A Comparison with Other States FY 02

State

Percent

Rank

Connecticut

2.5%

20

US Avg.

2.3%

--

Maine

3.0%

11

Massachusetts

3.2%

8

New York

4.5%

1

New Jersey

2.1%

35

Source of Data: Census Bureau 2002

To compare this with the national average and those of neighboring states, staff used ratios for 2002, the last year comparable data are readily available. In that year, Connecticut ranked somewhat above the national average of 2.3 percent, but below neighboring states like Massachusetts (3.2 percent) and New York (4.5 percent), and Maine (3 percent). (see Table II-16).

Equity and Fairness

Progressivity. One of the measures of fairness of a tax is whether it is “progressive” -- taking a greater share of individuals’ incomes at higher income levels than at lower levels. Program review assessed the progressivity of Connecticut’s income tax in a couple of different ways. The Department of Revenue Services provided income tax data for all Connecticut resident filers -- aggregated and categorized into $1,000 income increments -- for 1995, 1999, and 2003. Committee staff analyzed these data using the Suits index, a widely used measure in tax analysis to determine the progressivity of taxes on a scale from -1 (very regressive) to +1 (most progressive), with 0 being a flat or proportional tax. The analysis of Connecticut’s income tax produced the following results, shown in Table II-17 below.

Table II-17. Assessment of Connecticut’s Personal Income Tax Using Suits Index

Year

Index Results

1995

.12 – slightly positive, slightly progressive

1999

.14 – slightly positive, slightly progressive

2003

.12 –slightly positive, slightly progressive

It is important to note that this analysis of progressivity is based only on the incomes of, and taxes paid by, Connecticut filers. It cannot measure the impact of the tax structure on those exempt from filing because of lower incomes.

Effective tax rates. Another way of looking at the fairness of the income tax is the ratio of taxes paid of adjusted gross income, (i.e., the effective tax rate, by different income groupings). To calculate this, program review staff first divided the total number of income filers into roughly equal quintiles (5 groupings, roughly 20 percent each), and also separated the top 1 percent out as a subcategory for analysis.

Figures II-12 and II-13 show the distribution of total income and taxes paid by quintile (and top 1 percent) for the three years. As Figure II-12 shows, the bottom quintile of filers accounted for less than 5 percent of the AGI income in all three years, while the top quintile accounted for at least 50 percent in all three years and more than 60 percent in 1999 and 2003. In fact, in the latter two years, the top 1 percent accounted for more than 25 percent of the income.

Figure II-13 shows similar results regarding the distribution of taxes paid. The bottom quintile paid little of the total taxes. (In fact, it is not measurable in the graph.) The top quintile paid more than 70 percent of all income taxes in 1999 and 2003, and the top 1 percent of filers paid at least 20 percent in all three years.

Table II-18 on the following page shows for income tax returns for 1995, 1999, and 2003: the number of filers in each group; the income groupings; the average income for the group; average tax paid for the group; and the tax paid as a percent of AGI, or the effective tax rate, for the group.

Table II-18. Distribution of Income, Taxes Paid, and Effective Tax Rates by Quintile: 1995, 1999, and 2003

1995

# filers

Income group

Avg. income

Avg. Tax Paid

% AGI in tax

Quintiles

245,994

$0-17K

$9,670

$10.54

0.11

 

238,087

>$17K - $29K

$22,853

$272.88

1.19

 

244,886

>$29 -$45K

$36,488

$864.97

2.37

 

246,870

>$45 - $70K

$56,124

$1,796.65

3.2

 

246,694

>$70 - $2m+

$163,498

$6,000.78

3.62

Top 1%

11,208

>$400K

$1,134,784

$37,495.56

3.3

Total

1,222,531

 

$58,031

$1,802.00

3.11

1999

# filers

Income group

Avg. income

Avg. Tax Paid

% AGI in tax

Quintiles

266,296

$0-17K

$9,310

$4.48

0.04

 

269,239

$17.01-$31K

$23,860

$167.83

0.70

 

272,331

$31.01-$50K

$39,695

$675.84

1.70

 

273,342

$50.01-$82K

$64,089

$1,779.93

2.70

 

272,945

$82.01 -$2m+

$242,477

$8,495.24

2.24

top 1%

13,607

>$550K

$2,051,230

$69,321.63

3.4

Total

1,354,153

 

$76,369

$2,241.77

2.93

2003

# filers

Income group

Avg. income

Avg. Tax Paid

% AGI in tax

 

291,764

$0-$18K

$9,628

$3.59

0.04

 

277,161

$18,01-$33K

$25,316

$198.21

0.78

 

278,766

$33,01-$54K

$42,623

$907.77

2.13

 

279,207

$54,01-$90K

$69,914

$2,384.24

3.41

 

269,805

$90,01-$2m+

$244,684

$9,378.81

3.83

top 1 %

13,333

>$550K +

$1,927,535

$68,112.43

3.53

Total

1,396,703

 

$76,784

$2,509.61

3.27

Source of Data: DRS Income Tax Return Data for 1995, 1999, and 2003

Some of the key findings from the distributional analysis of the income tax are:

• the threshold of income for the top 1 percent of filers increased sharply from $400,000 in 1995 to $550,000 in 1999, but has remained at that level in 2003;

• the average income for the top 1 percent in 1999 was slightly more than $2 million; it was below that in 2003 at $1.9 million;

• the average income for all filers in 2003 -- $76,784 -- had hardly increased from the $76,369 average AGI of 1999, due largely to the drop in income for the top 1 percent;

• the effective tax rates are slightly higher at greater income levels, reinforcing the results of the Suits index, showing that the income tax as structured is slightly positive and thus slightly progressive; and

• the slight increase in the progressivity of the tax in 1999 (as shown by the Suits index) was due to increased income for the top 1 percent, rather than a structural tax change.

Economic Competitiveness

When the income tax was enacted in 1991, there were fears it would drive wealthier individuals from the state. This has not happened. While Connecticut’s overall population has increased only slightly (3.6 percent) from the 1990 to the 2000 census, Connecticut’s wealth ranking remains high. The profile of Connecticut’s income outlined earlier in this chapter, using 2002 IRS data, shows that the federal AGI income for all filers in Connecticut is $64,724 – 40 percent higher than the U.S. average of $45,974, and 9 percent higher than New Jersey at $59,159.

Connecticut’s personal income tax rate structure is competitive, and may even be attractive to high-income earners whose employment might limit their residence choice to one of the states in the tri-state area. Table II-19 presents the top rate comparison for joint filers in New York, New Jersey, and Connecticut. Even at income levels of $150,000, there is a rate advantage to Connecticut’s tax over the other states.

Table II-19. Comparison of Upper-Income Tax Rates for Joint Filers in New York, New Jersey, and Connecticut

State

Rate

Taxable Income Level

New York

7.25%

7.7%

$150,001 -$500,000

over $500,000

New Jersey

6.37%

8.97%

$150,001 -$500,000

over $500,000

Connecticut

5%

Over $20,000

Profile of Connecticut’s Local Property Tax

Background

While the property tax plays no role in providing the state government with revenue, it is the basic and critical revenue source used to provide local services. Consequently, Connecticut municipalities rely heavily on the property tax. Since many services provided by county governments in other states are the responsibility of municipalities in Connecticut, local governments are an important component of Connecticut’s system of governance. They also provide a medium through which local preferences for public services can be expressed.

Some basic characteristics of the property tax in Connecticut are described below. In addition, an analysis of how the tax performs against the NCSL criteria is provided.

What The Tax Covers

All real property and tangible personal property is taxable unless expressly exempt. Real property includes land and improvements that are permanently attached to land. Personal property is all property not classified as real property, such as machinery, equipment, furniture, fixtures, and motor vehicles. Intangible property, such as copyrights, stocks, and bonds, is not taxed in Connecticut.

How The Tax Is Calculated

The property tax calculation is dependent on a determination of the value of property in a municipality and of the tax (or mill) rate. In Connecticut, all property taxes are assessed at the town level. Although some towns also have special taxing districts, the assessor of each town is ultimately responsible for establishing the value of each property, even if an assessment company is hired to assist the assessor. The Office of Policy and Management (OPM) has developed certain assessment practices and procedures and provides for the training and certification of tax assessors and assessment companies. There is no state law that requires an assessor to be certified, but a certified assessor must sign off on and approve each town’s grand list annually.

Valuation. Because the value of property fluctuates over time, state law requires towns to periodically reassess or revalue property. Reassessment allows towns to appropriately assign tax burden. Generally, real and personal property is taxed based on its present true and actual or fair market value. Each municipality must assess all property for local tax purposes at a uniform rate of 70 percent of true and actual value. Except in a few cases, the state does not employ a classification system of taxation -- that is, the same rules apply to the assessment of residential, commercial, industrial, and other types of property.

Frequency. Each town must revalue real property (e.g., land, homes, and office buildings) every five years (a requirement that started in October 2003). Personal property, such as motor vehicles, is revalued annually. Personal property typically owned by individuals (e.g., clothing, furniture) is exempt, but businesses are required to pay taxes on most of the personal property owned by the business.

At least once every 10 years a revaluation of real property must be based on a physical inspection; during intervening years towns can use statistical means. The Office of Policy and Management may impose a 10 percent penalty for failure to implement a revaluation. A town may apply to OPM for a delay in implementing a revaluation based on a reasonable cause as outlined in statute, or if a municipality shows a “good faith effort” toward implementing the required revaluation. A bill passed in 2003 permitted a delay in certain revaluations so that revaluations required to be implemented as of October 1, 2003, 2004, and 2005 do not have to be performed prior to October 1, 2006. To date, a total of 43 towns have deferred revaluations under this provision.

Reassessment relief. There are three mechanisms that serve to mitigate the impact of revaluation:

• two options allow towns to use different methods in determining gradual increases of assessed values of real property over a four-year phase-in period; and

• municipalities are allowed to implement a tax relief program that gives owner-occupants of one- to three-family homes a tax credit equal to the amount by which their property tax exceeds 1.5 percent of the property’s fair market value, provided the municipalities also impose a 15 percent surcharge on all other property owners. Only Hartford uses this mechanism.

Rate. The tax rate is expressed as a mill rate with one mill equal to one thousandth of a dollar. This means one mill is equivalent to one dollar of tax for every $1,000 of assessed value. The mill rate is calculated by dividing the net grand levy by the town’s net grand list. The net grand levy is the amount of money a town needs to raise through property taxes; that is, total expenses minus federal and state aid, fees, and other revenue. The net grand list comprises a town’s total taxable property (i.e., the grand list is the annual record of all taxable and tax –exempt property; the net grand list is the grand list minus exemptions and adjustments). Figure II-14 illustrates how the tax rate is calculated and the relationship to assessed property value.

Appeals/Disputes. Taxpayers are entitled to an appeal process if they dispute the assessed value of their property. Practically speaking, the taxpayer typically begins the process with an informal hearing with the firm performing the assessment or town assessor. This meeting can usually resolve obvious errors, such as the number of bathrooms or the size of a building. The taxpayer may continue the appeal to the local Board of Assessment Appeals. A taxpayer who wants an assessment reduced must be willing to appear in person or be represented by an attorney or agent and be willing to answer questions under oath. Taxpayers who feel aggrieved by the board’s decision may appeal to the Superior Court and must do so within two months of the board’s final decision.

Who pays the tax? Figure II-15 shows the types of property included in the statewide property tax base. Residential property represents the largest percentage of the base (67 percent) followed by commercial/industrial/public utility property (16 percent) and motor vehicles (8 percent). Since 1989, the residential portion of the tax base has increased from 58 percent to 67 percent (a 16 percent increase), while the commercial/industrial/public utility portion of the base has declined from 23 to 16 percent.

Payment method. Municipalities may determine whether the property tax is due in a single installment, semiannually, or in quarters. Typically, the first installment is due on July 1. In addition, many taxpayers have their tax placed in an escrow account as a condition of obtaining a mortgage and effectively pay a portion of taxes every month, while the mortgage company makes the payment to the town.

Exemptions/Credits, PILOT, and Tax Relief Programs

There are many methods that can be employed to exempt, reduce, or assist with the payment of property taxes. They include:

• various property tax exemptions or credits;

• exemptions that are reimbursed by the state;

• property tax relief programs; and

• statutorily authorized delays after revaluation.

Credits and exemptions. Several specific exemptions and credits against property taxes are mandated by statute. Municipalities are also authorized to adopt certain exemptions and credits by local ordinance. Exemptions can be organized by eligibility factors, such as age or physical impairments; property type, such as manufacturing equipment; or location and use of property. Major property tax exemptions include: agricultural products and equipment, charitable organizations, disabled persons and senior citizens, government property, and manufacturing. Property tax exemptions are summarized in Appendix F.

Table II-21 below lists the major state-mandated exemptions that municipalities must grant to property owners. These exemptions are divided among totally exempt property, such as state government property, and property that is partially exempt because the owner or the property meets specific statutory criteria, such as individuals who are visually impaired. These exemptions totaled about $42 billion in FY 03 or about 16 percent of the total value of the statewide grand list.

Municipalities are authorized to provide additional exemptions. However, no information on these exemptions is provided to the state nor does any other organization quantify the use of these local options on a statewide basis.

Table II-21. Statewide Property Tax Grand List Total and Partial Exemptions: FY 03

Exemption Type

FY 03 Estimated Reduction ($ Millions)

% of Total Exemptions

% Grand List Exemption

Totally Exempt Property

Municipal

$13,968.85

33.03%

5.190%

State

6,627.43

15.67%

2.462%

Private Colleges & General/Chronic Disease Hospitals

4,795.50

11.34%

1.782%

Religious

3,382.54

8.00%

1.257%

Scientific, Educational, Literary, Historical, Charitable

3,093.39

7.31%

1.149%

Federal

903.34

2.14%

0.336%

Connecticut Resource Recovery Authority

408.00

0.96%

0.152%

Cemeteries

351.17

0.83%

0.130%

Nonprofit Camps & Recreational Facilities

297.03

0.70%

0.110%

Hospitals & Sanitoriums

183.81

0.43%

0.068%

Volunteer Fire Dept.

149.78

0.35%

0.056%

Railroad

69.22

0.16%

0.026%

Agriculture & Horticultural

58.08

0.14%

0.022%

Veterans Organizations

49.54

0.12%

0.018%

American National Red Cross

14.97

0.04%

0.006%

CT Student Loan Foundation

5.03

0.01%

0.002%

Total Tax Exempt Property

$34,357.68

81.24%

12.77%

Partial Exemptions

Phase-In Residential Properties

$2,654.77

6.28%

0.986%

Manufacturers and Trucks

2,319.69

5.48%

0.862%

Economic & Developmental - Non Reimbursed

960.48

2.27%

0.357%

Phase-In Non Residential Properties

584.58

1.38%

0.217%

Non Reimbursed Veterans

487.29

1.15%

0.181%

Environmental & Developmental – Reimbursed

326.14

0.77%

0.121%

Reimbursed Ad Vets - Non Income

183.08

0.43%

0.068%

Solar Energy & Pollution Control

132.46

0.31%

0.049%

Reimbursed Ad Vets – Income

92.91

0.22%

0.035%

Personal Property Tax Exemptions

56.48

0.13%

0.021%

Farm & Mechanics

43.23

0.10%

0.016%

Miscellaneous

32.14

0.08%

0.012%

100% Disabled Non Reimbursed

24.21

0.06%

0.009%

Various Exemptions for Individuals

19.76

0.05%

0.007%

Blind

10.65

0.03%

0.004%

100% Disabled Reimbursed

4.21

0.01%

0.002%

Residential Fixed Assessments

3.56

0.01%

0.001%

Total Partial Exemptions

$7,935.66

18.76%

2.95%

       

Grand Total Grand List Exempted

$42,293.34

100.00%

15.73%

Source: Office of Policy and Management and LPRIC calculations

State formula grants. There are a number of programs that provide payments from the state to municipalities for the loss of tax revenue due to state-mandated real and personal property exemptions. Generally, these are called payment in lieu of taxes (PILOT)15. The payment is equal to a percentage of the amount of taxes that would have been paid if the property were not exempt from taxation. Some of the properties and programs subject to PILOT are:

• state-owned property;

• private colleges;

• distressed municipalities; and

• manufacturing machinery and equipment.

In addition, there are a number of state grants that assist municipalities in paying for various services; some are mandated (e.g., education) and others are not (e.g., town road aid). Appendix G lists the major programs for which the state provides reimbursement or grant payments to municipalities, the amount required by statutory formulas, and the amount and rate of actual reimbursement. It can be noted:

• Not all PILOT programs, even when fully funded according to statutory formulas, are intended to reimburse municipalities for their entire loss of revenue due to state-mandated exemptions. Consequently, municipalities receive less than they would if the exemptions did not apply.

• Over the last several years, the state has not fully funded all of its grants according to the original statutory formulas. In FY 05, for example, the state reimbursed municipalities 82.5 percent of the total owed for various PILOT grants.

• In FY 05, total reimbursement for all major state statutory formula grants, including the Mashantucket/Mohegan fund and education, was about 92 percent of what was owed under the statutory formulas.

Tax relief programs. Various state and local programs are available to provide some property tax relief for certain individuals. Several programs are targeted to totally disabled persons, the elderly, and indigent taxpayers, though the largest program, the property tax credit, applies to a broad range of taxpayers.

• Freeze program – The freeze program was established by the state in 1967, but because of a lack of funding it stopped accepting new applicants in 1979. This program freezes a qualified homeowner’s property tax at the amount of those taxes in the year in which the person first filed for benefits. To qualify a homeowner (or spouse) must be at least 65 years of age (or be a surviving spouse over 50) with an annual income of $6,000 or less. In FY 05, $1.6 million was paid out by the state to 128 municipalities on behalf of 910 individual participants.

• Circuit breaker for elderly and disabled - This program provides a property tax credit, based on income, for homeowners who are over 65 years of age or are totally disabled and have incomes that do not exceed $27,140 for unmarried individuals and $33,000 for married couples. Credit amounts are up to $1,250 of property tax bills for married couples and $1,000 for single persons. In FY 04, $20.5 million was paid out by the state to 175 municipalities/special taxing districts on behalf of 43,657 participants. (A related program provides a grant to certain elderly and disabled renters based on income and is paid to the individuals.)

• Local tax relief - Municipalities have the option to provide a number of exemptions or abatements that provide tax relief to certain individuals. For example, municipalities may provide property tax relief to disabled and elderly persons not to exceed 10 percent of the total real property tax assessed. In addition, municipalities may abate the property taxes due on an owner-occupied residential dwelling to the extent the taxes exceed 8 percent of the taxpayer’s income. The owner must agree to reimburse the municipality for the amount of the taxes abated with 6 percent interest or a rate set by the municipality. Tax relief provided under these provisions is not reimbursed by the state.

• Property tax credit - Since 1995, residents who pay property taxes on a residence or motor vehicles and also pay state income taxes are entitled to a credit on their income tax liability. For calendar year 2004, the maximum credit was $350. In 2003, about 943,000 filers claimed a credit through this property tax relief program at a total cost of almost $272 million.

• Other programs - Other non-government sponsored (but government sanctioned) options, like reverse mortgages, may be available to individuals to help elderly residents turn property equity into an income stream that can help pay property taxes.

Revenue Trends and Economic Comparisons

Local property taxes raised about $6.2 billion statewide in FY 03, as shown in Figure II-16. Between 1990 and 2003 the amount of revenue raised from the property tax, after adjusting for inflation, increased about 27 percent as shown in the figure (from $4.9 to $6.2 billion). Over the last five years alone, the increase was about 11 percent.

The yearly changes in property tax revenues raised statewide fluctuate, as shown in Figure II-17. Over the last 13 years, the greatest yearly increase occurred in 1991 (6.14 percent). However, increases were much smaller in the mid-1990s -- and actual decreases were experienced in 1994 and 1996 with larger increases beginning in 2001.

It is important to consider tax growth in terms of overall economic changes. Property tax revenues often grow in relation to a surging economy because new buildings are built, demand for housing increases, and existing property increases in value. Economic growth also leads to income growth. Consequently, comparing property tax levels as a percent of income and gross state product is more appropriate than just nominal dollar changes.

Figure II-18 presents total property tax collections as a percent of total state personal income and as a percent of the gross state product since the early 1990s. In general, property tax revenues as a proportion of both those measures rose slightly in the early 1990s and declined from the mid-1990s through 2000. But by 2003, both measures returned to nearly the same percentage as they began in the early 1990s.

Connecticut collects a higher percentage of personal income in property taxes than the national average. The nationwide average was 3.25 percent of state personal income in property tax collections from 1990 through 1999. In Connecticut, the average for that time period was 4.26 percent or about 30 percent more.16

Comparisons with Other States

Table II-22. Property Taxes as a Percent of Total State and Local Taxes, FY 2002

Rank

State

Percent

1

New Hampshire

60.3

2

New Jersey

46.3

3

Maine

42.1

4

Vermont

41.9

5

Texas

41.6

9

Connecticut

39.6

 

United States

30.8

47

Arkansas

15.5

48

New Mexico

15.5

49

Alabama

15.2

50

Delaware

14.9

51

Hawaii

14.5

Source: Federation of Tax Administrators based on U.S. Census Bureau 2002 State and Local Government Finances. Rankings include the District of Columbia.

The local property tax is the one of the few taxes levied in all states and is the principal source of tax revenue for local governments in all 50 states. Thirty-five states also impose a statewide property tax.17 Connecticut does not. The following analysis compares Connecticut’s property tax to the top five states, the bottom five states, and the U.S. average on a variety of comparative measures.

Table II-23. Property Taxes per Capita, FY 2002

Rank

State

Per Capita

1

New Jersey

$1,907.50

2

Connecticut

$1,760.30

3

New Hampshire

$1,755.30

4

Maine

$1,499.70

5

New York

$1,413.70

 

United States

$991.80

47

Louisiana

$434.20

48

Oklahoma

$429.50

49

New Mexico

$415.60

50

Arkansas

$375.10

51

Alabama

$331.40

Source: NCSL, Ranking of State-Local Revenue and Expenditure Data, based on U.S. Census Bureau 2002 State and Local Government Finances. Rankings include the District of Columbia.

Property tax and overall state revenue. As noted previously, Connecticut’s local property tax accounts for about 40 percent of total state and local revenue and that reliance has increased recently, but is at the same level as a decade ago.

As Table II-22 shows, this places Connecticut ninth highest in state comparisons, and three of the states that rank higher have no broad-based income tax.18 This contrasts with the situation in most states where reliance on the property tax has declined as a proportion of local government revenue as well as a proportion of combined state and local government tax revenue. Nationally, as a percent of total state and local government revenue, the property tax has decreased from about 50 percent of collections in the 1940s to about 31 percent in 2002.19

Property taxes per capita and compared to income. Table II-23 compares state property taxes on a per capita basis. On this measure, Connecticut ranks second highest in the nation at about $1,800 compared to the national average of about $1,000.

Property taxes compared to income. When property taxes are compared to personal income in Table II-24, Connecticut ranks seventh highest in the nation at $4.10 per $100 of personal income. The national average is $3.10.

Table II-24. Property Taxes Per $100 of Personal Income, FY 2002

Rank

State

Per $100 of Personal Income

1

Maine

$5.30

2

New Hampshire

$5.00

3

New Jersey

$4.80

4

Vermont

$4.50

5

Wyoming

$4.50

7

Connecticut

$4.10

 

United States

$3.10

47

New Mexico

$1.70

48

Oklahoma

$1.60

49

Arkansas

$1.60

50

Delaware

$1.50

51

Alabama

$1.30

Source: NCSL, Ranking of State-Local Revenue and Expenditure Data, based on U.S. Census Bureau 2002 State and Local Government Finances and Bureau of Economic Analysis. Rankings include the District of Columbia.

Property taxes and local revenue. In FY 02, property taxes represented 73 percent of total taxes collected by local governments nationwide. Table II-25 reveals that Connecticut municipalities were the second most dependent on property taxes, representing over 98 percent of local tax collections, while the District of Columbia was the least at about 25 percent.

Table II-25. Local Property Taxes as Percent of All Local Taxes, FY 2002

Rank

State

Percent

1

New Jersey

98.44

2

Connecticut

98.41

3

New Hampshire

98.00

4

Rhode Island

97.74

5

Maine

97.37

 

United States

72.87

47

Oklahoma

54.31

48

Arkansas

41.87

49

Alabama

39.84

50

Louisiana

39.49

51

District of Columbia

24.89

Source: U.S. Census Bureau 2002 State and Local Government Finances. Rankings include the District of Columbia.

Table II-26. Local Property Taxes as Percent of

General Own-Source Revenue, FY 2002

Rank

State

Percent

1

Connecticut

83.8%

2

Rhode Island

83.3%

3

New Hampshire

79.1%

4

Maine

77.5%

5

New Jersey

76.1%

 

United States

45.1%

47

Oklahoma

29.6%

48

Louisiana

24.0%

49

Arkansas

20.6%

50

District of Columbia

19.7%

51

Alabama

16.5%

Source: U.S. Census Bureau 2002 State and Local Government Finances. Rankings include the District of Columbia.

Property taxes as a percent of own-source revenue. Similar to many states in the Northeast, the diversity of Connecticut’s municipal revenue is very limited. When local property taxes are considered as a percent of total own-source local revenue (e.g., property taxes plus fees, charges, fines, etc.), Connecticut’s municipalities rank first in the nation as the most dependent on the property tax, as shown in Table II-26. This is not surprising given that Connecticut is one of only 12 states that do not authorize a local option sales or income tax or both.20

Table II-27. Average Property Taxes Paid by Federal Income Tax Filers Taking the Property Tax Deduction, 2002

Rank

State

Avg. Prop. Tax

Avg. AGI

% of AGI

1

New Jersey

$5,582.32

$59,159

9%

2

New York

$4,597.02

$52,774

9%

3

Connecticut

$4,429.50

$64,724

7%

4

New Hampshire

$4,416.67

$49,720

9%

5

Texas

$4,088.00

$43,546

9%

 

United States

$2,812.53

$45,974

6%

47

Louisiana

$1,036.65

$37,102

3%

48

Hawaii

$1,008.05

$41,329

2%

49

West Virginia

$953.56

$34,941

3%

50

Arkansas

$884.48

$35,467

2%

51

Alabama

$751.26

$38,472

2%

Source: IRS, Selected Data for 2002. Rankings include the District of Columbia.

Average property tax payments. Based on 2002 IRS data of filers who took property tax deductions, the average amount paid in property taxes in the U.S. was about $2,800. As Table II-27 shows, Connecticut ranked third in the nation with an average of about $4,400. These findings provide a limited snapshot of a national comparison because nationwide only about 35 percent of all federal filers itemize.

Other significant features and differences compared to other states21

• Homestead exemptions/credits. Homestead exemptions reduce the amount of assessed property subject to taxation for residential property, while homestead credits provide a state-financed (typically) rebate to taxpayers or a credit to property owners. Fourteen states offer homestead credits, and 40 states offer homestead exemptions. Connecticut provides for a property tax credit on income taxes for all filers with an income tax liability (though reduced at higher income levels) and grants limited exemptions to certain populations (e.g., veterans). Various local option exemptions are also available.

• Circuit breakers. Circuit breakers provide property tax rebates or credits targeted to low-income homeowners and/or renters, and to the elderly. Typically, when property exceeds a certain percentage of the taxpayer’s income, states provide a rebate. Thirty-five states offer circuit breakers. Connecticut has a circuit breaker program, described earlier in this chapter, that targets the elderly poor and people who are disabled.

• Property tax deferrals. Tax deferral programs typically allow a taxpayer over a specified age to defer taxes until the property is sold or the taxpayer dies. The deferred tax becomes a lien against the property. Twenty-four states offer property tax deferral; Connecticut does not offer a tax deferral program, but a local option deferral program is allowed under statute.

• Property tax rate limits, assessment limits, and freezes. Property tax rate limits establish a maximum amount that a mill rate may increase per year, while tax freezes prevent increases in property taxes when certain conditions are met. Assessment limits curb how much assessed values may increase per year. Forty-two states have programs that limit or freeze assessed property values, property tax rates, or property taxes -- 31 have tax rate limits, 20 have caps on increases in assessed property values, and 23 have limits on property taxes. Only eight states, including Connecticut, do not have statewide limits that apply to all property taxpayers or residents.

• Assessment ratios and differential rates. As described earlier, municipalities typically assess property at fair market value and then multiply that amount by a percentage (70 percent for all Connecticut property, except as noted). This is called the assessment level or ratio. Eighteen states apply lower legal assessment ratios for residential property than for commercial or industrial property for the purposes of calculating taxes. Seven states apply lower property tax rates to residential property. Both practices result in shifting the local tax burden from residential owners to other property owners. In Connecticut, only Hartford has a lower rate for certain residential property. In addition, forest land, open space, and other agricultural land is assessed differently.

Assessment: NCSL Principles

Reliability/Volatility

Generally, the property tax is the most stable and reliable of all the major taxes. In simple terms, the property tax base cannot be moved, a key factor in considering stability. Volatility is measured by the annual change in growth rates and the standard deviation around the rate of annual changes over time. For the property tax, both the changes in the revenue produced and the changes in the equalized net grand list were measured. The equalized net grand list (ENGL) is the estimate of the market value of all taxable property in a municipality. It can be thought of as a measure of a town’s total taxable wealth. Because towns revalue property at different times, equalizing the tax base allows for town-to-town comparisons. Although recently there has been some rapid appreciation in property values, it usually takes several years before such changes are reflected in a town’s grand list. Unlike sales and income taxes, changes in consumption patterns do not affect property tax liability.

Change in ENGL. Figure II-19 shows the value of all property in Connecticut and the statewide mill rate since 1990. Inflation-adjusted property values based upon the statewide ENGL declined through the early to late-1990s and the equalized mill rate increased. As property values rose, the equalized statewide mill rate dropped. While in Connecticut considerable variation is possible on a town-by-town basis, the total value of property has nearly returned to its 1990 level. It is important to note that ENGL values have a built-in lag of two years; for example, the FY 2003 equalized grand list represents the equalized value of the grand list in 2001.

As shown in Table II-28, the average annual growth rate for ENGL since 1990 has been 2.15 percent, though over the last five years it has been 8.3 percent, and the standard deviation is 5.85.

Table II-28. ENGL: Growth Rate and Standard Deviation, 1990-2003

Total Percent Growth for the Period

28.0%

Average Annual Percent Change Since 1990

2.15%

Average Annual Percent Change Since 1999

8.31%

Standard Deviation for the Period

5.85

Source: LPRIC calculations based on OPM Municipal Fiscal Indicators

Change in property tax revenue. As shown in Table II-29, the average annual growth rate for property tax revenues has been about 4.6 percent, and the standard deviation of local property tax revenue growth is 2.47 percent. This means that for most of the time (68 percent), the average revenue growth has been between about 2.1 and 7.1 percent. The ENGL, or what the property tax is based on, has been somewhat more variable than the tax collected. This is most likely due to the slow to negative growth in the ENGL in the early to mid-1990s, compared to the more recent appreciation.

Table II-29. Property Tax Revenue: Growth Rate and Standard Deviation

1990-2003

Total Percent Growth for the Period

59.8%

Average Annual Percent Change since 1990

4.6%

Average Annual Percent Change Since 1999

5.0%

Standard Deviation

2.47

Source: LPRIC calculations based on OPM Municipal Fiscal Indicators

Adequacy

Adequacy is calculated by comparing overall growth in tax revenue to growth in the economy, as measured by personal income. Again, a comparison of both property tax revenues and ENGL is provided below. Figure II-20 compares the annual percent change in property tax collections and ENGL to personal income. From an adequacy perspective, ENGL measures the strength of the local tax base.

• ENGL growth is negative, in inflation adjusted terms, until 1998.

• Beginning in 2001, both the ENGL and property tax collection growth begin to outpace personal income.

The comparison can also be illustrated in actual, non-inflation adjusted terms. Table II-30 shows the comparative aggregate percentage growth in ENGL (property value), property tax collections, state personal income, inflation, and municipal expenses. Total growth in ENGL has nearly matched inflation and been about half the growth of personal income and total local expenditures. Property tax collections have exceeded the growth in income, inflation, and total local expenditures.

Table II-30. ENGL, Property Tax Revenues and Municipal Expenses:

Total Percent Growth, 1990-2003

Total Percent Growth for ENGL

28.0%

Total Percent Growth for Property Tax Revenues

59.8%

State Personal Income

55.7%

Inflation (CPI-U)

32.5%

Total Local Education Expenditures

64.5%

Total Local Operating Expenditures

41.1%

Total Local Expenditures

53.7%

Note: Total local operating expenses consist of total local expenditures less education expenditures

Source: OPM Municipal Fiscal Indicators, US Bureau of Economic Affairs, and LPRIC calculations

Equity and Tax Burden

Determining if the property tax is equitable is a complicated and difficult analytical exercise. Briefly, equity is defined in both horizontal terms -- similar taxpayers in similar circumstances have similar tax burdens -- and vertical terms -- taxpayers in different economic circumstances have different tax burdens. A regressive tax takes a larger percentage from a low-income taxpayer than from those with a high income, while a progressive tax takes a higher percentage of income from wealthier taxpayers. A proportional tax obtains a constant percentage of income across different income levels. As noted earlier, a fair tax system should minimize regressivity and the tax burden on low-income households.22

Views on tax burden. Economists do not agree as to whether the property tax takes a higher percentage of income from poor households than from wealthier ones.23 There is not always agreement on how to handle certain analytical issues, such as the identity of the taxpayer and the measure of income.

• Taxpayer. Equity measures require a determination as to who ultimately pays the tax. The person who is legally responsible for a tax (legal incidence) may not be the person who ultimately pays the tax (economic incidence). For example, a landlord who is legally responsible for paying a property tax increase, will often pass this cost to the tenant through increased rent. Taxes on businesses and other nonresidential property can result in indirect burdens on other taxpayers, through higher prices, lower labor earnings, or lower capital income.

• Ability to pay. In addition, equity requires that tax burden be compared to the ability to pay but the definition of “ability to pay” is a knotty question. Income, like wages and pensions, is typically used as a measure of ability to pay. Many argue that wealth is a better indicator, and thus would include investments, savings, and even the value of property into the equation. Additionally, some criticize the use of annual income preferring instead long-term or lifetime income in comparing tax burden.

Old view. Generally, under the “old view,” economists believe the property tax is regressive because property tax liability is not dependent on income, but on the value of property.

New view. Many economists adhere to the “new view” that the property tax is really a tax on capital. As such, it is largely a progressive tax because high-income households own a disproportionately larger share of the property stock

Benefits tax. It should also be noted that there is an alternative view that considers residential property tax a “benefit tax.” This concept is based on the connection between the source of revenue (property) and the benefits received (services). The tax cost reflects the value of services received. If residents select locations based on the tax and services offered, then incidence cannot be considered separately from the provision of public services under this perspective.

The program review committee study does not resolve property tax equity measurement issues discussed above. The arguments among economists are presented to critically inform the analysis that follows in that they may contribute to a fuller but imperfect understanding of how property tax burden is distributed. The results of two recent studies are presented along with basic measures of property tax burden. One study examines how taxes relate to income groups on a statewide basis, while the other study and subsequent measures calculated by program review relate taxes to towns arranged by household income and per capita income.

ITEP study. The Institute of Taxation and Economic Study of incidence of state and local taxes in Connecticut in 2002, discussed in Chapter I, shows that the property tax is regressive as measured by the impact on different income groups. The lowest 20 percent of families pay 3.8 percent of income on property taxes, while the top 1 percent of taxpayers pay 1 percent of income toward property taxes.

Table II-31. Property Taxes per Capita, 2003

Per Capita

Income Decile

Residential Portion

per Capita

Total Property Tax

per Capita

First

$671.95

$1,279.75

Second

$876.84

$1,357.37

Third

$850.86

$1,389.80

Fourth

$1,059.51

$1,577.30

Fifth

$1,163.53

$1,673.31

Sixth

$1,259.29

$1,888.29

Seventh

$1,423.57

$1,935.57

Eighth

$1,492.09

$2,202.45

Ninth

$1,794.73

$2,330.62

Tenth

$2,591.68

$3,125.47

Statewide

$1,261.18

$1,785.16

Source: OPM Municipal Fiscal Indicators, Connecticut Economic Resource Center, and LPRIC calculations

Connecticut Economy study. A study authored by James Stodder and published in the Connecticut Economy (Fall 2002) examined Connecticut’s property taxes in relation to property wealth and household income. The study concluded that the property tax in Connecticut was regressive with respect to wealth – towns with higher property values charge a lower rate – but rates were nearly flat when considered in relation to household income.24

Other tax burden calculations. Using another approach to analyze the burden of the property tax, committee staff grouped Connecticut municipalities by their 2003 estimated per capita income levels by deciles, ranging from the lowest (first) to the highest (tenth). Each decile contains 17 towns except the first, which has 16. Recalling the caveats above, per capita income is often used as a measure of ability to pay. All the following tables compare burden based on total property taxes in each town, and some tables separate the taxes paid on residential property. Generally, separating the residential portion provides some indication of the tax burden borne directly by residents versus business in a particular town.

Table II-32. Property Taxes and Equalized Value, 2003

Per Capita

Income Decile

ENGL

Per Capita

Property Tax as Percent of

Equalized Value

(Effective Total Tax Rate)

First

$53,222

2.40%

Second

77,385

1.75%

Third

89,692

1.55%

Fourth

98,354

1.60%

Fifth

107,056

1.56%

Sixth

131,731

1.43%

Seventh

134,073

1.44%

Eighth

174,251

1.26%

Ninth

159,959

1.46%

Tenth

366,458

0.85%

Statewide

$127,435

1.40%

Source: OPM Municipal Fiscal Indicators, Connecticut Economic Resource Center, and LPRIC calculations

Property taxes per capita. One of the simplest measures of tax burden is property taxes for each individual in a town or “per capita.” Table II-31, on the preceding page, shows total property taxes per capita rise from about $1,280 in the first decile of towns to $3,125 in the tenth. The pattern is the same when just residential property is considered. This may reflect the fact that towns with high income may purchase more public services per capita than poorer towns and are more likely to charge for those services through the property tax.

Property taxes as percent of ENGL. Tax burden can also be expressed as a ratio of taxes paid to the equalized value of property (ENGL) in each town. This percentage is also referred to as the effective tax rate. By calculating tax burden on an equalized basis, valid comparisons can be made across jurisdictions, which revalue property in different years. The equalized value may also be viewed as a measure of wealth and, thus, also a measure of a town’s fiscal capacity.

Table II-32 lists the value of the equalized net grand list by decile on a per capita basis and property taxes as a percent of ENGL. Generally, the ENGL per capita, or fiscal capacity, increases across all income deciles. The table shows the property tax as a percentage of equalized value at the lowest decile is 2.4 percent and at the highest is 0.85 percent. The bottom five deciles have higher effective tax rates (percentages) than the top five deciles. Therefore, towns with higher per capita income tend to have a lower effective tax rate.

Property taxes in relation to income. Another measure used to assess tax burden in Connecticut towns is to compute property taxes per $1,000 of personal income. This measure uses income, not wealth, as an indicator of ability to pay on a town-wide basis. This differs from the ITEP study, which compares burden on an individual basis.

Table II-33. Property Taxes and Income, 2003

Per Capita

Income Decile

Residential Property Taxes

per $1,000 of Income

Total Property Taxes

Per $1,000 of Income

First

$37.23

$70.91

Second

$37.80

$58.51

Third

$33.70

$55.04

Fourth

$38.47

$57.27

Fifth

$40.41

$58.12

Sixth

$40.86

$61.26

Seventh

$42.86

$58.27

Eighth

$40.21

$59.36

Ninth

$42.73

$55.49

Tenth

$37.72

$45.49

Statewide

$40.48

$57.30

Source: OPM Municipal Fiscal Indicators, Connecticut Economic Resource Center, and LPRIC calculations

The ratios in Table II-33 are calculated based on the aggregate of taxes of all the towns in each decile, divided by the aggregate of all income earned by all the residents in those towns. The table shows, except for the top and bottom deciles, total property taxes per $1,000 of income is not related to income. In comparing the top to the bottom deciles, though, the tax appears regressive.

However, residential property taxes per $1,000 of income appear fairly proportional across the deciles. It is important to note that the effect of federal tax deductions and credits may alter the outcome of this finding to the extent higher-income families are more likely to take such deductions.

Property tax and education tax rate. As Table II-34 shows, on average, education expenses are the largest single expenditure for Connecticut municipalities by far. In 2002, 57 percent of all municipal expenditures went to education. It is useful to consider the impact of education expenses on the mill rate among municipalities on a relative basis.

Table II-34. Municipal Spending in Connecticut by Function (in millions)
 

Fiscal

2001

Percent of Total

Fiscal

2002

Percent of Total

Education

$4,717.5

56.7%

$5,014.4

57.1%

Public Works

649.3

7.8

669.0

7.6

Debt Service

617.2

7.4

664.4

7.6

Police

551.1

6.6

569.4

6.5

Fringe Benefits

505.2

6.1

530.0

6.0

General Government

300.2

3.6

324.5

3.7

Fire

315.6

3.8

320.4

3.6

Other Expenditures

204.5

2.5

206.2

2.3

Parks & Recreation

141.8

1.7

148.6

1.7

Health & Social Services

137.0

1.6

142.9

1.6

Libraries

111.6

1.3

118.4

1.3

Planning & Development

71.7

0.9

72.2

0.8

         

Total Expenditures

$8,322.70

100.00%

$8,780.50

100.00%

Note: Based on budgeted amounts

Source: Connecticut Policy and Economic Council, Connecticut Municipal Profiles, 2001/2002 (most recent years available)

Even though education is a state responsibility and towns receive some financial assistance from other sources, the majority of funding for education in Connecticut has and continues to come from local government sources. As shown in Figure II-21, in FY 04, local governments contributed 56 percent of total education costs, while the state contributed about 38 percent and the balance was from the federal government and other sources. Furthermore, the state share has been declining. In FY 00, the state share was 42 percent, and in FY 90, it was nearly 46 percent.

Education mill rate. The local share of all current education expenditures was obtained from the State Department of Education for each town in the state in order to compare relative educational effort among towns. These local expenses were divided by each town’s ENGL to determine each town’s education mill rate on an equalized basis. This represents a measure of tax effort for education, the largest municipal expenditure.

Figure II-23 shows the rate by decile for the local expenses that support the minimum education requirement (MER) and for total regular local education expenses. The MER represents the minimum level school districts are required by the state to spend in certain areas. The MER consists of all regular public elementary and secondary educational expenditures except those related to special education, state and federal grants (except ECS and federal impact aid) transportation, most construction and debt service expenditures, and adult education.25 Total local education expenses represent all expenditures above the MER, including special education and transportation. All municipalities spend above the minimum.

The tax rate to support the MER is highest in the lowest five income deciles compared to the highest income five deciles. The tax rate to support total local education expenditures is lowest by far in the top decile; it is well below all other income deciles and nearly half that of the first decile.

Balance

Connecticut is very reliant on the property tax as a source of total state and local government revenue. Property tax as a percent of all tax revenues reached its high point in 1991 with almost 45 percent of all revenues coming from local property taxes, as illustrated in Figure II-24.

The percentage of all revenue raised by local property tax leveled off during the mid-to late-1990s and reached its low point in 2001 when less than 35 percent was raised by the local property tax. However, this trend changed dramatically during 2002 and 2003, with local property taxes accounting for more than 40 percent of all state and local revenue. Still, this is the same percentage as a decade ago.

Fairly Administered/Accountable/Promotes Compliance

Proper tax administration means that tax burdens are distributed among taxpayers according to the way the law intended. Professional administration enhances effectiveness of the system and improves taxpayer compliance. An accountable tax system requires that tax laws be explicit. Proposals for change must be well publicized and allow for citizen input. Overall, compared to other taxes, the property tax is fairly easy to administer and to comply with. The tax base is largely immobile and is difficult to hide, unlike income and sales transactions. The tax is accountable to taxpayers because it is due annually and the exact amount of the tax is known.

Administration. Problems with property tax administration usually relate to valuation.26 The responsibility for property assessment in Connecticut is assigned to the town assessor. The state’s role, through the Office of Policy and Management, is to certify and regulate revaluation companies, ensure revaluations are completed, and provide technical assistance to municipal assessors. There is also an appeals process that requires each municipality to maintain a Board of Assessment Appeals. Each assessment appeal typically begins with an informal meeting with the firm or town assessor conducting the assessment. The taxpayer may also continue his appeal to the Board of Assessment Appeals, and, if not satisfied with the board’s decision, may appeal to the Superior Court.

A fairness issue arises in the administration of the property tax as it relates to assessment practices. The state used to require that real property be assessed every 10 years. In 2003, the law was changed to require at least a statistical update every five years and at a minimum a physical revaluation every 10 years. The legislature has delayed full implementation of this requirement. Personal property and motor vehicles are revalued every year. Because most personal property owned by individuals is exempt, this tax is mostly a tax on business personal property.

It is important to note that changes in the real estate market during the time between revaluations will result in assessments that vary from the required 70 percent assessment ratio – that is, 70 percent of market value. This means that tax burden shifts among, and even within, classes of property will not be recognized in a timely manner. Because real property is revalued on a five to 10-year cycle and business personal property is revalued annually, a shift in tax burden will occur between these classes of property each year since one mill rate is applied to all property within a town. If real estate values are increasing between revaluations, then real property is under-assessed and business personal property and motor vehicles assume a greater share of the tax burden. If real estate values decrease, then real property is over- assessed and assumes a greater share of the tax burden.

Promotes compliance. Taxpayer compliance with the property tax is straightforward. In Connecticut, the property tax collection rate for 2003 was 97.8 percent and is typically the highest rate of all taxes. It is the only tax where the government computes the value of the asset (and base) and the tax due. Unlike the income tax, the tax bill does not require the completion of forms; it is generated automatically and does not require the assistance of an accountant. If the taxes go unpaid, the government can place a lien on the property and can ultimately seize the property. In addition, payment of the property tax for many taxpayers occurs automatically through a mortgage company or bank when they pay their mortgage.

Accountable. Nearly all aspects of the property tax are transparent. Taxpayers know the amount, frequency, and purpose of this tax. The assessment process is open, as anyone can compare the value of a neighbor’s or similar property, and the option to appeal is available. The high visibility of the tax, though, is believed to be associated with the public’s discontent with it. One of the unique aspects of the property tax is that taxpayers often have an opportunity to influence the tax rate through referendum. The tax’s high visibility ultimately allows citizens to evaluate and have direct input into the cost of their local government.

Connecticut municipalities have been increasing the use of referenda to adopt their budgets. In 2004, 62 municipalities adopted their budgets by referendum, while in 1999, only 48 did. In 1994, the number was 50. In addition, the number of votes taken to approve a budget has increased. In 2004, for all methods of final budget adoption (e.g., town meeting, referendum, council, representative town meeting, and other), 22 percent of municipalities took more than one vote to approve a budget, while in 2000 only 10 percent took more than one vote.

Economic Competitiveness

Typically, economic competitiveness refers to the effect of taxes on the business climate and usually has more connection with state taxes and interstate competition. However, the state has a number of major and minor property tax exemptions that are intended to provide tax relief to businesses and improve overall state competitiveness. The exemptions include:

• business inventories of manufacturers and wholesalers/retailers;

• manufacturing machinery and equipment;

• commercial trucks, truck tractors, tractors, and semi-trailers; and

• cable television service companies.

Connecticut has also attempted to level the playing field to some degree between manufacturers, who tend to use expensive machinery in the production process, and service and knowledge-based firms, with the five-year exemption of manufacturing equipment.

Neutral

Ideally, tax policy should minimize its impact on the economy and should not attempt to influence taxpayer behavior. As the nature of business changes to a more knowledge-based economy, there is the potential for property-intensive businesses, such as manufacturing to carry a larger tax burden because many modern businesses no longer need extensive real property holdings. Connecticut’s system introduces a level of neutrality by not taxing the intangible property of service firms, such as patents and copyrights, and by allowing exemptions for manufacturing machinery and equipment, as discussed above.

Connecticut also generally avoids the use of multiple classification systems that are employed in many states. Classification systems establish different taxable values of properties depending on the type of property, which typically means commercial property is taxed at a higher effective rate than residential property, unfairly shifting the burden from one segment of taxpayers to another.

Profile of the Corporate Income Tax

Background

In 1909, Congress passed a federal corporate income tax. By 1930, approximately 20 states (including Connecticut) had imposed a similar tax, and by 1940, about 35 states had levied a tax on the income of corporations. Connecticut is one of 45 states that currently impose a state corporate income tax.

Who pays the tax. Any corporation (or association taxable as a corporation) that carries on a business or has the right to do so within Connecticut, must file a Connecticut corporation tax return. There are certain types of corporations and businesses that are exempt from filing and others that must file a return but are exempt from paying the tax. Table II-34 below summarizes these categories.

Table II-34. Corporation Tax: Businesses Subject to Tax and Businesses Exempt

Subject to Tax

Exempt*/No filing required

Exempt but Must File

These companies must file a corporation tax return

• Companies conducting business in Connecticut, and not organized as a business entity that is specifically exempt

• Conducting business typically includes:

o owning or leasing property, or maintaining an office

o having employees (or independent contractors) perform business or business-related activities in CT

• Any corporation dissolved or withdrawn from CT is subject to the tax until date of dissolution

These companies are exempt from filing a return and paying the tax:

• Insurance companies

• Companies (e.g., non-profits) exempt under the federal corporation tax law

• Certain types of investment companies (e.g., those owned by savings banks or non-U.S. corporations whose sole activity is trading in stocks, etc. for their own account)

• Cooperative housing corporations defined in federal law

• Railroad companies

• Subchapter S corporations and pass-through entities like limited liability corporations (LLCs) and limited liability partnerships (LLPs)

• Domestic international sales corporations (DISCs) that make that election under federal tax laws

* Many of these are exempt from the corporation business tax but are subject to another type of business tax. See below.

These companies must file a return in order to claim the exemption from paying the tax:

• Homeowners associations (a federal income tax designation)

• Certain political organ-izations and associations exempt from federal income taxes

• Financial service com-panies whose corporate headquarters are located in the export zone in the City of Hartford and who conduct all their business outside the U.S.

• Passive investment com-panies, as defined in statute, typically related to qualifying real estate mortgage loans

• Independently owned companies engaged in research and design of alternative energy systems or electric-powered motor vehicles

How the Tax is Calculated

Nexus. Before the corporation tax is calculated, it must be determined whether or not the business is actually subject to the tax. The state must establish that the company has sufficient business presence -- either that it is registered in Connecticut as a corporation, or if organized out-of-state, that the company has business contact within Connecticut (i.e., nexus)to be required to pay the tax. While nexus is continually being redefined by case law, it typically includes companies with the characteristics listed in Table II-34.

Starting base for tax. Typically, states use one of two methods as a starting point to determine corporate tax liability: 1) a corporation’s federal taxable income before net operating loss and special deductions; or 2) a corporation’s net federal taxable income. Connecticut uses the first.

Federal returns. Connecticut is one of 27 states that require a corporation to file its federal income tax return with its state corporate income tax return. A corporation must use the same accounting methods and accounting periods for Connecticut as it does for its federal income tax. In Connecticut, corporations that file federal returns must generally file their state tax returns by April 1st.

Payments. Any corporation whose estimated current year tax liability is $1,000 or more must make four estimated payments on the 15th of March, June, September, and December. These prospective payments are required to be a certain percentage of the company’s prior or current year’s tax liability. Once the company files its return, the estimated payments are reconciled with the amounts owed on the return, and the company either receives a refund or must make an additional payment to reach the total tax owed.

Tax Calculation Method

Many steps are taken in calculating corporate income in order to finally arrive at the amount of tax owed in Connecticut. (See Figure II-25).

Business vs. non-business income. First, business income must be separated from non-business income. The nature of a business’ income is important in the determination of nexus and in the apportionment factor discussed below. In Connecticut, all income is considered business income by statute.27 Some states use the Uniform Division of Income for Tax Purposes Act (UDITPA) approach that allows a company to allocate or apportion all business income among the states where the company does business (i.e., has nexus) and allocate all non-business income to a single state (e.g., where it is domiciled). Still others states use the Multistate Tax Commission definition that presumes all income to be of a business nature, with the onus on

Table II-35. State Comparison of Carryforward Periods for Companies’ Net Operating Losses

Carry forward period

Number of states (N= 44)

5 years

8

7 years

2 (NJ suspended this for 2002 and 2003)

10 years

3

12 years

1

15 years

8

20 years

19 (includes CT)

Source: 2004 Multi-state Corporate Tax Guide, Aspen Publishers

the taxpayer to show that it is not. To some extent, these efforts provide uniformity among the states with respect to the taxation of multi-state corporations.

Net operating losses. Because of the cyclical nature of many businesses, the IRS code generally allows net operating losses (NOL) on federal returns to be carried back two years and carried forward for up to 20 years. States may adopt the federal treatment of net operating loss, but states also have the option of adopting their own variations. For example, 24 states, including Connecticut, do not allow carry back periods. All states allow carry forward periods although three states limit the definition of an NOL, and New Jersey suspended the carryforward allowance for two years. Obviously, longer carryforward periods mean longer periods to write off losses, and thus lessen tax liability. Table II-35 shows the number of states using various carry forward periods.

Apportionment. Once the net income for the corporation is established – from the federal tax form -- it is necessary to calculate what portion of the income can be attributed to the taxing state (and therefore taxed). Most states use an apportionment formula based on three factors -- 1) payroll; 2) property; and 3) sales. Some states equally apportion among the three factors, but 24 states double-weight the sales factor, and another few states use only the sales factor. This use of sales as the only factor, or giving it extra weight, benefits those corporations that have a significant physical presence in the taxing state, by lessening the weight of payroll and property in the formula.

Apportionment Formula. Connecticut uses the three factors -- with sales double-weighted – for most businesses, but uses sales as the only factor for three major business categories:

• manufacturers;

• broadcasters; and

• financial service companies.

The sales factor requires a company to compare its sales in the taxing state with its sales in the nation as a whole, but a corporation can attribute sales to states where it has no taxable nexus or where there is no corporation tax. These sales, called “nowhere” sales, are not taxable in a state that requires a corporation to subtract its nowhere sales from its total (throwout) or add those sales back into the total in the taxing state (throwback). In either case, the relative weight of the in-state sales is increased and so is the taxable income apportioned in the taxing state. Connecticut uses neither -- see Table II-36 for a state comparison of throwback use.

Filing. Some states require combined (unitary) reporting, where all income from an affiliated group of businesses is combined together and then apportioned to all states where the companies do business. Connecticut does not require combined reporting, but does allow it. If a corporation chooses to file a combined return, the corporation is assessed $25,000 as a return preference surcharge. (See Table II-36 for a state comparison of filing requirements.)

Rate. Connecticut is one of 32 states that have a flat corporate income tax rate. It currently is 7.5 percent of net taxable income. (See Table II-36 for state comparisons.)

Alternative calculations. Connecticut requires that corporations calculate their taxes two ways – on net income and on capital -- and pay the higher of the two amounts. However, if both amounts are less than $250, the corporation must pay the alternative minimum of $250. (See Figure II-25 on page 90 for calculation description.)

Major Changes in Corporate Income Tax Since 1992

• Rates reduced from 11.25% in 1995 to 7.5% in 2000 (remains at that rate in 2005)

• Surcharges assessed in the early 1990s: reduced from 25% to 10% as of 1/1/92; eliminated 1/1/93; 20% surcharge resumed in 2003; 25% in 2004; none in 2005, but 25% will resume in 2006 and 2007 (surcharges are calculated before reductions for credits.)

• Single factor apportionment: allowed for financial service companies (1998) and for manufacturers and broadcasters (2001)

• Carryforward period: for net operating losses extended from 5 years to 20 years (1999)

• S-chapter corporations exempt from the corporations tax (2001). Now considered a business entity – all S corporations and other entities like LLCs and LLPs that file an annual report with the Secretary of the State must pay a $250 business entity tax (2002). Rate increased to $300 in 2003; reduced to $250 for 2004 and thereafter.

Trends in Filers and Revenues

While data on corporate income tax revenues are available through FY 05, numbers on corporate filers by type are available only through 2001 (from DRS’ last annual report for 2002-03). The trends in corporate revenues and filers are reflected in the figures below.

Filers. Figure II-26 shows the filers by type. DRS categorizes filers according to the method they use to calculate the taxes they owe: 1) net income; 2) capital base; 3) alternative minimum; or 4) combined filers. As the figure shows, by far the largest category (typically about two-thirds of filers) includes corporations paying the alternative minimum tax of $250, while the smallest number of filers is in the combined return category; that number remained relatively stable at between 1,000 and 1,200.28

Revenues. As Figure II-27 illustrates, corporate income tax revenues in Connecticut have been declining. In actual dollars, the amounts collected have declined from more than $700 million in the mid-1990s to a low of less than $400 million in FY 02, before recovering somewhat to almost $600 million in FY 05. The decline in corporate income tax revenues is more extreme if it is adjusted for inflation (measured in 2004 dollars). If measured in this way, the corporate revenues would have been worth almost $1 billion at their high point in FY 93. Many reasons are cited for the decline in revenues collected including the reduction in rates and changes in the apportionment formula. The application of the corporate income tax to subchapter S corporations was phased out over a four-year period. The Office of Fiscal Analysis has estimated that this phase-out has cost between $4 million and $7.5 million from 2000 to 2002. Another major reason is the expansion in the number and use of business tax credits discussed below.

Other Business Taxes

There are 12 other specific taxes, grouped in five categories described below, which are assessed against various types of businesses or business activities. In FY 04, collections for these individual taxes ranged from about $275,000 for the tax on railroads to $140 million for the tax on foreign insurance companies (i.e., companies chartered in another state). The 12 taxes combined amounted to about $595 million in FY 04, about the same as the revenues collected from the corporate income tax. Except for the business entity tax and the tax on insurance premiums, each tax affects less than 700 companies. Figure II-28 shows the trends in collections for these taxes since 2001.

• Unrelated Business Taxable Income Tax – Any nonprofit corporation is liable for any business income that does not substantially relate to its tax-exempt purpose. Similar to the corporate tax, a rate of 7.5 percent is levied on the net income from the unrelated business activities. In FY 03, only 241 organizations paid this tax, and the revenue totaled $903,944.

• Business Entity Tax – Corporations defined as limited liability companies, limited liability partnerships, limited partnerships, or S corporations are required to pay $250 annually. (In calendar year 2003, the tax rose to $300, and returned to $250 in 2004.) In FY 03, 96,280 entities paid a total of $24,071,137.

• Public Service Companies Tax – This variable tax is imposed on the gross earnings of railroads (2-3.5 percent); gas and electric utility companies (4-8 percent); and express (2 percent), telegraph or cable (4.5 percent), and community antenna television system companies (5 percent). In FY 03, 117 companies paid a total of $197,959,721.

• Insurance Premiums Tax – Both authorized and unauthorized insurers as well as health care centers are required to pay a special tax referred to as the insurance premiums tax. Domestic and foreign insurance companies pay 1.75 percent of net direct premiums, while unauthorized insurers (i.e., an insurer operating without a valid certificate of authority) are taxed at 4 percent of gross premiums. Health care centers pay 1.75 percent of net direct subscriber charges. In FY 03, 1,400 companies paid a total of $229,484,101.

• Petroleum Gross Earnings Tax – The gross earnings of companies distributing petroleum products (e.g., gasoline, aviation and diesel fuel, crude oil, benzol, and petroleum derivatives such as paint detergents, fertilizers, and plastics) are taxed at 5.8 percent. After July 1, 2006, the tax will increase in increments to 8.1 percent on July 1, 2013. In FY 03, 660 companies paid a total of $125,451,235.

Corporation Tax Credits and Use

Connecticut, like most other states, has introduced and expanded the use of tax credits as a way of reducing a corporation’s tax liability. The intended purpose of such credits is to promote economic development, foster certain types of business growth, and promote jobs.

Credits. Currently, Connecticut has 26 different business credits. The three most-used -- the research and development credit, the fixed capital investment credit, and the credit for property tax paid on electronic data processing equipment—account for more than three-quarters of the value of all credits. There is no limit on the number that can be used but deductions from credits cannot reduce the company’s tax by more than 70 percent of the tax without credits. Further, companies cannot reduce tax liability pay below the $250 minimum. The credits must be taken in a certain order, and the DRS commissioner may disallow use of credits if the company owes any back taxes, interest, or penalties.

Credit use. Figure II-29 shows the use of all credits by all Connecticut corporations since 1990. As the figure depicts, both the number of credits used and the total value have grown dramatically. The number of credits used dropped substantially in 2001 although the value of the credits did not. This decline was because S-corporations, which had been allowed to take the credits prior to 2001, no longer had to pay the corporation tax and so were ineligible for the credits. Additional discussion of credit use is contained in Chapter V under the Neutral principle.

Corporate Tax: State Comparison of Selected Features

Table II-36. Selected Features of Corporate Tax Structures: A State Comparison

State

Rate(s)

Amt Collected as % of GSP (2003)

% Reduced*

FY 89 - FY 03

Reporting Requirements**

Throwback of Sales

% Change in GSP 1999-03

Alabama

6.5

.18

-44

C NR

Yes

15.4

Alaska

1 - 9.4

.65

-69

C R

Yes

26.1

Arizona

6.98

.22

-27

C R

No

21.4

Arkansas

1 - 6.5

.24

-23

C NR

Yes

14.2

California

8.84

.47

-34

C R

Yes

20.2

Colorado

4.63

.11

-56

C R

Yes (certain factors)

19.1

Connecticut

7.5

.20

-77

C NR

No

15.5

Delaware

8.7

.47

-45

C NA

No

21.8

DC

9.975

.34

-19

C NR

Yes

24.3

Florida

5.5

.25

-17

C NR

No

22.4

Georgia

6

.15

-62

C NR

No

15

Hawaii

4.4 - 6.4

.06

-80

C R

Yes

20.2

Idaho

7.6

.23

-49

C R

Yes

21.1

Illinois

8.5

.34

-18

C R

Yes

11.8

Indiana

8.5

.17

-38

C NR

Yes

13.9

Iowa

6 –12

.14

-64

C NR

No

17

Kansas

4

.14

-68

C R

Yes

16.6

Kentucky

4 – 8.25

.22

-56

C NR

No

11.5

Louisiana

4 - 8

.13

-67

C NR

No

13.3

Maine

3.5 – 8.93

.22

-48

C R

Yes

20.8

Maryland

7

.18

-43

--

No

22.3

Massachusetts

9.5

.40

-48

C NR

Yes

16.5

Michigan

BAT/VAT

   

C NR

No

10.8

Minnesota

9.8

.29

-44

C R

No

20.2

Mississippi

3 – 5

.40

-21

C NR

Yes

12.8

Missouri

6.25

.11

-56

C NR

Yes

14.7

Montana

6.75

.18

-61

C R

Yes

22.1

Nebraska

5.58 – 7.81

.18

-33

C R

No

20.6

Nevada

None

     

N/A

24.8

New Hampshire

8.5

.34

-44

C R

Yes

20.6

New Jersey

9.0

.60

-6

C NR

Yes Throwout

20

New Mexico

4.8 –7.6

.17

-44

C NR

Yes

14

New York

7.5

.25

-42

C NR

No

13.8

North Carolina

6.9

.29

-51

C NR

No

20.8

North Dakota

2.6 – 7.0

.26

-37

C R

Yes

23.2

Ohio

5.1 – 8.5

.20

-54

C NR

No

11.3

Oklahoma

6.0

.11

-50

C NR

Yes

17.8

Oregon

6.6

.18

-42

C R

Yes

13.9

Pennsylvania

9.99

.27

-47

C NA

No

17.3

Rhode Island

9

.16

-57

C NR

No

24.5

South Carolina

5.0

.14

-61

C NR

No

15.4

South Dakota

$500 bank

.17

-26

 

N/A

20.7

Tennessee

5

.31

-25

C NR

No

16.2

Texas

F/T 2.5m

.21

-18

C NA

Yes

20.3

Utah

5

.20

-40

C R

Yes

17.7

Vermont

7.0 – 9.75

.20

-54

C R (2006)

Yes

20.7

Virginia

6

.12

-47

C NR

No

24.6

Washington

Franchise

     

N/A

13.8

West Virginia

9

.41

-47

C NR

Yes. Throwout

11.8

Wisconsin

7.9

.28

-43

C NA

Yes

16.2

Wyoming

None

     

N/A

32.3

GSP = Gross State Product. * % of reduction of the ratio of corporate tax/gsp

**CNR = Combined Not Required (but may be allowed) CR= Combined Required, C NA= Combined Not Allowed

Sources of Data: Federation of Tax Administrators, Multistate Tax Commission; Aspen Publishing 2004 Multistate Tax Guide; BEA; February 2005 Report on Corporate Taxes by Citizens for Tax Justice and Institute on Taxation and Economic Policy, and Taxing Smarter and Fairer, A Report by Prof. Richard Pomp conducted for Common Cause, March 2005

Assessment: NCSL Principles

Simplicity. The corporate income tax is not a simple tax. All filers must first calculate the tax two ways and then pay the higher of the two or a minimum tax of $250. While the rate is a flat rate of 7.5 percent, it is subject to many exemptions, variations on the apportionment formula depending on the business area, and the use of credits after the tax liability is calculated.

Administration. According to the literature and interviews with Department of Revenue Services staff, the corporate income tax is a difficult one to administer. The tax has many steps in arriving at a corporation’s tax liability, with each step subject to both legal and accounting interpretation on what are legitimate reductions, exemptions, losses, expenses, and credit use.

Also, according to the department, auditing a corporate income tax filing can be extremely complex and time consuming, especially if it involves a combined return (of affiliated companies). Further, DRS staff express frustration at what has become commonplace in the corporate tax area – tax planning to minimize or avoid the tax. One broad indication of the extent of the avoidance, and what it could mean in lost revenue to Connecticut, is computed from the results of the corporate audit statistics over the past three fiscal years. As Table II-37 shows, while the number of corporate audits is a small percentage (2.6 percent) of the overall number of audits conducted by DRS, the yield in corporate assessments (what is determined to be owed after an audit) is a much higher percentage of all audits.

Table II-37. Corporate Audits: Three-year Average FY 03 – FY 05

Corporate

Total Corporate

% of All Audits

Number of Audits Conducted

1,972

2.6%

$ Assessed after Audit

$123,030,372

34%

Source of Data: Department of Revenue Services, Audit Division

However, almost 10 percent of the corporate audit cases have been appealed, as opposed to about 4.6 percent of the sales and use tax audits and 2.2 percent of the personal income tax audits, a further indication of the difficulty in administering the corporate income tax.

Balanced. This is a difficult concept to evaluate. Some economists and policymakers believe that corporate income should not be taxed, that only individuals should pay taxes. Figure II-30 shows what the corporation tax contributes as a percent of all state general fund revenues. That ratio has been declining dramatically – from almost 10 percent in FY 93 to about four percent in FY 04. Thus, while corporate income tax has never been a major source of Connecticut’s revenue, it has become a very minor source. If the reliance on corporate taxes as a percent of state and local revenues raised were measured, the percent would be even lower.

Adequacy. Figure II-31 shows the corporate income tax as measured as a share of the state’s economy (gross state product). As this figure shows, the ratio of corporate taxes as a percentage of GSP, has also declined dramatically, indicating that the tax has not kept pace with the state’s economy. While one might argue that the ratio of corporate tax to GSP in the early 1990s was too high, by 2003, 25 states ranked ahead of Connecticut.

Volatility. The corporate income tax is the most volatile of all the taxes used in Connecticut. Figure II-32 shows annual percent changes in the corporate income tax (with adjustments made for legislative changes) so that the tax is measured against changes in the economy only. As the figure shows, the corporate income tax is prone to dramatic swings while the state’s economy is much more stable.

Program review staff also measured the volatility of the corporate income tax using the average annual changes (with the legislative adjustments removed) for the period between FY 93 and FY 04 and compared that to the standard deviation for the same period. Table II-38 shows that while the average growth was only 3 percent, the standard deviation was 10.3 indicating the tax is fairly unpredictable and quite volatile.

Table II-38. Volatility in Corporate Income Tax – FYs 93-04

Average Annual Growth

3.0%

Standard Deviation

10.3

Fairness and Equity. As indicated in the profile earlier, about two-thirds of corporate filers pay only the minimum tax of $250, and through the use of tax credits corporations in the aggregate are able to reduce their tax liability by one-third. It is difficult to measure how fair the burden of paying the corporate income tax is distributed even among businesses, because no information relates back to income earned, even by filer group, so no assessment can be made about any corporation’s “ability to pay.”

The committee examined the distribution of the tax credits taken by individual filers as a proportion of the total credit value for each filing group, as well as the average value and percent of tax liability reduced by credits by type of filer. The results of the analysis are shown below.

Figure II-33 compares the percent value of corporate credits, percent of companies taking any credits by method of filing, and percent of total corporate income tax paid. It shows that a very small number of filers claim the overwhelming majority of credits. Thirteen percent of all companies filing a corporate income tax received 77 percent of the total value of all credits taken. Net income filers pay the most in corporate income taxes.

Table II-39 shows the average tax reduction after the application of credits by the method under which the company filed its corporate income tax. The combined filers achieved the greatest average reduction of 50 percent, followed by those that filed under the capital base method – 45 percent.

Table II-39. Average Tax Reduction by Method of Filing, 2001

Method of Filing

Number of Companies

Average Tax Before Credits

Average Tax After Credits

Percent Reduction

Net Income

9,917

$14,208

$12,511

12%

Capital Base

5,325

$6,335

$3,493

45%

Minimum

32,134

$225

$209

7%

Combined

7,255

$29,428

$14,801

50%

Source: DRS and LPRIC calculations

Economic competitiveness. Although there is considerable controversy over how important a factor overall tax burden is in business location decisions, state and local governments have become increasingly concerned about their tax competitiveness. Competitive tax policies are those that do not place business enterprises at a disadvantage relative to other states and increase a jurisdiction’s ability to attract and retain businesses.

While rates matter less than many of the other aspects of the corporate tax structure, as discussed previously in this chapter, Connecticut’s corporate tax rate is competitive with other neighboring states. Connecticut’s 7.5 percent rate is exactly the same as New York’s, below the 9 percent in New Jersey and Rhode Island, and below Massachusetts’ 9.5 percent rate. Further, as Table II-40 shows, a number of the other aspects of the corporate tax in Connecticut – extended carryforward periods, the apportionment formula, with no throwout or throwback rules -- all seem to create a favorable tax structure for business.

A study released in 2004, authored by an economist at the Federal Reserve Bank of Boston, examined business tax competitiveness among the states using 2000 data for a number of different measures including: business taxes as a percent of: total state and local taxes; personal income; and business profits.29 Table II-40 compares Connecticut to seven neighboring states in the Northeast, other comparison states, and the U.S. average using the data from that study.

Table II-40. Business Tax Comparison Measures, FY 2000

Business Share of State and Local Taxes

 

Business Taxes as a Percent of

Personal Income

 

Business Taxes as a Percent of Business Profits

State

%

Rank

 

%

Rank

 

%

Rank

CT

39.1

40

 

4.5

28

 

32.5

40

ME

44.1

21

 

5.9

10

 

40.5

13

MA

36.1

48

 

3.7

47

 

27.5

49

NH

58.3

6

 

4.7

20

 

35.9

25

NJ

40.6

34

 

4.4

30

 

36.6

23

NY

44.4

20

 

6.0

8

 

38.8

15

RI

43.8

22

 

5.1

16

 

43.2

10

VT

45.9

17

 

5.3

14

 

42.5

11

US

43.6

   

4.7

   

35.8

 

CA

39.9

38

 

4.5

25

 

33.7

33

CO

42.6

27

 

4.0

23

 

28.0

47

MI

38.8

41

 

4.3

36

 

34.4

31

                 

Source: Robert Tannenwald, Massachusetts Business Taxes: Unfair? Inadequate? Uncompetitive?, Public Policy Discussion Paper, Federal Reserve Bank of Boston, (August 20, 2004) Tables 1, 2, and 3.

• When state and local taxes on businesses are considered as a percent of total state and local taxes, Connecticut ranks second lowest in the Northeast and among the lowest in the nation (40th among the 50 states).30 This indicator, however, may suffer from the fact that Connecticut industries are relatively high-wage and labor-intensive (e.g., financial services, health care, education, etc). Therefore, the household tax base is large relative to the base of taxes paid by businesses.

• A second measure compares states in terms of the ratio of business taxes to personal income.31 A state’s personal income is thought to be an indicator of its business profits.32 Connecticut ranks 28th in the nation, about average, but third lowest in the Northeast.

• The third measure relates state and local taxes on corporations to business profits. This is arguably a better measure because presumably businesses care about how taxes affect their bottom line. However, there are not any easily obtainable state level measures of corporate profit, so that statistic had to be estimated.33 The resulting figures for business taxes as a percent of profits in FY 00 ranks Connecticut among the lowest states in the nation (40th out of 50 states) and the second lowest in the Northeast.

It can be noted that the state’s rank differs between the second (28th) and third measures (40th). Two factors seem to explain this discrepancy. One is that incomes from sole proprietorships and partnerships were high relative to personal income and second, the state has a high concentration of payroll and receipts in the highly profitable financial services industries.

Table II-41. Comparison of Corporate Tax Credits

State

Number of Corporate Tax Credits

Total Value of Credits Used1

(millions)

Largest total credit

Total of largest credit (millions)

Total Paid in Corporate Tax

(millions)

Ratio of Credit Value to Corporate Tax Paid

Connecticut

21

$175

Fixed Capital

$60

$380

46 %

Massachusetts

10

$156

Research Credit

$76

$1,301

12%

New York

21

$365

Enterprise Zones2

$196

$2,045

17.8%

1 Credits used equal the amount of credit the taxpayer actually used to reduce tax liability

2 Two programs that target enterprise zones have been combined

Sources: Connecticut estimated amounts for 2005 from Connecticut Tax Expenditure Report 2004, pg 8; Massachusetts estimated amounts for FY 2006 from Tax Expenditure Budget Fiscal Year 2006, Executive Office for Administration and Finance, Commonwealth of Massachusetts; New York estimated amounts for FY 2005 from Annual Report on New York Tax Expenditures, NY State Department of Taxation and Finance, pp. 33-34.

Another tool states offer to make their tax structures competitive are business tax credits. The tax credits and how they are used to reduce tax liability was explained in the profile earlier. Program review was able to obtain data on the use of business tax credits in two neighboring states and the information is presented in Table II-41. The dollar value of tax credits in Connecticut is greater than Massachusetts, and when the value of the credits is measured against the total corporate income tax paid in 2004, Connecticut’s value of credits is far higher than that of New York or Massachusetts.

Accountability. It is difficult to demonstrate whether or not the measures taken by the legislature to reduce the corporate income tax have produced the desired results. The tax has been reduced in terms of the actual amounts collected, and the state’s reliance on the tax as a percent of state General Fund revenues, and a percent of the economy (gross state product), has also been cut. The state has also reduced the volatility in the corporate income tax, but it is difficult to say whether the burden of the tax is fairly distributed among businesses, because there is no information that connects tax liability to incomes among business.

The legislature is increasing its oversight of the business tax credits and overall business tax policy through the revamping and restructuring of a dormant committee and expanding its charge. The new committee, the Business Tax Credits and Tax Policy Review Committee, will be evaluating business tax credits, changes in the corporation tax, and modifications to business tax policy to determine if there are measurable improvements that result, such as new business investment, job growth and/or retention, or other enhancements to the state’s economy.

Profile of the Estate and Gift Tax

Background

Estate taxes, along with inheritance and gift taxes, are referred to as transfer taxes since they are levies on the transfer of wealth. In addition to raising revenues, these taxes prevent permanent accumulation and concentration of extreme wealth. Estate and inheritance taxes sometimes are called death taxes since they are imposed, in different ways, on accumulated wealth when someone dies. Gift taxes apply to transfers of wealth from living donors, which often are made in anticipation of death. In general, they are designed to prevent estate tax avoidance.

Estate taxes are applied on the value of an estate before any assets are distributed to heirs. Inheritance taxes, also known as succession taxes, are the responsibility of each individual receiving a bequest from a deceased person. In both cases, tax rates are graduated. Estate tax rates are based on the value of the estate, while inheritance tax liability depends on the amount of the bequest and the relationship of the beneficiary to the decedent. Typically, inheritance tax rates are lower for immediate family members and highest for unrelated beneficiaries.34 Gift taxes, like estate taxes, are also graduated based on value; payment is the responsibility of the donor.

Link to federal taxes. While no inheritance taxes are imposed at the national level, there are federal estate and gift taxes. Until recently, most states that had their own estate and gift taxes linked them to the federal taxes, using the same definitions and similar calculations, for example. In addition, as the federal tax allowed taxpayers a credit against the amount of state estate taxes they paid, most states including Connecticut based their own estate tax on the federal credit provision.

In effect, the state estate taxes that were coupled with the federal credit “picked up” revenue that would otherwise have gone to the federal government. However, changes enacted under 2001 federal legislation (the Economic Growth and Tax Relief Recovery Act) phased out the state credit over four years, eliminating it entirely as of January 1, 2005. Unless states with “pick up” estate taxes decoupled from the federal credit, their estate taxes effectively ended on this date as well.

Most states allowed their estate taxes to terminate with the federal credit repeal but 17 states including Connecticut’s neighbors--New York, Massachusetts, and Rhode Island-- decoupled from the federal tax by redefining their state taxes (e.g., making their redefined tax equal to the federal credit amount in effect prior to the 2001 change.) Connecticut took action to decouple from the federal estate tax temporarily but scheduled it to end on January 1, 2005. As discussed below, recently enacted legislation (P.A. 05-251) established an entirely new estate tax in Connecticut with a retroactive effective date of January 1, 2005.

Current status. While transfer taxes have a long history and were common throughout the country until recently, few states currently impose either inheritance or gift taxes. In response to the federal changes noted above, 19 states and the District of Columbia had decoupled or taken other actions to impose their own estate tax as of December 2004. As of the same date Connecticut was also one of only 14 states with a succession (inheritance) tax and one of only 4 states that imposed a gift tax. Until the 2005 legislative session, Connecticut was in the process of phasing out both its succession and gift taxes, in 2008 and 2010, respectively; its estate tax had already expired on December 31, 2004.

During the 2005 legislative session, the General Assembly established a new unified estate and gift tax in Connecticut and repealed the state’s former gift tax as well as the succession tax, all effective as of January 1, 2005. The Department of Revenue Services issued forms and instructions for the new tax in late September 2005 and is continuing to develop policies and guidelines as the new tax is fully implemented and the old transfer taxes are phased out. The main provisions of Connecticut’s unified estate and gift tax, and some general features of transfer taxes, are described briefly below.

Description

The current Connecticut unified estate and gift tax applies to transfers of taxable gifts and estates that exceed a combined lifetime total value of $2 million and are made on or after January 1, 2005. For Connecticut residents, taxable gifts include real property, or tangible personal property located in the state, and intangible property wherever it is located. For nonresidents, taxable gifts only include real property or tangible personal property located in Connecticut.

Tax rates for the unified estate and gift tax, shown in Table II-42, are the same as those in effect under the state’s former “pick up” estate tax, which were equivalent to federal tax credit rates in 2001. Estates, aggregate gifts made over a lifetime, or the combination of an estate and lifetime aggregate gifts that have a value of less than $2 million are exempt from the tax. Graduated rates are applied to taxable estates and gifts with higher values and range from a low of just over 5 percent to a maximum of 16 percent for estates and gifts worth over $10,100,000.

Revenues Produced

Only estimates of the potential revenues produced by the new unified estate and gift tax are available at this time. According to the Office of Fiscal Analysis, the new tax is expected to produce $108.2 million in revenues for FY 06, $149.7 million in FY 07, and $151.7 million in FY 08. These numbers represent only the collections from the new tax; they do not include any adjustments for revenues lost or gained from the former estate and gift taxes.

Table II-42. Connecticut Unified Estate and Gift Tax Rate Table: Department of Revenue Services

Historically and at present, transfer taxes represent a very small portion of total revenue collections in all jurisdictions. Nationally, estate, inheritance, and gift tax revenues account for around 1 percent of state tax collections. In Connecticut, the state’s former transfer taxes produced about 2 percent of all state tax revenues and just over 1 percent of total state and local revenues in FY 03.

Transfer tax revenues fluctuate dramatically from year to year because they depend on how many wealthy individuals die and leave large estates or, as part of their estate planning, decide to make taxable gifts. Figure II-34, which shows actual tax collections under Connecticut’s previous estate tax over a recent five-year period, illustrates this pattern.

Since the unified estate and gift tax was just enacted, comparisons of Connecticut’s revenue collections with those of transfer taxes in other states is not possible at this time. Information compiled by the Tax Foundation on state estate and gift tax collections in 2004 is summarized in Table II-43. The table shows on a per capita basis, Connecticut’s previous estate and gift taxes together were 4th highest in the country and, like all the Northeastern states, were higher than the national average. Whether the state will rank similarly after the new tax is fully in effect remains to be seen.

Table II-43. State Estate and Gift Tax Collections 2004:

Connecticut and Selected Other States

 

Collections

Per Capita

Rank Among 50 States and D.C.

Link to

Federal Tax

Connecticut

$37.23

4

Decoupled

U.S. Total

$19.57

-

-

Maine

$24.36

8

Decoupled

Massachusetts

$30.34

6

Decoupled

New Hampshire

$23.49

10

Linked

New Jersey

$59.32

1

Decoupled

New York

$38.28

3

Decoupled

Rhode Island

$23.42

11

Decoupled

Vermont

$23.69

9

Decoupled

Source of Data: Tax Foundation, Dec. 2004

Assessment: NCSL Principles

There is considerable debate about the equity of transfer taxes. Since they generally apply only to the wealthiest group of taxpayers, many consider estate, inheritance, and gift taxes to be the most progressive of all tax types. Others point out estate taxes have horizontal equity problems in that different approaches to estate planning can produce vastly different tax liabilities for individuals with very similar estates. Many opponents of estate and gift taxes believe they are unfair if they impede the ability of taxpayers to pass on farms or small businesses to family members.

Transfer tax revenues, as noted earlier, can be extremely volatile and among the most difficult of all taxes to forecast. Their stability is not a serious concern, however, as these taxes tend to be relatively small contributors to total state and local revenues.

Compliance and administration, however, can be big issues for transfer taxes if they prompt taxpayers to undertake complicated and expensive estate planning activities. Some transfer tax critics also claim that state estate taxes provide an incentive for wealthy individuals to reside where the tax is not imposed or where rates are lowest.

The impact of estate taxes on investment decisions as well as where taxpayers reside is another matter of academic as well as political debate. There is general agreement that transfer taxes are not economically neutral. However, some recent research indicates migration to avoid estate taxes may not be a significant problem. (See discussion on pages 208 and 209 in Chapter V.)

THIS PAGE INTENTIONALLY BLANK

Chapter III

Administration of Connecticut Taxes

Any tax policies a state adopts need sound administration to ensure:

• fair implementation;

• prompt and clear communication to the public;

• efficient revenue collection;

• administrative opportunities for taxpayers to appeal a tax bill; and

• enforcement against those who attempt to avoid paying taxes owed.

In Connecticut, administrative functions for all state taxes are carried out by the Department of Revenue Services. While this study was not intended to be an in-depth performance audit of DRS, the study scope called for an assessment of administrative simplicity, efficiency, and compliance within the state tax system. This chapter provides information and analysis about Connecticut tax administration, much of which is the basis for the discussion of the ninth principle about fairness and efficiency in Chapter V. Specifically, this chapter explains the organization and structure of the Department of Revenue Services, outlining major functions and profiling primary resources over time. The chapter also provides a description of activities performed by certain DRS divisions: Operations; Taxpayer Services; Audit; Collection and Enforcement; and Appellate. The current status of the agency’s automated tax information system, ITAS, is also discussed.

An analysis of department workload and outcome measures, where available, along with an assessment of agency performance in terms of efficient administration and promoting compliance are provided in this chapter. It was neither the intent of the committee, nor feasible within the scope and resources of this project, to conduct a comprehensive performance audit or “typical” program review of DRS. Further, drawing any conclusions about how well DRS administers state taxes is problematic for a number of reasons, which are discussed in greater detail later in this chapter. In general, administrative efficiency and effectiveness measures, when they are discussed, are broad indicators, not precise gauges, of agency performance.

Department of Revenue Services: Organization and Structure

The Department of Revenue Services is the state agency responsible for tax administration, collection, and enforcement in Connecticut. The department processes all tax returns for major state taxes (personal income, corporation and other business taxes, general and selected sales taxes, and the estate tax) and ensures the accuracy of amounts paid. DRS also ensures compliance with state tax laws and regulations. To carry out this mission, the agency currently is organized into four major program areas and eight divisions, which are described briefly below.

Major Programs and Functions

The organizational structure of the Department of Revenue Services is shown in Figure III-1. The department is organized along management reporting lines rather than by the programs and functions described in the state budget document. The description of the department summarized below is presented by major program and function.

Management Services

Executive Office includes the commissioner and deputy commissioner. The office establishes the policy and direction for the department; oversees legislative activities and programs; handles all public and government relations; performs planning and organizational development and taxpayer advocate functions; and implements the agency’s affirmative action plan.

Legal Division is responsible for drafting regulations and legislation, issuing rulings and legal opinions, and reviewing issues regarding tax policy. This division also represents the commissioner in all succession tax litigation.

Taxpayer Services focus is to promote voluntary taxpayer compliance. To accomplish this, the division maintains five field offices and a call center through which it provides public education and information, responds to taxpayer inquiries, assists with applications and returns, and offers speakers for organizations and businesses. In addition, the division administers the exemption programs for farmers, fishermen, and nonprofit organizations.

Tax Research Unit analyzes, prepares, and disseminates statistics generated by DRS as well as prepares the annual report and statistical overview of the income tax. The unit researches and estimates the effects of various taxing options proposed by policy makers, performs legislative liaison work, and responds to requests from other states and agencies.

Appellate Division receives and reviews all taxpayer protests of audit assessments, liability impositions, disallowance of refund claims, and penalty waivers. The division conducts hearings of appeals and issues final administrative adjudications.

Administrative Services is responsible for preparing and administering the agency budget, monitoring expenses, and providing training opportunities for DRS staff. Administrative Services also acts as the personnel and payroll units administering the rules and regulations regarding state employment and recruitment.

Litigation Division represents DRS in litigated appeals and all court-ordered pretrial/settlement conferences held by and before the Tax Session of the Connecticut Superior Court. In addition, the division acts as a liaison for the Office of the Attorney General in preparing and arguing appeals of the Tax Session decisions.

Figure III-1. Department Of Revenue Services

Operations

Operations Division processes and deposits the revenue from taxpayer returns, verifies timely issuance of refunds, creates bills for delinquencies, and develops reports based on tax collection revenues. The division also develops tax forms and publications, enters data, and issues permits, licenses, motor carrier decals, and tax registration numbers.

Information Services Division is responsible for system design and implementation for all agency functions as well as providing technical support and technological training. Staff is in charge of the department’s equipment including acquisition and maintenance.

Audit/Compliance

Audit Division -- determines the accuracy of tax reporting through field and office audits of targeted accounts. The program consists of seven field audit units. The units conduct approximately 3,400 field audits and 60,000 office audits annually. Staff develops both computerized and manual audit selection programs and maintains a centralized automated program to develop pertinent audit and statistical information. In addition, they direct a discovery program, which investigates new areas of tax compliance, assists taxpayers with preparing returns and advises them on maintenance of records, and monitors internal activities for compliance with established policies, procedures, and performance standards. The audit division also develops and administers the electronic data processing audit program and handles all aspects of inheritance taxation.

Collection and Enforcement

The Collection and Enforcement Division encompasses three major functions:

Outreach -- agents mail overdue tax notices, work with taxpayers to establish repayment schedules, initiate telephone contact to resolve overdue accounts, and refer chronic debtors or high-risk cases for enforcement.

Enforcement -- agents obtain tax warrants to garnish wages, schedule permit suspension hearings, file tax liens, and obtain evidence of bankruptcy claims. Agents conduct on-site investigations of complaints regarding tax violations, regularly inspect problematic vendors, and follow-up on leads from audit examinations.

Criminal investigations -- agents of the Special Investigation Section have police powers and may make arrests in cases involving operating without valid permits, bad checks, refusal to file/pay or filing fraudulent returns, and smuggling of contraband fuel, cigarettes, and alcohol.

Agency Resources

Adequate resources are critical to efficient and effective tax system administration. Both the quantity of staff and quality, in terms of training and experience, contribute to how well a tax agency performs its key administrative and compliance functions. Automated information systems that incorporate up-to-date, high quality software and hardware and integrate major functions are also critical for successful tax system administration.

Operating budget. The trend in funding for the Department of Revenue Services over the past eight years is presented in Figure III-2. The figure shows the agency’s operating budget has grown very little over this period. Current funding is still below a peak of about $59 million in FY 03 and only 14 percent more than the budget for FY 98. When adjusted for inflation, DRS expenditures during the just completed fiscal year (almost $56 million) were actually less than FY 98 expenditures (almost $59 million). It is important to note, the operating budget does not include most expenses related to agency computer systems and equipment, which are covered, like nearly all automation costs, in the state’s capital budget.

Staffing. Staffing levels within the Department of Revenue Services since FY 00, in terms of filled positions on July 1 of each year, are shown in Figure III-3. This period includes the two years of staffing reductions through employee layoffs and early retirements put into effect across all agencies to help reduce state budget deficits. The impact of these personnel reductions at DRS was a sharp drop in filled positions, about 21 percent, to a low of 641 in FY 04.

As the figure indicates, a little over half of the lost positions (93) were recovered by FY 05. In addition, funding for 20 new positions was included in the agency’s budget for the current fiscal year (FY 06) (FY 06). Department managers point out, however, that many of the employees who retired early were among the most experienced staff in the agency. Frequently, the individuals replacing them are new to DRS and to state tax administration duties in general.

Automated systems. At present, the Department of Revenue Services is in the midst of implementing an entirely new, agency-wide automated information system called ITAS (Integrated Tax Administration System). ITAS is replacing what has been long recognized as an inadequate collection of antiquated and incompatible computerized operations. These include the agency’s more than 30-year-old mainframe-based primary information system, which requires extensive programming for all data retrieval and reporting, and a totally separate computerized system developed to handle just the personal income tax when it was enacted in 1991.

ITAS has been in development since 1994 and is expected to have a final cost of about $70 million. Progress has been slow, and costs have increased for a number of reasons including: funding issues; personnel changes; restructuring the state information technology function; and implementation of other statewide computer projects (e.g., Y2K conversion and the CORE-CT system). The new system is being introduced in four phases; at this time, all businesses taxes have been converted to ITAS, and the personal income tax will be incorporated during 2006.

The goal is to integrate all taxes and all taxpayers in one automated system, a “best practice” recommended by tax administration experts and professional organizations. Once it is fully in place, ITAS is expected to:

• promote compliance and enforcement (e.g., through automated “cross referencing” internally and externally);

• permit automated case management and taxpayer assistance (e.g., on-line access to all data by case/taxpayer, allowing quicker updating and correction); and

• allow extensive research and analysis (e.g., automated historic data retrieval, statistical reporting across all taxes, tracking of trends and patterns, and preparation of projections and impact evaluation of proposed changes).

Limitations in Assessment

To complete this administrative part of the tax system assessment, the committee relied on what workload and performance measures the Department of Revenue Services provided. In some areas, department management tracks broad indicators such as revenue collected as a ratio of agency operating expenses and staffing over time. In a few selected areas related to customer service, the department measures and tracks its performance against some standards. But, for the most part, the study relied heavily on the activity measures that DRS reports for the governor’s budget, which are only produced for the initial year of each biennium. The department was able to develop and provide additional information in some areas at the committee’s request but follow-up frequently took months, indicating the data are not produced and maintained by DRS on an ongoing basis.

Comparative data from other states are not available in a centralized source, making any comparative analysis extremely difficult. Committee staff reviewed annual reports, performance audits, and sunset studies of selected other state tax departments that often contained detailed information on major tax functions, but wide variation in state tax structures, organizational frameworks, and budgeting limited their use for comparative purposes. A national benchmarking project being conducted by the Federation of Tax Administrators, which is intended to develop and report on performance standards for state tax agencies, is still in its initial stages, and no data are available for state comparison at this time.

The instability in staffing also makes it difficult to assess DRS’s workload efficiency over time. It appears that some divisions have been able to cope better than others with the staffing losses and efficiency has not declined; in other units, productivity has been impacted.

In addition, the new computerized system DRS is implementing to replace its antiquated mainframe systems has become an all-consuming priority for department staff. While recognizing that it is imperative to have ITAS become operational, the staff resources dedicated to the system’s implementation have limited the department’s ability to complete other tasks, and at least temporarily impaired DRS data collection and reporting capabilities.

Further, the ITAS system is not yet producing management information and some indicators collected under previous DRS computer programs are not and will not be captured by the new system. On-going implementation of CORE-CT, the statewide automated system for all agency accounting functions, also complicates evaluation of personnel and budgeting matters in every state department including revenue services. In fact, final financial statements for fiscal years 04 and 05 have yet to be issued by the Office of the Comptroller because of outstanding accounting issues related to the CORE-CT system.

Overall Performance Measures

In response to a program review committee request, DRS provided several broad statistics on overall agency performance for four recent fiscal years. The four types of performance indicators discussed below are the main measures the current commissioner uses to review agency administration with top managers each year. The measures are best used to examine general trends and identify where additional research may be needed as they show year-to-year changes, but provide little insight into the reasons for fluctuations. Furthermore, the jumps and drops in state revenue collections appear to be more strongly related to economic cycles than particular tax administration policies or procedures.

Collections versus costs. One indicator some states use to track overall tax agency performance is a comparison of revenues collected to the costs of collection, or what sometimes is referred to as “return on investment.” This measure is calculated in several ways, including tax revenues collected per dollars expended (e.g., the agency operating budget), and the ratio of revenues collected to personnel costs or the number of full-time employees. The program review committee tried to gather cost-to-collect statistics from other states but found there were too many differences in the structures of their tax systems, as well as in their organization and scope of functions, to allow for reliable comparisons.

Two revenue-to-expenditure measures DRS tracks are presented for four recent fiscal years (FY 00 – FY 04; FY 05 data are not available for these or other overall measures because of ITAS conversion issues) in Figures III-4 and III-5. Basically, the trends in both dollars collected per dollar spent and total dollars collected per employee mirror the impact of the economy on Connecticut’s state tax revenues.35 Both measures were at their lowest when the recent recession was at its worst in FY 02; both measures have risen as the economy has improved and the agency’s budget has stayed about the same.

Voluntary compliance. A high rate of voluntary compliance, the extent that taxes owed are paid accurately and on time without the need for collection or enforcement actions, is the common chief goal among tax agencies. In a broad way, it may indicate taxpayer confidence in the fairness and effectiveness of the system. It may also reflect the effectiveness of public education efforts. As might be expected, voluntary compliance rates also vary with the economy, tending to dip during downturns when some taxpayers have less ability to pay what they owe on time or in full.

DRS regularly tracks the portion of state tax collections that are remitted voluntarily (paid without state compliance efforts) and involuntarily (paid as the result of collection and enforcement actions). According to the agency, the portion of total tax collections remitted voluntarily in Connecticut is more than 90 percent every year and the rate reached a high of 97 percent in FY 04. As Figure III-6 shows, in recent years the rate was lowest for FY 02 when economic times were hardest in the state.

Voluntary remittance is most useful for monitoring internal trends in the agency’s collection efforts and is only a rough proxy for voluntary compliance. This is because it only measures the portion of total tax dollars collected, not the total amount of taxes owed, that is paid voluntarily. Also, the rate could improve for any number of reasons ranging from better public education efforts to less effective compliance programs that result in lower involuntary collections. Ideally, this statistic should be examined in conjunction with other compliance performance measures such as taxpayer error rates and dollars collected per tax audit hour to fully evaluate effectiveness in promoting voluntary compliance.

Taxes owed versus taxes collected. Another way to broadly evaluate tax agency effectiveness is to compare revenues collected with total payments outstanding or accounts receivable. The best measure of success in achieving taxpayer compliance, as described earlier in Chapter I, is a state’s tax gap. However, estimating tax gap, which is the difference between total tax liability and the amount of taxes paid voluntarily, is such a complicated process that few states including Connecticut regularly compute it. A simpler way a number of states monitor taxpayer compliance trends is by tracking the size of their accounts receivable, which is revenue owed after audits and other review of tax payments.

Figure III-7 shows total accounts receivable as a percent of total revenues collected by DRS each year from FY 01 through FY 04. The rate ranged from nearly 5 percent in FY 02, the worst year of the state’s latest recession, to about 3.5 percent in FY 04. As might be predicted, accounts receivable were at their highest (almost $456 million), and collected revenues at their lowest (about $9.2 billion) when the state’s economy was at its lowest point (FY 02). As illustrated in Figure III-8, collections had grown to more than $10 billion in FY 04 while outstanding tax payments owed had shrunk to about $365 million.

DRS top management monitors the “age” of its accounts receivable cases as well as the trends in total outstanding revenues owed. While payments owed as a portion of total revenue collections has grown smaller in recent years, the average age of accounts receivable has been increasing, as Figure III-9 indicates.

Over the four-year period, the time an account receivable case has been open has grown steadily and substantially, from about four and half years to nearly six years. DRS officials indicated the primary reason for this trend is a reduction in staff resources available for accounts receivable functions. The statistic, which does not take into account the dollar value of cases, may reflect the department’s decision to allocate available staff to the outstanding accounts with the largest payoff, meaning the many lower value cases will remain open longer.

Operations and Taxpayer Services

The Operations Division is responsible for ensuring efficient revenue collection. The Taxpayer Services Division ensures prompt and clear communication to the public. These important functions impact the reliability, accountability, compliance, and fair administration of the state’s tax system by DRS.

The Operations Division is responsible for processing and depositing the revenue from taxpayer returns, issuing refunds on a timely basis, creating bills for delinquencies, and developing reports on tax collection revenues. The division also develops tax forms and publications, enters data, and issues permits, licenses, motor carrier decals, and tax registration numbers. The division collects more than $9.5 billion in tax revenue annually and verifies the information presented on more than 5,000,000 returns for a variety of taxes annually.

Staffing for the Operations Division remained constant at 275 from FY 98 to FY 00. It experienced an increase of five additional personnel between FY 00 and FY 02, but between FY 02 and FY 04 the division experienced a loss of 55 filled positions.

Returns processed. Figure III-10 illustrates the trend in the number of returns processed each year as well as the number of refunds processed per filled staff position for each year provided in the governor’s budget from FY 98 to FY 04. The average number of returns processed annually was 5,338,750. The number of returns processed per staff person increased by 26 percent between FY 98 and FY 04.

Although the return workload increased according to DRS data, during the FY 98 – FY 04 period examined, the division has consistently resolved 90 percent of tax return errors within the quarterly filing cycle.

Refunds processed. The total number of refunds processed for all types of taxes between FY 98 and FY 04 was 4,377,808. As Figure III-10 illustrates, refunds processed per staff position increased by 5 percent between FY 98 and FY 04.

The increase in efficiency exhibited in both returns and refunds processed is likely due to the successful implementation of electronic filing, which requires fewer staff and financial resources to process. The trend for electronic filing is fast growing, as nationwide, 54 percent of all state income tax returns in the 2005 tax season were submitted electronically; in Connecticut the rate was 67 percent.

According to DRS, in FY 05 it processed a total of 996,000 returns electronically while 1,940,000 returns were filed on paper. According to DRS the cost per electronic return is approximately $0.46, including contracting costs as well as human and information technology support services. DRS did not have the costs for processing a paper return. As of January 2005, Connecticut is one of 13 states that require tax return preparers to file returns electronically.

Refunds issued. Increased efficiency was also noted with the timeliness of issuing income tax refunds. Between FY 03 and FY 04 the number of income tax refunds issued within five to 10 days increased by 84,995. As Figure III-11 shows, this means that 56 percent of all income tax refunds were issued within this time frame in FY 04, up from 49 percent in FY 03. Overall, income tax refunds were issued more quickly in FY 04 than in FY 03. The Operations Division has maintained a constant rate of 90 percent for the amount of all tax refunds being issued without requiring interest to be paid (interest must be paid at the rate of two-thirds percent per month on refunds issued more than 90 days after a return is filed or due, whichever is later).

Despite decreases in both budget and staffing levels, the Operations Division appears to have managed its resources well through successfully implementing electronic filing and prioritizing responsibilities like refund processing. By maintaining its standard of timeliness and avoiding unnecessary expenses due to interest, the division minimized the financial impact that decreases in staff can have on state revenues.

Taxpayer services. The Taxpayer Services Division maintains five field offices and a call center, through which DRS provides public education and information, responds to taxpayer inquiries, assists with applications and returns, and offers speakers for organizations and businesses. DRS regularly compiles call center statistics including quality of service standards established by a blend of customer service industries, such as call volume and category (e.g., income, sales, or corporate tax), to monitor call center performance. DRS provided the committee with these statistics for 2003 through 2005. Using the month of April as a point in time for year-to-year comparisons, the committee calculated the average for this month each year for calls regarding the major state taxes. The program review committee assessed the performance of the call centers against the standards provided by DRS for each statistic.

The committee found that over the three-year period the call center handled about 17,000 calls, on average, during the month of April. Each April, between three and five percent of the calls received are “abandoned” (e.g., the caller hangs up), while the percent of calls answered ranged from 86 percent to 82 percent. As shown in Figure III-12, this falls on the lower end of the DRS standard to answer between 80 and 95 percent of the calls.

The committee examined the percentage of calls answered within a specified service level measure -- the ability of the call center staff to answer calls within 20 seconds, which is a standard for phone service quality used across several customer service industries. The department’s goal is to answer 80 percent of the calls received within this time. As Figure III-13 illustrates, in the month of April about half of all calls met the “20 second standard.” (Data were not available from the department for 2003.)

For those calls that cannot be answered within 20 seconds, the call center aims to keep callers waiting no longer than 30 to 60 seconds. For the three-year period presented in Figure III-14, the call center was able to meet this goal in April of 2005 and was close in April 2003.

Once answered, the department’s standard for the length of a call is between two and three minutes. The program review committee found that over the last three years the length of each call has been slightly increasing. Figure III-15 shows average “talk time” grew from three minutes in April 2003 to almost four minutes in April 2005. However, without more information about the calls, such as the subject involved (e.g., type of tax, complexity of the question), as well as staffing levels, it is difficult to pinpoint reasons for the increasing length of call time.

Overall, it appears the call center receives a high and relatively steady volume of calls each April. While fewer than half of the calls are answered within the 20-second industry standard, the majority of the calls are answered in a little over one minute, and only a small fraction of the calls are abandoned. Given the predictability of the call volume and the trend toward increasingly longer calls, the call center may have to reassign staff from other areas to meet its quality of service standards during what is notoriously one of the busiest months of the year for the department. DRS is currently working on consolidating staffing and several other options to improve performance of the call center function.

Compliance and Enforcement

Taxpayers must feel confident that taxes are fairly administered – that others are paying what is owed, and enforcement measures are taken against those who do not comply. At the same time, if persons believe they are being taxed unfairly, they must be given an opportunity to appeal. The department’s efforts in these areas are discussed below.

Audit Division

The Audit Division determines the accuracy of tax reporting through field and office audits of targeted accounts. The unit consists of seven field audit units. Staff develop both computerized and manual audit selection strategies and maintain a centralized automated program to develop pertinent audit and statistical information. That system is being replaced by ITAS.

Staffing. As noted earlier, DRS incurred a decline in staffing of about 20 percent during FY 03 and FY 04, due to state employee layoffs and early retirements. Some of the positions have been refilled in FY 05, and additional positions were authorized in the FY 06 budget.

The audit division, like the rest of DRS, was impacted by the staffing reductions. The unit had 310 filled positions in FY 00; by FY 04, the filled positions totaled only 268, a reduction of 13 percent. By February 2005, the number of filled positions had increased to 277, and another 13 positions were authorized for FY 06.

Audits conducted. DRS provided program review with the number of audits conducted annually from FY 03 through FY 05, the three-year average, and projected for FY 06. The audit activity, by type of tax, is shown in Table III-1. As the table indicates, the number of audits conducted has declined since FY 03 -- a 31 percent decrease in FY 04 and a 27 percent decline in FY 05.

Table III-1. Summary of DRS Audit Activity FY 03 -- FY 06 (projected)

Unit(Tax Type)

FY 03

FY 04

FY 05

3-year average

FY 06 (proj)

Sales and Use

5,159

4,566

4,777

4,834

2,150

Corporate Income

2,112

1,904

1,898

1,972

1,950

Personal Income

39,639

20,316

24,560

28,171

28,000

Total – income

42,781

22,398

29,834

31,701

29,950

Excise/Public Service

44,204

36,397

32,398

37,666

33,000

Total – All Taxes*

92,234

63,361

67,009

74,201

65,100

Source of Data: Department of Revenue Services

* “Total – All Taxes” is greater than the sum of each type because a number of audits are conducted by the division’s Discovery Unit but not always specified by type.

Although DRS audit numbers have decreased, it is still auditing almost 1.5 percent of all returns filed, and more than 2.1 percent of personal income tax returns. The ratio of personal returns audited is higher than that of the federal IRS, which overall audits less than 1 percent, (but does audit about 1.6 percent of filers with incomes of $100,000 or more). According to press reports, the IRS appears to plan to focus its audits on returns that appear to use “abusive tax shelters” (i.e., those that include transactions with no real economic purpose other than dodging taxes).36 DRS was given additional authority by legislation enacted in 2005 to assess additional penalties for those detected using abusive tax shelters as well.

Certainly the loss in staffing in the division is a contributing factor to the overall decline in the number of audits. In other units in DRS, individual productivity increased for the individual staff remaining. However, that is not the case in the Audit Division, and, as Figure III-16 indicates, the individual audit workload for remaining staff actually decreased since FY 03. There are a number of probable contributing factors for this declining efficiency in per-worker productivity:

• The department is in the process of implementing an entirely new computer system, ITAS, which has been delayed and taken more staff time to oversee than originally anticipated. This detracts from day-to-day operations like conducting audits.

• The operational disruption of staffing reductions probably does not translate into a one-for-one decline in productivity. In other words, while the organization attempts to adapt to less staffing, the workers who remain may not maintain their previous productivity level. Also, those left behind with the most experience might take over large, complex cases, thereby reducing their output.

• While the staffing in audits has gained back some lost positions, most of these persons are new to the divisions if not the department. It will be a period of time before these people are fully trained and at optimal productivity.

Audits by type. As shown in the Table III-1 above, the number of audits conducted varies considerably depending on the type of tax. Using the three-year average as a base, the percentage of the total audits conducted by type was analyzed. The results indicated:

• 7 percent in sales and use tax;

• 2 percent in corporate income tax;

• 38 percent in personal income tax; and

• 50 percent in excise and public service tax areas.

Areas that have not been a focus of DRS auditing in the past have been personal income tax withholding by employers, and small business and self-employed taxes. In fact, when the committee asked for the number of persons who file exempt status for withholding taxes, DRS indicated its systems did not keep such aggregate information, but ITAS will have that capability. In the 2007 budget, DRS received funding to hire 20 revenue examiners and two systems developers to increase audits in these areas.

Audit results. One of the outcomes of an audit may be that the auditor finds the taxpayer owes more in taxes than the amount declared. In that type of case, the auditor makes an assessment of what the amount of tax liability should be. The total audit assessment amounts by type of tax are shown in Table III-2. As shown in the table, the amounts assessed from audits have declined since FY 03, a 27 percent reduction in FY 04 and an 8 percent reduction in FY 05.

Table III-2. Summary of DRS Audit Assessments FY 03 – FY 06

Unit

(Tax Type)

FY 03

FY 04

FY 05

3-year average

FY 06 (proj)

Sales and Use

$129,526,302

$108,005,572

$114,142,269

$117,224,714

$117,000,000

Corporate Income

$154,778,854

$88,998,767

$125,313,493

$123,030,372

$123,000,000

Personal Income

$64,796,330

$51,124,279

$85,448,741

$55,497,586

$67,000,000

Total – income

$224,305,335

$140,360,823

$210,811,381

$191,825,846

$190,000,000

Excise/Public Service

$49,611,495

$47,049,111

$45,083,517

$47,248,041

$47,000,000

Total $ – All Taxes

$403,443,132

$295,415,506

$370,037,167

$356,298,602

$354,000,000

Source of Data: Department of Revenue Services

*”Total $ - All Taxes” is greater than the sum of amounts for each types because the $ amounts of assessments resulting from Discovery Unit audits are not always specified by type of tax.

Audit results by type. The committee also analyzed assessments by type of tax area using the three-year average. The results indicate:

• 33 percent of assessments in sales and use tax;

• 35 percent of assessments in corporate income tax;

• 16 percent of assessments in personal income tax; and

• 13 percent of assessments in excise and public service taxes.

The ratios for assessments are almost opposite the ratios for the number of audits conducted. For example, while corporate and sales taxes are a small percentage of the audits conducted, they produce a much greater percent of the assessments.

Trends in assessments. It might be expected that overall assessment amounts have declined given that the number of audits has decreased. If examined on a per-audit basis though, the amount of assessments has increased each year since FY 03, which indicates better results for each audit, and might suggest better audit targeting.

Appellate Division

Audit assessments do not automatically translate into revenue collected because taxpayers may appeal the audit results. The ratio of audit assessments appealed is very low, about 1.3 percent. Those appeals are handled by the DRS Appellate Division. The Appellate Division currently has 12 staff – 10 appellate officers, one tax appellate specialist, and a unit manager. However, the unit has not always been fully staffed, nor has there been stability by staffing category. In 2001, the unit had only nine staff; staffing increased after 2001, but from 2002 through 2004, the unit was without a manager.

Figure III-18 shows the division caseload and caseload per-officer numbers for 2001-2005. As the figure shows, the caseload spiked in 2002, when the average number of cases for each officer increased by about 50 percent (almost 200 each) from 2001. Since 2002, cases have leveled off; at 2005 staffing levels, the average caseload for the division and each appellate officer will be at (or lower) than 2001 levels.

Age of appellate cases. During the period between 2001 and 2005, the case backlog grew; thus cases were taking longer to close. This is illustrated in Figure III-19, which shows division staffing levels measured against the percentage of resolved cases that were more than a year old when closed. As the graph shows, the staffing reduction appears to have had an impact (although a somewhat delayed one) on the length of time before a case is closed. Using this measure, the percent of cases that were more than a year old at closing, went from about 60 percent to almost 70 percent in 2004, before dropping to slightly more than 62 percent in 2005. Probably more notable than the trend is the fact that, over the five-year period, substantially more than half of the cases are more than a year old when closed.

Another negative impact of the delays in the Appellate Division on taxpayers is that delays can be costly to the appellant. The program review committee heard complaints that delays in closing appeal cases at DRS are costing taxpayers greatly because of the monthly interest charged on the audit assessments. The statute currently sets the interest rate at 1 percent per month (or 12 percent a year) from the date when the original tax was due and payable. The rate appears high compared to the IRS, which sets its annual rate at the federal short-term interest rate plus 3 percent, and Massachusetts, which is adjusting its interest rates to the federal short-term interest rate plus 4 percent.

Appellate cases. DRS provided program review with data on the number of “hearings” held by the Appellate Division over the past four years. However, DRS explained its appellate proceedings are informal, and “hearings” can mean a telephone conference call, or any other opportunity for taxpayers to submit additional information or present a case to dispute the audit findings and/or the assessment amount.

Thus, there may be more than one “hearing” in a case, while on the other hand the appellate may review the additional information and make a decision based on that without further input from the taxpayer. In addition, hearings held in one year may be related to a case from a prior year. Committee staff requested to observe DRS appeal hearings, but were told these are considered confidential. DRS was also unable to indicate how many of the taxpayers appealing cases had legal representation.

If a taxpayer is not satisfied with the DRS appellate decision in the case, the taxpayer may appeal to the Tax Session of the New Britain Superior Court, the court that handles all appeals of administrative decisions of any state agency, including DRS. The department did provide the number of the cases appealed to court, but not the outcomes of the cases, indicating that all but those decided by court rulings are considered confidential. Cases that are appealed to court are not considered closed by DRS while under appeal.

Despite these qualifiers, the Appellate Division has more comprehensive data on workload and outcomes than other DRS operational divisions. The information on appellate cases is presented in Table III-3.

Table III-3. DRS Appellate Cases: FY 01—FY 05

 

Cases Received by DRS Appellate

“Hearings” held

Appealed to Court

% of Cases

Appealed

Cases

Closed

FY 01

1247

N/A

N/A

-

1091

FY 02

1307

767

48

3.6%

1169

FY 03

1136

924

72

6.3%

1260

FY 04

781

1178

36

4.6%

1166

FY 05

971

1224

41

4.2%

1097

Total

5442

4093

197

4.7%*

5783

Source of Data: DRS Appellate Division (* based on FY 02-FY 05)

The table shows that there has been a reduction in the number of cases appealed to DRS Appellate Division since the high point of 1307 cases in FY 02 – a 40 percent reduction in FY 04 and a 26 percent reduction in FY 05. However, the activity level – measured by “hearings” held-- has increased, which could indicate that the cases were harder to settle, or that with fewer cases received in FY 04 and FY 05, the division was processing cases received in FY 03 or earlier. Further, over the period, the division closed more cases than it received, again indicating it was reducing previous backlog. The table also indicates that the percentage of DRS cases appealed to court has not changed substantially over the period and, except for FY 03, is under five percent of cases.

The composition of the 5,442 appellate cases averaged over the period broke down as follows:

• 34 percent were personal income tax cases;

• 27 percent were sales and use tax cases;

• 14 percent were corporate income tax cases; and

• 11 percent involved the gift tax.

Appellate outcomes. The Appellate Division does not keep statistics on whether cases were closed in favor of the taxpayer or upheld the action of the Audit Division. This is because often cases are not closed in favor of one party or the other, but rather there is a reduction in the amount assessed at audit. The Appellate Division provided information on the total assessed amounts under appeal each year and the revised amounts after appeal. These overall amounts are presented in Table III-4 below. As the table shows, the amounts assessed are reduced by more than half at the Appellate Division.

Table III-4. Appellate Division Outcomes

 

FY 01

FY 02

FY 03

FY 04

FY 05

Gross Billing $

$143,077,112

$113,118,035

$236,448,862

$162,299,731

$157,534,295

Revised $ Amount

$67,076,550

$55,107,185

$116,784,208

$70,120,512

$62,521,163

% Revision of Total

46%

49%

49%

43%

40%

Source of Data: DRS Appellate Division

The composition of audit assessment dollars that are appealed shows a somewhat different distribution than appellate cases. For example, while the personal income tax accounted for about 36 percent of the cases in three of the four years included in Figure III-20, PIT as a percent of assessment dollars is barely measurable. (2004 was the exception when more than 40 percent of the PIT assessment amounts were appealed.)

Corporate income taxes, on the other hand, made up less than 14 percent of the appellate cases, but in 2005, the amount of assessments appealed was about 80 percent of the total, and in 2002 about 40 percent. Sales and use tax were about 25 percent of the appellate cases, but, like corporate, accounted for 80 percent in 2003 and almost 50 percent in 2002. Only in the gift tax area do the percentages of appeal cases and assessment dollars appealed closely match.

The program review committee further analyzed the Appellate Division outcomes to determine if there were differences in the revisions by tax type. The results of the analysis are presented in Figure III-21. For the four-year average outcomes (the grouping plotted on the right side of the figure), all the revised amounts for each tax, except the sales tax, were less than half the initial amounts under appeal. In other words, the reductions in assessment at appeal are great, typically more than half.

It is difficult to determine the reasons why the reduction amounts are so significant at appeals without more detailed information about the cases and without being able to observe the proceedings. Useful information would include the major issues surrounding the appeal or whether r whether the taxpayers had legal representation and if that had an impact.

Possible explanations include:

• DRS auditors are zealous in performing the audit function, determining high assessments, recognizing the amounts will likely be reduced through the appeals process;

• contestable statutory, regulatory, and policy definitions on issues as complex as nexus and apportionment or as commonplace as interpretations of what is a taxable food item are to be expected; and

• a litigious environment and an attitude among taxpayers that they would rather contest tax liability than pay.

Collections and Enforcement

Once a case has been closed at appellate, the vast majority of cases go to Collection and Enforcement for collection. A small fraction of cases (less than 10 percent as noted above) are appealed to Superior Court. These cases are not considered closed at the Appellate Division until the court disposes of them in some manner. If the disposition from court requires any collections, that case would also go to DRS Collection and Enforcement.

Activities. The Collections and Enforcement Unit is composed of revenue agents who pursue collections through a variety of means:

• establish written, phone, or direct contact with taxpayers;

• set taxpayers with an unpaid tax liability up on payment schedules;

• place liens; and

• make arrests as a result of criminal investigations conducted by certain authorized personnel within the Collection and Enforcement Unit.

DRS also contracts with three private collection agencies to collect delinquent accounts. The assignment of the cases and amounts are made by the unit.

One action that can be taken by private collection agencies that DRS does not do is to report delinquent taxpayers to credit reporting agencies. The committee was unable to determine how frequently this action is taken by the collections agencies, or with what results. Also, the committee could not determine within the timeframe of the study if other state tax agencies have that authority. It does appear to be a less drastic enforcement step than placing a lien, yet taxpayers might be more responsive, knowing how credit scores can impact one’s ability to engage in many financial transactions.

The Collections and Enforcement Unit has also experienced staffing reductions. Prior to the layoffs and early retirements, the unit had a staff of 99 filled positions. The staffing estimate for FY 05 is 76 permanent full-time positions, a reduction of 23 percent.

Collections as a percent of accounts receivable were provided by DRS for FY 02 and FY 03; those rates were 67 percent and 51 percent, respectively. However, DRS could not calculate the rates for FY 04 or FY 05, again due to changes in the way data are being collected with ITAS implementation. The committee was also unable to analyze enforcement activity or workload measures over time, because much of the activity data reported under the division’s former automated system is no longer available under ITAS.

Automated Systems

Automated information systems that incorporate up-to-date, high quality software and hardware and integrate all major functions are critical for successful tax administration. DRS has been working to replace and upgrade all of its existing computer systems, some of which are more than 35 years old, since 1994. The goal is to have one database and a single system for all common administrative functions for all state taxes. Implementation of the agency’s new Integrated Tax Administration System will permit more efficient operations, increased compliance, improved customer service, and better information for management decisions.

The project has experienced delays and cost overruns, but system implementation, which is occurring in four major phases, is actively underway at this time. The current status of the each major phase of ITAS is summarized in Appendix H.

At present, integrated taxpayer registration, return processing, and accounting functions for all business taxes are up and running. Development of similar functions for the personal income tax is in progress, and they are expected to be fully operational by July 2006; PIT revenue accounting is already functioning. The last two phases, which primarily involve automating a variety of internal management and customer service functions, are scheduled to be completed by September 2006.

Upon completion of all four phases, DRS anticipates all tax administration functions will be operated through the ITAS system, management functions will be integrated and automated department wide, and the agency’s former computer systems will be retired. Agency staff is expected to have greater user control over data entry and retrieval and be less reliant on technical support to both access and report information. On-line customer service functions such as registration, address changes, refund inquiries, and help menus will be available to all taxpayers.

DRS staff have explained the capabilities of ITAS, but the committee did not receive any reports produced by the new system. Over the last few months, the agency has focused almost exclusively on getting the system operational, and report production has been a lower priority. In addition, ITAS is not maintaining data in the same way or even capturing some of the same information as the old systems, and thus may not generate the same types of reports.

In preparation for ITAS conversion, DRS has upgraded a number of its business systems and made electronic improvements in agency operations. For example, the agency has improved its centralized call center capabilities for handling taxpayer inquiries, and DRS has also made great strides in providing for electronic filing of returns.

Funding for the ITAS project was essentially unaffected by recent agency budget cuts but many familiar with the agency believe the loss of a number of experienced staff due to early retirements in the midst of final development contributed to delays in its implementation schedule. The impact of staff reductions, along with the allocation of resources to ITAS implementation, can be seen in some of the activity statistics described later in this chapter but generally is not evident in broad measures linked to total revenue collections. According to DRS, this is at least partly because when cuts were made, remaining resources were allocated first to the agency’s highest priorities such as voluntary remittance and timely processing, which are activities reflected by total collection numbers.

Automation improvements occurring with the phase-in of the new system may have helped sustain levels of employee productivity in return processing and some collection-related functions. In contrast, lower priority functions, such as follow-up on accounts receivable files or hearings on appeals, clearly had drop offs in performance coincide with decreased staffing.

A significant system deficiency, however, is that ITAS produces very few management reports and has little ability to track administrative activities. What management information the new system will be able to provide and whether it will be comparable to previous revenue and work activity report data is not clear at this time.

The main measures of overall agency performance monitored by the commissioner described earlier in this chapter, for example, cannot be produced by ITAS at present. Information on agency enforcement actions (e.g., warrants issued, liens place, arrests made) that were reported by a former system within the collections unit, are unavailable through ITAS for all taxes at this time. Most of the productivity statistics the collections manager formerly tracked (e.g., dollars collected, percent of receivables assigned to collection and enforcement, inventory “turnover” in terms of cases and dollar value, and average age of cases) are not reported by ITAS and may not be for some time.

As the result of a data request from the program review committee, DRS management also recently became aware of problems related to the agency’s collection rate statistics (e.g., the amount of the accounts receivable inventory sent to the collections unit that is collected and deposited each year). According to the agency’s ITAS consultant, collection rates cannot be produced for fiscal years 04 or 05 due to the phase-in process used to convert data to ITAS; a method for calculating comparable rates in the future is expected to be developed in a few months.

Further, it has not been determined how ITAS, specifically its data warehouse component, will capture certain information that is currently provided on income tax returns but not compiled, such as the amount of local property taxes paid or the total income earned by pass through entities. These data would be helpful to the department in targeting auditing efforts and to policymakers interested in researching the distribution of tax liability by income group.

The fact that ITAS is, as DRS managers have told the committee, “management report poor”, and unable to produce many previously available basic statistics on agency operations seems evidence of a low priority given to performance measurement by the agency as well as insufficient planning for the conversion process. According to top managers, reporting improvements are planned but will not be taken up until after the system is in place and running for a time, perhaps within two years. At that point, an assessment of information needs of the operational units and top management will be made and a strategic plan will be developed, most likely with the help of the Office of Planning and Organizational Development (OPOD).

Selected Management Practices

In carrying out this aspect of the study, the program review committee observed both strengths and weaknesses in some of the department’s overall management practices that have an impact on administrative efficiency and effectiveness. The committee’s findings concerning several key agency management functions are highlighted below.

Internal controls. Preserving the confidentiality of taxpayer information is a top priority of the Department of Revenue Services. Internal security controls seem strong; an internal audit unit was created two years ago with a primary function of protecting the state and federal taxpayer data held by the agency. The department expects to expand the unit’s scope of activities and staffing to all internal control processes as well as selected transactional areas that could have security risks.

Like a number of states, Connecticut has a statutory taxpayer “bill of rights” (C.G.S. Section 12-39n). According to DRS policy, it “…. guarantees that the rights, privacy, and property of Connecticut taxpayers are safeguarded and protected during tax assessment, collection, and enforcement processes administered under the revenue laws of this state.” Information about taxpayer rights is available on the DRS website although it is not prominently displayed; a link to the policy is provided under business taxpayers’ information at present.

DRS strictly interprets its obligations to maintain taxpayer privacy and ensure confidentiality of its tax records. It exercises firm control over access to data in compliance with state laws intended to promote public confidence that information submitted by taxpayers will be kept confidential. It also implements IRS standards, “Tax Information Security Guidelines of Federal, State, and Local Agencies,” for safeguarding federal tax information.

However, the department’s interpretation of “confidential information” seems extreme. For example, the committee could not obtain all the aggregate non-identifying taxpayer data it sought.37 The statute that governs DRS’ disclosure of “return information” (defined as a taxpayer’s identity, the nature, source or amount of the taxpayer’s income, etc.) is understandably restrictive (C.G.S. Sec. 12-15). However, the statute also defines what “return information” does not include: “…data in a form which cannot be associated with, or otherwise identify, directly or indirectly, a particular taxpayer.” Despite that provision, DRS would not provide, for example, the median tax paid for specific tax types as it would come from individual tax information. Further, DRS stated appellate proceedings are confidential and denied committee staff’s request to observe, and similarly, any description of outcomes from appellate activities (except for court decisions) were described as confidential. These access issues hampered the assessment of overall tax policy and tax administration.

The department requires all of its permanent and temporary employees to sign a confidentiality agreement about the disclosure of tax information, and it only shares its data with other state agencies in accordance with formal written agreements for ensuring confidentiality. In addition, DRS indicates it performs background checks on all potential agency employees before being hired. However, similar checks are not conducted on all employees of agency contractors and vendors, although they are required to sign confidentiality agreements. DRS further indicated access to confidential taxpayer information by contractor personnel is limited.

It appears from statistics provided by the internal audit division that there have been few confidentiality breaches and when violations are found to occur, disciplinary actions are taken. The division has been responsible for investigating potential ethics code (including confidentiality) violations since it was formed in January 2004. Since that time to December 2005, the division has handled a total of 25 potential violations, 23 of which involved DRS employees and two of which involved employees of other agencies (and were therefore forwarded to the head of that agency for investigation and any disciplinary action). Regarding the DRS cases: in 11, no actions were taken because the division found no violation; in one, no action was taken because the temporary employee involved was no longer with the agency; and in 11, violations were found. In these cases, the following actions were taken: one termination; nine suspensions (from one to five days); and one reprimand.

Research. The department has limited capacity for research and planning activities. At present, there are only three positions assigned to the agency research office and those staff also have responsibility for legislative affairs. The primary role of the research office is to provide statistical information on state taxes as required by statute and requested by OFA and OPM for forecasting and policy analysis purposes. The office does not conduct tax policy research; according to the commissioner, that function within the executive branch is appropriate for the Office of Policy and Management, not DRS whose mission is to “… administer the tax laws of the State of Connecticut and collect the tax revenues in the most cost effective manner.”

Recently, the demands of ITAS implementation on the research staff have meant the office has had little time for many of its regular duties. It has been unable to produce the agency’s annual tax report, a primary way DRS meets its public accountability obligations, since FY 03.

Strategic planning. The strategic business plan that led to the development of ITAS is the last comprehensive document prepared to guide the department’s activities. Before the most recent series of employee layoffs, the department had a small planning office, but currently there is no centralized responsibility for strategic planning. Therefore, DRS has not maintained an up-to-date strategic plan. That function, though, may be included in the scope of OPOD duties in the future.

Strategic planning is more than just long-term planning. The Office of Policy and Management defines strategic planning as “a process of organizational self assessment, goal setting, strategy development, and performance monitoring.”38 Strategic planning helps to shape and guide what an organization is, what it does, and why it does it. It has been long recognized as an important part of successful, results-oriented management. Among other things, the strategic planning process, when conducted properly, not only identifies agency objectives but assists in ascertaining an agency’s strengths and weaknesses and determines if its internal capabilities are adequate to accomplish its mission and goals.

Performance measurement. DRS collects a variety of data about its major activities, reports on a number of program indicators in its budget documents, and has developed performance measures for some areas of the agency. For example, the information collected and standards established for the taxpayer services division’s call center activities represent an example of what a well developed performance measurement system can provide.

Most of the activity data DRS prepares and provides in its public documents, however, are measures of inputs and outputs rather than outcomes. The information included in the department’s budget, which the program review committee found necessary to rely on in completing this part of each study, covers a narrow scope of agency activities and is only produced for the initial year of the biennium. In general, little workload (e.g., cases per staff person), timeliness (e.g., days to process), or functional cost information was available from the department. In most cases, basic outcome measures such as error/accuracy rates or rates of compliance by type of tax or taxpayer could not be provided to the committee within the timeframe of study. As discussed earlier in this chapter, a number of activity measures tracked with prior automated systems are not produced by ITAS.

Performance measurement is closely related to strategic planning. The development of a performance measurement system helps in understanding the links between the department’s performance and successful accomplishment of its strategic objectives. In a revenue-constrained environment, public agencies should continually assess whether what they are doing can be accomplished in a better, more cost-effective manner.

Enhanced and more complete management information would, for example, allow DRS to understand the reasons for variation in performance over time and across the agency. For example, better data on inputs and outcomes could explain why, as noted in the above program review analysis, some parts of the department appear to have maintained productivity levels despite staff reductions, while others have not. It could also be used to examine specific aspects of performance such as why it takes over a year to resolve most tax appeals, and what contributes to average assessment reduction rates of 50 percent at the Appellate Division.

Ultimately, sufficient, credible, and timely information about how the department is administered will assist managers and policymakers ensure the department is being effectively and efficiently administered and is providing fair, high quality services. By the end of this year, ITAS will be the agency’s only automated information system. The extent to which ITAS can provide good quality management information, including appropriate performance measures, is unknown at this time.

THIS PAGE INTENTIONALLY BLANK

Chapter IV

Other States’ Experiences

Of interest in this assessment of Connecticut’s tax system is what other states have done to modify their tax structures to better align their revenue sources with their economic framework or delivery of services, and to respond to voter/taxpayer sentiment. Presented below is a general discussion regarding the use of tax and expenditures limits, followed by case studies of states that have changed their tax systems in a fundamental way.

One of the mechanisms states have used is to place restraints on the growth of government budgets either by limiting the taxing or spending side or both. The National Conference of State Legislatures released a report in June 2005 on the states’ use of these tax and expenditure limitations (TELs), and the report illustrated their use in the following map.

Figure IV-1. Tax and Expenditure Limits Use Among the States

Source: National Conference of State Legislatures, State Tax and Expenditure Limits Report, June 2005

The NCSL report found that 30 states used TELs. Several states had considered imposing new TELS during the past three legislative sessions, but Maine is the only state to have adopted such an initiative in 2005. (The report limited its scope to TELS at the state level, and therefore does not include any limits states may place on revenues or spending through local property taxes.)

Tax and Expenditure Limitations

While NCSL found there was no one method used to restrict spending or taxes, the report concluded that TELs fall into one of the following categories:

• Revenue limits – tie allowable yearly increases in revenue to personal income growth or some other type of index like inflation or population. Typically, amounts that exceed the limit are refunded to taxpayers.

• Expenditure limits – typically tie growth to increases in personal income or some other index. The impact depends on the limit parameters – ones that are less restrictive are tied to growth in the economy, while TELs with tighter controls often require refunds if revenues exceed expenditure level thresholds.

Connecticut is one of 23 states that impose an expenditure limit. The “spending cap” limits increases in budget expenditures to the greater of either: 1) the five-year average in growth of Connecticut’s personal income; or 2) the 12-month rate of inflation as measured by the consumer price index.

• Appropriations limited to a percentage of revenue estimates – ties appropriations to a portion (e.g., 90 percent - 95 percent) of forecasted revenues. This TEL does not establish an absolute limit or tie growth to a measurable index.

• Hybrids – a combination of components that sets limits. For example, Oregon has a spending limit tied to personal income growth, and a provision requiring refunds if revenues are more than 2 percent above the revenue forecast. In a way, this type of TEL restricts spending and also limits revenues by tying them to forecasted amounts.

Voting Requirements

In addition to TELs, states also may have in place mechanisms that can limit revenue and spending actions. These specific voting requirements typically: 1) call for outright voter approval of all tax increases or those over a certain amount; or 2) require a supermajority vote in both chambers of the legislature in order to pass a new tax or increase an already existing tax. Three states use the first method, and 16 states use the latter. Often these measures are even more restrictive than technical tax and expenditure limitations.

Impact of TELs

The NCSL report states that a number of academic studies have examined how well TELs work and what ramifications their use may have had for state fiscal policy. Drawing on the results of several studies of TELs, it can be concluded that:

• the impacts of TELs vary depending on such factors as formula of limits, method for approval of limits, requirements for passing increases, and treatment of surpluses;

• limits on government growth through fiscal caps are more prevalent than limits on property taxes;

• Colorado has the most restrictive TEL structure and Rhode Island the least;

• states with strict spending limits faced lowering borrowing costs, while states with strict taxing limits incurred higher than average borrowing costs;

• TEL states did not show a strong link to limiting the size of governments, but states with slow income growth did have more size limitation effects, while states had greater increases in government if they had high income growth.

Table IV-1 below lists other pros and cons of TELs that may not be proven in studies, but are widely cited by supporters or detractors.

Table IV-1. Commonly Cited Pros and Cons of TELS

Pros

Cons

• Makes government more accountable

• Forces more discipline to budget and tax practices

• Controls growth of government/makes it more efficient

• Enables citizens to vote directly on tax increases, and thus the level of government services

• Helps diffuse the power of special interests

• Forces government to evaluate and prioritize

• Raises questions about the advisability of providing some government services

• Helps citizens feel empowered

• Makes government think of other ways to raise revenue

• Shifts fiscal decision making away from elected officials

• Causes disproportional cuts for non-mandated or General Fund supported programs

• Does not account for disproportional growth in populations that use government services (e.g., children and the elderly)

• May result in extra costs for rebates and refunds

• Fails to provide revenues to meet continuing services during tough economic times, and results in declining services over time

• Shifts tax base away from the income tax to the more popular (but more regressive) sales tax if voter approval required

• Shifts tax base away from broad taxes to narrowly defined sources from gaming or user fees

Source: NCSL, State Tax and Expenditure Limits, 2005

Case Studies of Specific States

Program review staff selected, based on committee interest and suggestions, several states that have changed their tax structures in some manner over the past couple of decades. The case studies summarize each state’s experience including: the problem or issue each state was addressing that necessitated the policy change; the strategy or initiative developed and its features; and what the impacts have been since the strategy was implemented. It is important to note the analysis and conclusions in these case studies are based on committee staff’s review of the literature, and not the result of independent analysis. Case studies are presented for California, Massachusetts, New Jersey, New Hampshire, Colorado, and Michigan.

California: Proposition 13 and Its Impact

Problem: Perceived runaway local property taxes

• During the 1970s, home values in California increased dramatically.

• As property values soared, local governments did not adjust rates adequately, creating very high property tax bills.

• California residents, angry about their high property taxes and about what they perceived as unresponsive local government, voted a ballot initiative known as Proposition 13

• Proposition 13 was enacted in June 1978 – voters passed the measure by a vote of 65 percent to 35 percent.

• The California tax revolt continued into 1979 with the passage of Proposition 4, which limited state spending to the previous year’s with allowances for increases in population and inflation.

Strategy: Proposition 13

• Proposition 13 cut local property taxes in California by about $6 billion (53 percent).

• It set property values at 1975-76 levels.

• The measure limits property taxes to 1 percent of assessed value.

• Proposition 13 limits annual increases in assessments to 2 percent.

• Property reassessment is only allowed when the property is sold.

• The measure also made raising taxes more difficult by requiring approval by two-thirds of the legislature to increase state taxes, and prohibits local governments from imposing new taxes without a two-thirds vote of the electorate.

Impact: 25 Years of Direct and Indirect Consequences

On the property tax:

• The property tax becomes very unfair -- owners of similar houses in the same neighborhood pay hugely different tax bills because one house was bought more recently than another.

• Homeowners have assumed a greater share of local property tax than businesses, largely because commercial property turns over much less frequently than residences, and businesses have been able to change hands while circumventing sales and thus new assessments.

On school funding and education:

• The California legislature passed Assembly bill 8 in 1978 increasing the state’s responsibility for school district funding.

• Because resources are equalized across districts, local voters have less incentive to spend as much on schools, leading to larger class sizes.

• By 1982-83, California per-pupil spending dips below the national average.

• School district funding becomes more prone to fluctuations in the state’s economy.

• By 1988, California voters, unhappy with state spending on local education, pass Proposition 98, which provides a formula-driven guarantee of state funding for local schools.

• During the 1980s -- a period of relative prosperity in California -- the state met its obligations for school funding.

• The funding impact of Proposition 13 is acutely apparent during the recession of the early 1990s – a series of state budget shortfalls prompts the state legislature to shift responsibility for funding services back to local levels.

• Some local jurisdictions – especially counties -- experience a fiscal crisis.

• The California legislature in 1996 passes a class-size reduction measure providing an additional $650 (later $800) for each K-3 student in classes of 20 or less. This incentive unintentionally hurts lower income and predominately minority schools and increases the gap between rich and poor districts and educational results.

• In 1998, California voters pass Proposition 1A, a state bond measure earmarking $6.7 billion for school construction and repairs, and in 2002, another $11.4 billion in local bonds is approved through Proposition 47. Despite these measures, per-pupil spending in California is still below the national average and a recent Rand study showed California students scored 3rd from the bottom in achievement tests taken between 1990 and 2003.

On other funding:

• Both Proposition 13 and Proposition 4 have had a ripple effect on funding for other services, leading to passage of a number of propositions (in addition to those above) that established dedicated funding. These initiatives allowed revenues from a particular tax (or rate increase) to fund a particular service. For example, Proposition 111 funds transportation from the gas tax; Proposition 172 earmarks some of the sales tax revenues for local public safety; and Proposition 99 funds some public health programs with tobacco taxes.

• Recent state financial woes have also had other impacts – the state has had to seek additional sources of revenue to fund public services. For example, in November 2004, California voters approved Proposition 63, which imposes a 1 percent surcharge on incomes over $1 million to fund mental health services. While an increase in the top rate for California’s income tax rate was also considered it was not enacted.

• A proliferation of initiatives were on the ballot for a November 2005 special election. Those measures up for vote included repealing Proposition 63 and enacting a “Live Within our Means Act,” which would impose new state spending limits (including on those revenues guaranteed under other propositions) and would allow the governor broad authority to cut spending if revenues fall below forecasted levels.

Massachusetts: Proposition 2 and Its Impact

Problem: Perceived High Tax Burden as Evidence of Government Inefficiency

• Massachusetts residents have voiced their discontent with the property tax since the 1960s. In 1967, per capita property taxes were almost 50 percent above the national average; by 1977, property taxes were the highest in the country. A tax revolt in Massachusetts led to the adoption of Proposition 2 in 1980.

• Supporters of Proposition 2 believed it would reduce taxes without cutting services.

• Proposition 2 was enacted in November 1980 - passing by a vote of 59 percent to 41 percent; 81 percent of communities voted in favor.

• The original legislation was amended in December 1980 to exclude from the limit new growth from construction and to provide communities with mechanisms to raise additional revenue when necessary via overrides and exclusions.

• The legislation implemented five changes:

1. limited state agency assessments on cities and towns;

2. prohibited unfunded mandates;

3. repealed binding arbitration for certain public employees;

4. reduced the motor vehicle excise tax rate; and

5. allowed renters a deduction on their state income taxes.

• The limits went into effect in 1982.

Sstrategy: Proposition 2

• Proposition 2 established two types of levy limits on property taxes.

o Levy Ceiling: a community cannot levy more than 2.5 percent of the total full and fair cash value of all taxable real and personal property. It is calculated as follows:

(Full and Fair Cash Value) x (2.5 percent) = Levy Ceiling

o Levy Limit: is a constraint on the amount a community can increase a levy from year to year. It includes new growth to account for increased service costs associated with new development. This is calculated as follows for each city/town annually by the Department of Revenue:

(Prior year’s levy limit) + (prior year’s levy limit x 2.5 percent) + (additions to the tax base from new growth during the year) + (any approved overrides or exclusions) = Levy Limit

• This amount is then compared to the levy ceiling; the lesser amount becomes the levy limit for that year.

• Exceptions can be made through overrides and exclusions that must be approved by a referendum.

o An override is a permanent increase in the tax limit; it becomes a part of the base for calculating future years’ levy limits. It allows residents to reduce the levy and raise additional revenues to put funds in local operating budgets. It must be for a specific amount, approved by a two-thirds vote of the local legislative body, and placed on the ballot for voter approval. It cannot exceed the levy ceiling.

o An exclusion is an allowable tax increase for debts, bonds, or local project funding (e.g., new school or land acquisition, etc.). Exclusions are not permanent. Instead, they remain in place for the duration of the expenditure and do not add to the base for calculating future years’ levy limits. Like overrides, they must be approved by a two-thirds vote of the local legislative body before they can appear on the ballot.

Impact:

• In 1980, 54 percent of Massachusetts cities and towns had effective tax rates that exceeded the 2.5 percent levy ceiling. Those communities had to reduce their tax burden by 15 percent annually until they were in compliance with the law. Over one-third of the communities needed only one year of reductions, and another 9 percent needed two to three years to reach the limits.

• During the first few years, 1981-1988, the effects on local budgets were mitigated by significant increases (64 percent) in state aid provided to assist municipalities in avoiding budget shortfalls. In addition, the real estate boom in the 1980s increased new growth and added to levy limits causing a decline in effective property tax rates.

• Property tax reductions in the first three years of the limit reached over $500 million.

• The late 1980s experienced a recession, a decrease in property values and new construction, and a reduction in state local aid (over 30 percent between 1989-1992). In addition, the need for school funding grew as baby-boomers’ children reached school age and increased enrollment.

• During the late 1980s and early 1990s, many communities passed overrides to deal with their limited revenues. Some communities experienced increases in property values with voter-approved overrides that increased spending. This indicates that Proposition 2 resulted in lower levels of spending than what was preferred by some towns.

• From 1990-1994, changes in house values ranged from an increase of 7 percent to a decrease of more than 20 percent. Despite the constraints, communities that experienced gains in property values were able to increase school funding. School spending increased more substantially in areas where the number of pupils quickly increased.

• During the late 1990s and into the early 2000s, state aid was generous to the towns. Therefore, Proposition 2 did not have an impact on local revenues or services. However, between 2002 and 2004, state aid to municipalities dropped 8 percent; in 163 of the 311 towns, aid was cut by 15 percent.

• Because of recent reductions in state aid to municipalities, local property taxes have increased substantially. Between 2001 and 2004, local property growth averaged 6.2 percent per year. This growth was largely fueled by new construction, which over the three-year period added $650 million to local property tax rolls. Also contributing to the growth, however, is that towns are increasingly making decisions on exemptions and overrides of Proposition 2. Those shot up by 60 percent in 2003 alone.

• In addition to raising taxes to deal with the reduction in state funding, towns also cut their own spending. According to the Bureau of Labor Statistics, Massachusetts dropped almost 8,500 jobs from municipal payrolls in 2003, the largest drop in the nation. Almost two-thirds of the job cuts were teachers and front-line public safety personnel.

Summary: Key Findings

• Voters’ views of local government are strongly influenced by their individual property tax burden.

• The constraints imposed by Proposition 2 had a considerable impact on both school and non-school spending adjustments. Studies found school-spending changes to be significantly correlated to changes in house values. The theory is that Proposition 2 may have contributed to the demand for housing in communities that prioritized school spending. The state system for financing local schools has since been reformed by earmarking a portion of the state sales tax.

• Overall, property tax burden in Massachusetts (3.5 percent of personal income) and its reliance on the property tax (36.5 percent of all state and local taxes) are somewhat lower than the rest of New England, but both are higher than the national average despite Proposition 2.

• According to the Government Performance Project, Massachusetts has one of the highest debt burdens in the country. Factors cited include the lack of county government and local government reliance on the state due to limitations on local borrowing imposed by Proposition 2.

• Imposition of a cap on property tax makes towns more reliant on the state to provide needed financial aid to provide local services. When that aid is forthcoming, the cap causes little pain. When the state aid drops, towns are forced to cut essential services, implement cap waivers, or both, and still face deterioration of their financial condition.

New Jersey: Finance Education and Lower Property Taxes

Problem: Local school funding found unconstitutional

• In 1973, the New Jersey Supreme Court ruled the practice of relying solely on local property tax to finance education was unconstitutional.

• In response, then-Governor Brendan Byrne proposed a state income tax, which New Jersey did not have at the time. The New Jersey legislature initially failed to approve the tax, but the state Supreme Court closed the schools, and the legislature approved the tax in 1976.

Strategy: Income Tax With All Revenues Going to Local Towns

• When the income tax was approved in 1976, a provision was included to constitutionally guarantee that all money raised from the income tax would go into the Property Tax Relief Fund, and that money could be used in very limited ways, like funding schools, municipalities, and counties, and financing actual property tax reduction programs like the Homestead Rebate Program (which was passed in concert with the income tax).

• For almost two decades, the legislative and judicial branches wrangled over school finance. Large state tax increases and aid restructuring came in response to a starte Supreme Court decision.

• Former Governor (then a gubernatorial candidate) Christine Todd Whitman ran on a platform to cut state taxes. In 1994, after Whitman was elected, she successfully spearheaded enactment of cuts in the state income tax totaling 30 percent during her first term in office.

• Resulting cuts in state aid to towns were estimated at about $250 million, prompting municipalities to increase property taxes about the same amount (although experts argue some of that increase would have occurred without cuts in aid).

• The extraordinary boom in the New Jersey economy (as with the nation) during the late 1990s and early 2000s provided generous funding from the state, even with the cut in the income tax.

• Also, during these good economic times New Jersey passed another property tax reduction program for individuals called NJ SAVER (School Assessed Value Exemption Rebate), authorizing an exemption of a portion of a home’s value from the school property tax. The value of the exemption – beginning at $9,000 to a maximum of $45,000--was to be phased in over five years from 1999 through 2004.

Impact: Attempts to Provide Property Tax Relief Only Partially Successful

• When New Jersey’s economy slumped (like most other states), the funding for local services, like education, declined, and so did the funding for local property tax relief programs. Funding for the NJ Saver program and other property tax relief programs was severely curtailed, and the Senior Property Tax Freeze Program was suspended in 2003. The NJ Saver Rebate and Homestead Rebates were combined into the FAIR rebate program, with more limited rebates of up to $1,200 for seniors or disabled persons, but only $300 for other residents.

• To fill the gap, some state taxes were raised. For example, in 2002, then-Governor McGreevey proposed and the legislature enacted significant changes in New Jersey’s corporate business taxes, which brought in over $1 billion more in revenue in FY 03, but that went to fund state expenses, not property tax relief. In 2004, the top rate of the personal income tax was raised to 8.97 percent for incomes of $500,000 or more.

• The increase in income tax revenue helped pay for property tax relief, including the resumption of the Senior Freeze program.

• However, even with the rebate programs and exemptions from taxable income, New Jersey residents have one of the highest property tax burdens in the country. The 2002 census data indicates that 46.5 percent of state and local revenues come from the property tax, the second highest in the country and the highest of any state with a broad-based income tax.

• Further, even with all revenues from the income tax distributed to the towns in aid and property tax relief, increases in the local property tax were 7.2 percent in 2004 and 52 percent over the last 10 years.

• The continuing dependence on the local property tax to fund education perpetuates the inequities among income levels and among poor and rich towns. But the financial input from the state has reduced the disparities in local school tax rates among districts somewhat by redistributing school aid to the more needy towns.

New Hampshire: Statewide Property Tax and School Finance

Problem: System of school financing declared unconstitutional

• From 1984 through 1999, the State of New Hampshire provided about 5 percent of the total cost of education for public schools through a “foundation aid” program.

• In two cases, Claremont I (1993) and Claremont II (1997), the New Hampshire Supreme Court ruled that the state constitution requires the state to provide an adequate education to public school children and tax rates levied to fund education must be “proportional and reasonable.”

Strategy: Statewide property tax and a new education funding formula

• The 1997 court decision gave the legislature until April 1999 to develop a new education finance formula. The legislature developed a plan in October 1999.

• In FY 00, the state’s required financial contribution to ensure the provision of an adequate education, under the new plan, was estimated at $825 million.

• The state created a new aid formula and established a statewide property tax set at $6.60 per $1,000 of equalized property value, administered by each municipality, to fund about half of the new program. The other portion is funded by sweepstakes revenue and business taxes. The tax rate has been adjusted through the years, and for FY 06, it is $2.84 per $1,000.

• The idea behind the plan was to have wealthier towns donate a portion of what they raise to poorer towns.

• The statewide property tax, for the most part, represents a conversion of existing local property tax. For many towns, a portion of local property taxes was essentially renamed as a state property tax. Only certain “donor towns” contributed some portion of the statewide tax to the new state fund.

• “State” property taxes retained locally must be subtracted from the $825 million to calculate the real amount of state education aid. In 1999, real state education aid increased from $97 million to just over $400 million, and is scheduled to increase to over $470 million in FY 06. It has been estimated that, up to FY 06, 95 percent of the statewide property tax is raised locally and kept locally, meaning donor towns contributed about $25 million to the state’s $400 million contribution.

• Many political leaders, including Governor Lynch and the speaker of the house, have made statements calling for the elimination of the statewide property tax and the donor town concept.

• The general aid formula was changed in FYs 03, 05, and 06. The current law is supposed to better target aid and nearly eliminates all donor towns. The new law is currently being challenged in court.

Impact: Some improvements, but reforms are not working entirely as intended

• A study completed in June 2003 compared education finance data in the year prior to reform with the three years after reform. This assessment examined what progress had been made in raising expenditure levels and lowering tax rates in New Hampshire’s less wealthy communities relative to communities with greater property wealth. It found:

- Reform has done little to change the overall per pupil expenditure patterns. Although towns with less property wealth received larger grants, spending increases were nearly the same across property wealth quintiles regardless of size.

- Tax rates declined, but decreases in local property taxes since reform were greater in communities with higher median household incomes than in communities with lower median incomes. With the exception of donor towns, upper, middle, and low property wealth towns saw reductions in tax rates. Rates declined in poor communities by 16 percent, but the middle quintile communities experienced reductions of 21 to 26 percent.

- The system had defined rich and poor towns solely on the basis of property valuations. Consequently, the town with the lowest median household income in the state was classified as rich, as were 21 other towns with below average incomes, while the four highest income towns received $10 million in state aid.

• Another study, published in March 2005, examined how new state education aid affected local budgets and which towns benefited from the increase in state education aid between FYs 00 and 04. It found:

- Less than 40 percent of new state education aid was used to educate New Hampshire students. The remainder of the additional aid spurred additional municipal or county spending or tax relief.

- Before the Claremont decisions, education aid was highly targeted to low-income towns, and after the decision middle- and high-income towns received the largest percentage increases in state education aid.

- In FY 04, low-income towns received only 22 percent of the total state general education aid, compared with 37 percent before Claremont.

• The new aid formula for 2005/06 apparently allows poorer communities to receive more education aid, while more prosperous communities receive lesser amounts compared to 2004. Communities that are losing aid, under the revised formula, would be guaranteed at least 85 percent of what they receive now in state aid for two years, but drop another 15 percent for the next two years.

- Overall, the total real state aid to towns for FY 06 of $473 million is seven times the aid in FY 98 of $70.8 million (pre-Claremont I).

- The wealthiest towns will receive 17 times what they did in 1998; in FY 05, they received 19 times what they had in 1998.

- The poorest towns will receive five times as much as they did in 1998; in FY 05, they received four times what they had in 1998.

- The poorest communities did and continue to receive the greatest amount of state aid; however, relative to other towns on a proportional basis, they receive less. For example, towns in the two poorest quintiles received 68 percent of state aid in FY 98 and will receive 50 percent in FY 06, while towns in the wealthiest quintile received 5 percent of state aid in FY 98 and will receive 14 percent in FY 06.

Colorado: TABOR and Its Impact

Problem: Perceived lack of accountability and unrestrained government growth

• Colorado has a long tradition of direct democracy, and over the years has adopted a number of voter-initiated fiscal policies ranging from a ceiling on the state’s operating budget (annual increases are limited to 6 percent) to restrictions on local property tax assessments.

• Beginning in the 1970s, concerns over excessive growth in state and local government led to a number of proposals to limit taxes. By the 1990s, anti-tax groups concerned about government’s ability to control spending on its own, especially during exceptionally strong economic times, had gained wide public support for adding a “taxpayer bill of rights” (TABOR) amendment to the state constitution as a way of limiting government growth and preventing tax increases.

Strategy: The TABOR (“Taxpayer Bill of Rights”) amendment, a constitutional limit on state and local revenue growth

• In 1992, Colorado voters approved a ballot initiative known as TABOR that amended the state constitution to require:

- voter approval of any state or local tax increase;

- growth in state and local revenues be limited to the inflation rate plus population growth (“allowed tax collections”); and

- any revenues received in excess of allowed collections be refunded to taxpayers.

- However, the amendment also allows voters to exempt governments from these limits for a set number of years and at certain times vote to allow governments to retain excess revenues.

Impact: Limited spending growth, state government is actually shrinking relative to the economy at present, and conflicts between tax and spending mandates

• TABOR, generally viewed as the most restrictive tax limitation in the country, kept government spending levels in check in Colorado throughout the economic boom of the 1990s. During the subsequent economic recession, when tax receipts dropped sharply, the TABOR limits were also rebased to a lower level. Despite the recent improvement in its fiscal conditions and healthy revenues, Colorado spending levels are still limited to inflation plus population growth and will take years to return to pre-recession levels.

- In fact, state government growth has fallen below growth in the economy. Because the largest items in the budget (i.e., Medicaid and K-12 education) grow at rates faster than those allowed under TABOR and offer limited opportunities for significant cuts, Colorado is experiencing serious budget shortfalls at the same time the state is required to provide taxpayer refunds.

- TABOR’s provision that all excess revenues be returned to taxpayers also prevents creation of an effective “rainy day fund.”

• Critics claim TABOR has significantly reduced the quality of many Colorado services. Some comparative statistics cited as evidence of this decline include the following: the state ranks 48th in higher education per capita spending; it ranks 49th in K-12 expenditures as a percent of personal income; it has the 6th lowest rate for Medicaid enrollment; and the percent of uninsured low-income children jumped from 15 to 27 percent between 1991 and 2003.

• Supporters point out TABOR has been successful in limiting government growth and preventing tax increases, which contributes to a favorable tax climate. Among the comparative statistics cited as evidence of this success are the following: Colorado currently has the 10th lowest per capita state/local tax burden; Colorado state and local taxes account for 9.5 percent of state personal income, ranking 37th among all states; and its business climate according to Tax Foundation rankings is the 8th “friendliest” in the country.

• TABOR tax limits conflict with a mandatory spending initiative. In 2002, Colorado voters approved another constitutional provision, Amendment 23, that requires per pupil K-12 education funding be increased at the rate of inflation plus 1 percent each year through 2010 and at the annual inflation rate each year after. Many believe the restrictions TABOR places on revenue growth will not permit compliance with the spending requirements of Amendment 23 and they also expect additional constitutional funding mandates will be pursued by various interest groups in the future.

• Another unintended consequence of TABOR is a more complicated state and local tax structure. A voter-initiated tax limit enacted in 1982, the Gallagher amendment, established restrictions on property taxes. Specifically, it requires 55 percent of revenues to come from commercial properties and 45 percent from residential properties. It also sets the commercial assessment rate at 29 percent of value, while residential rates are variable.

- Over time, as the value of residential properties has increased in relative terms, residential rates have had to drop to maintain the required tax ratio. In some cases, residential rates are so low they cannot produce adequate revenues for local budgets but, under TABOR, any property tax increase requires voter approval.

- Without approved property tax increases, towns must further cut spending or find other sources of revenue, usually from changes to local option sale taxes. As each of Colorado’s approximately 2,500 local governments can set its own rates and exemptions, the result is an extremely complicated and confusing tax structure for businesses and individual taxpayers.

Status: Changes to TABOR provisions under consideration

• Legislation to relax the TABOR restrictions and allow the state to retain more revenue over the next five years was approved by the legislature and the governor earlier in 2005. Implementation of these provisions, however, requires voter approval. A vote on this proposal was held in November 2005, with voters approving the measure to relax the restrictions.

Michigan: Local Property Tax and State Business Tax Reforms

Problem: Property tax reforms from the 1990s limit local revenue-raising options; a declining state economy is raising questions about revenue adequacy and the business climate

• At the beginning of the 1990s, the local property tax burden in Michigan was among the highest in the country (34 percent above the national average in 1992). In addition, state support for education costs was among the nation’s lowest, and spending disparities among local school districts were great.

• Property tax reforms enacted in the mid-1990s have helped to address local tax burden and school finance issues, but have had an unintended consequence of severely limiting local revenue-raising authority. If state revenue sharing is not adequate, local officials are concerned they will be unable to meet necessary expenses.

• Michigan’s weak economy in recent years is consistently producing revenues below anticipated levels. At the same time, a major state revenue source, the Single Business Tax (SBT), is being phased out, and there is no agreement about how it will be replaced.

Strategy: Enactment of Proposal A and elimination of the Single Business Tax

• To provide local property tax relief and reduce school funding inequities, Michigan restructured its tax system in 1994 in accordance with voter-approved ballot Proposal A, which:

- increased state tobacco taxes, increased the sales tax rate, established a new state education tax (6 mills on all property), and created a new real estate transfer tax to replace about two-thirds of local school property taxes;

- earmarked all resulting new revenues to a new state School Aid Fund;

- placed a per parcel cap on annual increases in the taxable rate for property of 5 percent or the inflation rate, whichever is less;39 and

- required legislative approval by a three-quarter vote of any increase in local property taxes for school operating expenses.

• Michigan enacted its unique Single Business Tax in 1975 as a means of insulating state revenues from dramatic fluctuations related to its volatile business cycles. The SBT, the only value-added type tax on business gross receipts in the country, replaced Michigan’s corporate income tax and six other businesses taxes including the local property tax on business property. In addition to being more stable and transparent, the SBT was intended to be a more neutral business tax, treating all entities (incorporated and unincorporated) the same, encouraging investment, and not penalizing businesses for being profitable.

- Since its enactment, the SBT has been amended over 60 times to add exemptions and exclusions, which has significantly reduced its original broad base.

- Its low 2.3 percent tax rate remained unchanged, however, until 1998. That year a proposal was put in place to phase the tax out over a 20-year period by annually reducing the rate (unless the state rainy day fund balance drops below a set level, which temporarily halts the phase-out).

- Prompted by business concerns about competitiveness given the state’s poor economy, the SBT phase-out was accelerated in 2002. The tax is now scheduled for elimination by 2010.

Impact: Several reform goals achieved but with some unintended consequences

• Michigan’s Proposal A reforms have resulted in lower property taxes, substantial improvement of state support of education, and less disparity in district spending. According to a recent university study:

- Michigan ranked 18th in property tax burden in 2002 compared to 5th in 1992;

- the state now supports almost 80 percent of K-12 general education funding versus 29 percent in FY 93; and

- the difference in per pupil spending between the highest and lowest spending local districts was reduced from three times to two times between the 1993-1994 and 2002-2003 school years.40

• At the same time, with the restrictions Proposal A placed on local tax options, some towns report they may be unable to raise sufficient revenues to meet expenses. Given Michigan’s current economic conditions, increases in state aid levels seem unlikely.

• According to most reports, the SBT has been a significant, stable, and countercyclical revenue source for the state.

- Despite rate reductions as it is being phased out, the SBT produced nearly $2 billion in revenues for FY 05, almost one-quarter of the state’s general fund revenues and about 6 percent of all state revenues.

- The SBT base, however, has been eroded over time reducing its neutrality and fairness. As a result of the numerous exemptions and exclusions, it is estimated at least half the businesses in the state are no longer required to file a return.

• An unintended consequence of the SBT is it can provide generous incentives for investments multi-state corporations make in other states, while measures to limit such tax benefits to Michigan firms have been found to violate interstate commerce provisions of the federal constitution.

Status: The direction and impact of tax reform is uncertain.

• In September 2005, Michigan legislators and the governor reached agreement on a state spending plan that appeared to preserve present levels of state education aid to municipalities. After considerable debate and negotiation, a tax plan that included a number of business tax reforms was subsequently adopted.

• At this time, it is not clear if state revenues resulting from this plan will be sufficient to meet both state and local spending needs.

THIS PAGE IS INTENTIONALLY LEFT BLANK

Chapter V

Findings, Policy Options, and Recommendations

This chapter summarizes major committee findings about the performance of the state and local tax system based on an assessment of the various criteria encompassed by the nine NCSL principles for a high quality revenue system. The principles include: Complementary, Balanced, Reliable, Equitable, Economically Competitive, Neutral, Promotes Compliance, Accountable, and Fairly and Efficiently Administered. While some findings are based on analysis presented in this chapter, many are based on information, state comparisons, and analysis contained in the first four chapters.

When committee findings indicated a deficiency in the tax structure’s performance in meeting a principle, broad policy options for change were developed. These options are offered for further consideration by the full legislature as ways that could improve performance of various aspects of Connecticut’s revenue structure. However, it must be remembered that improvements intended to achieve better performance in one principle could diminish the system’s ability to meet the goals of the other principles. Policy options and their possible implications, if implemented, are described below. In a number of areas, operational changes intended to strengthen administrative aspects of the system are also recommended.

I. Principle: Complementary

Objectives of the tax system should be consistent and the system must recognize limitations and responsibilities of local government.

Findings:

Connecticut has a complementary system, with no overlap in taxing authority, but policymakers do not have an accounting of the cost impact of state mandates on towns, and the state does not fully fund its obligations to municipalities.

• The state’s tax structure contains no significant overlap in state and municipal tax bases.

- Primary revenue sources for state government include income and sales taxes, but not the property tax.

- Local government revenue-raising authority is limited to the property tax, representing over 98 percent of all local taxes, but municipalities have no legal constraints on levels of taxing property or levels of spending.

• There is no formal recognition of the total cost of state mandates on municipalities.

- Individual fiscal impacts of proposed mandates on municipalities are noted during the legislative process in fiscal notes, but there has never been a full accounting of the cost of state mandates.

- In November 2005, the governor established a commission “to study whether unfunded and partially funded mandates serve an actual need or if they can be curtailed or eliminated.”41 A similar legislative proposal died in committee during the 2005 legislative session.

- As required under statute, in 2002, the Advisory Commission on Intergovernmental Relations (ACIR) identified state mandates and characterized the cost of each as being significant, moderate, or minor -- though a total cost of mandates was not developed. ACIR is required to publish a complete compendium of mandates every four years and compile an annual supplement in the intervening years.

Recommendation:

1. Amend C.G.S. Section 2-79a to require the Connecticut Advisory Commission on Intergovernmental Relations to identify and describe each unfunded and partially funded state mandate affecting municipalities, quantify the actual cost of major mandates, and determine the effect of eliminating or reducing any such mandates. ACIR shall submit a report to the legislature every four years.

• The state does not fully fund grants to municipalities, notably in the education area and the payment in lieu of taxes (PILOT) reimbursements, or reimburse for other mandated exemptions to the property tax.

- Not all grant programs, even when fully funded according to statutory formulas, are intended to reimburse municipalities for their entire loss of revenue due to state-mandated exemptions. For example, the grant to reimburse municipalities for state- owned property provides a reimbursement of only 45 percent of the property tax loss for most state property. Consequently, municipalities receive less than they would if the exemptions did not apply.

- It is estimated for FY 06 that the state has underfunded major statutory grant programs by about $177 million. (See Appendix G for more detail).

- Scientific, educational, literary, historical, recreational, religious, and other charitable nonprofit institutions are exempt through state statute from paying the property tax. Except for certain colleges and hospitals, the state does not reimburse municipalities for this loss of taxes. These institutions combined have property valued at over $6 billion and represent 16 percent of all exemptions.

- According to the latest U.S. Census Bureau report (2003) that compares state support for funding elementary and secondary public school education, the state of Connecticut ranks among the lowest (47th) in the nation. The national average for state funding of education is 49 percent, while Connecticut contributes 36 percent. This figure includes state support of school construction, debt service, and payments to the retirement system on behalf of local schools. The governor has recently appointed a Commission on Education Finance to examine and develop possible revisions to Connecticut’s Education Cost Sharing (ECS) formula.

Policy Options: Complementary

Option Description

Implications

A. Increase State Grant Funding

Increase state grant funding to recognize the limitations of municipal revenue capacity relative to municipal responsibilities and to relieve the property tax burden.

Specifically: i) fully fund the current Education Cost Sharing grant; ii) fully fund formula grants, including PILOT; and iii) increase the statutory percentage of reimbursement for PILOT to better reflect the amount of revenue lost.

• Additional state funds for this purpose would be required and could mean cuts to other areas of spending, revenue increases, revisions to the spending cap, or revenue earmarking (that is set aside the revenue for a particular purpose). The shortfall in funding for major formula grants for FY 2006 is about $177 million. As discussed above, the statutory formula for the state PILOT program is not intended to fully reimburse municipalities. If the assessment on state-owned property was funded at 100 percent of what was owed to municipalities, they would receive an additional $118 million.

• Total state spending is already very close to permitted levels. Within two years there will be no room under the cap for any increases in local aid unless resources are reallocated (e.g., cuts are made to other programs) or changes are made to the spending cap.

• Current forecasts show state revenue shortfalls beginning in FY 08. (Projected revenues will not keep up with current services spending levels or even the lower levels allowed by the cap.)

B. Remove Barriers to Increased State Grants

Avoid spending cap restrictions on increased state grants to municipalities by either: i) revising the calculation of the spending cap; or ii) earmarking revenues.

Capital gains are a significant component of income in Connecticut. The spending cap could be revised to better reflect the state’s ability to pay for public services by including capital gains in the cap’s definition of personal income. Adding a capital gains factor would make the personal income measure more accurate and possibly lift the allowed rate of increase in annual appropriations.

Spending cap issues can also be avoided by earmarking revenues. Funding earmarked from a particular source for a specific purpose is not annually appropriated and, therefore, is not subject to the spending cap.

• Providing more state aid to towns could ease reliance on local property tax revenues and achieve better balance among the main components of the state and local tax system.

• Higher allowed state spending levels would permit increases in state aid to towns for mandated programs, but it could be difficult to ensure the new funding is restricted to that purpose at either the state or local level.

• Instituting a less “conservative” spending cap might be viewed as a broken promise by those who supported the 1991 budget reforms.

• Revisions of spending cap provisions would require statutory and possibly constitutional changes.

• Earmarking revenues can ensure new state funding is used for intended purposes, but it is not a practice generally endorsed by fiscal policy experts. It limits flexibility in the use of financial resources and puts decision making outside the appropriations process.

• State revenue shortfalls projected within the next five years will likely limit how much new state aid can be provided to municipalities by any mechanism.

C. Review Nonprofit Tax Exemptions

Require the Office of Policy and Management or a special task force to examine the issue of property tax exemptions for private institutions holding tax-exempt properties, except those institutions already reimbursed by the state (i.e., certain private colleges and hospitals).

The focus of the review would be to determine the extent to which these exemptions are limiting the towns’ ability to raise revenue through the property tax, and would also compare state tax policies and municipal approaches to the issue in Connecticut to those of other states and cities.

In addition, the study would also explore and develop possible policy options for increasing revenue, such as methods to require or encourage institutions of a certain size or with large endowments to provide PILOT payments to municipalities, as well as an expansion of the state PILOT program to include additional reimbursements to municipalities for exemptions claimed by nonprofit organizations.

• Nonprofits provide services that either replace or supplement what would be provided by government, so they should not be taxed.

• Nonprofits, though, benefit from services that they do not pay for, and other taxpayers are forced to subsidize them.

• If taxed, services provided by nonprofits may have to be cut back or eliminated, and government may have to replace the services at taxpayer expense.

• Nonprofits may engage in activities that compete with local businesses and, therefore, get a competitive advantage by not paying taxes.

• Nonprofits constitute an important part of the local economy (e.g., salaries, wages, capital expenditures), and many contribute to the desirability of an area. Taxing nonprofits may impair their ability to make such financial contributions.

• It is argued that some organizations have gone beyond the original intention of a nonprofit entity, amassing large endowments, and, with larger nonprofits compensating executives with relatively generous salaries and benefits, may have resources to defray the cost of municipal services.

II. Principle: Balanced

A high quality revenue system relies on a diverse and balanced range of sources that tend to mitigate the weaknesses of each individual tax. The major taxes (personal income, sales, and property) should be contributing a nearly equal proportion to total revenues.

Findings:

By most measures, Connecticut is heavily reliant on the property tax and, therefore, the state’s revenue structure does not meet the principle of a balanced tax system.

• Connecticut levies all the major taxes, but the system is most reliant on the personal income and the property tax, which when combined amount to over two-thirds of total state and local revenue.

- The property tax, providing about 40 percent of total tax revenues, is the major contributor to the state and local tax system. The personal income tax contributes about 27 percent, while the sales tax adds approximately 19 percent to the total.

• Connecticut’s revenue system is more reliant on the property tax than 42 other states, and three of the states that are more reliant do not impose a broad based income tax.

- In Connecticut, like all states in the Northeast region except New York, property taxes account for a higher portion of total state and local tax revenues than the national average of 31 percent.

- Of the eight Northeast states (New England, New York and New Jersey), two -- Massachusetts and New York -- rely less than Connecticut on property taxes as a proportion of total tax revenues, but they rely more on the individual income tax.

- When comparing property taxes paid on a per capita basis, Connecticut ($1,760) ranks second highest in the nation and 77 percent above the national average ($992).

- When comparing property taxes paid as a percentage of personal income, Connecticut ranks seventh highest in the nation at 4.1 percent, which is 32 percent above the national average of 3.1 percent.

- Connecticut municipalities are the second-most dependent state in the U.S. on property taxes as a source of tax revenue; property taxes make up over 98 percent of all local tax collections.

- The statewide business proportion of the property tax base has been declining. Since 1989, the residential portion of the property tax base has increased from 58 percent to 67 percent, while the commercial/industrial/public utility portion of the base has declined from 23 to 16 percent. The personal property component of the property tax base, typically paid by businesses, has also declined from 9 to 7 percent. Motor vehicles (8 percent) and other (2 percent) make up the balance of the tax base.

• Connecticut’s reliance on the sales and corporate income tax has declined considerably during the 1990s.

- Prior to the implementation of the broad-based personal income tax in Connecticut in 1991, the sales tax represented about 28 percent of total revenues, and the corporate income tax represented about 7 to 9 percent. After implementation of the personal income tax, the sales tax initially declined and then leveled off to about 19 to 20 percent of total revenues, while the corporate income tax has declined to about 3 percent.

• Forty-two states have programs that limit or freeze assessed property values, property tax rates, or total property taxes in order to provide property tax relief.

- Thirty-one states have tax rate limits, 20 states have caps on increases in assessed property values, 23 have limits on total property taxes, and 11 states have freezes on assessed property values or property taxes. (Some states have a combination of limits).

- Only eight states, including Connecticut, do not have statewide limits that apply to all property taxpayers or residents.

- A program review analysis of tax rates for the 104 Connecticut municipalities that implemented a revaluation from 2002 through 2004 shows the average rate increase to be about 7 percent above what it would be if the amount raised from taxes was kept level compared to the year before revaluation. Twenty-six towns, however, experienced double digit increases. See Appendix I for a town-by-town breakdown.

Policy Options: Balanced

Option Description

Implications

A. Reduce Property Tax Portion of State and Local Revenues

Reduce reliance on the property tax to about 33 to 35 percent of all tax revenues in a three- to-five year phase-in period. This would effectively shift about $1.3 billion from the state to municipalities.

This could allow the state to achieve the often discussed goal of 50/50 funding for local education. Currently, the state would have to invest an additional $563 million to meet this goal.

• Under this proposal, replacement revenues would have to be found of about $1.3 billion.

• Raising the personal income tax or raising the sales tax to fund this proposal would make the state and local revenue system more volatile.

• Because the state has not historically funded its obligations to local government, increased reliance on state funding for local needs may destabilize the local finance structure.

• This proposal would probably require at least on a time-limited basis that municipalities reduce the property tax on a dollar-for-dollar basis.

• Unless cuts in state spending can be found, the spending cap may limit the state’s ability to implement this option. (See policy option B regarding the spending cap under the Complementary principle.)

B. Increase Local Taxing Authority

Expand the taxing authority of local governments to levy an income or sales tax. For example, 31 states allow local governments to levy a local sales tax, and 10 states allow local governments to levy an income tax.

• This option would negatively impact the complementary nature and simplicity of the current system, and may lead to taxpayer confusion and resentment.

• It may generate competition among municipalities and possibly encourage sprawl.

• This would circumvent issues with the spending cap but still allow funding to go to towns.

C. Redistribution of the Sales Tax

To assist targeted municipalities in providing property tax relief, earmark 1 percent of the 6 percent sales tax (1/6th of sales tax revenues) to return to one of the following:

• Under this proposal, replacement revenue for the state would have to be found.

• The towns would not be able to use this funding for any purposes other than to provide property tax relief.

1) the 10 most distressed municipalities, based on quantitative physical and economic distress thresholds defined in C.G.S. 32-9p(b), which would currently include:

- Hartford

- New Haven

- New Britain

- Waterbury

- Bridgeport

- East Hartford

- East Haven

- Winchester

- Meriden

- New London

• Based on OPM’s 2005 rankings, the 10 most distressed municipalities would receive approximately $88.4 million total (using 2002 collections data). The amounts each distressed municipality would receive are included in Appendix J.

• This option would target towns most in need; however, funding would be limited to a portion of the dollars generated through the state sales tax.

2) the 10 towns whose businesses generate the most sales tax revenue. Currently, these are:

- New Haven

- Hartford

- Stamford

- Danbury

- Norwalk

- Manchester

- North Haven

- Greenwich

- Bridgeport

- Berlin

• Using DRS’ 2002 collections, this option would return a total of approximately $154.7 million in property tax relief to these municipalities. (See Appendix C for a complete listing of what these 10 towns generated in sales tax collections during 2002.)

• This option, which might encourage sprawl, conflicts with smart growth objectives that try to deter sprawl.

3) the 10 towns generating the most sales tax revenue (minus collections from sales on new and/or used cars);

- New Haven

- Hartford

- Danbury

- Stamford

- Norwalk

- North Haven

- Manchester

- Greenwich

- Bridgeport

- Berlin

OR

• Using DRS’ 2002 collections, this option would return a total of approximately $144.6 million in property tax relief to these municipalities. See Appendix C for a complete listing of these 10 towns and their individual collections estimates.

• This would provide these towns with a cumulative $144.6 million in property tax relief.

• This option conflicts with smart growth objectives.

4) A less targeted approach, returning 1 percent of the sales tax revenue to each of the 15 municipal planning regions.

This option could be combined with an incentive program to regionalize municipal service delivery to reduce the overall cost of local government.

• Based on 2002 collections data, the municipal planning regions would receive approximately $394.3 million in total. The amounts for each municipal planning region are provided in Appendix C. The amounts would have to go to towns for property tax relief, but the regional planning groups would decide on how the revenue would be distributed.

• This option would be more equitable in that all regions would receive a portion of their sales tax collections, and it provides no increased incentive for sprawl.

D. Enact Local Tax and Expenditure Limitation (TEL)

Require municipalities to limit the growth in the property tax through one or a combination of the following:

• a tax rate limit - limits overall property tax payment or restricts tax levies;

• an assessment limit – restricts how much property values may increase in a year for tax purposes;

• a revenue roll back – requires local governments to reduce mill levies when assessments grow by more than a certain percentage;

• an expenditure limit – directly restricts the growth in local government spending to factors such as increasing population and inflation; or

• revitalization of Connecticut’s closed property tax freeze program – require reopening of the property tax freeze program in Connecticut and expand eligibility.

• This proposal may require more discipline over local budget and tax practices.

• These options may require local governments to evaluate programs more formally and prioritize services.

• TELs would contain property taxpayer burden over time.

• TELs provide certainty, stability, and predictability for property taxpayers.

• These proposals would make the system more complicated, and often substitute one set of inequities for another.

• Enactment of a TEL may fail to provide enough revenue to meet continuing levels of service in hard economic times.

• These types of limits often fail to account for growth in intensive local government service areas, such as education, and would, therefore, require additional state aid to make up some of the lost revenue.

• An increasing reliance on state government to provide funding, while limiting local government tax burden, may diminish local autonomy and destabilize the local finance structure, especially given the state’s pattern of underfunding obligations to municipalities.

• Assessment limits can cause disparities between long-time homeowners and new residents.

• Assessment caps result in ambiguous subsidies and tax shifting with no clear public purpose or benefit.

• Local government service quality in general may be impaired. For example, per-pupil spending and student performance declined in California.

• In California, Proposition 13 increased the use of dedicated funding, which is contrary to best practices in fiscal policy.

• Municipalities may turn to increasing local fees and other mechanisms that are much more narrow sources of revenue to recover the loss in taxes, which tend to be less equitable and more volatile.

E. See also Policy Option A (Increase State Grant Funding) under the Complementary Principle.

Implications are discussed under the Complementary Principle.

III. Principle: Reliable

Revenues produced by a tax system should be stable, certain, and sufficient. Revenues should be relatively constant and predictable over time and at levels adequate for balancing the budget each year and adapting to desired spending changes.

Findings:

Connecticut’s state tax revenues are volatile and some state taxes are prone to frequent revision. Local property tax growth is relatively slow but steady and adds stability to Connecticut’s overall revenue structure.

In total, state and local tax revenue growth is well above the rate of inflation and generally keeps pace with growth in the economy. State revenue collections, however, do not always match state spending levels, large General Fund budget shortfalls have occurred during severe economic downturns, and deficits are forecast within the next five years.

• Connecticut state tax revenues are more volatile than the state economy and, like other Northeast states, more volatile than the national average for state revenue systems.

- State tax collections in Connecticut (adjusted to remove the impact of legislative changes) have higher highs and lower lows over time than growth in state personal income.

- Actual state revenue growth in Connecticut fluctuates more than for the U.S. on average and for four states in the region -- Maine, New Jersey, New York and Rhode Island. (See Appendix K, Table K-1 for all comparative data.)

- Much of Connecticut’s revenue instability seems related to highly fluctuating state personal income tax collections, which are due primarily to the very volatile incomes of taxpayers in the top brackets.

• The local property tax is the system’s least volatile revenue source and provides an important stabilizing effect on Connecticut’s overall tax structure. Property taxes are highly predictable, once assessments are finalized, and less sensitive than sales and income taxes to short-term economic changes.

- However, when revaluations occur, the impact on tax liability can be more significant for some taxpayers than others. It is important to “level out” the impact of revaluations through mill rate reductions.

- More frequent revaluations lessen the “sticker shock” of large tax increases due to rapidly escalating property values.

• Certainty of the revenue system is somewhat reduced by frequent modifications of Connecticut’s corporate income tax including periodic surcharges, continual changes in excise tax rates for motor fuels and cigarettes, and the exemptions added to the sales tax during most legislative sessions. The state personal income tax, however, has undergone little significant revision since its adoption in 1991, and while some changes have been made to the sales tax base, its rate has remained the same since 1992.

• A recent Federal Reserve Bank of Boston report found Connecticut has a high level of “fiscal comfort,” meaning relative to other states, it has high revenue capacity and low fiscal need. The state’s consistently high bond ratings also reflect sufficient fiscal resources in comparison to expenditure requirements.

- Among the state’s fiscal strengths cited by the major bond rating agencies are its wealth, healthy personal income growth, its reasonable cap on state spending, and its budget reserve (“rainy day”) fund.

- Concerns of the bond agencies include Connecticut’s heavy debt load, large unfunded pension liabilities, and use of nonrecurring resources to meet expenditure requirements.

- Based on recent bond agency reports, Connecticut’s ratings would likely move up (from levels that are good to the highest tier) if: high reserve levels were achieved and maintained; a trend of structural budget balance was established; and debt ratios were reduced.42

• Since enactment of the state’s broad-based income tax in FY 91 through FY 03, state and local revenues together grew a total of nearly 63 percent; while inflation was just under 33 percent, state personal income rose almost 56 percent, and state and local spending increased about 60 percent.

- Revenue shortfalls, however, still occurred at the state level and Connecticut has been unable to avoid spending cuts and tax hikes that are disruptive to business and individuals and to the management of public programs.

- The significant volatility of the state revenue stream combined with the severity of the most recent recession contributed to General Fund deficits of more than $800 million in FY 02 and almost $100 million in FY 03.

- The state Budget Reserve Fund, with a required maximum balance of only 5 percent of total appropriated spending before 2002, was of limited use in cushioning the effects of Connecticut’s substantial revenue shortfalls. (This problem was addressed to some extent by legislation enacted in 2003 that raised the fund balance requirement to 10 percent.)

• Fiscal forecast information presented in November 2005 to the finance and appropriations committees by the legislature’s Office of Fiscal Analysis (OFA) and OPM in accordance with P.A. 05-262 shows the state could face budget shortfalls again beginning in FY 08. (See supporting data presented in Appendix K, Table K-2.)

- Under OPM assumptions for the longer term, state spending at current service levels will exceed projected state revenues by significant amounts each year from FY 08 through FY 10. In each of these years, state expenditures at the current service rates will also exceed the level allowed under the state spending cap.

- Projected state revenues will not even keep up with the lower, capped spending levels beginning in FY 08.

- It is estimated Budget Reserve Fund monies would be available to offset possible state deficits in FY 08 and FY 09, but by FY 10 the fund would be depleted. (The state’s FY 02 deficit exhausted the fund in one year and it has only recently started to rebuild its balance with deposits of surplus monies from FYs 04 and 05.)

- At its present level, the Budget Reserve Fund balance represents 4.3 percent of appropriated spending and is almost $808 million short of the 10 percent target. Anticipated surpluses in FY 06 and FY 07 could raise its balance to over 6.2 percent ($1.12 billion).

• Based on an analysis of OFA expenditure data from FY 00 through FY 05, the major expense categories for the state General Fund are Medicaid, employee compensation and fringe benefits for active and retired employees, education aid, debt service, other agency operating expenses, and human service programs at the Department of Children and Families (DCF) and the Department of Mental Retardation (DMR). (See supporting data presented in Appendix K, Table K-3.)

- Most of the costs in the General Fund’s largest major accounts represent mandatory spending (e.g., required by federal or state law, contracts and agreements, or court order). In each case, growth in these expenditures is greater, sometimes significantly, than growth in General Fund revenues.

- Between FY 00 and FY 05, the average annual increase in total General Fund expenditures was 3.8 percent while General Fund revenues grew, on average, 2.7 percent per year.

- Total growth in Medicaid spending, the largest major account, was almost 30 percent while debt service, the fourth largest major account, increased almost 40 percent. The Retired State Employee Health Services Costs account, which made up about 3 percent of the FY 05 General Fund budget, almost doubled between FY 00 and FY 05 (a nearly 88 percent cumulative increase).

- When state budget cuts are necessary, aid to municipalities is often the first expenditure area subject to reduction. Cumulative growth among the major General Fund accounts was smallest (15.1 percent) in funding for the ECS grant, perhaps indicating the negative impact of state revenue volatility in terms of stable financial support for cities and towns.

• The sources of spending pressure in Connecticut appear similar to those in other states. A recent fiscal survey found rising health care costs to be the single biggest obstacle to states’ economic recovery; also, while state revenue growth during the past fiscal year was strong, expenditure pressure is very high.43 Programs identified as presenting the largest fiscal challenges to states were: Medicaid, K-12 education, corrections, underfunded pensions, and infrastructure.

- Connecticut seems to rely more heavily on bonding to fund state activities (almost 10 percent of General Fund spending in FY 05 and 6 percent over the past 10 years), based on comparative data and the amount the state pays in debt service.

- National studies consistently find Connecticut has one of the highest debt burdens in the U.S. A recent report by Moody’s Investors Services on state debt burden shows Connecticut, compared to all states, ranked number one on the measure of per capita debt and number three on the measure of debt as a percent of income.44

• Ten factors that place states at risk for structural budget problems were identified in a recent report by the Center on Budget and Policy Priorities, a national nonprofit policy research group.45 Most are associated with tax structure (e.g., a lack of services in the sales tax base; weaknesses in the corporate income tax; untaxed e-commerce; extensive tax preferences for the elderly; limited personal income tax progressivity; a tax mix that worsens budget gaps), but spending pressures from growing resident needs and other types of fiscal policies (e.g., failure to detach from federal funding requirements, process restrictions like tax and expenditure limits) are also included.

- The report found the majority of states, 44 including Connecticut, faced five or more risk factors, and all states faced at least three.

- Compared to other Northeast states, Connecticut had the same number of structural gap risk factors (six) as New Hampshire and Massachusetts, fewer than Rhode Island (eight), and more than Maine, New York, New Jersey and Vermont (three to five).

- The report’s main finding, supported by similar analysis by the National Conference of State Legislatures, is gaps in state budgets will persist, and continually require policymakers to cut spending, hike taxes, or both, although modernizing tax structures to capture the full range of growth in the economy might help.

• California, like Connecticut, experiences more dramatic variation in its revenue collections than most states. A study conducted by that state’s nonpartisan Legislative Analyst’s Office (LAO) found two major reasons for California’s revenue volatility are the state’s dynamic economy and its heavy reliance on a highly progressive personal income tax.

- The LAO report found volatility could be lessened by either revising the state’s basic tax structure (e.g., reducing personal income tax progressivity, rebalancing the tax mix away from the income tax) or managing volatility with budgeting strategies (e.g., building up substantial reserves, allocating a portion of revenue growth during good times to certain one-time purposes like debt reduction) or some combination of both options.

- LAO concluded the least disruptive and most effective volatility reduction strategy was a large reserve fund.

• Recent research, including reports by the Government Finance Officers Association and the Center on Budget and Policy Priorities, suggests an adequate level of reserve funding for most states, particularly those with high budget volatility, is at least 15 percent of annual expenditures. Automatic deposit rules along with flexible withdrawal and replenishment policies are other recommended best practices for “rainy day” funds.

- Connecticut’s currently required fund size, 10 percent of General Fund net appropriations, was put in place in 2003 largely in recognition of the inadequacy of the prior maximum balance (5 percent from the time the fund was created in 1978 until 2002 and then 7.5 percent for one year).

- A 10 percent balance would have been sufficient to cover the last serious deficit (more than $800 million in FY 02) but may not be adequate for any extended economic downturn.

- As discussed above, the fund’s current balance is less than 5 percent at present and is unlikely to reach the 10 percent level in the near future. Achieving a 15 percent reserve would take many years given the state’s projected fiscal condition.

- The state constitution requires any unappropriated General Fund surpluses be transferred first to the state’s budget reserve fund to raise its balance to the maximum required. The fund can only be applied to state operating deficits at the end of a fiscal year but there are no other withdrawal or replenishment requirements.

- The legislature has a fairly good record in making reserve fund deposits and using surpluses as required (see PRI Connecticut Budget Process, 2003). However, surplus funds can be “intercepted” and appropriated for a variety of current budget purposes. In the current fiscal year (FY 06) some surplus money was used to increase aid to local governments.

- If all surplus monies from the past two fiscal years had been deposited in the Budget Reserve Fund, the fund would be at its 10 percent target.

• State sales tax revenues have not kept pace with the economy, and growth has been slow; however, these revenues have become less volatile and more predictable in recent years.

- From FY 90 to FY 04, the cumulative growth in the state’s personal income was 61.8 percent, while actual sales and use revenues grew in total by 42.4 percent and inflation was 43.7 percent.

- The substantial lag in sales tax revenue growth behind personal income is reflecting what appears to be a nationwide trend that is likely the result of an increasing number of exemptions, a shift away from consumption of taxable tangible goods toward tax-exempt services, and the increased consumer preference for purchasing goods online and tax free.

• One way to address the erosion of the sales tax base is to capture lost revenue from Internet and catalog sales by participating in the Streamlined Sales Tax project. At present, Connecticut is not an active participant – meaning it has not signed the Streamlined Sales Tax Agreement or amended its sales tax law to conform to the standardized definitions.

- The Streamlined Sales Tax Project is a coordinated effort of 40 states (19 full member states) to simplify and modernize sales and use tax administration in order to gain the authority to require businesses, including Internet vendors, to collect sales taxes for each member state.

- By adopting uniform definitions and eliminating thresholds, the project simplifies the tax laws and improves the efficiency of tax administration.

- Participating states also significantly reduce the burden of tax collection by implementing new technology that enables businesses to more quickly, easily, and accurately determine what is taxable and at what rate in each state in which they conduct business.

Policy Options: Reliable

Option Description

Implications

A. Maintain Stronger Reserves

Make building and maintaining the Budget Reserve Fund a priority by depositing all surplus monies until the fund reaches its 10 percent maximum balance.

Require OPM in consultation with OFA to conduct an economic analysis of the possible uses of surplus funds to determine the long-term costs and benefits of various alternatives including but not limited to debt reduction, funding pension liabilities, and increasing the BRF balance.

Based on the study results, consider increasing the maximum reserve fund size to 15 percent and statutorily requiring the deposit of all surplus monies (not just the unappropriated amount) until the maximum balance is reached.

• Adequate, accessible reserves contribute to state revenue stability and good bond ratings; budget stabilization funds allow avoidance of spending cuts and tax hikes when conditions are least favorable for such actions.

• The California LAO revenue volatility study showed restructuring the mix of state taxes to improve stability involves significant policy tradeoffs; stability may be gained but adequacy (e.g., less revenue growth) or equity (e.g., increased regressivity) may be diminished.

• A reserve balance greater than 10 percent could better handle a serious recessionary period such as ones Connecticut experienced in the early 2000s and the early 1990s; applying all surplus monies to the BRF would build up the balance more quickly during good economic times, placing the state in a better position to handle a fiscal crisis.

• High level reserve funds require fiscal discipline. This is difficult to legislate and hard to maintain, especially if advocates for programs that were cut or flat funded during downturns question keeping a high reserve balance in “good times” when needs are going unmet.

• Given projected fiscal trends, it appears unlikely surplus funds will be available after FY 08 to build or maintain the reserve fund, even at a 10 percent balance. According to bond rating agencies, other states (e.g., Massachusetts) have maintained their reserves despite revenue drop offs by strongly controlling the expenditure side of their budgets.

• In their recent fiscal forecasts, both OPM and OFA point out the state may be better off using some portion of surplus funds to reduce long-term financial obligations (such as bonded indebtedness or unfunded pension liabilities) rather than increasing its budget reserves. Conducting an economic analysis would provide policymakers with the information necessary for making the best decisions about surplus use.

B. Improve Sales Tax Reliability

1) Broaden the base and lower the rate of the state sales tax to improve its reliability; specifically, reduce the rate to 3.5 percent and eliminate all current exemptions. Do not apply the tax to business purchases.

OR

2) Broaden the base while maintaining the exemptions that decrease the regressivity of the tax (i.e., food, clothes, prescription drugs, patient care services and utilities for residential use).

• According to economists, lowering the rate while broadening the base (eliminating exemptions) would have a neutral effect on the amount of revenue raised by the tax in the short-run; however, over time it would raise more revenue because it would be more responsive to modern consumption patterns.

• These proposals would still maintain autonomy of sales tax administration at the state level.

• Broadening the base may increase the occurrence of pyramiding/cascading, which is when businesses decide to shift the burden of their taxes onto the consumer by raising prices. For this reason economists and business agree that the base should not include business purchases.

• Lowering the rate would make the tax more competitive. In 2005, the 3.5 percent suggested rate would be the lowest and simplest single state rate in the country.46

• Eliminating exemptions would simplify the administration of the tax for businesses, retailers, consumers, and DRS and, therefore, promote better compliance.

• Broadening the base will increase the transparency and equity of the tax.

• Broadening the base will increase the number of merchants requiring sales permits and remitting the tax.

• Consumption of services is growing faster than that of goods. From 1945 to 2002 consumption of goods decreased from 67 percent of personal income to 41 percent, and consumption of services rose from 33 to 60 percent of personal income. A broad base would avoid losses resulting from increasing consumption of tax-exempt services.

C. Increase Participation in the Streamlined Sales Tax Project

Become a full or associate member in the SST project, and capture more e-commerce and mail transactions, which will improve the reliability of the state sales tax.

• Full SST participation would provide additional revenues and stem the erosion of the sales tax base.

• The state still retains its authority to decide what is taxed and at what rate.

• Full participation would require the state to eliminate thresholds – SST members cannot tax items at different or partial rates or only above a certain baseline amount (e.g., all clothing would have to be taxed at the full rate, providing an additional $120 million in revenue, or be completely exempt).

• Adopting the uniform definitions will ease administration of the tax for businesses, retailers, consumers, and DRS and, therefore, promote better compliance.

• Standardized definitions and more sophisticated technology will ease the complications for business located in other states conducting business, such as sales, in Connecticut.

• It will allow the state to gain additional sales tax revenue from those businesses and retailers who choose to participate and potentially from all businesses should federal legislation ultimately pass. (OPM estimates the state is at risk of losing approximately $440 million in revenue from Internet and catalog sales in FY 06.)

• Uniform definitions could simplify administration by allowing for common application of case law decisions (e.g., clarifying how definitions are to be applied in practice).

IV. Principle: Equitable

The overall tax system should minimize regressivity and not place an unfair burden on people with lower incomes.

Findings:

Connecticut’s tax system is similar to the rest of the nation in terms of the state’s overall tax burden.

• Connecticut’s state and local tax burden was 10.2 percent of state personal income in 2002. This was slightly lower than it was in the mid-1990s.

• The national average was the same as Connecticut – 10.2 percent.

Personal Income Tax

• Connecticut’s personal income tax is mildly progressive, but it does not offset the regressivity of the state’s sales, excise and property taxes.

- The Suits Index, a widely used measure to determine progressivity of taxes, indicates that Connecticut’s income tax is mildly progressive, meaning that higher-income earners tend to pay a somewhat higher effective income tax rate (the percent of the tax of adjusted gross income).

- While Connecticut’s sales tax appears to take a lower proportion of income from lower- and middle-income taxpayers (6.3 percent) than the national average (7.8 percent), low wage earners still devote a higher percentage of income to sales taxes than the top 20 percent of wage earners (about 1.5 percent) in Connecticut.

• Connecticut’s tax system is about in the middle of the Northeastern states in measuring overall equity, but it ranks behind only New Hampshire when burden on the top earners is considered. Connecticut places less burden on the top income group than the U.S. average.

- Connecticut’s top 1 percent pays 6.4 percent of income in taxes, while the U.S. average is 7.3 percent.

- When the federal offset47 is considered, the burden in Connecticut is only 4.4 percent versus the national average of 5.2 percent.

• Connecticut places less tax burden on high income earners than any of the other Northeast states except New Hampshire, which has no income tax. As Table V-1 indicates, tax burden in Connecticut takes 6.4 percent of income from the top one percent of earners, much less than in New York (9.1 percent) and New Jersey (8.4 percent), and slightly less than in Massachusetts (6.8%).

Table V-1. Tax Burden in Low and High Income Groups: A Comparison of Northeast States

Income Group

CT

MA

ME

VT

NY

NJ

RI

NH

U.S. Avg. (all states)

Lowest 20%

10.3%

9.3%

10%

10%

12.7%

12.5%

13.0%

8.1%

11.4%

Highest 1%

6.4%

6.8%

9.7%

9.7%

9.1%

8.4%

8.6%

2.4%

7.3%

Difference

3.9

2.5

0.3

0.3

3.6

4.1

4.4

5.7

4.1%

Source: Program Review Analysis of ITEP “Who Pays?” Data.

• The program review committee used the Institute of Taxation and Economic Policy information to establish an equity measure on how taxes in the Northeast states affect the poorest 20 percent and the top 1 percent. The committee took the percent of income paid in taxes (sales, income and property) by the two income groups and ascertained the difference between the two. The greater the difference, the more inequitable the state tax system, meaning the lowest income group pays a greater share than the highest income group. The results are shown in Table V-1. (See Appendix L for full comparisons among the Northeastern states).

• All of the Northeast states place a greater burden on the lowest-income group than on top income earners. However, Maine and Vermont have the least difference -- 0.3 -- indicating greater equity than other states.

• Connecticut was fifth of the eight states in terms of equity with a difference of 3.9. New Hampshire appears to have the most inequitable tax system, with its lowest income group paying a much higher share (8.1 percent) of income than the top group (2.4 percent). This is largely because the personal income tax is typically one of the most progressive taxes, and New Hampshire has no income tax.

• Connecticut ranks second (after New Hampshire) in the low percentage of income paid in taxes by the highest income group (at 6.4 percent) followed closely by Massachusetts (6.8 percent).

Policy Options: Equitable

Option Description

Implications

A. Earned Income Tax Credit

Adopt an Earned Income Tax Credit (EITC) Program similar to other Northeast states.

Establish a piggy-back EITC based on federal EITC and establish it as a refundable credit, meaning a filer would receive the amount of the credit, even if it were more than income tax liability.

A federal earned income tax credit program has been in place since 1975. The objective is to offset the burden of payroll taxes, reduce poverty, and provide an incentive to work.

Certain states are using the state personal income tax system to reach the same objectives and to relieve the regressive nature of the sales and property tax, and hence make the system more equitable. For example, 28 states use child or dependent care credits depending on income, and 18 states use an earned income tax credit.

Of the 18 states with an EITC, all the states in the Northeast are included except New Hampshire and Connecticut. New Hampshire has no income tax.

Most states “piggyback” on the federal earned income tax credit (FEITC), using a percent of that as the state earned income tax credit.

The federal income limits for 2005 are $38,348 for a married couple filing jointly with two or more qualifying children. The maximum credit allowed for that family is $4,400. The FEITC is refundable, meaning a qualifying filer receives that amount even if the tax liability is less than the credit. Some states have a similar refundable provision while other states limit it to a credit of the tax liability.

The following states use a variety of percentages of the federal tax credit for the state credit.

- New Jersey uses 20 percent, but income must be less than $20,000;

- New York uses 30 percent;

- Massachusetts uses 15 percent;

- Maine uses 5 percent;

- Rhode Island uses 25 percent; and

- Vermont uses 32 percent.

All but Rhode Island and Maine allow for refundable tax credits.

• If Connecticut were to adopt an earned income tax credit of 20 percent of the federal tax credit, it is estimated to cost about $55 million in 2005.48

• It is not assured that a state EITC would make Connecticut’s tax system more equitable. New Jersey and New York, which have state EITC programs in place, have greater burdens on their lowest income groups than does Connecticut.

• Would provide an incentive for people to work, even if income is low.

• Using $55 million and the same number of CT filers who receive the FEITC would mean an average credit of $338 in 2005.

• It is unlikely the same number of filers would apply for a CT EITC program as apply for the FEITC -- 162,541 filers, or almost 10 percent of all CT filers claimed the federal EITC) -- because the federal filing requirements are markedly different from Connecticut’s. A single filer under 65 must file a 2004 federal return if his/her income was $7,950; in Connecticut the filing requirement threshold was $12,625 for a single person. For those married filing jointly the IRS threshold was $16,850, while it was $24,000 in CT.

• Given Connecticut’s filing thresholds, the state would want to offer a refundable credit otherwise it would not benefit lower-income persons exempt from filing.

• An EITC program may be administratively burdensome for the filer to submit a return and DRS to process it for a very small amount of money—average of $338.

• This type of program is prone to error and abuse. The Internal Revenue Service conducted a study of the federal earned income tax credit program and found that 27 to 32 percent of the claims were erroneous. It is likely there would also be a high error rate with a state EITC program, although Connecticut could delay the credit until each filer’s federal EITC were approved by IRS.

B. Modify Personal Income Tax Structure

1) Modify the Connecticut personal income tax structure by establishing an income tax rate of 5.5 percent (from current 5 percent) for filers with income above $250,000 Connecticut adjusted gross income.

OR

2) Modify the Connecticut personal income tax structure by establishing two new rates for higher-income filers-- 5.5 percent from $150,000 to $250,000, and 6 percent at $250,000 and above.

• This would make the state’s income tax somewhat more progressive, by adding a third rate for higher-income groups. However, it would also make personal income tax revenues more volatile, with greater increases during good economic times and more significant declines when the economy slows.

• Based on 2003 Connecticut income tax data, this option would conservatively raise about $130.8 million in additional income tax revenue.

• Based on 2005 revenues collected, a conservative estimate is $168.4 million in additional revenue.

(Assumptions: personal income tax revenue increased over $931 million between 2003 and 2005. Based on calculations from 2003 filings, 40 percent of taxes paid are by filers at $250,000 and above. Thus, using these figures, the program review committee calculates, at 2005 collection rates, an additional $168.4 million in additional revenues.)

• This would make Connecticut’s personal income tax structure more progressive, but again would increase volatility by relying more heavily on revenues from top earners.

• Based on 2003 filings and using conservative estimates, this option would increase personal income tax revenues about $306 million. Using increases in collection amounts between 2003 and 2005, and estimating that 50 percent of taxes are paid by filers at $150,000 and above, this second option should raise an additional $390 million.

• Raising the top rates would still keep Connecticut’s effective tax rates competitive for top income earners. For example, the first option would raise the effective rate on the top income groups to 4.01 percent – compared to:

- Massachusetts at 4.3 percent;

- New Jersey at 4.2 percent; and

- New York at 5 percent.

• Further, because of the federal offset for deductions like state and local taxes, and the mortgage interest payment deduction, which are especially beneficial to higher-income earners, the effective tax rate is even less.

• To keep the system revenue neutral, the additional revenue earned through the income tax could offset the costs of other options adopted (e.g., targeted property tax relief programs, adequately funding the state’s grant obligations, or the earned income tax credit program).

Property Tax

Findings:

• Property taxes in Connecticut take a larger share of the incomes of lower- and moderate-income taxpayers than in most other states.

- ITEP national data show that property taxes took 2.6 percent of the income from low- and middle-income groups nationally; in Connecticut it took 4.1 percent.

- In the Northeast states, only New Hampshire (4.3 percent) and New Jersey (4.6 percent) took a higher percent from low and middle income groups.

- Although there is some dispute over how regressive the property tax is, towns with lower per capita income tended to have higher effective property tax rates.

• Current property tax relief programs are limited or are poorly targeted.

- The property tax freeze program that applies to individuals with annual incomes less than $6,000 has been suspended since 1979. It has only 910 participants, who were enrolled in the program before it was suspended.

- The circuit breaker program for the elderly and disabled has about 44,000 recipients and cost about $21 million in FY 04.

- The property tax credit for the income tax is not well targeted. In 2003, over 940,000 filers claimed credit through this program at a cost of $272 million. The tax credit does not provide any relief to individuals who are not required to file an income tax return but pay other taxes. Further, fairly high earners are able to take the full credit – for example, a single filer with CT AGI up to $55,000 gets full credit. A married couple filing jointly gets full credit if CT AGI is $100,500 or less.

- Municipal governments have the option to provide a number of abatements or exemptions to certain individuals. Municipalities, for example, may abate the property taxes for an owner-occupied residential dwelling to the extent the taxes exceed 8 percent of the taxpayer’s income. Tax relief provided under these provisions is not reimbursed by the state.

- Reverse mortgages are available to the elderly to turn property equity to an income stream that can help to pay property taxes.

• The property tax is perceived of as unfair and it is the focus of much resentment.

- Program review committee public hearings and testimony indicated a high level of frustration on behalf of the public and town officials with the annual growth of the property tax, increases due to revaluation, and overall dependence on the property tax.

- According to a survey conducted in November 2005 by UConn’s Center for Survey Research and Analysis, 69 percent of residents say reforming local property taxes is either an “Extremely Important” or a “Very Important” issue in influencing their vote in the 2006 governor’s race.

- Similarly, a 2002 survey, conducted by the Center for Research and Public Policy at Fairfield University for the Connecticut Conference of Municipalities, found over 81 percent of respondents agreed that the state and local tax system in Connecticut needed to be overhauled to reduce the property tax burden, while nearly 71 percent agreed that property taxes should be reduced even if it means some state taxes are increased and some state tax breaks are eliminated.

• Because different property tax rates are applied to the same motor vehicles valued at the same price among different towns in the state, individuals in similar circumstances do not pay the same amount. For example, a taxpayer with a motor vehicle valued at $20,000 would pay about $220 in property taxes in Washington and over $1,200 in Hartford.

Policy Options: Equitable

Option Description

Implications

C. Property Tax Refund Program

Eliminate or modify current property tax credit from the income tax and redirect the funds to better target tax relief to lower-income individuals through a refund program. This option would essentially be an expansion of the current circuit breaker program.

The program could also include an asset test that considers the value of investments such as stocks, bonds, savings accounts, certificates of deposit, individual retirement accounts, and other real estate to ensure finer targeting of tax relief funding.

The state of Maine, for example, offers a property tax and rent refund up to $2,000 to single residents who earn less than $74,500 per year and couples or residents with dependents who earn less than $99,500. The property tax must exceed 4 percent of the applicant’s income or the rent paid must exceed 20 percent of income. Also, the state of Maryland offers a credit to all homeowners whose net worth is less than $200,000.

• Depending on how the program is structured, some redirection of the property tax credit on the income tax could provide some of the funding given the current credit costs about $275 million to $300 million.

• The current income tax credit is very popular with middle-income taxpayers, and depending how the new program is structured, this group may not realize any benefit under this proposal.

• The current circuit breaker program is limited – the limits for an elderly single/couple are $27,100/$33,000 and the maximum benefit is $1,000/$1,250.

D. State Sponsored Property Tax Deferral Program

Create a property tax relief program for all Connecticut residents that defers that portion of the tax on their primary residence that exceeds a certain percentage of income. It would also require payment to the town of an amount equal to the total amount of taxes deferred plus interest when the property is sold, changes owners, or a change in property use occurs.

An example of eligibility guidelines could include the following requirements:

- Applicant must be a Connecticut resident for the last 12 months

- Applicant must own and occupy a home in Connecticut for at least 6 months in the last year

- Defer the amount of the property tax bill that exceeds 5 percent of household income

- Maximum deferral amount plus simple interest (at prime rate plus 1 percent) and the balance of any mortgage cannot exceed 85 percent of the assessed value

- Proof of fire and homeowners insurance

- Other requirements to maintain property

The tax deferral becomes a lien on the property with interest accruing on the deferred amount until the balance is paid.

Municipalities would be required to administer the program, but the state would have oversight responsibilities and fund the program.

To ensure better program targeting, the definition of household income could be broad to include all income received by all household members (i.e., the applicant, applicant’s spouse, and any dependents) including wages, pension, annuities, retirement income, investment income, Social Security income, veteran’s benefits, Supplemental Security Income, and other income (e.g., rental income, non-taxable income, alimony, child support).

• A broad-based deferral program would help many taxpayers who have high property taxes relative to income (the so called “cash-poor but house-rich”) and could cushion the impact of revaluation for individuals who find the rate of property appreciation has dramatically outstripped their income.

• Unlike this proposal, federally- sponsored and private reverse mortgages have an age limit (62 years). In addition, federally-backed reverse mortgages have an income limit. Reverse mortgages that are not federally backed tend to have very high interest rates.

• According to an American Association of Retired Persons (AARP) study in 2002, 24 states and D.C. offered some type of government sponsored deferral program. The eligibility options varied, but most targeted the elderly with low- to moderate-incomes.

• Unlike other deferred payment type loans, this proposal would not charge origination fees or other fees associated with obtaining a loan, and the interest rate is simple instead of compounded.

• This proposal would require some form of state assistance (through bonding or other mechanism) to towns to finance the loss of tax revenue during the deferral period.

• An option for funding could be to redirect the current property tax credit from the income tax, which costs about $275 million to $300 million annually.

• Deferral programs tend to be more targeted and less costly than other types of property tax relief because the deferred taxes are ultimately recovered.

• This option requires that homeowners have equity in their homes (about 40 percent under this proposal) in order to qualify.

• This option addresses the lack of liquidity in a major asset, while minimizing the concern of homeowners who believe they may lose their homes because they cannot afford the taxes.

• Homeowners may be reluctant to put a lien on their property and older property owners especially may not want to reduce the amount of the asset they have to pass on to their heirs.

• If homeownership is considered a form of wealth, then this proposal, compared to any proposal for a property tax subsidy, would be a more equitable solution because the government would ultimately recoup the deferred taxes.

E. Single Motor Vehicle Tax Rate

Create a single property tax rate for motor vehicles either:

• at the median (middle) rate (half of the towns’ rates are higher and half are lower); or

• at a revenue neutral rate, which brings in the same amount of total revenue.

Municipalities would still be required to administer the program.

• The motor vehicle tax would be easier to understand from a taxpayer’s perspective and simpler to administer.

• The result would be more equitable -- everyone would pay the same tax rate and the same amount of tax on the same vehicle.

• It would eliminate the incentive to illegally register motor vehicles in communities with lower mill rates and reduce the amount of time assessors have to spend discovering this practice.

• If the motor vehicle tax rate is established at the current statewide median mill rate of about $27.00:

- taxpayers in half of the towns would pay a total of $46 million more in motor vehicle taxes, while taxpayers in the other half of the towns would pay about $96 million less;

- at the extremes, Greenwich would raise an additional $10.4 million in motor vehicle taxes and Waterbury’s taxes would be reduced by $8.6 million; and

- to prevent any town from losing money, the state would have to provide an additional $96 million to towns who lose revenue.

• If the motor vehicle tax rate is established at a revenue neutral mill rate of about $29.45:

- taxpayers in 101 towns would pay $71 million more in motor vehicle taxes, while those in 68 towns would pay less;

- at the extremes, taxpayers in Greenwich would pay $12 million more in motor vehicle taxes and Waterbury taxpayers would pay $7.8 million less; and

- the state would need to establish a redistribution mechanism.

See Appendix M for a town-by-town breakdown.

V. Principle: Economically Competitive

Tax burden in a state should not be very different from other states, especially burdens in neighboring states.

Corporate Income Tax

Findings:

Taxes on businesses in Connecticut have been reduced significantly, and by most measures, are not considered more burdensome than other states.

• During the 1990s, Connecticut policymakers enacted several milestone tax policies aimed at making Connecticut more economically competitive, including:

- allowing a sales-only factor for apportionment for certain businesses;

- expanding the carry-forward period for corporate losses from five years to 20 years;

- reducing the corporate income tax rate from 11.25 percent to 7.5 percent; and

- creating and significantly expanding corporate tax credits.

Table V-2. Corporate Income Tax Rates

State

Rate

Connecticut

7.50%

Massachusetts

9.50%

New York

7.50%

Rhode Island

9.00%

Pennsylvania

9.99%

Vermont

7.00-9.75%

New Jersey

9.00%

Maine

3.50 - 8.90%

New Hampshire

8.50%

• These legislative efforts appear to have lessened the tax burden on business in Connecticut.

- The corporate income tax rate in Connecticut is among the lowest in the Northeast as Table V-2 shows.

- Measured by the share of corporate income tax revenue as a percent of gross state product, Connecticut businesses realized a 77 percent reduction in that ratio from 1989 to 2003, the 2nd largest decrease of all states.

- Using the same ratio – percent of corporate income tax revenue as a percent of gross state product – Connecticut currently ranks 24th (along with three other states) of the 46 states with a corporate income tax.

- By other measures -- from a 2004 study by the Federal Reserve Bank of Boston that used 2000 tax year data -- Connecticut business ranks:

• 40th in business share of state and local taxes;

• 28th in business taxes as a percent of personal income; and

• 40th in business taxes as a percent of business profits.

• In interviews with the committee, Connecticut business community representatives indicate that while there are a number of factors that make up a state’s economic climate, and taxes may not be highest on the list, “taxes do matter”.

Policy Options: Economically competitive

Policy Description

Implications

A. See Policy Options for Corporate Income Tax presented under the Neutral Principle

Implications concerning corporate income tax changes are discussed under the Neutral Principle

Pass-Through Entities

Findings:

Connecticut’s tax structure for pass-through entities, meaning limited liability corporations (LLCs), limited liability partnerships (LLPs), and S-corporations, appears favorably competitive to neighboring states.

• Pass-through entities in Connecticut pay a business-entity tax of $250 per group. Other than that, for each pass-through entity, income is “passed-through” to its members, and members pay only the personal income tax (three or five percent) on their portion of income the entity generates.

- In New York, each member of an LLC or LLP is charged a $100 filing fee, with the minimum fee being $500, and the maximum $25,000. Each member also pays the New York state income tax based on his or her distributive share.

- In New Jersey, a $150 per partner filing fee is required for each LLP and LLC partnership deriving income from New Jersey sources. For professional service entities (like accountancy), the $150 fee applies to each registered professional who owns or is employed by the enterprise. The annual filing fee is capped at $250,000.

- Recently, articles in the New York Times49 identified Greenwich, Connecticut as having become a thriving financial “headquarters” for locating hedge funds, a relatively new area of financial investments. Because these funds are established as pass-through entities the only business income taxed is the personal income earned by the managers. The articles cite Connecticut’s lower rate than neighboring states as an attraction.

• Connecticut has experienced a 10 percent decline in the number of C-corporations since 2001, while there has been an increase of approximately 30 percent in pass-through entities during that period.

- It is difficult to say how much of this shift in business types has to do with tax policy.

- It is impossible to tell what portion of the personal income tax revenue comes from members of LLCs, LLPs, and the like. While such data are required to be submitted to DRS per C.G.S. Sec. 12-726, the data are not collected by DRS.50

Personal Income Tax:

Findings:

Connecticut’s personal income tax rates are low – three percent and five percent -- and Connecticut has the lowest tax rate in the region for joint income filers who earn $100,000 or more.

Table V-3. Personal Income Tax Rates

State

2005 Rates

Taxable Income Level (Joint filers)

Connecticut

5%

$20,000

Massachusetts

5.3% or 12%

Depends on type of income

New Jersey

6.37%

8.97%

$75,000 to $500,000

$500,000 and over

New York

7.25%

7.7%

$100,000

$500,000

Individual Income Tax Provisions, An Informational Paper. Wisconsin Legislative Fiscal Bureau, January 2005

• While Connecticut’s personal income tax rate is close to that of Massachusetts, Massachusetts taxes short-term capital gains (held less than one year) at 12 percent. (Based on IRS federal return data, Connecticut is one of the highest-ranked states in terms of high unearned income, including capital gains).

• Effective tax rates – the percent of income paid in taxes after all deductions and exemptions -- are generally higher for higher-income filers ($500,000) in neighboring states than in Connecticut as shown in Table V-4.

Table V-4. Effective Tax Rates for High Income Filers

State

Income Group

Effective Rate

Connecticut (2003 returns)

$54,001-$90,000

$90,001-$2 million

$550,000 and over

3.41%

3.83%

3.53%

New Jersey (2003 returns)

$90,000-$100,000

$100,000-$150,000

$500,000-$1 million

2.6%

2.2%

4.2%

New York (estimated 2005)

$75,000-$100,000

$500,000-$1 million

4%

5%

Massachusetts (2000 returns)

$158,315

$443,000

4.5%

4.3%

Annual Reports for New Jersey, New York and Massachusetts, and LPR&IC analysis of DRS income tax data for Connecticut

Other elements of economic competitiveness

Findings:

In addition to tax policy, there are other important measures that impact Connecticut’s economic competitiveness.

• Total government spending as a percent of gross state product is relatively low in Connecticut, indicating that the private sector makes up more of the economy, a measure of competitiveness.

- Connecticut ranks fourth from the bottom of all states – with all levels of government contributing 8.7 percent of Connecticut’s gross state product.

- The table below shows that Connecticut is second-lowest among Northeastern states, and substantially below the U.S. average.

Table V-5. Percent of Gross State Product Attributed to Government: A Comparison

State

CT

MA

ME

NH

NJ

NY

RI

VT

U.S. avg.

Percent

8.7%

8.5%

14.2%

9.0%

10.1%

10.2%

11.8%

13.1%

11.9%

Source of Data: Bureau of Economic Analysis, 2005

• Despite tax policies and government spending that appear to be economically competitive, Connecticut’s competitive status gets mixed results.

- Recent data show Connecticut still has the highest per capita income, substantially ahead of second-place New Jersey.

- However, other data indicate Connecticut’s competitive position is not great. The rise in the state’s personal income between 1993 and 2003 was less than the U.S. personal income growth, and Connecticut’s job growth lags behind almost all other states as reported by the Federal Deposit Insurance Corporation in June 2005.

- A September 2005 report issued by the Connecticut Economic Resource Center, benchmarking Connecticut’s economy, identified several impediments to growth including population shifts. Connecticut has the 8th-oldest population in the country. Further, the report points out Connecticut had the greatest decline in the population between 18-34 years old (23 percent decrease) of any state in the nation during the 1990s.

- Connecticut is a high-cost state. Its 2004 average hourly wage of $17.88 is the second highest in the country. Its energy costs are the 5th-highest in the country, and Connecticut’s health care costs are the third-highest on a per capita basis, after D.C. and Massachusetts. These cost factors may affect Connecticut’s competitive position more than any corporate, business entity, or personal income tax policies.

Sales and Use Tax

Findings:

• In Connecticut, businesses pay a greater share of the sales tax than in most states.51

In FY 03, Connecticut consumers paid 51 percent and businesses paid 49 percent of the state’s total revenue from the sales tax.

In comparison, the national average for the consumer share of the sales tax was 57 percent and business, 43 percent. The average consumer share for neighboring states (RI, ME, MA, NJ, and NY) is 54 percent and 46 percent for business.

• In comparison to its neighboring states -- Massachusetts, Maine, New Hampshire, Vermont, New York, New Jersey, and Rhode Island -- Connecticut ranks first in the number of services taxed: 52

Connecticut (80 services)

New York (56 services)

New Jersey (55 services)

Rhode Island and Vermont (29 services each)

Maine (24 services)

Massachusetts (19 services)

New Hampshire (11 services)

• Table V-6 contains the major categories for services possible for a state to tax and the number within each category Connecticut currently taxes. It also shows where Connecticut ranks on the number of services taxed in each category compared to all 50 states. (See Appendix N for additional tables detailing the services within each category and for a comparison of the types taxed in Connecticut versus other neighboring states.)

Table V-6. Major Categories of Services Typically Taxed

Type of Service

Number Taxed in CT

Connecticut Ranking

Business Services

20

7th

Professional Services

0

n/a

Computer Services

6

8th

Finance, Insurance and Real Estate

0

n/a

Utilities

10

19th

Personal Services

10

13th

• In general, states taxing as many or more services as Connecticut are not among its primary competitors. The states taxing a broad array of services include: Hawaii (taxing all business activities under a general excise tax), Washington, New Mexico, South Dakota, Delaware, West Virginia, Iowa, Texas, and Nebraska.

Policy Options: Economically competitive

Option Description

Implications

B. Tax Final Consumption Not Business Inputs

Tax goods and services being sold and not business inputs used to develop final products.

This option eliminates taxes on business services that are anticompetitive (i.e., business analysis, management consulting, public relations, employment agencies, and advertising agency fees), and taxes additional personal services purchased by consumers to replace the revenue lost from taxing business services/inputs.

Services subject to sales tax would be those that are bought and sold in the marketplace as a commodity (i.e., salon and barber shop services, spa services, gift wrapping services, personal instruction services, and shoe repair).

• This option alleviates tax burden inequalities between businesses in Connecticut and competitor states.

• The option shifts the burden from business services to personal services, which do not impact economic competitiveness to the same degree, as consumers are less likely to relocate.

• Residents of towns that border other states may consume personal services in those states.

• This option makes the sales tax easier to administer since there are no interpretation or definitional issues about what should or should not be taxed.

• There will be an increase in the workload for DRS staff as there will be more retailers submitting sales tax returns.

• This option makes the tax more transparent because consumers pay the tax when making purchases.

• There are no data to demonstrate whether this option would be revenue neutral, cause a decrease in revenue, or an increase in revenue to the state. Should the tax on business services be exempt without adding the sales tax to additional personal services, this option would decrease revenue collections.

Property Tax53

Finding:

The effective property tax rates on industrial and commercial property in Connecticut’s cities are not competitive. Connecticut’s rates are among the highest in the Northeast and in the nation.

• Table V-7 compares Connecticut’s policy on taxing business inventory and machinery and equipment to those of other states in the Northeast (New England, New York and New Jersey). Like most of the Northeastern states, except Vermont and Rhode Island, Connecticut municipalities do not levy an inventory tax on business.

Table V-7. Tax on Inventory and Manufacturer’s Machinery and Equipment

State

Inventory Tax

Manufacturer’s Machinery and Equipment Tax

Connecticut

No

Partial

Maine

No

Partial

Massachusetts

No

No

New Hampshire

No

No

New Jersey

No

No

New York

No

No

Rhode Island

Yes

No

Vermont

Yes

Yes

     

Number of States Nationwide with this Tax

15

36

Sources: NCSL 2002 for Inventory Tax and Connecticut Business and Industry Association 2005 for Manufacturer’s M&E tax.

• In the Northeast, only Connecticut, Vermont, and Maine allow municipalities to tax manufacturer’s machinery and equipment; however, 33 other states allow municipalities the option of levying this type of tax. Vermont allows municipalities to fully exempt manufacturers from this tax, while Maine and Connecticut partially exempt this tax. (Connecticut provides for a five-year, 100 percent exemption of local property taxes on newly acquired manufacturing machinery and equipment and reimburses municipalities for a portion of the exemptions.)

• Figure V-1 compares the FY 2004 effective tax burden for commercial property valued at $1.2 million in the most populous cites in each of the Northeast states as well as the U.S. average. Connecticut’s effective tax rate – at 2.73 percent -- was fourth highest in the Northeast, 13th highest in the nation, and was 33.3 percent higher than the U.S. average.54 (For more information about this study, see Appendix O.)

• The same study also compared “typical” rural communities nationwide. The effective tax rate for a commercial property valued at $1.2 million in rural Connecticut was 1.57 percent and ranked 24th in the nation, or 5 percent below the national average.

• Using the same methodology as above, Figure V-2 compares the tax burden for industrial property valued at $2.5 million among the most populous cities in each of the Northeast states as well as the U.S. average. With an effective tax rate of 2.07 percent, Connecticut ranks second highest in the Northeast and 9th highest in the nation. In comparison, the effective tax rate in rural Connecticut for industrial property valued at $2.5 million, at 1.33 percent, ranked 17th in the nation and 9 percent above the national average.

• Connecticut generally avoids the use of mechanisms that serve to shift the tax burden from residential property to business property.

- Except in the case of farmland, forests, and designated open space, the state does not have different assessment ratios or valuation requirements for different classes of property. These techniques that are employed in many other states lower the legal assessment levels for residential property.

- The state also does not have a general homestead exemption55, although it does allow for a few smaller homestead credits or local option exemptions for individuals meeting certain requirements.

Policy Options: Economically competitive

Option Description

Implications

C. Reduce or Eliminate the Tax on Manufacturer’s Equipment and Machinery.

• The change would make Connecticut’s property tax burden on business more competitive in the region and nation.

• Eliminating the tax would be consistent with the principle that business inputs should not be taxed.

• The option would reduce revenues to towns and replacement revenues would have to be found.

• The option would place manufacturers – who are more dependent on updating equipment and machinery to conduct their business – on a more level playing field with other types of commercial enterprises.

D. See all Policy Options under Balanced Principle to reduce property tax reliance overall.

Implications are discussed under the Balanced Principle.

VI. Principle: Neutral

A tax system should not be used to influence economic decisions on spending or investments.

Findings:

Connecticut has been more restrained than most states in using tax policy to influence economic behavior or in creating dedicated funds. The major exception is that Connecticut has used the corporate income tax to attempt to promote economic development.

• Connecticut has not extensively used its personal income tax structure to treat income types differently or offer many exemptions or credits.

- Connecticut offers only two credits from its income tax; many states offer more than 15.

- Connecticut treats virtually all income the same. (Only Social Security is exempt but only if a filer’s income is below a certain level, and in the future, only half of military retirements will be taxed.) Most other states treat certain types of income (e.g., pensions, retirements, capital gains) differently from wage income.

• The only major earmarking occurs with the Special Transportation Fund; special dedicated funds appear much more prevalent in other states.

• Connecticut’s sales tax contains many exemptions, but often the exemptions apply to items considered necessary like groceries and medicines, which tends to promote equity and lessen the regressiveness of the tax.

- Connecticut has frequently used the corporate income tax (CIT) structure to influence business decisions, as outlined previously.

• Because of the variations to the corporate income tax, it is difficult to administer. Further, corporations with resources can minimize taxes owed resulting in lower revenues and make compliance difficult to gauge and enforce.

- Corporate income tax revenues have declined considerably in inflation-adjusted dollars.

- Corporate income tax revenues have declined both as a percent of state revenues and a percent of gross state product.

- Audits of the corporate income tax accounted for 2.6 percent of all audits but resulted in 36 percent of the assessment amounts resulting from audits, which may be a measure of tax minimization and avoidance.

- Currently, at least half of the 44,277 corporations in Connecticut pay only the minimum tax.

- Eighteen of the top 100 corporations headquartered in Connecticut paid the minimum CIT for 2003.56 Only 82 of the top 100 companies paid the corporate income tax; others paid the $250 business entity tax. Only one corporate filer paid more than $1 million in CIT, after credits.

- Overall, corporate income tax liability is reduced about 23 percent through credit use. However, the use and value of tax credits is concentrated; fewer than 13 percent of corporations took any credits, and only 13 corporations took five or more credits.

- The credits to the 13 filers were valued at about $20 million, or almost one-quarter of the overall CIT liability reduction.

- Current use of the credits is also concentrated in certain types of industry. Manufacturing accounts for about 10 percent of corporate filers, and 22 percent of corporate tax liability, yet manufacturing accounts for over half of the reduction in liability. (See Appendix P for a list of credit usage by industry).

- Most of the growth in businesses has been in pass-through entities. The number of these entities has grown about 30 percent since 2001, while the number of C-corporations has declined 10 percent during the same period. Only C-corporations are eligible to use credits to offset tax liability.

• Evaluating the ongoing effectiveness of legislative changes intended for a particular purpose is difficult. While corporations may be able to superficially demonstrate the use of a particular feature or credit (e.g., number and value of research and development credits taken), it is difficult to assess whether these policies are achieving the desired outcome. However, there are legislative efforts underway to increase the oversight of these credits, including how beneficial they are.

- A study by the University of Connecticut’s Center of Economic Analysis57 (CCEA) for the legislature’s Finance, Revenue and Bonding Committee found that corporate rate reductions and the credit and exemption programs enacted in the 1990s have been a “mixed and small success for the Connecticut economy.” It also found that rate reductions had a greater positive impact than exemptions or credits.

- The Business Tax Credits and Tax Policy Review Committee has statutory authority to examine and analyze tax credits and revise those not having a measurable benefit to the state.

- Based on usage alone (not considering other measures of effectiveness), 10 of the 26 credits are used by five or fewer filers, and 6 of the 26 credits each account for $5,000 or less in credit value. By this measure these credits appear of little benefit to the state’s economy, and should be eliminated.

Policy Options: Neutral

Policy Description

Implications

A. Reduce the Corporate Tax Rate and Eliminate Credits

Reduce the corporate tax rate on net income by half – to 3.75 percent – but eliminate the use of credits.

Economic Development grants would continue.

• This option would raise about $109 million less in revenue –at least initially. The loss from the rate cut would be about $202 million, but about $93 million would be recaptured as a result of eliminating tax credits for a net loss of about $109 million.

• This option would make the system fairer by eliminating the use of credits with which some corporations are able to reduce their tax liability significantly.

• Reducing the rate to 3.75 percent would make Connecticut’s CIT rate one of the lowest in the country, and might be as beneficial as credit use in spurring growth in jobs and income.

• The growth in non-C corporations indicates credit use may not be a great economic development incentive in spurring job growth.

• The option would promote the principle of neutrality by stopping the practice of using the tax code to select types of businesses or activities for beneficial treatment and might help with Cuno58 compliance, depending on the Supreme Court decision.

• The lower rate would benefit all corporations – not just large ones or those in a certain category. Lowering the rate appears to offer most benefit to the economy, according to the CCEA study.

• The option would promote the principle of equity through a broader base and lower rate, and lessen economic distortions.

• This option makes the tax easier to administer; the rate is based on income and not reduced by credits.

B. Replace the Corporate Income Tax with a Broad-Based Tax on Gross Receipts.

A gross receipts tax would be levied on the total receipts of all goods sold and services rendered in the state. It would not allow for deductions for the costs of goods, labor, delivery, or taxes, or other deductions.

Set the rate on all receipts over $1 million at about 0.26 percent –similar to Ohio.

Eliminate the use of tax credits; economic development grants would continue under DECD.

• The option applies the tax to any type of business transaction – sales, all services, and rentals—and applies it to any size and types of business, from sole proprietors, to partnerships, to large corporations.

• This is not a widely used tax; the state of Washington has a business and occupations tax with six major classifications taxed at rates from .00138 percent to .00471 percent. Michigan has had a hybrid business activity tax, like a value-added tax. Ohio is in year one of a five-year phase-in of a gross receipts tax to replace its corporate income tax. Businesses will pay only the $150 minimum on receipts up to $1 million, and 0.26 percent on receipts over $1 million.

• Restructuring the business tax in a state is not a guarantee of more stability or of improving economic competitiveness. Washington experienced incredible volatility in its tax structure from 1999 through 2004; Michigan’s economy is in serious trouble and the state is examining further significant restructuring. Indiana had a gross receipts tax, but it was eliminated in 2002 because it was viewed as anti-competitive.

• It is difficult to predict what a gross receipts tax in Connecticut would generate in revenue. The business and occupation tax in Washington totaled $2.067 billion in FY 04, with a gross state product of $261.5 billion (0.79 percent of gross state product). Using Connecticut’s 2004 GSP as a base ($185.8 billion), and estimating a similar collection ratio of GSP (0.79 percent of GSP) a gross receipts tax might raise about $1.4 billion.

• However, a gross receipts tax might have implications for other taxes like the personal income tax or the sales tax. Washington does not have a personal income tax; some of the gross receipts tax in that state is likely capturing some of what the PIT tax captures here.

• Exemptions, deductions, and credits are used in Washington and Michigan and begin to erode the value of this type of tax. Also, the tax requires exemptions, etc. for sales made out of state; thus the issue of in-state and out-of-state business activity still exists.

• This type of tax creates winners and losers. The business community in Connecticut gave a mixed review of the Ohio plan indicating only minor increases in the rate can have significant tax implications. Further, the national business tax policy organization, Council on State Taxation, opposes the Ohio gross receipts tax indicating it lacks transparency, diminishes neutrality, and makes Ohio business less competitive.

C. Modify Corporate Tax by Changing Certain Factors

Modify the corporate income tax structure in Connecticut in several ways to:

• Return to 5-year carry-forward period for net operating losses (NOL) rather than current 20-year period.

• Limit the deduction of NOL to 50 percent of entire net income

• Limit a corporation’s credit use to same ratio as its apportionment fraction. (For example, if only 20 percent of a corporation’s income is earned in Connecticut, limit its credit use to the same fraction.)

• Maintain the corporate income tax structure, but apply an alternative minimum assessment (like New Jersey) either on gross receipts (excludes up to $2 million in receipts) or on gross profits (excludes up to $1 million in profits) with graduated rates depending on amount of receipts or profits. Maximum tax is $5 million.

• Use a computed alternative minimum tax as a substitute for the current minimum tax of $300; corporations that would be subject to the alternative minimum tax would not be permitted to reduce it through tax credits.

• Apply a “throwout” rule to calculate the apportionment formula – those sales that are apportioned to a state where they are not taxed are removed from the numerator and denominator.

• Other modifications to corporation business tax should be considered by the Business Tax Credits and Tax Policy Review Committee (BTCTPRC).

• Place recommendations of the Multi-state Tax Commission 2004 Report on Corporate Tax Sheltering on the committee’s agenda for consideration during 2006.

• The BTPCRC should establish reporting requirements on the use of credits establish “effectiveness” criteria for continuation of the credits, and consider a “sunset” schedule for tax credits, beginning with those not frequently used.

• Other states have tightened the corporate income tax successfully.

• These proposed modifications are similar to those taken in New Jersey to tighten its CIT, which increased revenues from the CIT about $1 billion without raising the rate.

• Brings an element of fairness to the use of credits by using the same ratio as the company’s business in Connecticut (the apportionment formula).

• This would help alleviate the issue of corporations reducing their tax liability down to the minimum ($300 for 2003).

• Twenty-five other states use either a “throwback” or “throwout” rule, which lessens the impact of placing sales in a state with no corporate income tax.

• Tightening the sheltering and reporting requirements for corporations rather than adopting either Option A or B would lessen a perception that businesses can minimize taxes that individuals cannot. If these proposals were implemented, individual income taxpayers would have more assurance that corporations must also “play by the rules” and pay their fair share.

• The Multi-state Tax Commission report estimates that Connecticut loses about 25 percent of CIT because of tax sheltering. In 2001 the loss estimate was almost $100 million. These proposals would tighten these shelters and perhaps recapture some of the losses.

• The Business Tax Credits and Tax Policy Review Committee is an appropriate entity to address the Multi-state Tax Commission recommendations. Some of the commission’s proposals, like unitary filing (which ignores the formal corporate structure and treats the income of subsidiaries as if they were divisions of the same parent) are controversial and need to be explored by policymakers on the committee with input from DRS tax administrators to determine the best way to proceed.

• There are other states that are tightening their approach to credits. Michigan has begun to use a “sunset” approach to some of the tax credits. The Washington state legislature required its Department of Revenue to survey companies using three selected tax deferral or credit programs and analyze and report on the results at five-year intervals so the legislature can begin evaluating whether the incentives are having an economic impact or not.

Estate Tax

Findings:

Connecticut is one of a minority of states that has retained an estate tax, which can, like other transfer taxes, prompt tax planning and affect taxpayers’ investment and location decisions. Research on the full economic impact of estate taxes is inconclusive and data available to assess Connecticut’s current combined estate and gift tax that went into effect only last year are limited.

• At present, Connecticut is one of only 18 states and the District of Columbia that impose an estate tax.

- All eight states in the Northeast region except New Hampshire currently have estate taxes.

- Connecticut was planning to phase out all of its transfer taxes (i.e., estate, gift, and succession) by 2010 and, in fact, the previous estate tax expired on December 31, 2004. However, to help address the state’s serious budget problems, a new combined estate and gift tax with a retroactive effective date (January 1, 2005) was enacted during the 2005 regular legislative session. (The state’s succession tax and prior gift tax were also eliminated as of January 1, 2005.)

• Transfer taxes like estate, inheritance, and gift taxes are generally considered among the most progressive types of taxes but are not economically neutral.

- Estate taxes are paid by a small number of high-wealth individuals. (Nationally, it is estimated only 2 percent of all estates are large enough to have any estate tax liability.) The current Connecticut estate tax applies only to taxable estates over $2 million.

- There is evidence a significant amount of giving (gifts and bequests including charitable donations) is tax-motivated and that some individuals may change their state of residence (“migrate”) to avoid high state tax liabilities including estate taxes.59

- A recent study by two university professors suggests migration and other avoidance behaviors in response to estate taxes would cause some economic losses but they would not be large compared to the revenues such taxes raise for states.60

• At this time, academic research on the role and effect of transfer taxes mostly raises rather than answers questions and seems best used to clarify policy trade-offs and issues for further study. Little or no reliable evidence has been presented to support claims that estate taxes negatively affect family-held business or farms, reduce savings and impair economic growth, or generate huge compliance costs. 61 In addition, there is considerable academic and political debate over estate tax equity issues that involve views about fairness as much as empirical research findings (e.g., whether estate taxes promote fairness by reducing unequal opportunities and concentration of wealth, cause horizontal inequity because taxpayers with the same wealth are treated differently depending on their approach to estate planning, etc.).

• Estate tax revenues are highly volatile (since in any given year they depend on how many wealthy individuals die and leave large estates or, as part of their tax planning, decide to make taxable gifts) and a very small part of total tax collections.

- On average, revenues from the Connecticut’s estate tax make up about 2 percent or less of total state tax collections and approximately 1 percent or less of combined state and local tax revenues.

- Annual revenues collected from Connecticut’s former estate tax ranged from almost $30 million to nearly $112 million between FY 00 and FY 04.

- The new combined estate and gift tax is estimated to generate around 500 estate tax filings per year and produce about $108 million in FY 06, $150 million in FY 07, and $152 million in FY 08. (These are estimated revenues solely from the new tax and do not include any residual collections from the prior state estate, gift, and succession taxes.)

- During the current fiscal year, one very large payment (about $21 million) was made under the new estate tax.

• Connecticut’s new combined estate and gift tax has a threshold of $2 million, meaning individuals with estates valued less than $2 million have no estate tax liability. However, a taxpayer with an estate valued at just one dollar over the threshold becomes liable for taxes on the entire value of the taxable estate. Many view this sharp eligibility “cliff” as unfair and believe an exemption, perhaps set at even a higher level, would be more equitable as well as acceptable to taxpayers than the current threshold.

- An accurate estimate of the fiscal impact of instituting an exemption at the $2 million or any level cannot be made at this time.

Policy Options: Neutral

Option Description

Implications

D. Eliminate the Connecticut Estate Tax

Repeal the current statutory provisions for the state’s combined estate and gift tax.

• Elimination of the state’s estate tax would improve revenue system neutrality and remove any disincentive the tax presents for residing or locating in Connecticut.

• Repeal of the new estate tax would result in revenue losses to the state, perhaps up to $150 million per year, and diminish progressivity of the overall revenue system.

• While estate tax collections tend to be very volatile and difficult to forecast, these revenues have helped the state to deal with unexpected economic downturns and periodic budget gaps.

• Without any kind of transfer tax, the state loses the opportunity to tax wealth of very high income individuals that may otherwise go untaxed (e.g., appreciation of held assets, unrealized capital gains) and contribute to further concentration of wealth.

E. Replace Current Estate Tax Threshold With an Exemption

Eliminate the existing threshold for tax liability and establish an estate tax exemption for at least the first $2 million of a taxable Connecticut estate.

• Creating an exemption to estate tax liability rather than a threshold eliminates the current eligibility “cliff,” which improves the fairness and acceptability of the tax.

• Establishing an exemption will reduce revenues produced but the amount lost cannot be estimated accurately with currently available data.

VII. Principle: Promotes Compliance

A tax system should be easy to understand and comply with and minimize compliance costs for taxpayers and tax program administrators.

Findings:

The vast majority of state tax revenue in Connecticut is collected through voluntary compliance.

• The state personal income tax is relatively simple, which promotes taxpayer compliance.

- Connecticut’s personal income tax treats most income similarly, and has only two rates.

- The personal income tax has only two credits; many states have 15 or more credits.

• The sales tax has many exemptions, but it is applied only at the state level and has essentially only one rate. Consumers pay the tax at the time of purchase, and retailers remit the taxes monthly or quarterly.

- Cash businesses pose compliance problems, but DRS plans to address the problem with new software (D-Tax) and its overall new ITAS system.

• Connecticut has higher than average excise tax rates that increase vulnerability to evasion.

- For example, Connecticut has the 6th-highest cigarette tax, at $1.51 a pack, which prompts cigarette buyers to seek other ways and places to buy the product.

• The complexity of the corporate income tax provides many opportunities for reducing tax liability.

• Compliance rates for the local property tax, which is probably the most transparent tax, are very high, with almost 98 percent of taxes collected. Compliance rates are also helped with many people paying their property tax through their mortgage lender.

Connecticut’s state tax agency, the Department of Revenue Services, has made progress in helping taxpayers comply with tax law by automating its filing, payment, and taxpayer information activities.

• Operations that can be conducted electronically improve accuracy and speed, making compliance simpler and less costly for taxpayers.

• The DRS website is easy to access, is user-friendly, and offers forms, publications, and information on the various state taxes, and how to complete and submit a return. The website is accessed more than 200,000 times each month, on average.

• DRS operates a call-center where taxpayers can call an “800” number and get answers to specific tax questions. DRS received approximately 152,963 calls from January through June of 2005 and a total of 197,863 for 2004.

• Connecticut is ahead of most other states in promoting electronic filing of returns -- 67 percent of personal income tax returns are filed electronically, while the national average is 54 percent. This effort has been strengthened by regulations mandating tax preparers to file electronically.

• A key indicator of the success of efforts to promote compliance is what is generally referred to as the “tax gap” of a revenue program or system. A tax gap is generally defined as the difference between tax liability (what is owed under full compliance with all tax laws) and taxes voluntarily paid. The difference results from taxpayers not filing at all, underreporting their liability, or not paying all taxes owed.

- Identifying the amount and reasons for taxpayer noncompliance can help administrators determine the effectiveness of their enforcement and collection activities as well as the need for tax policy changes that could improve voluntary compliance.

- Estimating tax gaps, particularly for income taxes, is a major undertaking, requiring sophisticated analysis and large sets of data. A few states (e.g., California, Minnesota, and most recently, New York) and the federal IRS regularly conduct tax gap studies, but most jurisdictions including Connecticut do not, usually due to limited research resources.

- Results from analysis conducted by the IRS and the above states indicate that the personal income tax “gap” is between 10 and 15 percent of tax liability.

- Connecticut’s ability to develop state tax gap information will significantly improve with the full implementation of DRS’s new automated information system (ITAS). A high level of voluntary compliance is the primary goal of state tax agencies, and the tax gap is a critical indicator of performance in this area.

Recommendation:

2. Once ITAS is fully in place, DRS should make estimating and reporting of the tax gap a priority of future agency research. A more precise picture of the extent and areas of non-compliance should assist DRS in developing an overall strategy to promote compliance and deter tax avoidance.

• A major way state tax agencies including DRS are seeking to improve compliance rates is through expanded and improved system automation. New software programs in combination with data warehouses containing extensive tax and other financial and regulatory information are being used to address noncompliance with targeted audit and enforcement efforts in several states.

- Last year, Massachusetts invested $4 million in a software program to discover tax evaders (DTAX) that generated $70 million in new revenue collections during its first year of use. In addition to interconnecting data from multiple sources to identify noncompliance, the program computes payment data and generates bills. The program also automates the refund process for taxpayer overpayments, allowing reallocation of audit and collection staff time to compliance activities.

- Connecticut is developing a similar automated auditing program (Discover Tax) that will be applied to new ITAS data warehouse to identify non-filers. In its original budget option regarding this program, DRS estimated it would produce $49 million in new revenues because of better application of the agency’s audit resources.

- Improved automation provided by ITAS has increased the effectiveness of a number of the agency’s special compliance projects and will permit the development of new efforts. For example, a special unit in the Audit Division has focused on using cross-agency information on alcohol purchasing and volume to better calculate and enforce the alcohol excise and sales taxes on alcohol. DRS has also submitted a budget option for a licensing renewal compliance project that would involve ensuring various tax obligations are settled before an applicant can renew most state licenses (driver’s licenses and vehicle registrations would be excluded). With new and expanded computer capabilities, DRS could pursue a similar tax compliance requirement for all vendors and contractors seeking to do business with the state.

- The results of the department’s special compliance projects are not formally tracked, compiled, or reported. Documentation of the outcomes could be used to evaluate their effectiveness as well as demonstrate their value and build legislative support for continued or additional investment in staff and other resources associated with successful projects. In addition, public reporting of compliance results might act as a deterrent for those looking to avoid or underpay taxes.

Recommendations:

3. DRS should conduct a cost benefit analysis of each major tax compliance initiative, including amnesty programs, and report the results to the appropriations committee.

4. DRS should publicly report the results of tax compliance efforts on its website. Such efforts assure the taxpaying public that non-payers are being detected and promote overall compliance.

• There are other efforts in which DRS participates, to varying degrees, that also promote compliance and detect non-compliance.

- DRS is an “associate” member in the Multi-state Tax Commission, an organization of state government tax agencies that work with taxpayers to administer tax laws efficiently and equitably. This is the minimum level of participation a state can have. Membership features include participation in a joint audit program, national nexus program, property tax fairness project, and the property tax audit program.

- The commission has in the past few years formed working groups that issued reports with proposals aimed at improving compliance in three tax areas: corporate tax sheltering, pass-through entities, and the sales and use tax. Three DRS staff served on the working group dealing with pass-through entities, but not on the other two.

- DRS also participates in the Federation of Tax Administrators (FTA), an organization made up of the principle state taxing agencies in all 50 states. Some of the ways in which such membership helps with compliance is through adopting uniform definitions among states, or in states implementing model agreements to help taxpayers comply with a certain tax. For example, Connecticut uses sale and use tax compliance agreements (SUTCAs) or (called management compliance agreements in Connecticut), endorsed by the FTA, that ease the process of reporting and collecting sales tax.

- Another FTA project facilitates sharing successful compliance strategies and techniques. Connecticut is one of 14 regular participants in this exchange.

• DRS periodically offers amnesty programs, authorized by the legislature, which provide non-compliant taxpayers an opportunity to remit taxes owed without penalty, and typically DRS grants a grace period when a new law takes effect before instituting penalties for noncompliance.

- Three amnesty programs have been offered since 1990: one in 1990; 1995; and the last one in 2002. Amnesty periods for the three programs each lasted three months, from September 1 through November 30.

- A state law passed during the 2005 session penalizing those found to be engaging in abusive tax shelters. The law became effective January 1, 2006. DRS granted an amnesty period for people to declare before that date, with reduced penalties.

• DRS does not use all enforcement tools it should to deter non-compliance.

- For example, DRS is not consulted before state contracts or awards are granted to ensure the person or business being issued a grant or award is not delinquent in payment of taxes. The IRS found earlier this year that billions of dollars of defense contracts were being awarded to businesses delinquent in tax payments. While no state figures on this exist, it seems to make good public policy sense not to reward those who don’t comply with state tax laws.

- DRS does not report delinquent taxpayers to credit reporting agencies, although DRS indicates that private collection agencies under contract with the department do report that information. The committee contacted the Federation of Tax Administrators and NCSL requesting information on which state tax agencies employ this practice, but neither agency had information.

- DRS lists the names of the top 100 delinquent taxpayers for the personal income tax on its website, but not delinquent taxpayers for other state taxes.

Recommendations:

5. The Department of Revenue Services shall study the impact of amending the statutes to require that any person or entity doing business with the state must be in compliance with state tax laws. The study should assess the methods that might be employed by DRS to provide verification of tax compliance to state agencies before issuing a contract or grant, as well as any anticipated legal issues that might arise including definitions of compliance and confidentiality, any anticipated delays in awarding of contracts, and an estimate of resources necessary for implementation.

VIII. Principle: Accountable

A tax system should be explicit in how revenues are raised, changes should be well publicized, and the costs and benefits of tax policies should be examined.

Findings:

Accountability is strongest for the local property tax; state taxes are less transparent. The state has minimal capacity for tax policy research and little is known about the distribution of tax liability within Connecticut’s revenue system or its component taxes. Tax system information that is available to the public is mostly collections statistics and scattered in a variety of agency documents.

• At the local level, taxpayers receive bills clearly showing the amount of property tax they owe, the process for determining assessments and rates is public, and in many towns, the local budget must be approved at a town meeting or by referendum.

• At the state level, it is difficult for taxpayers to know how much they pay directly and indirectly in state sales, excise, and various business taxes. Final legislative action on revenue and spending bills is public and legislative changes to the state taxes are publicized in print and electronic media. Connecticut’s spending cap and balanced budget requirements provide some taxpayer accountability regarding the legislature’s fiscal decisions.

- DRS issues press releases about new and revised state taxes and includes detailed notices about tax changes on its website.

- It appears the cap has been effective in helping to curb state spending growth and any related need for higher revenues. Connecticut’s state government spending as a percent of either personal income or gross state product compares well with the national averages for these measures of state tax burden (7.3 percent versus 7.0 percent of personal income and 6.5 percent versus 6.0 percent in 2002, the most recent year with available data).

• Information about state and local taxes is produced and regularly reported by executive branch agencies including the Department of Revenue Services, the Office of Policy and Management, the Office of the State Comptroller, and the legislative Office of Fiscal Analysis. All municipalities regularly report on the property the property tax.

- However, there is no single, up-to-date source of even basic state and local tax collection statistics for Connecticut that is available to legislators or the general public.

• DRS is required by law to: report a variety of detailed tax payment data by type of tax and taxpayer categories to OFA each year; include in that annual report specific data on corporate tax payments and penalties; supply information on corporate tax exemptions and credits and other business tax-related issues needed by the newly established legislative business tax credit and tax policy review committee; and maintain a list of delinquent taxpayers that is available to the public.

- As part of its statutory annual report to OFA, the department publishes a comprehensive statistical report on state taxes, similar to annual reports produced by most state tax agencies, that is available to the public. It includes revenue collections and numbers of taxpayers by type of state tax over time as well as data on sales tax exemptions, sales and real estate conveyance taxes by town, and aggregated information on corporate tax credits.

- Due to the heavy demands from ITAS implementation on research staff resources, DRS has been unable to publish this annual report since FY 03.

• The comptroller is responsible for issuing the official, audited statements of state revenues; problems with the state’s new computerized accounting system (CORE-CT), however, have prevented final reporting for either FY 04 or FY 05 to date. At one time, the comptroller did some economic analysis and reporting on state finances but that function was discontinued in 2003 due to agency staff reductions.

• OPM is responsible for overseeing the administration of the local property tax by Connecticut cities and towns. As part of that duty, it collects a variety of tax and expenditure information from all cities and towns and prepares an annual municipal fiscal indicators report.

- By statute, OPM also reviews and certifies a variety of statistics concerning the quality of local assessment procedures. To date, that information has not been compiled and reported in a form available to the general public.

- At present, OPM is the only centralized source for local property tax policies, procedures, and related data.

• Public information on tax expenditures, which are tax credits or exemptions intended to benefit certain taxpayer groups (e.g., low-income households, the elderly, or the disabled) or promote specific public policy goals (e.g., job creation, pollution abatement) enhances accountability.

- OFA, in addition to its main function of supporting the appropriations and finance committees in developing the state budget, is statutorily required to issue a report on state tax expenditures every two years.

- At present, the OFA report is the only comprehensive source of information on the use of existing tax credits by individuals and businesses in the state and the data it includes are highly aggregated.

• The research office of DRS has a small staff and its role as defined by current top management does not include tax policy research. The resources within OFA and OPM available to carry out revenue forecasting, long-term financial planning, and policy analysis including examination of the costs and benefits of tax changes are also limited.

- At present, the DRS research office is staffed by three people who also have legislative liaison duties in addition to their primary function of providing statistical information on state taxes to OPM and OFA for their revenue forecasting and tax change analysis functions. As noted above, over the past two years, the research office devoted much of its time to facilitating the agency’s ITAS project implementation.

- DRS expects full implementation of the agency’s new ITAS system, specifically the data warehouse function scheduled to be in place by the middle of 2006, will vastly improve its research and reporting abilities. However, other than ensuring all currently required reports will be produced, nothing specific in terms of the research office’s goals and objectives, major duties, or resource requirements has been planned or discussed at the agency.

- OFA and OPM, which have major responsibilities for tax policy research, also have small numbers of staff assigned to their revenue functions (i.e., about the equivalent of four full-time analysts in each office), use private economic research services for assistance with these duties, and must rely on DRS to supply necessary state tax revenue data.

- Bond rating agencies interviewed by the program review committee noted the positive characteristics of the most highly rated states (i.e., those with steady AAA ratings) include strong revenue analysis and research capabilities along with a commitment to long-term financial planning.

• Several recent legislative initiatives should improve both the quantity and quality of information about the state’s revenue system that is available to policymakers and the public.

- Legislation enacted in the most recently completed session (P.A. 05-262) requires the appropriations and finance committees to meet annually in November to consult and receive “fiscal forecast” information from OFA and OPM, including short- and long-term revenue estimates and trends in spending, projected reserves, and debt burden.

- The legislative committee established under P.A. 05-251, is responsible for evaluating corporation business tax credits and business tax policy changes according to specific criteria, including measurable economic development or state workforce benefits. The committee must also analyze each tax credit or policy change and recommend revisions for those found redundant, unnecessary, or insufficiently beneficial.

- The current budget authorized funding to establish and maintain a multi-tax revenue estimating and forecasting system in the Office of Fiscal Analysis. An RFP to develop the system was issued by the Office of Legislative Management in October 2005 and an evaluation committee is currently reviewing the submitted proposals. Under the RFP, the system’s main functions would include: revenue forecasting; revenue estimates of proposed changes to current law; distributional and incidence analysis and data analysis and periodic analysis of the current tax structure and proposed changes to the major component taxes including the local property tax.

Recommendations:

6. DRS should take immediate steps to formally establish an agenda for its research office. It should begin this task by identifying, assessing, and prioritizing both currently required reports and projects and internal and external requests for new or expanded research products. Based on this assessment, DRS should also determine: the amount and type of staffing and other resources needed to effectively carry out its research agenda; the types and sources of data required; and how ITAS will be used to support these research efforts.

7. Amend the statutes to require the Department of Revenue Services to include information on total local property tax collections each year for the most current five-year period available in its annual statistical report.

8. The Office of Policy and Management should include in the municipal fiscal indicators report it publishes each year information on trends in local property values and taxes such as: the average and median single-family home tax bills and percent change in those amounts over time; town-by-town information on the availability and use of local option property tax exemptions; and measures that indicate the accuracy and uniformity of local revaluations (e.g., sales assessment ratios, coefficient of dispersion, price related differentials).

Policy Options: Accountable

Option Description

Implications

A. Regular Tax Incidence Analysis

Statutorily require the legislature every five years to: i) assess the state and local tax system in terms of the NCSL principles of a high quality revenue system; and ii) produce a tax incidence analysis report.

• Periodic reporting on the system’s performance in terms of NCSL principles, particularly concerning the distribution of tax burden, would allow policymakers to regularly assess the cumulative impact of tax revisions as well as changes in the economy on the state’s revenue system.

• Better informed discussion of tax policy changes would be possible since incidence analysis provides detailed information on the distribution of tax liabilities across different income groups and types of taxpayers as well as the costs of proposed changes.

• The research and analysis needed, especially for a tax incidence report, is relatively expensive, requiring dedicated staff resources and up-to-date software and databases.

• Access to tax-related information deemed confidential by federal or state agencies may be a problem and limit the scope of analysis as well as its usefulness.

B. Tax Change Impact Notes

The impact of all legislative proposals for new taxes and major revisions to existing taxes should be assessed in terms of the NCSL principles for a high quality revenue system, and, prior to final action on any proposal, the results of this assessment should be available for legislative consideration.

• Analysis of tax changes in terms of each revenue system principle would provide more information about costs and benefits of policy revisions and permit fuller discussion.

• The analysis would increase awareness of the impact on the overall system of changes in any component parts.