PAI: A flexible, effective revenue adjustment tool

by Jack Hoffman, Public Assets Institute Twenty years ago, Vermont lost a valuable tool that let the state easily adjust state revenues to respond to fluctuating demands for public services. It’s time to find a replacement.

In 2002, the state ended the simple, straightforward system for assessing personal income taxes that had been in place for more than 30 years. Vermont stopped using the “piggyback,” whereby the amount of income tax a person owed to Montpelier was calculated from the amount owed to Uncle Sam. Typically, the rate was about 25 percent of a person’s federal tax liability. But it varied, which was the beauty of that system.

Vermont started using the piggyback in 1968. As a result, it had one of most progressive personal income taxes in the country because the federal income tax was much more progressive than typical state income taxes.

Under the federal system, income is taxed in tiers, and income in the higher tiers is taxed at higher rates than the income in the lower tiers. Such systems are fairer because they better reflect people’s ability to pay. Thanks to the piggyback, Vermont’s income tax system mirrored the progressivity of the federal system.

When first instituted, the rate was 25 percent. But over the years, it fluctuated between 23 percent and 28.75 percent. However, in 1991, when Vermont faced major budget deficits, the piggyback rate on the highest income rose to 34 percent. In 1994, the rate dropped back to 25 percent across the board.

The piggyback had two big advantages.

First, it was easy to understand and administer. But more importantly for state fiscal policy, it was extremely easy to adjust from year to year to respond to changing economic conditions. Between 1969 and 2000, Vermont’s piggyback rate was tweaked at least 16 times to raise or lower the amount of income tax revenue the state collected.

The strength of the piggyback system—being tied to federal tax policy—was also its weakness.

Vermont saw revenue fall in the early 1980s when President Ronald Reagan started the move toward lower tax rates for the wealthy.

Then in 2001, Vermont faced the loss of $20 million thanks to federal tax cuts promoted by President George W Bush. The Bush tax cuts were the last straw for Vermont policy makers, and in 2002 the Legislature adopted its own set of tax brackets and tax rates.

Initially, there were five tax brackets, with rates ranging from 3.5 percent on income in the lowest bracket to 9.5 percent on income in the highest bracket. The rates applied to a person’s federal taxable income (with some minor adjustments).

The problem with a system of state tax brackets and tax rates is that they are difficult to change. Not literally; the Legislature could change the percentages anytime it wanted.

But practically speaking, the Legislature and the administration are reluctant to change tax rates—and almost allergic to raising them.

The tax rates first established in 2002 were changed only twice over the next 16 years, although there were tweaks to other tax provisions. Then in 2018, Vermont broke free from the federal system, established its own exemptions and deductions, and reduced the tax brackets from five to four.

Vermont had good reasons for dropping the piggyback system, but what it lost was a system that was nimble and responsive to economic changes and Vermonters’ changing needs for services.

The “purpose of the state budget” statute Vermont adopted 10 years ago talks about “spending and revenue policies” that promote economic well-being and recognize people’s basic needs for health and work and housing and food and social security and a healthy environment.

But spending policies can’t effectively change without a corresponding change in revenue policies, and Vermont has made it much more difficult to make adjustments to its most progressive source of revenue.

Vermont is awash in federal money right now, which also has boosted state revenues. But now is the time to start planning for the future and thinking about how Vermont can have a tax system that is independent of federal tax policy but as flexible and responsive as the old piggyback tax.

Public Assets Institute. Montpelier. May 12, 2022