Opinion: Time to Revisit the New Jersey-Pennsylvania Reciprocal Tax Deal

Andrew Sidamon-Eristoff | December 9, 2015 | Opinion
On the upside, an easy $180 million; on the downside, an untold number of angry voters. You do the political math

Andrew Sidamon-Eristoff
Money’s tight. Hardly a New Jersey news cycle goes by without some discussion lamenting our lack of fiscal flexibility in meeting a range of critical needs, from “fixing” the Transportation Trust Fund and shoring up local governments in fiscal distress to funding the state’s long-term pension and healthcare obligations. And let’s not forget the need for long-overdue tax relief.

There’s no getting around it. To meet these challenges, we need to get serious about cutting back the scope of government services at both the state and the local level and, yes, we need to identify new sources of revenue that won’t make New Jersey into even more a tax hell. In short, these times demand that we look under every rock and challenge every sacred cow.

Let me start by taking on the mother of all South Jersey sacred cows: New Jersey should withdraw from the Reciprocal Personal Income Tax Agreement with Pennsylvania. This simple move, which does not require the state Legislature’s approval, would generate an extra $180 million a year for New Jersey. That won’t solve all our funding needs, but $180 million is real money.

What is the Reciprocal Agreement, how does it work, and why is withdrawal both appropriate and fair?

Some tax-law background. Under general constitutional principles, taxpayers who commute to work in another state pay tax to the state where they work and get a credit for that amount paid when computing their tax liability to their state of residence. Thus, Bergen County residents who commute to jobs in New York City pay taxes on their compensation to New York State and receive a credit for those taxes paid against their New Jersey tax liability. If they have no other income, the credit can wipe out any tax owed to New Jersey. (In practice, this costs New Jersey approximately $2 billion per year, but that’s a topic for another day.)

The Reciprocal Agreement reverses the general constitutional approach between New Jersey and Pennsylvania. Entered into in October 19, 1977, shortly after the enactment of the New Jersey Gross Income Tax, the Reciprocal Agreement provides that each state will tax compensation (wages) earned in the other state as if earned in the taxpayer’s state of residence. Thus a Pennsylvania resident who works in New Jersey pays tax to Pennsylvania, and vice versa. There is no need for commuting taxpayers to file in both states or use a credit mechanism.

The two states entered into the Reciprocal Agreement with the goal of simplifying tax compliance for their respective residents. At the time, the two states’ income-tax structures were comparable.

But times change and so do taxes. Notably, Pennsylvania maintains a flat income tax rate of just over three percent with no credits for local income taxes paid, while New Jersey has developed a highly progressive rate structure and does provide a credit for local taxes paid. As a consequence, although the Reciprocal Agreement is still a convenience for some taxpayers, it has become a bad fiscal deal for both states, especially New Jersey. As I said, current estimates are that New Jersey’s net annual loss is about $180 million.

The impact is asymmetric: New Jersey’s losses from not being able to tax wealthy Bucks County residents who commute to high-paying jobs in New Jersey far outweighs the taxes New Jersey collects on low- and moderate-income Camden and Gloucester County residents who work in Pennsylvania, typically Philadelphia.

There are two reasons for the asymmetry.

First, New Jersey’s income tax is much more “progressive” than Pennsylvania’s. Although Pennsylvania imposes a flat tax of just over three percent on most taxpayers, New Jersey’s effective tax rates are lower than three percent for most moderate-income taxpayers and much higher (up to 8.97 percent) for high-income taxpayers. There’s a reason why high-income earners move across the Delaware.

Second, New Jersey state tax law provides a credit for tax paid to localities such as the Philadelphia Wage Tax on nonresidents (currently 3.4828 percent), while Pennsylvania state tax law does not. That means a New Jersey resident who works in Philadelphia gets a credit for the Philly wage tax while her coworker living in Pennsylvania does not. Keep this confusing tidbit in mind as we continue the narrative.

As former Gov. Jim McGreevey found out when he proposed, and ultimately had to back away from, abrogating the Reciprocal Agreement as part of his 2002 Budget Message, asymmetric financial impacts can have incendiary political consequences. The political problem for any New Jersey politician is that abrogating the Reciprocal Agreement would result in relatively large numbers of low- and moderate-income New Jersey residents (voters) who work in Pennsylvania, mostly Philadelphia, paying more tax (albeit to Pennsylvania) while a relatively small number of high-earning Pennsylvania residents (voters) would pay more tax to New Jersey. Even though New Jersey would come out ahead, even the dimmest politician will understand the challenging voter math.

So, why is time to abrogate the Reciprocal Agreement? Here are some reasons:

  • We need the money. The aforementioned $180 million is not a total solution, but it’s real money that could make a difference. Take transportation funding, for example. Without finding some new source of revenue, the Transportation Trust Fund will not have enough dedicated revenues to support significant extra borrowing beyond fiscal year 2016. An extra $180 million a year could provide welcome flexibility. The state constitution’s dedication of all income-tax receipts to property-tax relief will prevent the use of this extra revenue for general TTF purposes. However, the State could probably use the extra revenue to support county- or local-government projects, either by using it to service debt allocable to local projects ($180 million a year could support approximately $2.7 billion in borrowing) or to provide debt-service aid and/or capital aid to local governments. Indeed, this may provide an opportunity to accommodate legislators’ desires to increase the amount of annual TTF funding for local projects beyond the approximate $200 million of recent years.
  • In the face of Trenton gridlock, this is as easy as it gets. Either state can withdraw from the Reciprocal Agreement on 120 day’s written notice. That’s it. No legislative action is required, which means no voting for or signing a tax increase bill.
  • Withdrawal is fair to the vast majority of New Jersey’s taxpayers. Yes, some New Jersey residents will lose a special benefit and have to pay more tax to Pennsylvania than they now pay to New Jersey. In some cases, due in part to the fact that Pennsylvania does not give a credit for the Philadelphia Wage Tax, the extra amount will be significant. But there’s no getting around the fact that the vast majority of New Jersey’s taxpayers bears the burden of covering the shortfall created by this special benefit. Is that fair?
  • Withdrawal is fair to those high-wage New Jerseyans who didn’t move across the Delaware. A New Jersey resident working alongside a Pennsylvania resident at a highly paid corporate headquarters job in, say, New Brunswick pays a marginal state income tax rate more than twice as high (8.97% versus 3.07%). Is that equitable? Even allowing for the small local earned income or local services taxes imposed by most of Pennsylvania’s municipalities and school districts, the state income tax differential combined with Pennsylvania’s generally lower property taxes can be an overwhelming incentive to move across the Delaware at, to be frank, minimal disruption to one’s lifestyle. Trouble is, when the Chairman of NJ Industries lives in Pennsylvania, the rest of us get stuck holding the bag.
  • Why should New Jersey’s taxpayers subsidize jobs in Philadelphia? If you think it through, the Reciprocal Agreement acts as a New Jersey taxpayer-financed subsidy for jobs in Philadelphia. As noted, Pennsylvania does not give a credit for the Philadelphia Wage Tax, but New Jersey law does. By giving New Jersey residents who work in Philadelphia access to the New Jersey credit, the Reciprocal Agreement takes some of the political and financial sting out of the Philly wage tax and thus, everything else being equal, makes it artificially attractive to create or accept a job in Philadelphia. Why should New Jersey’s taxpayers subsidize jobs in Philadelphia, especially when Pennsylvania’s taxpayers don’t provide a similar subsidy to Pennsylvania residents who work in Philadelphia? At a time when New Jersey is granting hundreds of millions of dollars in economic development incentives for job creation in Camden, just across the river from Philadelphia, the current agreement makes no sense.
  • The Reciprocal Agreement is bad for Pennsylvania, too. As a former secretary of revenue for Pennsylvania, the current governor of Pennsylvania probably appreciates the little-known fact that Pennsylvania is also a net loser under the Reciprocal Agreement to the tune of some $35 million annually. Pennsylvania gains less from taxing the relatively small number of residents who commute to high-paying jobs in New Jersey than it loses from not taxing the larger number of New Jersey residents who commute to Pennsylvania. This is a function of the fact that Pennsylvania has a low flat rate (limiting the revenue gain on ex-commuters) and does not grant a credit for local taxes (augmenting the amount of foregone revenue in respect of in-commuters to Philadelphia). Now that a bitter political dispute over raising taxes has scuppered his most recent budget deal with the Pennsylvania Legislature, perhaps Gov. Tom Wolf might consider taking bold action that will coincidentally help his neighboring state.
  • I am fully aware that, despite its merits, this proposal’s politics are absolutely horrendous. That’s typical of what happens when government creates a special benefit or entitlement that, over time, becomes part of the landscape of political expectations. But if there was ever a time to have a reasoned public discussion on this thorny issue, it is now.