Opinion: New Jersey Scores Another Own Goal with ‘Horrendous’ Tax Choices

Andrew Sidamon-Eristoff | July 9, 2018 | Opinion
Garden State’s competitiveness severely weakened by political leaders’ budget deal. Taking the easy way out, they made worst possible policy decisions

Andrew Sidamon-Eristoff
If I were asked to make a list of tax policy changes that would do maximum harm to New Jersey’s competitive position and long-term economic vitality, I would have a hard time improving upon the last-minute budget compromise announced on June 30. The months of budget brinksmanship might have been worthwhile had they resulted in a better budget supported by better tax policy. But, alas, once again New Jersey’s leaders took the easy way out while making some of the worst tax policy choices possible.

To support Gov. Phil Murphy’s expansive $37.4 billion spending plan, the deal includes three notable tax clunkers: a new 10.75 percent tax on megamillionaire incomes over $5 million (raising $280 million), a “temporary” corporate tax surcharge averaging 2 percent ($425 million), and a general tax amnesty ($200 million). Each has fundamental flaws that will harm New Jersey for years to come.

Millions of New Jerseyans will no doubt welcome the new megamillionaires tax under the assumption that someone with that level of income can surely “afford” to pay his or her “fair share.” Besides, who really cares if someone else pays higher taxes, especially if that someone else lives on another financial planet?

Truth is, every New Jerseyan should care deeply.

The purpose of taxation is to raise revenue sufficient to support a desired level of government spending (which includes tax expenditures such as deductions, exemptions, credits, and even progressive tax rates). In general, good tax policy generates a stable revenue stream at the least possible cost while imposing a minimum of economic distortion. Unfortunately, the new megamillionaires tax will increase New Jersey’s revenue volatility at considerable cost while imposing maximum economic distortion.

Who are these people?

According to published reports, one reason that our legislators were comfortable with this new tax is that it will impact “only” a reported 1,760 individuals out of New Jersey’s 4.7 million tax-return filers. This reflects a fundamental misconception as to who these taxpayers are, how they realize income, and how tax considerations impact the way they arrange their personal and financial affairs.

Who are these people? For one thing, megamillionaires are by far the most mobile segment of our taxpayer population. They typically have more than one residence in more than one state (or country) and have access to sophisticated tax planning. Maybe it’s true that the vast majority are selfless, loyal New Jersey patriots who would never consider relocating their tax residency simply to minimize their exposure to a 10.75 percent top marginal tax rate that is almost 2 percent higher than New York State’s 8.82 percent, 3.76 percent higher than Connecticut’s 6.99 percent, 7.7 percent higher than Pennsylvania’s 3.05 percent, and unimaginable in states like Florida or Texas without a personal income tax. Yet, according to the most recent state tax data, if just 350 (about 20 percent) “average” megamillionaires out of our cohort of 1,760 succumbed to self-interest and relocated their tax residency (which doesn’t necessarily involve moving in the traditional sense), New Jersey could lose revenue on this new tax. Does that sound like good tax policy?

Second, the bulk of our megamillionaires’ income over $5 million comes in the form of bonuses, capital gains, or investment income — not a regular paycheck. This income is both highly volatile and extremely manageable.

What do I mean? People with very high incomes generally have the flexibility to manage or adjust their taxable income in any one year in accordance with their cash-flow requirements and tax-planning priorities. Financial planners will readily advise them on ways to structure income or loss realizations to mitigate tax exposure. My hunch is that more than a few of the 1,760 will report slightly less than $5 million in taxable income in future years.

Third, at least some individuals who report more than $5 million in a single year do so as function of a one-time, extraordinary event such as the sale of a closely held business, typically in the form of an interest in a passthrough entity such as a partnership or limited liability company (LLC). Five million dollars may sound like a lot, but it’s not an unusual price for a successful small business. Under current law, a nonresident doesn’t have to pay New Jersey tax on income realized from the sale of a New Jersey passthrough so long as the nonresident doesn’t realize any other New Jersey-source income during the year of disposition. Even before the new megamillionaires tax, well-advised New Jersey business owners routinely relocated their tax residency in advance of selling their New Jersey businesses. The new tax will supersize the incentive to do so, resulting in the loss of current revenue as well as any extra revenue from the higher marginal rate.

What are we left with?

With this new megamillionaires tax, our leaders will have raised little, if any, additional sustainable revenue while increasing the volatility of our revenue base and making New Jersey even more of a competitive outlier in our region. Long term, the real risk is that New Jersey’s economic growth will continue to lag the country and our region.

A convoluted mess

The budget deal raises an estimated $861 million from corporations, including $425 million from a temporary surcharge on corporate incomes over $1 million, assessed at 2.5 percent for two years and 1.5 percent for the succeeding two years. Although the business tax changes as a whole are a convoluted mess, the new surcharge deserves a special shout-out as a prime example of destructive tax policy.

In championing the surcharge, the leader of the State Senate argued that corporations can pay more since they received a “windfall” under President Trump’s tax reform. That may be true and a compelling political rationale, but it makes no sense considering New Jersey’s fragile competitive position. Large corporations are often highly mobile and extremely tax-sensitive at the margin, especially when making site location decisions. In this context, a corporation’s national tax burden is of zero consequence.

New York State’s top corporate rate is 6.5 percent, Massachusetts’ is 8 percent, Connecticut’s is 8.25 percent, and Pennsylvania’s is 9.99 percent. In raising its top rate from 9 percent to 11.5 percent, even temporarily — yeah, right — New Jersey will surge into the Number 2 spot nationally and the Number 1 spot in our region. This will make New Jersey even less desirable as a place for corporations to locate, invest, and maintain employees.

Ironically, the surcharge will inevitably generate immense political pressure to expand or create new corporate tax-development and job-creation incentives, which act to reduce effective tax rates to competitive levels. If history is any guide, the same politicians who today champion corporate-tax increases and decry “corporate welfare” will be at the forefront of future efforts to expand economic-development incentives. Moreover, this situation is unfair to small and medium-sized corporate taxpayers: In the real world, most incentive dollars go to large corporations with the means and sophistication to lobby for and qualify for benefits.

Meanwhile, the corporate tax, already a volatile and unpredictable source of revenue, will become even more volatile and unpredictable. Once again, instead of a surge in sustainable revenue, the likely result over time will be lagging corporate investment in New Jersey. That’s fine, unless your livelihood depends upon selling to or working for a large corporation in New Jersey.

Roulette pays off for tax cheats

The budget deal expects to raise $200 million from a second general tax amnesty in less than a decade. This is such a bad idea it’s hard to know where to start.

The only sound justification for a tax amnesty is to “reboot” the tax-collection system and bring delinquent taxpayers back into long-term compliance using a combination of positive incentives (waived penalties and interest) and negative incentives (heavy penalties for failure to come forward during the amnesty). Offering amnesties with any degree of predictable frequency undermines both types of incentives. Since even the best tax administrations can reasonably expect to identify only a fraction of noncompliance, offering periodic amnesties invites dodgy taxpayers to play Amnesty Roulette. In other words, amnesties tend to reward tax cheats while effectively penalizing compliant taxpayers who play by the rules. Inevitably, voluntary compliance revenue declines.

By the way, that nice, round $200 million figure is misleading. Tax amnesties generate revenue, but experience in New Jersey and other states shows that the bulk of the revenue will either be money that would have been collected in the ordinary course or a one-time acceleration or “spin-up” of future revenue as taxpayers rush to take advantage of penalty and interest waivers under amnesty.

For example, an official analysis concluded that New York State’s 2002 amnesty program, which generated an eye-catching $527.5 million in gross revenue, actually delivered a much less sexy $82.8 million in net new revenue while accelerating $131.2 million of collections into the amnesty year, which of course
created a budget hole for the succeeding year. Applying these ratios to New Jersey’s budgeted $200 million — crude but fair — suggests that the forthcoming amnesty will produce about $30 million in real new revenue and about $50 million in accelerated revenue. I fear the numbers could be even lower because New Jersey’s Division of Taxation has already picked much of the low-hanging fruit through special compliance initiatives over the past few years. We may never know, because the budget deal doesn’t require that the division publish a post-amnesty analysis.

Weakening NJ’s tax administration

Running a general amnesty imposes an enormous burden on tax administration. The budget agreement provides $25 million for amnesty tasks such as advertising, reprogramming data systems across several state agencies, developing guidance for taxpayers and practitioners, and specialized training for collections and taxpayer services personnel. It is unclear whether the budgeted $200 million in extra revenue is net of this amount. If not, the $25 million in program costs would nearly wipe out my estimate of $30 million in real new revenue.

Under normal circumstances the expense and effort of running an amnesty might be worth it as an opportunity to upgrade collection processes, improve training, and clean up data files. But the circumstances are not normal. The budget agreement contains a host of complex tax changes, such as mandatory combined reporting for corporations, that will require administration. Moreover, the Division of Taxation recently launched a long overdue, complicated, and very expensive modernization initiative involving both technology and personnel. Administering the new tax laws and an amnesty will necessarily take priority, diverting management’s time and attention away from the modernization initiative and substantially raising the risk of delays and/or a failure that would weaken New Jersey’s tax administration for years to come.

Yes, there was a better way

Even if you concede that it was necessary to raise $1.7 billion in additional revenue — which I do not — were these horrendous tax-policy choices the only or best options available? Absolutely not. As I have noted, our leaders had a range of better options for increasing sustainable revenues with much less negative impact on New Jersey’s competitive position.

For example, they could have adopted a New York-style income tax “rate recapture” provision that denies higher-income taxpayers the benefit of lower marginal rates as they move up in income. That might have been worth $500 million or more, mostly from higher income taxpayers, without raising the headline top marginal rate. Another example: They could have raised an estimated $600 million by reversing the largely symbolic 2016 reduction in New Jersey’s sales tax from 7.0 percent to 6.625 percent.

Of course, our fearless leaders could have eliminated the unfair and counterproductive New Jersey – Pennsylvania Reciprocal Tax Agreement ($180 million a year), eliminated the ineffective Urban Enterprise Zone program ($385 million a year), or not voted to waste $85 million a year on shake-down subsidies for the wealthy film industry ($425 million over five years).

You get my point: plenty of alternatives, zero leadership. Hey, there’s always next year!