Explainer: A Look Under the Hood of NJ’s Income Tax and Its Special Quirks

Rules that hew to the state constitution limit the uses of the state’s biggest source of revenue to items that lower property taxes

Residents across New Jersey are sending their state income-tax returns to Trenton this month, helping provide the revenue for what’s by far the largest single source of tax dollars for the state budget.

But even as state spending has become increasingly reliant on the income tax — more than 40 percent is now supported by just that one source of revenue — it’s not widely known exactly how those dollars can and can’t be spent under a constitutional restriction on income-tax proceeds that was enacted decades ago.

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The income tax is also a particularly hot issue this year as Gov. Phil Murphy has projected an increase in tax collections that had yet to fully materialize heading into the crucial April tax-filing season, meaning last-minute cuts or other spending adjustments could be looming in a matter of weeks. The governor has also made the establishment of a true millionaire’s tax a key element of his overall $38.6 billion budget plan for fiscal year 2020, but that proposal is getting very little support so far in the Legislature.

How it works: The state collects income taxes in a number of ways, including by regularly withholding funds that are deducted from individual worker paychecks. Estimated payments are also collected every few months from those who are self-employed or have large amounts of non-wage income — things like capital gains and stock dividends. Year-end payments are also collected in April from residents who did not fully fund their income-tax liabilities throughout the course of the tax year and must submit a check with their return.

The rates: In New Jersey, income taxes are paid under a “progressive” system of marginal tax rates that generally increase as more income is earned by an individual taxpayer. For example, residents who face the state’s highest marginal rate of 10.75 percent don’t pay that rate on all of their earnings, just on the portion that surpasses the $5 million income threshold set under current state law. The result is most taxpayers pay what’s known as an “effective rate” — a blend of the various rates that can be applied to their income as it moves up the scale.

The history: Believe it or not, there was a time when New Jersey didn’t levy any income tax at all. But that changed in the 1970s, after a court ruling said the state had to play a bigger role in paying for education. After a few tries, an income tax was eventually established in 1976, and it originally functioned with only two tax rates: 2 percent levied on income under $20,000, and 2.5 percent on income over $20,000. Several new marginal rates were added in the 1990s during former Gov. James Florio’s tenure, and a then-top-end rate of 8.97 percent was set for earnings over $500,000 by former Gov. Jim McGreevey in 2004.

The current rates range from 1.4 percent up to the 10.75 percent rate, which was just added last year. If Murphy eventually can get lawmakers to go along with his true millionaire’s tax proposal, the 10.75 percent rate would be applied to all earnings over $1 million, generating an estimated $447 million in new revenue.

The catch: Unlike the state’s other big revenue sources, like the general sales tax and the corporate-business tax, New Jersey’s income-tax revenues are wholly dedicated under the state constitution to providing property-tax relief. To ensure those rules are followed, the constitution requires income-tax dollars to flow directly into a fund that’s separate from the budget’s General Fund. That fund is called the Property Tax Relief Fund.

What is and isn’t property-tax relief? The most obvious items for which officials can tap the Property Tax Relief Fund are the state’s direct-relief programs, such as Homestead and Senior Freeze reimbursements. But other items also qualify for income-tax funding, like state aid to K-12 education, county colleges and even teacher pensions, because those things would otherwise have to be paid for using revenue from local property taxes.

Many categories fall completely outside the property-tax relief designation, such as the subsidy for New Jersey Transit and aid provided to four-year colleges, even though those are sometimes falsely identified as items that would benefit from the millionaire’s tax by its proponents.

It’s also no longer the case that revenue from the income tax can readily be used to ease pressure on the General Fund. Years ago, General Fund revenue helped cover state spending on property-tax relief. But in more recent years, newly enacted tax cuts like the 2016 reduction of the sales tax have eaten into the General Fund’s revenue stream, making it more difficult to simply “move money around.” Just last year, the Murphy administration needed to use a creative accounting maneuver to ensure the General Fund had enough money in it even as the Property Tax Relief Fund was flush.

The latest: The Department of Treasury has been keeping a close eye on the income tax this year as officials wait to see how taxpayer behavior is being influenced by a new cap on a federal income-tax write-off for state and local taxes that was enacted in late 2017 by President Donald Trump and Congressional Republicans.

The federal deduction, known as SALT, used to be unlimited, and the highest earners would usually pay their state and federal income-taxes well before April to take advantage of the federal tax benefit. But with the federal SALT deduction now capped at $10,000 annually, Treasury officials believe there’s no longer an incentive for many taxpayers to pay ahead of time.

Income-tax collections were running behind the Murphy administration’s year-end growth target heading into April, but Treasury officials have remained confident that taxpayers are just waiting until the last minute to pay up this year. In fact, they expect a full $3 billion to come in just this month to keep spending in line with revenues and obviate the need for cuts.

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