A RESPONSE TO RICHARD WOODBURY’S WORKING PAPER ON

INCOME TAX REFORM IN MAINE - How it Works and Who Benefits?

By: Albert A. DiMillo, Jr. retired Corporate Tax Director, CPA and life-long Democrat

Mr. Woodbury’s working paper on income tax reform in Maine has some useful
information, but it contains factual mistakes and leaves out many facts that one would
need to fully understand Maine’s so called “Tax Reform” and “How It Works and Who
Benefits?” The result is the paper is at best incomplete and misleading.

On page 1 of the paper; the author repeats the false and misleading statement that “the
reform is calibrated to retain broadly similar progressivity in tax burden across the
income distribution, while lowering the income tax assessments on 96% of resident
taxpayers.”

The 96% comes from a new Maine Revenue Services (MRS) report of the impact of the
new tax law (LD 1495) on the income tax for the year 2010. However, what is not
included in these numbers is the MRS estimate that at least 50% of low income taxpayers
who currently don’t pay any income tax will only have an income tax decrease, if they
file an income tax return to receive a $50 - $70 tax refund. MRS estimates that at least
50% of these taxpayers will not file for the refunds, because of the small amount of the
refund and the cost to file the return. (In calculating the revenue impact of the new law
MRS estimated that $5.7 million of these small refunds would never be collected and that
this revenue was utilized to help make the law revenue neutral). When one includes a
conservative estimate of 125,000 low income non filers, the percentage of Mainers with
an actual income tax cut goes down from 96% to 77.6%. The other fact missing from the
author’s analysis is that the MRS report for the year 2013 shows that the number of
Mainer’s with an income tax decrease goes down another 3% to about 74.6%, because
the new law does not index the income tax for inflation until 2014, as compared to the old
law that had inflation adjustments every year. Finally, what the author does not tell you
is that 100% of Mainers will see a sales tax increase, that eliminates the vast majority of
the income tax decrease in year 2010 and by 2013 the average taxpayer will have a small
net tax increase.

With regard to the progressivity, the income tax cuts for the most wealthy Mainers is over
18%, which is more than twice the percentage income tax cut for all other Mainers,
which averages less than 9%. In addition, when one adds in the regressive sales tax
changes, the net tax changes reduce the combined income and sales tax progressivity
significantly. The MRS report for year 2013, estimates that a group of 4,638 taxpayers
with income over $350,810 will get a net income and sales tax cut of $34.8 million. The
other 99.3% of Mainers will have a net income and sales tax increase of $3.5 million. No
reasonable analysis of this fact could conclude that this result improves the progressivity
of Maine’s sales and income tax systems.

On page 3, the author describes the new law’s “Structural Reform” which replaces
personal exemptions and standard or itemized deductions with a limited and phased out
household credit. The word “Reform” is used by the author and proponents of the new
law in such a way that many might assume the “Reform” makes the system better. In
fact, of the 42 states with an income tax, 32 states allow personal exemptions, standard
deductions and itemized deductions like old Maine law before LD 1495, 8 states allowed
no itemized deductions and 2 states allow limited itemized deductions. Under LD 1495,
Maine would allow a limited tax credit that will partially replace itemized deductions for
taxpayers. Accordingly, Maine will move to an income tax structure like no other state.
The new credit system is much more complicated than the old system and the author does
not give any arguments why this new credit structure is better than the old system.

On pages 4 – 10, the author illustrates detail calculations of the income tax under the old
law and the new law for various income levels and prepares numerous graphs that are
relatively uninformative, because they only look at the income tax changes and do no add
in the sales tax increases for the various income levels. In addition, the author’s
calculations are correct only for the year 2010 and do not attempt to calculate the impact
to taxpayers in years 2011-2013, which will be different due to lack of inflation
adjustments until 2014 under the new law. It is unclear whether the author did not
understand the substantial impact of the lack of inflations adjustments in the new law, or
if he just intentionally left this information out as most proponents of LD 1495 have done
to date on this issue.

On pages 4-5, the author prepares detail calculations of the income taxes due under the
old law and the new law for a family of four with $90,000 of income and $20,000 of
itemized state deductions. He calculates the income tax under the new law as $3,475 and
$3,647 under the old law or an apparent savings of $172. Of course what he fails to tell
you is that the MRS model estimates this taxpayer’s increase in sales tax in 2010 will be
$163 and that because state income tax is deductible in calculating this taxpayer’s Federal
income tax while sales tax is not, their Federal income tax will increase by $26 (15%
federal tax rate x $172 state income tax decrease). In total, this taxpayer’s total taxes
actually increase by $17 in 2010 (-$172+$163+$26). That’s the good news, by 2013,
assuming zero inflation in 2010, and 2.5% inflation in years 2011-2013, the income tax
savings under the new law will decrease from the $172 to just $39 and the sales tax
increase will increase to $175. The total net tax increase for this taxpayer in 2013 will
grow from $17 in 2010 to $142 net tax increase in 2013.

The author correctly states on page 10 that the income tax under the new law is higher
than under the old law for taxpayers with a large amount of itemized deductions. He then
goes on to state that “Whether the tax increase for high income itemizers was a deliberate
objective, a calibration error in the new formula, or a cost-reducing necessity to achieve
revenue neutrality in the reform package as a whole is unclear from the legislative
history. There are reasons to believe that the redistribution was deliberate: that the large
tax advantages extended to high itemizes under the current tax code is something that
policymakers do not want to continue under a structurally reformed system.”

In a meeting I had with Representative Piotti and Michael Allen (from MRS) in March of
2009, I asked Mr. Allen why did the proposed new law limit the benefit of itemized
deductions. He responded that it was done not for a tax policy reason other than the
numbers just did not work. It was mathematically impossible to cut the top tax rate to
6.5%, allow full benefit of itemized deductions and keep the law revenue neutral.

The author also tries to justify the limiting of itemized deductions, by giving the example
of two taxpayers with the same income, but one has significantly greater mortgage
interest because of their personal choice to buy an expensive home. Of course, the author
fails to understand that thousands of Mainers will see substantial income tax increases
because the new law limits or eliminates the tax benefit from large medical and charitable
contribution deductions. Thousands of Mainers have very large medical deductions for
dependents either in nursing facilities or with other major health problems. I have
personally spoken with several taxpayers who will see their Maine income tax increase
by at least $2,500 in 2010, solely because of the limiting of the tax benefit for medical
expenses. If one of the “structural reforms” was to have Maine taxpayers with large
medical expenses fund windfall tax cuts for the rich, then this “tax reform” accomplishes
that goal.

With regard to charitable contributions, thousands of higher income Mainers, who make
substantial charitable contributions, will see very large Maine income tax increases under
the new law. The most extreme example of this however, is with the top 912 taxpayers in
Maine that are estimated to have yearly income over $1.0 million. The expanded MRS
report of the impact of the new law on Mainers in year 2010, estimates that 751 taxpayers
with income in excess of $1.0 million will have a income tax cut of $17.0 million or
$22,665 each under the new law, while the other 161 taxpayers with income over this
$1.0 million, will have a tax increase of $3.4 million or $20,893 each. The main reason
these 161 taxpayers will have a tax increase is because they will not receive any tax
benefit from their substantial charitable contributions. For example a married taxpayer
with $1.0 million of income and itemized deductions of $40,000, will have an income tax
reduction of $12,157 under the new law. If this same taxpayer with $1.0 million of
income had an additional $250,000 itemized deduction for charitable contributions, their
tax under the new law would increase by $9,093 rather than decrease by $12,157. If the
“structural reform” and tax policy is to reward millionaires, who give back little or
nothing to the community and to penalized those millionaires that are generous, then the
new “tax reform” law is structured correctly.

On pages 12-14, the author talks about the winners and losers under the new tax law. As
I stated before, this analysis is misleading and incomplete because it does not combine
both the sales tax increase with the income tax changes and also does not quantify the
impact of the loss of the inflation adjustments for years 2011-2013. The MRS report of
the impact of the new law on taxpayers in year 2013, estimates that all Maine taxpayers
will have an average net income and sales tax cut of $45 each or a 1.4% tax reduction.
The detail breakdown of this group, however, reveals that Taxpayers with income under
$35,970 will on average have a net tax cut of $39 each, that taxpayers with income from
$35,970 to $350,810 will have a net tax increase of $22 each and that taxpayers with
income over $350,810 will on average have a $3,680 tax reduction or a 6.8% cut. Clearly
the only real winners under this so called “tax reform” are those earning over $350,810.
It should also be noted that the group of taxpayers with income from $35,970-$350,810,
who will see a net tax increase of $7.5 million currently pay 73% of the combined sales
tax and income tax under the old law. The answer is simple as to who the winners are,
they are the very wealthy earning over $350,000 a year, who do not give any substantial
amounts to charities. The losers are most of the middleclass, low income taxpayers who
don’t file income tax returns, the elderly and others with large itemized medical
deductions and families with large mortgages and high property taxes.

While most taxpayers will see only a small net tax increase, the results are clearly not as
publicized by the proponents of the law, who falsely claimed that 87% of Mainers would
see substantial net tax reductions. By 2013, assuming a 2.5% inflation factor for years
2011-2013, single taxpayers with incomes from $20,000 to $40,000 who do not itemize
deductions will have a net tax increase in 2013. Married taxpayers with incomes from
$35,000 to $70,000 who don’t itemize will also have a tax increase by 2013. It is clear
that the majority of the middleclass taxpayers in Maine will have a tax increase by year
2013.

Finally, a significant group of winners are actually non resident wealthy taxpayers with
business income taxed in Maine. The MRS estimates that a group of non residents will
receive about a $6.4 million income tax reduction. Unlike the wealthy Maine residents
who will also see a substantial income tax reduction, non residents will be able to avoid
most of the increased sales tax. Accordingly, wealthy non residents are the biggest
winners in this “tax reform” law. The proponents of the new law will point to the fact
that the new law will however, increase income taxes on a large group of non residents
increasing revenue by $21.7 million based on MRS estimates. This group of non
residents is low and middle income non residents, who will see their income taxes
increase by as much as 425%. For example as noted on page 4 of the author’s paper, a
married couple with two children, who does not itemize and has income of $40,000 will
have an income tax of $400 under the new law for an effective tax of only 1%. If this
same taxpayer actually lived in Portsmouth NH, but worked in Kittery, Maine their
income tax would be $2,600 or 6.5 times that of a Maine resident. This clearly unfair tax
increase is a result of the law’s provision that taxes non residents and part year residents
at a flat 6.5% and does not give them the household credits given to residents. The MRS
data for the year 2007, calculated Maine’s effective income tax rate for all taxpayers as
3.2% of personal income. Under the new law, despite the stated tax rate of 6.5%, the
household credit given to residents actually reduces the over all income tax rate to
slightly less than this 3.2%. Accordingly, the average non resident, who previously paid
tax at an effective tax rate of about 3.2%, will see their tax rate more than double to 6.5%.
These unfair consequences will also applied to part year residents, so taxpayers will see
this unjust tax discrimination both in the year they move to Maine and in the year they
move out of Maine.

The proponents of the new law call this exporting the tax to non residents. While a small
increase in taxes to non residents may be justified, a 100% to 425% tax increase is
unthinkable. In total, the MRS estimates that the tax increase on non residents will bring
in about $21.7 million a year. Unfortunately, the proponents of this law ignored
warnings from MRS that the new law’s treatment of non residents and part year residents
could be unconstitutional. This past summer, several state tax experts concluded that the
law was unconstitutional. In the October 19, 2009 issue of the “State Tax Notes” the
legal editor Jennifer Carr wrote an article on Maine’s new tax law concluding that
Maine’s household credit provision and its inconsistent treatment of non residents is
unconstitutional. Unlike Maine’s partisan attorney general Janet Mills who has no state
tax experience and who has stated the new law is “defensible”, state tax experts believe
the law is unconstitutional. For those unfamiliar with state taxes, it should be noted that
“State Tax Notes” is recognized as the leading periodical in the state tax field in the US.

If the new law does not get repealed through the people’s veto, it will be challenged on
constitutional grounds and the State on Maine will have a $22 to $25 million yearly tax
refund due to non residents upon the courts ruling it to be unconstitutional. One would
have to ask why doesn’t Maine hire a leading constitutional state tax expert and get an
opinion as to the likelihood that the law will be overturned as unconstitutional.

On page 16, the author comments on the reduction of the published top marginal tax rate
form 8.5% down to 6.5% or 6.85% and its impact to economic activity. He correctly
points out that the effective overall rate is probably more important and that for most the
marginal tax rate under the new law is actually 8.0%. But he once again incorrectly
claims that 95% of Mainers will have an income tax reduction. In addition, as noted
above the sales tax increases more than eliminate the income tax cut. The more
important fact to understand is that the vast majority of successful small businesses (that
have their income passed through to the owners and taxed as individuals rather than as a
corporation) will have a net tax increase under the new law by 2013. The MRS report for
the year 2013 estimates that taxpayers with incomes from $62,853 - $350,810 will see
their net tax increase by $8.9 million. Less than 1% of Maine’s small businesses have
income over this $350,810 level.

While the author does not go into great length about the impact of lower tax rates on
economic growth, clearly any logical analysis would conclude that Maine’s tax rate
reduction would have almost no impact. A decision to either moved to Maine or expand a
business in Maine depends on many more important factors then the individual state
income tax rate. The important factors include labor rates, health care costs, utility costs,
transportation access, vendor and supplier impacts, governmental factors including
environmental considerations, quality of life and property tax rates and other non income
taxes. Also when one considers income taxes, the Federal income tax rate which is
schedule to rise to more than 40% by 2013 greatly over shadows whether Maine is going
to cut the top rate from 8.5% to 6.85%.

Finally, while the author states that his goal is to provide greater analytic substance to the
debate on the new law so voters can make a more informed choice to either veto or ratify
the legislatively enacted reforms, his paper clearly does not do that. He also does not
address many of the misleading of false statements regarding the sales tax changes. The
following are a few quick points on those changes.
1). Proponents of LD 1495 have deceptively stated that Maine’s “meals and lodging
taxes” are much lower than other states including vacation destination locations and that
raising these taxes will allow the state to export the tax increase to out of state residents.
The truth is that while these statements are somewhat true for lodging taxes, they are not
true for the meals tax. The MRS estimates that 68% of Maine’s meals taxes are paid by
Maine residents. In addition, Maine’s meals tax at 7% is not low as compared to other
states. Massachusetts just raised their meals tax from 5% to 6.25% and Connecticut’s tax
is only 6%. Orlando Florida’s sales tax on meals is 6.5%. All of these states have the
same meals tax rate as their general sales tax. While many states have a small differential
between their general sales tax and their meals tax, Maine at 7% already has a 40%
additional tax differential and an increase to 8.5% or a 70% differential would put Maine
in the very small minority of states.

2). The MRS estimates that lodging taxes exported to non residents will be about $6.5
million a year. However, almost all of this revenue pickup on non residents will be offset
by a yearly $4.5 million state payment to a tourism fund.

3). The proponents of LD 1495 have incorrectly claimed that most states tax services.
Based on 2007 law summarized by the CCH tax service, only 21 states either generally or
mostly tax services. Maine was one of the 29 states that either taxed no services or only
taxed a few services.

4). Proponents argue that Maine’s income tax is one of the highest in the US, while the
sales tax is below average. While is true that Maine’s top marginal income tax rate is one
of the highest, its overall effective income tax rate is rank much lower. Based on the 2007
census data, Maine’s income tax collections were the 17th highest based on its percentage
of personal income. Maine’s sales tax collected was ranked 21st highest of all states and
15th highest out of the 43 states with both an income and sales tax.

5). There is no evidence or study that proves increasing the sales tax base will reduce
volatility in the state budget, this is only an unproven opinion. Even if this opinion was
true, then why wasn’t the sales tax on services expanded to include more services and
why was golf and skiing excluded from the sales tax expansion? Also instead of
increasing sales tax revenue, why wasn’t there a proposal to expand the sales tax to all
services and eliminate most of the current exemptions. A revenue neutral law could have
been proposed to actually increase the sales tax base and reduce the overall tax rate from
5% down to 3%. If the goal was to broaden the tax base to reduce volatility, this plan
would make more sense.

In conclusion, it is my opinion that the new tax law should be repealed and it is very
difficult to see how an informed voter would disagree. But even if the proponents of LD
1495 are able to mislead the public with false statements about the law and the people’s
veto fails, the income tax side of the law will be found unconstitutional and the state will
have one more financial crisis on its hands to make up for the $22-$25 million in lost
yearly revenue.
Albert A. DiMillo, Jr.
aadimillo@yahoo.com
(207) 899-0165