Swap payroll for income tax?

Radical new plan would mean tax cut for everyone who works in Connecticut, at least in theory

Democrats including Gov. Ned Lamont are preparing to replace most of the state income tax with a payroll tax, a new way to raise cash for the state that would mark the most radical change in Connecticut finances since the income tax started 28 years ago.

The plan would mean a tax cut for every person who works in Connecticut, at least in theory.

At its heart, it’s a simple idea: Employers would pay a payroll tax of 5 percent on all wages and salaries. They would, presumably, cut employees’ pay by 5 percent to make themselves whole.

The key is that employees would make 5 percent less, reducing federal income taxes as well as Social Security and Medicaid taxes for them and their employers. Most would be free of the state income tax, and those who now pay more than 5 percent would pay the difference, perhaps with the state taking some of their new savings.

Those who pay less than 5 percent would receive a rebate from the state.

If it’s crafted right, according to documents top leaders are using as a blueprint, every taxpayer — rich, poor, middle-class, small business owners — would all save money even as the state gained a new source of added revenue.

Savings would amount to an estimated $1.6 billion for employers and residents,

and the state would take in $400 million on top of that by raising tax rates in people making more than $200,000 — even as those people paid less money overall.

“Everybody gets a tax break, from EITC to millionaires,” said Sen. John Fonfara, D-Hartford, co-chairman of the General Assembly’s finance committee, referring to low-income workers who receive the earned income tax credit. “Everybody will come out ahead.”

Details matter

The stumbling block is in the many complications on the path to making the plan work — not politics or ideology.

First among the questions is whether the IRS will try to block it. The plan came from the Connecticut School Finance Project, a nonprofit, nonpartisan group based in New Haven that works on public finance issues. It was based on thinking that arose after the late-2017 Republican national tax reform act capped federal deductions for state and local taxes at $10,000 — costing Connecticut taxpayers an estimated $2.8 billion.

The feds nixed an idea last year under which taxpayers could have “donated” money to cities and towns in exchange for lower property tax payments, for example.

In this plan, “There isn’t anything there for the IRS to disallow,” said Katie Roy, a tax attorney who founded the Connecticut School Finance Project and is its executive director.

It’s not an easy switch for the state and employers to make. For example, unions have negotiated pay levels that would need to change; self-employed people would act as both employer and employee, with complications; big companies with national pay systems would need to do some local tailoring; people who work in Connecticut but live elsewhere may have new filings to make.

And of course, employers would need to remit the new payroll tax to the state, replacing or augmenting withholding, depending on each employee’s salary.

The list of stumbling blocks continues. But as far as I can tell, there’s no deal-killer. The $2 billion or so in extra cash for Connecticut easily makes the headaches worthwhile.

Fonfara adds, “We will not need a capital gains tax.”

In other words, if lawmakers can make it happen this year, effective Jan. 1 — a big if — the payroll tax would eliminate the issue that’s dividing Democrats most sharply: Whether to raise an estimated $260 million a year by creating a surcharge on capital gains income for wealthy taxpayers in the highest income-tax bracket.

Lamont has said that won’t happen, though he has not threatened a veto outright. Democrats in the General Assembly want the capital gains tax. A standoff has seemed unavoidable.

A rush to deadline

As of this week, Lamont’s top aides, including Chief of Staff Ryan Drajewicz and Melissa McCaw, the policy and budget chief, are working on the payroll tax along with key agencies, chiefly the Department of Revenue Services, Fonfara and Rep. Jason Rojas, D-East Hartford, co-chairman of the finance committee, both said.

Rojas had a series of talks with people from the project and others, and thought the plan required months of planning. Let’s take the summer and work through it, he figured.

After the finance committee finished its tax plan last week, Fonfara turned to the payroll tax idea. “When I found out how many boxes it checks, I said, ‘We need to do this,’” he told me in the crazy hours Wednesday night into Thursday morning, as the House debated a minimum wage increase. “We can do this. We have a month.”

The regular legislative session ends at 11:59 p.m. on Wednesday, June 5 — less than four weeks from now. A special session is possible but implementing a payroll tax effective Jan. 1, to work with the rest of the 2019-20 state budget, would require huge systems work after it was approved.

“It’s certainly possible,” Rojas said. “There’s just a lot of details we have to work out.”

“This proposal is complex,” said Lamont spokeswoman Maribel La Luz, “but it’s an idea worth fully vetting and exploring with our colleagues in the legislature.”

On the Republican side, Gail Lavielle, R-Wilton, ranking member of the appropriations committee, said it may be part of the answer to the state’s fiscal crisis.

“Will it solve everything? No way,” Lavielle said early Thursday, but she added, “Any headway is good.”

How much will I save?

Documents prepared by the Connecticut School Finance Project give examples. A married couple making $100,000, for example, now pays $5,172 in state income taxes. The couple’s combined state income tax and payroll deduction would total slightly more, $5,250, but its federal tax bill (based on a standard deduction) would drop by $982, for a total savings of $904.

A single person making $40,000 a year would see his or her total state tax go up — in the form of a employer payroll levy — from $1,395 to $2,000. That worker would owe the federal government

$393 less, for a net increase of $212. The state would make that up, perhaps with a kicker.

A couple earning $1 million would see a net reduction of

$19,675 because their taxable income would drop by $50,000. If the state were to hike their Connecticut taxes by 1 percentage point, to a total of 7.99 percent from the current 6.99 percent, they’d still come out ahead by nearly $10,000 — and the state would pocket an extra $10,000.

In total, households would see a benefit estimated at about $1 billion, assuming those at the low end were made whole, or slightly enriched, and assuming the state grabbed an extra 1 percentage point from those making more than $200,000 for singles and

$400,000 for joint filers. Employers would benefit by

$600 million by paying Social Security and Medicaid taxes at a lower base, by reducing payroll by

5 percent while paying the state 5 percent on a slightly lower base. After eyeballing the numbers compared with state tax figures, I’d say that’s a conservative estimate — it could be a much bigger savings for employers.

The state would add an estimated $400 million a year to its coffers even after spending money to make lower-income people whole. That’s because it would eliminate certain exemptions in addition to raising overall tax rates for highend earners.

Looking at numbers of taxpayers, based on state tax collection data from 2017, it appears that a bit more than half of households would pay no state tax at all, and roughly another 25 percent, those making between $50,000 and

$100,000, would pay just one-half of 1 percent in state income tax, after their employers paid the 5 percent payroll charge.

Ironic end of a tax

Speaking of workarounds to beat the federal tax reform, this idea is similar in some ways to the employer tax on so-called pass though income that’s earned by partnerships such as law firms. That started last year as a response to the Trump tax reform.

Rather than pay out income, the partnerships tax themselves at the business level, thereby reducing each partner’s income. It was allowed by the IRS, as this should be, as well.

There’s no estimate of the cost of implementing this new tax plan. The Connecticut School Finance Project is not a consultant and does not charge the state for developing the idea in detailed documents. (As an aside, the group might need to change its name to reflect its new, broader focus.)

The payroll tax would eliminate all of the state income tax for most residents, and most of the tax for all residents, which was the centerpiece of Republican Bob Stefanowski’s campaign against Lamont for governor. Of course, Stefanowski proposed to do it without adding a different tax.

Stefanowski, in a message to me Thursday, suggested the feds will reject “a scheme that reduces federal tax receipts by hundreds of millions of dollars,” and that Lamont should focus on cutting state spending.

Still, the irony of the income tax going away for many state residents is lost on no one.

“Stefanowski ran on it,” Fonfara said, “but the crazy thing is that it’s Lamont that could make it happen.”