Brad Keithley’s chart of the week: Putting the impact of federal income taxes on the PFD in full context

During the debate this past legislative session about the size of the Permanent Fund Dividend (PFD), some argued the impact of federal income taxes was a decisive reason to maintain cuts to the PFD below the amount provided by current law.

Their starting premise was that, as income, PFDs received by Alaska families are subject to federal income tax, which would divert a portion of the money distributed to Alaska families ultimately to the federal government. They argued that cutting the PFD, instead, would retain some of that money in the state, to help fund spending as directed by the Legislature.

Some initially vastly overstated the amount at issue. For example, at a $5,500 PFD – or $3.5 billion in total – one commentator claimed that the amount diverted to the federal government would be about $800 million, or nearly 23% of the total.

As the smoke cleared and more informed voices came to the fore, however, the amount came down. Ultimately, one of the economists from the University of Alaska – Anchorage’s Institute for Social and Economic Research (ISER) estimated the amount would land somewhere between 10% and 20% of the total. Based on the most recent state level data available from the federal Internal Revenue Service, the average federal income tax paid by Alaskans is about 12%.

But such calculations – regardless of the level – scratch only the surface of the ultimate issue. They are, at most, only a half-look.

The reason PFD cuts are an issue in the first place is because more funding is required to pay for government than is available from traditional UGF revenues plus the portion of the annual percent of market value (POMV) draw from the Permanent Fund remaining after the statutory PFD.

As a result, the ultimate question isn’t simply what the federal tax effect is of distributing PFDs compared to using PFD cuts to meet state funding requirements, but instead is what the overall impact of using either approach is relative to the overall impact on state revenues and state income of other funding mechanisms.

The impact of federal income taxes on PFD’s is only one piece of that larger question.

A 2016 study prepared for the Legislature by ISER comparing the relative impacts on state revenues and state income of various funding options helps put the overall issue in focus.

There, ISER noted that, at least at higher income levels, state taxes are deductible from federal income taxes and, as a result, using state taxes to raise revenue would reduce the impact of federal income taxes on overall Alaska income. Rather than diverting money to the federal government, using state taxes to raise revenue in fact would have the opposite effect of reducing the amount of money otherwise paid to the federal government by Alaska families, retaining more money in the state.

Of course, some federal income taxes would still be due on the distributed PFDs. But the impact on overall Alaska income of distributing PFDs would be offset somewhat as the use of state taxes reduce the federal take.

And it’s not just the reverse impact on federal income taxes. Both the 2016 ISER study and a 2021 study prepared for the Legislature by the Institute on Taxation and Economic Policy (ITEP) add further context.

In its 2021 study ITEP analyzed the potential revenue which would be raised using a flat tax (instead of PFD cuts).

It made clear that one of the important advantages of using broad based taxes to fund government over PFD cuts is that non-residents would also contribute a material share of revenues. Using the previous 2016 study by ISER as its base, ITEP estimated that a flat tax would raise roughly 7% from non-resident sources, compared to none from PFD cuts.

Thus, if the goal was to raise $1 billion in additional revenues, by using a flat tax $70 million would come from non-residents and only the remaining $930 million from Alaskans. This compares to taking the entire $1 billion from Alaskans if raised through PFD cuts.

Taking all of these factors into account, the overall impact on both state revenues and state income between using PFD cuts or a state tax is roughly a wash.

Using the numbers from the 2016 ISER study (Figure II-4 from the study, below), as updated by the 2021 ITEP study, reducing the PFD by $1 billion and diverting the money instead to the state would avoid roughly $160 million (15.9%) in federal income taxes.

But using a flat tax instead would itself reduce federal income taxes (through deductions) by roughly $90 million (9.4%), plus raise $70 million (6.7% in the 2016 ISER study, 7.3% in the 2021 ITEP study) in additional, substitute income from non-residents.

Comparing the two approaches, the net overall impact is the same. Federal tax “losses” on distributing PFDs (15.9%) are entirely offset by the gains resulting from the deduction of a portion of state taxes from federal income taxes (9.4%) and the substitution effect of raising revenue from non-residents (6.7%).

The state would come out even under both alternatives. Either approach would raise $1 billion in state revenues.

And so would overall Alaska income. Using PFD cuts, Alaskans would transfer to the state $1 billion in PFD cuts, but avoid roughly $160 million in federal income taxes, for a net transfer from private sector income of roughly $840 million.

Using state taxes, Alaskans would transfer roughly $930 million in state taxes to the state and reduce their federal income taxes by roughly $90 million, again for a net transfer from private sector income of roughly $840 million.

So, if the net impacts are a wash, why should anyone care whether the state raises the money through PFD cuts or through state taxes?

Because the distributional – which Alaskans bear the burden of funding the state under the two alternatives – and economic – what’s the effect on the overall Alaska economy – impacts are dramatically different between the two approaches.

As previous readers of these columns will know, PFD cuts are hugely regressive, taking much more as a share of income from middle and lower income – 80% – of Alaska families than the top 20%.

According to the 2016 ISER study, through their disproportionate impact on middle and lower income Alaska families, PFD cuts also have the “largest adverse impact” on the overall Alaska economy of all the various funding options.

On the other hand, taxes – especially a flat tax – are much more equitable, taking largely the same share of income to fund state government from ALL Alaska families, regardless of their income bracket. Middle and lower income Alaska families contribute largely the same share of income as those in the top 20%.

And because the burden is spread much more broadly – including to non-residents – the impact on the overall Alaska economy also is much lower.

So if using state taxes is a wash with using PFD cuts on state revenue and overall state income, but also is much more equitable and has a lower adverse impact on the overall Alaska economy, why is anyone arguing for using PFD cuts instead?

Our response is simple: follow the money.

As is clear from the charts above, using PFD cuts reduces the contributions required from the top 20% to help pay for government to trivial amounts. They do so by pushing the burden, instead, increasingly to middle and lower income Alaska families.

State taxes, on the other hand, require the top 20% to make contributions at the same levels being borne by the remaining 80%. They result in equitable contributions by ALL Alaska families, replacing the preferred position which the top 20% otherwise achieve using PFD cuts.

Those making the argument for using PFD cuts – largely the top 20% – simply are looking out only for their own economic self-interest, ignoring the hugely adverse impact on the remaining 80% of Alaska families and the overall Alaska economy.

And so, why are some raising the half-argument about the impact of federal income taxes, conveniently leaving out the offsetting impacts of using state taxes instead?

Again, follow the money. Because using the half-argument (instead of acknowledging the whole truth) helps tilt the playing field in favor of using PFD cuts.

The bottom line is this. Viewed in full context, using PFD cuts to fund government isn’t any better from a state revenue or overall state income perspective than using state taxes. Both have pluses and minuses that ultimately wash out.

But there is a huge difference from the perspective of their distributional impact on Alaska families and on the overall Alaska economy. Using state taxes is far more equitable and has a lower adverse impact on the overall Alaska economy than PFD cuts.

The top 20% don’t like hearing that – and repeatedly try to obfuscate it by using various half stories – but it’s the truth.

Brad Keithley is the Managing Director of Alaskans for Sustainable Budgets, a project focused on developing and advocating for economically robust and durable state fiscal policies. You can follow the work of the project on its website, at @AK4SB on Twitter, on its Facebook page or by subscribing to its weekly podcast on Substack.

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Nunya
3 months ago

Best one in a while, thank you for keeping the drum beating.

Lynn Willis
3 months ago

Have we reached the point now that a “yearly” chart will send the exactly the same message?

turbodigits
3 months ago
Reply to  Lynn Willis

I’m not going to dial back my own comments about the PFD to one per year, even though my views on that topic are as firmly entrenched as yours, and my messaging just as repetitive. How about you? Any plans to limit your repetitive, negative comments about the PFD and the 80% of your fellow Alaskans to whom it makes a difference? You aren’t just stumbling onto Keithley’s articles. You have to go looking for them & click through to read them. I never see you argue with his premises, data, or conclusions. You seem to be more focused on… Read more »

Last edited 3 months ago by turbodigits
Kevin
3 months ago

You have genuinely changed my mind this year with these articles explaining how PFD cuts hurt the bottom 80%, and am now in favor of full PFDs. However, I’m a little confused by your solution to raise state revenue through taxes. You say a flat tax is most equitable but I always understood progressive tax rates as being more equitable. As is, the portion of disposable income lost through raised taxes was less affected through progressive than flat (for lower income). Also, your figure II-B shows property tax as having the lowest impact on Alaskans, and surely most burdensome for… Read more »