Nebraska Income Tax Modernization
Nebraska’s income tax was created in the Nebraska Revenue Act of 1967 and has been applied to both individuals and corporations since its creation. The income tax was increased soon after it was created, and it evolved into a less competitive structure over its first few decades. Nebraska policymakers took steps to improve the competitiveness of Nebraska’s income tax regime in 2022, which was an essential response to state tax competition that is accelerating on Nebraska’s borders and across the country. Further income tax reforms will benefit the Cornhusker State for decades to come.
The income tax has a greater impact on economic decision-making and tax migration than either the sales tax or property tax. Therefore, keeping a competitive income tax is a key to a state’s overall competitiveness. High tax rates and a progressive tax structure incentivize outmigration from states, while low flat income tax structures incentivize investment and inbound migration. Indeed, Tax Foundation finds a strong connection between recent taxpayer migration and the competitiveness of a state’s income tax. Economic researchers have found a causal connection between marginal income tax rates and the migration of firms and families for decades.
Unfortunately, Nebraska ranked 45th out of 50 states for the net loss of income due to taxpayer migration between the 2019 and 2020 tax years. Nebraska lost nearly a full percent of state income due to one year of outmigration. Higher income taxpayers are particularly sensitive to the top marginal income tax rate, and when they depart, they bring a lot of income with them.
A History of Uncompetitive Income Taxation
Nebraska’s individual income tax began in 1968 as 10 percent of Nebraskans’ federal income tax. It gradually rose to 20 percent of federal liability by 1983. Next, the individual income tax was made more progressive in 1993 with a 4-bracket tax structure and a top rate of 6.99%. The top rate was reduced in 1997 and then increased in 2003 and stood at 6.84% heading into 2022.
Nebraska’s corporate income tax began as a 2 percent flat tax in 1968. It was iteratively increased and evolved into a duel tax structure with rates of 5.58% and 7.81% by 1992. Those rates were maintained until tax changes in recent years.
Nebraska’s income tax was the state’s most-improved tax in 2022. LB 873, signed into law in April, reduced from the top individual income tax rate by 15 percent (from 6.84% to 5.84%) and the top corporate income tax by 24 percent (from 7.5% to 5.84%). These changes are an important pivot to towards a more competitive statewide tax regime.
Wyoming and South Dakota do not impose and income tax, while Colorado imposes a low flat income tax of 4.55%. Meanwhile, tax competition is heating up on Nebraska’s eastern border. Missouri and Iowa have reformed their income taxes over the last two years, with Iowa headed to a flat 3.9% rate and Missouri moving to a nearly-flat structure with a top rate of 4.5%. Missouri’s flat corporate income tax is 4% while Iowa’s will be 5.5%.
Modernizing Nebraska’s Income Tax
The pathway to modernize Nebraska’s income tax is straightforward. The income tax rate structure should be flattened and lowered for both the individual and corporate income taxes.
Under current law, Nebraska’s individual income tax rates will be 2.46%, 3.51%, 5.01% and 5.84% once the 2022 reforms are fully phased in. An income tax overhaul would collapse this multi-rate structure into a single flat income tax rate. In order to prevent a net tax hike on income earners of any level, the standard deduction should be increased.
For example, suppose Nebraska moved to a flat income tax of 4.5%. This might appear to cause a net tax increase on earners who fall into lower income tax brackets of 2.46% and 3.51%. Those brackets cover the first $21,000 of taxable income. However, policymakers could ensure a net tax cut at all income levels by expanding the standard deduction, which was $7,350 for individuals and $14,700 for those married filing jointly in 2022. Nebraska should aim for a low single-rate income tax structure, and should expand the standard deduction to ensure everyone gets a net tax cut.
The same structural change is needed for Nebraska’s corporate income tax. Flattening the corporate income tax will be easier to achieve compared to flattening the individual income tax. This is due in part to changes already made in LB 873 in 2022. Nebraska’s top corporate rate is scheduled to decline to 5.81%, and so Nebraska is on the path to a two-rate structure of 5.58% and 5.81%. Policymakers will easily be able to consolidate these two rates into a single-rate structure, and then iteratively lower that single rate.
Tax triggers are a valuable policy tool to effectuate these tax policy changes. Tax triggers create a schedule for lower income tax rates that are achieved so long as certain revenue targets are met. For example, Nebraska policymakers might allow revenues to grow by the lesser of 5% or inflation each year, with any excess revenue growth being deployed to rate cuts. This is a stable and effective way to lower the tax rates for the individual income tax and corporate income tax over several years.
Finally, Nebraska should preserve the 2022 structure of its business income tax base. Nebraska law currently allows businesses to immediately write off the cost of new investments in machinery and equipment. This policy is called full expensing, which Nebraska adopts from the federal tax code, and which states like Oklahoma have made permanent state law. However, with federal full expensing phasing out, Nebraska needs to lock in full expensing at the state level to avoid a business income tax hike starting in 2023. These changes are particularly important for physical capital-intensive industries such as manufacturing and agriculture. LB 827, proposed in 2022, would achieve this tax fix.
Policymakers can achieve these income tax reforms by cutting taxes against natural revenue growth, which will result in gradual tax reforms. This strategy has worked well in the recent high revenue years. On the other hand, policymakers could leverage revenue growth from sales tax modernization to pay to for income tax and property tax reforms. Ideally, both natural revenue growth and sales tax modernization will be leveraged to achieve broad tax improvements.
State tax codes need to be updated every few decades, and Nebraska’s tax code is due. In fact, the Cornhusker State’s tax restructuring is already underway. The code should be updated to fit the modern economy, and restructuring the income tax is perhaps the most important part of Nebraska’s broader tax reforms.
Modernization is critical for each of Nebraska’s major taxes, including the property tax, sales tax and the income tax. These tax reforms go hand in hand with each other. Reforms of one tax component make it easier to achieve reforms of another, creating synergies to achieve a broad tax overhaul.
This is the third blog in a three blog series on tax modernization in Nebraska. The other posts in the series can be found here: