Last week, Governor George Pataki signed into law state legislation abolishing the non-resident income tax for commuters who work in New York City but live elsewhere in New York State, effective July 1, 1999. The law leaves intact the tax on city-earned income of out-of-state commuters. This edition of Inside the Budget examines the fiscal impact of the law in light of the subsequent lawsuits and legal uncertainties that remain.
The legislation signed by the Governor eliminates the non-resident income (commuter) tax specifically for New York State residents, but not for out-of-state commuters. However, in anticipation of legal challenges to the geographically selective elimination of the commuter tax, the legislation includes a provision that would abolish the tax on all non-residents in the event that the courts ultimately determine that selective elimination is unconstitutional. If that provision takes effect, no one commuting into New York City would pay any city income taxes.
Indeed, lawsuits on behalf of out-of-state commuters were filed as quickly as the law was signed. In the meantime, the city has filed its own legal challenge, arguing that Albany's elimination of the commuter tax violates the State Constitution because the City Council has not approved a "home-rule message"-a special type of resolution which states that the city requests the state legislature to make a specific change to state law affecting New York City's government and budget.
An additional source of uncertainty stems from the fact that without state legislation, commuter tax rates are scheduled to decline at the end of 1999. Legislation permitting the city to continue the current rates for the non-resident tax has been sitting in committee for over two months.
The city stands to lose hundreds of millions of dollars in tax revenue from the action in Albany, though the specific impact is contingent upon the particular scenario of legal outcomes. In terms of the city's budget, the best-case scenario is one in which the city's lawsuit is successful and the current rates are renewed. In this case, the non-resident tax is retained in its current form and the city would suffer no loss of revenue. Many observers, however, consider such an outcome unlikely.
IBO has estimated the fiscal impact of eliminating the non-resident income tax under three other scenarios. These are discussed in order of increasing impact on the city budget, with the cost estimates presented in the table. The estimates are premised on the recent legal challenges to the tax elimination being decided before the end of fiscal year 2000-the first year in which there would be a revenue loss. As discussed below, however, it is quite possible that the legal issues will take considerably longer to resolve.
Alternative 1 is a scenario in which: a) the recent elimination of the non-resident income tax for in-New York State commuters is upheld in court; b) the legal challenge by out-of-state commuters is not successful (and these commuters continue to pay the tax); and c) legislation in Albany renews the current tax rates on city earnings of out-of-state commuters. Under this scenario, New York City's revenue loss is limited to the loss of non-resident tax payments from commuters from Long Island, Westchester, and other parts of New York State. Because the July 1 elimination of the commuter tax would affect the amount of income tax withheld by city employers, city tax collections would be affected almost immediately-at the beginning of fiscal year 2000. We estimate the loss of tax revenue under this scenario would grow from $209 million in fiscal year 2000 to $233 million in fiscal year 2003.
Alternative 2 differs from the first scenario only in that the current tax rates on non-residents' earnings expire because the state legislature fails to renew them. The non-resident tax was established in 1966, with initial rates of 0.25 percent on wage income and 0.375 percent on net earnings from self-employment. Since 1971, however, the rates have been set at 0.45 percent (wages) and 0.65 percent (self-employment income), subject to periodic renewal. Under current law, the higher rates will expire at the end of 1999 unless legislation renewing them is approved in Albany. Legislation calling for a two-year renewal of the higher rates was introduced in Albany before elimination of the commuter tax for in-state commuters became a major political issue. Because the issue's importance grew and the tax was eliminated for some commuters, it is uncertain whether there will be enough political support to renew the higher rates of the non-resident tax which remains in effect for out-of-state commuters.
If Albany does not renew the higher rates and the recent elimination is upheld in court but not extended to out-of-state commuters, the city's fiscal cost would be due to the loss of revenue from in-state commuters plus reduced collections from out-of-state commuters after 1999 (halfway through fiscal year 2000). We estimate the loss of revenue would grow from $242 million in fiscal year 2000 to $307 million in fiscal year 2003.
Alternative 3 is one in which the current legal challenges by out-of-state commuters to geographically selective tax elimination succeed in overturning the tax for those commuters in addition to in-state commuters. In terms of the city budget, this would be the worst-case scenario because the entire amount of non-resident income tax revenue would be lost. If the legal challenges are resolved quickly so that the revenue loss is felt immediately, the fiscal year cost to the city would grow from $361 million in 2000 to $402 million in 2003.
The assumption that the revenue loss would be immediately felt by the city, however, may not be accurate because of the time it could take for the legal challenge by out-of-state commuters to work its way through the courts. Because the legislation repealing the non-resident tax for in-state commuters states that the tax for out-of-state commuters is to be abolished only "after all rights to appeal have been exhausted," it is possible that the ultimate fate of the non-resident tax will not be known until after the end of fiscal year 2000 (June 30, 2000). Although the legislation states that any court ruling in favor of out-of-state commuters would eliminate liability retroactively from July 1, 1999, presumably these commuters would continue to have their non-resident tax liability withheld by their employers until the issue is finally resolved. Thus, from July 1, 1999 to the time of the ultimate ruling, the city would still be collecting taxes from out-of-state commuters, but this money would eventually have to be refunded.
Suppose, for example, that the courts decide that the non-resident tax for out-of-state commuters is invalid but all appeals are not exhausted until July 2001. For fiscal years 2000 and 2001, the loss of tax revenues would be attributable only to in-state commuters-$209 million and $214 million, respectively. In contrast, the revenue loss for 2002 would be at least $691 million-$384 million of revenues that would have been collected from both in-state and out-of-state commuters during that time period plus $307 million for the refunds that would have to be made to out-of-state commuters for liability paid during the two previous years. Any interest the city had to pay for collecting and holding money it was not legally entitled to would increase the cost even more.
If the city were to place income taxes collected from out-of-state commuters after July 1, 1999, into some sort of city or state reserve account that would be used to pay for any refunds made in the event the tax is eliminated, the fiscal impact would be felt more evenly over the next few years. But there is no modern precedent for this type of reserve at the city level. Alternatively, it may be possible for the state, which administers the tax for the city, to establish such an account and hold the money in reserve for the city. Even so, it would seem politically difficult for the city to fight the elimination of the non-resident income tax while simultaneously pushing for the establishment of a reserve fund to more evenly absorb the revenue losses that would result from the city's eventual defeat in that fight.
For more information about this issue contact Michael Jacobs, a Senior Economist at IBO, at (212) 442-0597.