Colorado: Let’s Implement a 1207800% Marginal Tax Rate!

Consider two taxpayers who enjoy gambling; both are single and residents of Colorado.  Both are amateur gamblers who earn $100,000 of wage income and rent.  Joe Unlucky broke dead even in his gambling, winning $299,000 (using the session method) and losing $299,000.  When he files his 2022 tax returns, he has a federal refund of $3,238 and a Colorado refund of $490.

Larry Lucky fared a little better: He had $301,000 of gambling winnings and $301,000 of gambling losses.  When he files his 2022 tax returns, he has the identical federal refund of $3,238.  However, he owes Colorado a whopping $11,632.  What caused Larry to have a ridiculous marginal tax rate of 606.1% on the additional $2,000 of gross winnings?

For 2022, Colorado implemented a $30,000 reduction in itemized deductions for taxpayers whose Adjusted Gross Income exceeds $400,000 and who itemize their deductions.  (The reduction is $60,000 if married filing jointly.)  Larry faced this; Joe didn’t.  Larry ends up with that 606.1% marginal tax rate on $2,000 of “winnings!”  Remember, Larry broke even so he really didn’t win anything.

I could have made this illustration even more ridiculous.  It truly is a hard cliff: If Joe had $300,000 of wins and losses he would have refunds of $3,238 from the IRS and $490 from Colorado; if Larry had $300,001 of wins and losses he would have the same federal refund of $3,238 but would owe Colorado $11,588.   That’s an insane marginal tax rate of 1,207,800% on the additional dollar of income!

Hard cliffs cause taxpayers to make decisions that are correct for themselves but bad for the economy.  Consider if Larry and Joe had their own businesses, each earning around $400,000 a year.  Assume both have net income of $399,000 right at year-end and have the opportunity for an additional $2,000 of net income.  There is no circumstance where it makes sense for them–if they reside in Colorado–to obtain that income in the year; they would be facing a tax rate of more than 100%.

Proposals like what passed in Colorado sound good, feel good (let’s tax the rich), but end up with perverse economic results.  Hopefully the Colorado legislature will fix this for the future.

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