By Matthew Knittel

Following several years of strong revenue growth, many state fiscal outlooks are starting to show significant long-term structural deficits. For the Commonwealth of Pennsylvania, the Independent Fiscal Office’s (IFO) Economic and Budget Outlook: Fiscal Years 2024-25 to 2029-30 projects operating deficits that will range from $4 billion to $6 billion per annum under current laws and policies. There will likely be difficult choices before the General Assembly and governor to reduce spending and/or raise revenues during the 2025-2026 legislative session.

Against that background, state policymakers and residents should have a clear understanding of the economic impact from the current tax system, as well as any proposed changes to that system. Effective tax rates (ETRs) are a useful tool in that regard, as they can evaluate specific taxes and the overall state and local tax system as being progressive or regressive. In a progressive tax system, the ETR (or ratio of tax paid to income) increases with the level of income; in a regressive tax system, the ETR decreases with the level of income. To compute an ETR, a tax incidence model traces taxes to the individuals that ultimately bear the incidence of the tax, as opposed to the entities that remit tax.

Taxes paid could generally manifest themselves in three ways:

• They’re passed forward to final consumers via higher prices.
• They’re passed backward to owners/shareholders in the form of lower returns.
• They’re passed to workers through lower wages.

Taxes remitted by businesses could also be exported out-of-state to nonresidents, while residents could bear the incidence of taxes remitted by businesses in other states. Tax incidence models reflect these pass-through and export adjustments in the computation of ETRs.¹

ETRs also reflect tax code provisions, such as the width of the tax base, targeted relief programs, and tiered rates. For example, Pennsylvania has relatively narrow income (retirement income is exempt) and sales (groceries and clothing are exempt) tax bases, which reduce ETRs. An ETR reflects the impact of those exemptions across income groups, and includes other provisions that provide tax relief to lower-income and older residents.

As part of its statutory duty to provide an analysis of tax and revenue proposals submitted by the governor or the Office of the Budget, the IFO recently published the results for the Pennsylvania state and local tax incidence model.² The table displays the ETR results for taxes paid in 2022 for six income groups across major tax types.

The combined state and local income tax (30% of total tax remitted) ETR increases notably after the lowest income group, then largely flattens out. (See “Income” column in table.) Despite Pennsylvania’s flat state tax rate (3.07%), some progressivity occurs due to the exemption of retirement income and government benefits (such as the Supplemental Nutrition Assistance Program, housing vouchers, and refundable tax credits that are counted as income) and tax forgiveness for lower-income filers. Nearly all local units levy an earned income tax, and most levy a combined rate of 1.5% on wages and self-employment income. ETRs for the highest income group decline because capital gains, dividends, and certain business income are not subject to local earned income tax.

Other points of note, moving from left to right in the table, are as follows:

• The property tax (28%) is regressive at the top end, which is a common result in tax incidence studies. The ETR shown only reflects homeowners and property tax passed through to renters. Property tax effectively paid by landlords, consumers, and shareholders is included in the All Other column. The impact of the Property Tax/Rent Rebate (PTRR) program is reflected in the ETR for the lowest-income group.
• The sales tax (19%) is regressive because high-income consumers save much of their income and remit more of it in taxes, which reduces after-tax income that can be spent.
• Miscellaneous consumption taxes (7%) are notably regressive due to tobacco purchases and, to a lesser extent, gasoline excise tax. Gaming taxes and lottery purchases (5%) are also regressive.
• The inheritance tax (2%) adds significant progressivity to the overall system.
• The All Other category includes corporate net income tax, insurance premiums tax, vehicle registration fees, and the business share of property tax, which is passed through to consumers, workers, or shareholders.
• The total ETR is within 1.0 percentage point for the first three income groups, then declines. This pattern implies that the tax system is moderately regressive, largely due to property, consumption, and gaming taxes. This is common for many states, especially those states that have a flat income tax rate or no income tax.

As noted, ETRs are a useful metric to gauge the relative progressivity of a tax or tax system. What they cannot do is facilitate a judgement on whether a tax system is “fair.” Beyond the subjective nature of the term, a tax system that relies heavily on consumption and sin taxes will invariably have regressive elements.

¹ Because they are not under control of state policymakers, taxes effectively paid by Pennsylvania residents but levied by other states are excluded.
² For a full technical description and list of data sources used, see Independent Fiscal Office, “Pennsylvania Tax Incidence Model Methodology,” (Dec. 2024).

Matthew Knittel has served as director of the Pennsylvania Independent Fiscal Office since its creation in 2011. Prior to his tenure, he was a financial economist for the U.S. Treasury Department and Michigan Department of Treasury. He received a PhD in economics from Michigan State University. He can be reached at mknittel@ifo.state.pa.us.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}