Despite losses as the recession set in, Connecticut’s wealthiest households came through 2008 with a six-year record of income growth more than five times greater than that of the average taxpayer.

Buoyed by a five-year stretch during which their collected adjusted gross income shot upward by more than 230 percent–a growth spike unmatched in the 19-year history of the state income tax — filers earning more than $1 million reported a total adjusted gross income for 2008 more than double that of 2002.

For those who didn’t top the $1 million mark, 2002 through 2008 offered more modest growth of 21 percent, according to new data from the state’s tax agency.

And with legislators laying the groundwork now for a landmark debate over Connecticut’s tax system after Election Day, advocates on all sides are trying to frame the relative positions of Connecticut’s upper and middle classes.

“It’s the slow disappearance of the middle class, and maybe it’s no longer so slow,” House Majority Leader Denise W. Merrill, D-Mansfield, one of the legislature’s most vocal advocates for a more progressive income tax, said Monday. “Ask yourself, did your income increase 233 percent over those five years? I think for most people in Connecticut, the answer was ‘no.’”

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Connecticut’s wealthiest households did just absorb an income tax hike. The new budget the legislature approved and Gov. M. Jodi Rell allowed to become law last September increased the rate on income above $1 million from 5 to 6.5 percent.

“We pit the rest of the state against Fairfield County and the problem is the legislature doesn’t even understand where all of the revenue comes from,” said Rep. Vincent J. Candelora of North Branford, ranking House Republican on the Finance, Revenue and Bonding Committee.

The fairness question has surrounded Connecticut’s income tax, the single-largest source of revenue for state government, since a flat, 4.5 percent tax on all wages was enacted in 1991 – and a capital gains tax with a top rate of 14 percent was abolished.

That income tax has been modified since then to make it somewhat more progressive, but critics say it still levies largely the same rate on many middle-income households as it imposes on the wealthy.

A 3 percent rate was set in 1996 on the first $10,000 taxed on individuals and the first $20,000 on couples.  That change, combined with a small series of standard deductions and a credit of up to $500 to offset municipal property tax payments help ensure most households earning less than $40,000 pay little or no taxes. The primary rate for most income increased from 4.5 to 5 percent in 2003.

But filers who earned too much to claim the property tax credit – individuals earning more than $145,500 and couples above $190,500 – paid largely the same effective tax rate as households earning millions of dollars annually, until last year and adoption of the so-called “millionaires’ tax.”

Connecticut’s top rate remains lower than those in neighboring states, including: New York, 8.97 percent; New Jersey, 10.75 percent, and Rhode Island, 9.9 percent. Massachusetts has a flat, 5.3 percent general income tax rate, but levies a 12 percent rate on capital gains.

And it’s capital gains and other investment income that particularly defines the Connecticut income tax.

A large portion of the state’s revenue stream, roughly one-third of the $6.4 billion in total income tax receipts projected for this year, comes from this source.

And while revenues from payroll withholding, the other major source of income tax dollars, routinely fluctuate anywhere from 2 to 10 percent per year, the annual variation for capital gains-related income over the past decade ranges from a 23 percent increase in 2004-05 to a 27 percent loss in the fiscal year that ended June 30, 2009.

And some of the numbers in that latter drop hint that Connecticut’s wealthy already have taken their worst hit in this recession.

Most of the damage done to Connecticut capital gains income occurred in the last six months of 2008, rather than in the first six of 2009.

The Dow Jones Industrial Average, one of the chief indicators of the stock market’s overall health, plunged nearly 4,500 points in 2008 finishing the year at 8,776. And though it bottomed out on March, 6, 2009 at 6,626 points, it rose steadily thereafter and finished the 2009 at 10,428. The Dow closed Monday at 10,552.

Senate Majority Leader Martin M. Looney, D-New Haven, said the fiscal cushion the wealthy amassed between 2002 and 2007 still has plenty of spring to it.

“There are far more wealthy people in Connecticut now than there were in 2002,” he said, adding that while the 9 percent unemployment rate has slammed the middle class, as far as the wealthy go, “last year was a fairly typical recession year.”

Still, Candelora said the state’s income tax is a fiscal rollercoaster and the highs and lows would only get worse if the state singles out the wealthy again for an increase.

Rep. Cameron C. Staples, D-New Haven, co-chairman of the finance committee and another longtime proponent of a more graduated state income tax, said the $3.9 billion budget deficit projected for the 2011-12 fiscal year will force a tax debate, but the solution won’t lie in singling out any one group.

“I think the income tax will be a big part of whatever we do, though I don’t know if it will be this year or next,” said Staples, whose committee recently launched a special commission to study the entire Connecticut tax code.

“We definitely have to look at things in context, where they are now and where they have been – for everyone,” Staples added. “At the end of the day you have to try to do what is fair. But we also have to keep in mind who we are competing with.”

And while Staples acknowledged Connecticut’s top tax rate is lower than those in neighboring states, he said keeping it low makes it an effective economic development tool.

Candelora agreed, noting that officials from Starwood Hotels and Resorts Worldwide testified before the committee last week that their plan to move 813 jobs from offices in Westchester County into Stamford was driven, in part, by Connecticut’s more favorable income tax rates compared with New York.

“We are going to have problems if we start going after the decision-makers,” he said. “These business executives are the people who create jobs and grow businesses. We want to provide them with a good quality of life.”

And economists warned Monday that regardless of whether tax revenues slip further, they aren’t likely to shoot back up significantly any time soon.

“I don’t think ordinary people are going to think we’re even in a recovery until the end of this year,” said Peter Gioia, vice president and economist for the Connecticut Business and Industry Association. “We’re not going to be firing on all cylinders until 2013.

The New England Economic Project, a Walpole, Mass.-based nonprofit organization that publishes bi-annual, macro-economic forecasts of the New England region and of its six individual states, projects Connecticut won’t regain more than 80,000 of the 105,000 jobs estimated to have been lost in the recession until 2013, Gioia added.

“People are obviously feeling less wealthy,” Don Klepper-Smith, chief economist and director of research for DataCore Partners in New Haven and chairman of Rell’s council of economic advisors, said.

Klepper-Smith warned that the “wealth effect,” – an economic theory which holds that for every $1 lost on the stock market, Americans are likely to spend 5 cents less on goods and services -also could keep any economic recovery modest for at least another year.

Keith has spent most of his 31 years as a reporter specializing in state government finances, analyzing such topics as income tax equity, waste in government and the complex funding systems behind Connecticut’s transportation and social services networks. He has been the state finances reporter at CT Mirror since it launched in 2010. Prior to joining CT Mirror Keith was State Capitol bureau chief for The Journal Inquirer of Manchester, a reporter for the Day of New London, and a former contributing writer to The New York Times. Keith is a graduate of and a former journalism instructor at the University of Connecticut.

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