SPECIAL REPORT: Michigan's tax reform playbook

By Susan J. Demas

If you’re looking to find consensus on tax policy in Michigan, good luck.

Chances are, your views on what the state should do about everything from the income tax to the beer tax are shaped more by your politics than by economics, according to economist Charles Ballard, one of the foremost tax experts in Michigan.

“An awful lot of it is ideology, not economics,” said Ballard, a Michigan State University professor and author of Michigan’s Economic Future. “If you strip away the entrenched ideological positions on both sides, I think you could get much more sensible tax policy. But the degree of partisan bitterness and ideological division is much more severe than it was years ago. That makes is really hard.”

Hard, indeed. But that’s precisely the challenge for Gov. Jennifer Granholm and state lawmakers as they seek to create a tax climate that’s fair and attractive to businesses while finally returning state government to stable financial footing.

Actually, there is one thing that most people involved in the tax debate can agree on: Passing the fiscal 2010 budget, which is at least $1.7 billion in the red, comes first.

“Job No. 1 is balancing the state budget,” said Michigan Chamber of Commerce CEO Rich Studley. “Job No. 2 is balancing the state budget and Job No. 3 is balancing the state budget. We think it’s important to get the right steps in the right order.”

Lawmakers have until Sept. 30 to pass a budget, something they failed to do two years ago. That agonizing battle resulted in a brief government shutdown, followed by both budget cuts and increases in income and sales taxes to dig out of a $1.8 billion hole. The latter was quickly rescinded after considerable outcry from business groups and replaced by a surcharge on the new Michigan Business Tax (MBT), which the same groups now want to eliminate. The messiness of 2007 has left an indelible imprint on the current debate over taxation and left some reluctant to revisit issues.

But with another towering deficit this year, tax changes and increases may prove to be part of the solution again. Granholm has suggested closing $500 million to $1 billion of so-called tax loopholes, although she hasn’t released specifics. Rep. Alma Wheeler Smith, a Salem Township Democrat who is running for governor, thinks it’s time to look at a graduated income tax, although legislative Democratic caucuses haven’t endorsed any tax hikes.

The idea of including tax reform in the final budget has received mixed reviews, with groups like Detroit Renaissance and the Michigan League of Human Services (MLHS) working on proposals. Doug Rothwell, CEO of Detroit Renaissance, said his organization’s work with former state deputy budget director Patrick Anderson on reform, especially through tax cuts for businesses, has “slowed” because the budget hasn’t been put to bed. The League wants its ideas to be part of the final budget, which includes a menu of loophole closures, like the exclusion on vending machine snacks, and a graduated income tax.

How Michigan stacks up

Rothwell said that Michigan’s tax burden puts it in the middle of the pack (the nonprofit Tax Foundation ranks the state 27th), but he argues that’s not good enough. Michigan needs “bold action to jumpstart the economy,” he said, and tax reform is critical.

“If it doesn’t happen this year, it won’t happen until we have a new governor (in 2011),” said Rothwell. “We can’t afford to wait that long.”

The list of those advocating a tax increase includes Ballard, Public Policy Associates Senior Policy Consultant Doug Drake, Department of Treasury economist Scott Daraugh and Tom Clay, director emeritus of state affairs for the nonpartisan Citizens Research Council of Michigan.

“The state budget, if anything, could use a tax increase rather than cutting taxes anymore,” said Clay, former deputy state treasurer under Gov. John Engler. “With the cuts to schools and especially higher education, an overall tax cut isn’t something that’s justifiable.”

But the Michigan Chamber said 2007 proves that tax reform doesn’t work when it results in a tax hike. What the Great Lakes State needs, Studley said, is lower business taxes, big government reforms and more spending cuts. Raising taxes will only make Michigan less competitive.

“We want tax relief, not a tax increase. We are not interested in rearranging the deck chairs on the Titanic,” Studley said. “Been there, done that.”

It’s also notable that there are serious political and, in some cases, constitutional challenges to major tax reforms. Recent polling from Lansing-based EPIC-MRA shows support for a graduated income tax and expanding the sales tax, although little public appetite for cutting business taxes. Still, Clay isn’t optimistic that significant changes will happen, despite a decade of dire times for Michigan.

Nonetheless, the debate over taxes isn’t going away, and the resolution could have a substantial impact on both state services and the state economy. The major areas of Michigan’s system identified by experts are the income tax, sales tax, business taxes, tax expenditures, gas tax, beer and wine taxes, gas tax and senior citizen tax breaks.

Here’s a breakdown of possible reforms for each area:

Sales tax

Any debate over the sales tax starts with the failed experiment of 2007, when lawmakers passed a last-minute levy covering a hodgepodge of services such as skiing, dating services and most notoriously, baby-shoe bronzing, while excluding things like golf courses and real-estate services. The tax ended up falling heavily on business-to-business services, which Ballard and MSU Institute for Public Policy & Social Research Director Doug Roberts say is a bad idea causing cascading, when an item is taxed more than once. That tax was quickly repealed.

Today, Michigan’s 6 percent sales tax applies to only 26 services, according to Daraugh, most of them utilities. We tax fewer services than most states and rank 30th, according to the Tax Foundation. Thirty years ago, Michigan collected 50 percent of its revenue from the sales tax, according to the Senate Fiscal Agency, and now it’s about 35 percent. MLHS CEO Sharon Parks describes the sales tax burden here as “less than onerous.”

“It was an incredibly bungled attempt in 2007,” Ballard said. “But just because it was bungled politically doesn’t mean that the argument for it economically isn’t there. It’s as close to a slam dunk as you ever come in economics.”

The general solution supported by Ballard, Clay, Daraugh, Parks and Roberts is to broaden the base of the sales tax – applying it to more services, the growing sector of the economy. Daraugh drew up a combination of dry cleaning, electronics repair, entertainment tickets, ground transportation, landscaping and cable/satellite TV that could bring in an extra $510 million annually. The more services added means the state could lower the tax rate to 5 percent or even lower and still take in more revenue, Ballard said.

Many business groups remain gun-shy after the ‘07 debacle about a service tax. The main arguments against it are that Michigan would be killing a growing sector of the economy by taxing it and any levy would be unfairly applied.

“Lobbyists for every organization that hasn’t previously been taxed will be arguing that world civilization will collapse if we tax tanning salons,” Ballard predicted wryly.

Income tax

After years of cuts, lawmakers in 2007 temporarily raised Michigan’s income tax from 3.9 to 4.35 percent. The flat rate will be rolled back to 3.95 percent on Oct. 1, 2011, and back to 3.9 percent on Oct. 1, 2015. The rate peaked at 6.35 percent in 1983. The Tax Foundation now ranks Michigan 34th in income tax burden.

There aren’t proposals circulating about increasing the flat rate any further, and the EPIC-MRA polling didn’t find support for the idea. Instead, talk of a graduated income tax is getting louder, as Michigan is one of only eight states with a flat rate. If Michigan adopted Georgia’s tax code, it would see $2 billion more in revenue each year, according to Ballard. If we went with North Carolina’s, that would be an extra $4 billion.

Parks argues that it is a matter of fairness and that low-income people should not be paying the same rate as corporate CEOs. Clay points out that a flat tax isn’t as responsive to the economy as a graduated tax and helps eliminate the state’s structural budget deficit. Under a graduated income tax, revenues would grow faster, especially since higher incomes have been increasing at a higher rate in recent decades. Ballard notes that even if Michigan structures the graduated tax to bring in the same amount of revenue as the current tax code, the state would receive $500 million more annually from the federal government, which also levies a graduated income tax.

However, the graduated income tax requires a constitutional amendment. That means either a two-thirds vote by the Legislature and approval by a majority of voters or a petition drive typically costing at least $1.5 million to collect 380,126 valid signatures (10 percent of votes cast for governor) to get a measure on the ballot. Clay notes there’s no obvious group out there to start and finance a campaign. The tax is a three-time loser in 1968, 1972 and 1976.

And resistance to the graduated income tax is fierce, especially from self-described conservatives and Republicans.

“We’ll support a graduated income tax when hell freezes over,” Studley said.

Ballard tried proposing a middle ground: Killing the MBT to appeal to Republicans in exchange for a graduated income tax to attract Democrats.

“I’ll admit it; that’s been unsuccessful,” Ballard said. “Some Democrats, especially Sen. Gilda Jacobs, D-Huntington Woods, liked the combo. I thought some Republicans would hate the MBT enough to consider it. But if you mention a graduated income tax to any Republican, they respond sort of like having a child molester living next door. I have sort of been stunned.”

Roberts, Engler’s former state treasurer, isn’t opposed to all tax increases. But he’s not a big fan of the graduated income tax option, citing a Wall Street Journal story on Maryland, which lost 1,000 millionaires after hiking its top rate. But Ballard said that there wasn’t one documented case of a millionaire establishing a legal residence elsewhere. Rather, he argues that the deep recession has meant a drop in millionaires nationwide.

Detroit Renaissance hasn’t taken a formal position on the graduated tax. But Rothwell, Engler’s former Michigan Economic Development Corp. (MEDC) director, said there are “many concerns for business” and it will “really hurt entrepreneurship.”

Business taxes

Michigan scrapped its one-of-a-kind Single Business Tax (SBT) in 2007 and replaced it with the one-of-a-kind MBT that features both a business income tax and gross receipts tax. Rothwell and Ballard agree that the latter is its worst feature, as it taxes the total gross revenues of a company, regardless of source, and leads to cascading. The gross receipts feature was one of the reasons business groups had pushed to dump the SBT.

“I never believed we’d be so stupid as to enact a gross receipts tax,” Ballard said, “but sure enough, we were.”

Michigan’s business climate is ranked 20th by the Tax Foundation. The MBT has roundly been criticized for being too complex and hurting Michigan’s ability to attract businesses, as they’re still unsure how to calculate their tax burden. Rothwell said that Michigan businesses pay 3 percent more of their profits than in the top state.

“For many budgets operating with such thin margins, 3 percent can make or break a businessman,” he said.

Rather than tinkering with the MBT, Rothwell said Michigan has to have a more comprehensive approach to cutting business taxes. The goal should be for Michigan to be a top 10 state for economic growth, something he said can be achieved in 10 years.

“It’s an aggressive goal, but probably not as aggressive as it should be,” said Rothwell. “We should be looking at being in the top 10 for the global market.”

The Michigan Chamber does not support repealing the MBT, but Studley said the MBT surcharge has to go – something the group isn’t alone in advocating. In late 2007, the Legislature enacted a 21 percent MBT surcharge to replace the ill-fated service tax. Studley refers to that action as “rubbing salt into the wound.”

“It makes a complicated tax even worse,” he said. “At best, it’s unnecessary. At worst, it’s a job killer.”

Killing the surcharge has near-universal support among the experts. Where they differ is on replacing the revenue lost, something business groups are loath to do.

For the second straight session, the GOP-controlled Senate has passed legislation phasing out the surcharge, but there’s been no movement in the House. Granholm last year suggested killing the surcharge in exchange for Corrections cuts, but that never materialized. As the state grapples with almost $2 billion in red ink, the idea of losing $700 million more in revenue has lost some steam.

Tax expenditures

Michigan loses $36 billion in revenue each year with tax expenditures, also known as “loopholes,” according to the Treasury Department. There’s a wide array, including church property exemptions; income tax exemptions; tax credits for historic preservation, the film industry and advanced battery technology; and the Earned Income Tax Credit for low-income workers.

Expenditures are growing at a faster rate than state tax revenue. The MLHS estimates that between 2005 and 2008, expenditures jumped by about 15 percent compared to 8.8 percent for state tax revenue.

“Not a day goes by that the Legislature doesn’t create a loophole for someone,” Parks said. “The trend is not sustainable.”

Granholm still hasn’t released her list. Clay estimates reform could mean a “few hundred million” more in revenue. While there appears to be some low-hanging fruit, like the $25 million lost for the vending machine industry’s exemption, there’s a debate over what should be included. Some experts don’t see much potential here.

“I’ve been through them all, and I don’t think the amount of money to be raised is worth the political fight,” Roberts said.

Beer and wine taxes

It’s been 43 years since Michigan touched its beer tax – and that was to lower it, according to the MLHS. Parks attributes that to the powerful Beer and Wine Wholesalers lobby. Michigan ranks 28th in its tax, the League reports.

The MLHS would like to see the tax raised from 2 cents per can to 6 cents to raise $100 million more annually.

Senior citizen tax breaks

Michigan has an “overly generous” tax code for senior citizens – more so than any other state, said Clay. That’s something that’s not politically popular to advocate. However, with more and more Baby Boomers retiring, this is posing an increasing strain on state revenue, something Parks calls the “giant sucking sound.”

Social security and public pension income are both completely exempt from the income tax, the MLHS reports. Private pension income is partially exempt, there’s an additional personal exemption and there are special homestead, renters and capital gains credits to claim. If Michigan reduced its tax benefits for seniors to that of the second-most generous state, Virginia, that would bring in another $200 million in revenue.

Opponents argue changes could trigger high-income seniors to relocate.

Gas tax

Michigan’s flat 19-cents-a-gallon gas tax was last raised in 1997. With the road fund running dry, even with the federal stimulus, the Michigan Department of Transportation (MDOT) projects the state will start forfeiting $570 million from Washington because it can’t match the dollars. That’s led MDOT to cancel 137 scheduled projects.

In a rare show of consensus, Granholm, MDOT officials and the Michigan Chamber all back changing the tax to a percentage of the wholesale price, which means the state would take in more when gas rises and less when it falls. Although the Chamber generally opposes tax increases, Studley said more money for roads is critical for businesses.

“Doing nothing on this key issue would mean lost jobs, bad roads, sending federal money for Michigan to other states, and a failure to improve public transit — which does not sound like a winning political strategy to me,” he said.

There was hope low gas prices could provide an opening, but the proposal has stalled in the Legislature. Senate Transportation Committee Chair Jud Gilbert, R-Algonac, acknowledges that the votes don’t appear to be there. Republican senators are now pushing for a federal waiver for matching funds