By Melissa Preddy
Michigan isn’t the only state struggling to balance its books during a recession without turning off business growth.
The National Conference of State Legislatures (NCSL) projects a $142 billion aggregate budget shortfall in the 2010 fiscal year, despite efforts to cut costs and increase revenue. Cash-strapped legislatures coast to coast are grappling with the tension of conflicting goals: compensating for budget deficits vs. retraining or attracting companies that might provide much-needed employment during a nationwide jobs drought.
It’s a dilemma everywhere, said Annette Nellen, a CPA and professor of taxation at San Jose State University in California.
“Competition among the states is becoming a real issue,” said Nellen, who also operates The 21st Century Taxation Blog, where she contends that despite a plethora of plans and studies, lawmakers are too timid when addressing tax reform.
Stop-gap revenue enhancements enacted as of late August range from a tax hike on candy and sweet drinks in Illinois to boosting income tax for larger Nevada businesses from 0.63 percent to 1.17 percent. Several states have raised personal income tax rates on high-earning filers, and a couple of states adjusted sales tax rates upward.
Kentucky now will tax digital downloads – including ringtones. North Carolina and Rhode Island adopted the so-called “Amazon tax” in an attempt to capture sales tax revenue from sites that feature click-through links to behemoth online retailer Amazon.com. That action backfired, prompting Amazon to instantly sever ties with associate retailers in those states, as it has elsewhere in the past.
And while a number of states have passed similar short-term or incremental measures, many more proposals failed – ranging from a Florida sales tax on bottled water and a $5 “pole tax” at Georgia strip clubs to proposed corporate and personal income tax hikes in Illinois. Some lawmakers are evading the third rail of tax hikes by boosting fees instead, with proposals pending on items ranging from fishing licenses to cell phones to death certificates.
“It all comes down to states not saying ‘what is our overall strategy for the long term and how do we get there?’” said Nellen. “Instead it’s ‘We’re desperate. What can we get passed?’”
Short-sighted strategies
Analysts and economists remain frustrated by the piecemeal approach. Many contend that sweeping tax code changes are needed to unshackle state revenue from the ebb and flow of modern business cycles.
“We have done a good job of telling people what tax reform looks like – if anybody were really interested in doing it,” said Roland Stephen, assistant director for policy and research at the Institute for Emerging Issues, a North Carolina think tank. “A lot of people understand what needs to be done, but nothing happens.”
For example, Stephen said, lawmakers during an extended session in North Carolina just defeated a proposal to base personal income taxes there on the filers’ federal adjusted gross income (AGI) – as Michigan and 26 other states do. But since AGI is figured before Schedule A deductions, North Carolinians would have effectively lost out on a state tax break for mortgage interest, charitable contributions, gambling losses and other common deductions.
Instead of that or something innovative like reducing the list of companies exempt from sales taxes, Stephen said, lawmakers compromised with a 1 percent increase on the existing sales tax base, which is expected to cover $750-800 million of the anticipated billion-dollar shortfall. A 2 percent surcharge on higher-income taxpayers will make up the rest.
Why – in a state that taxes only 33 services compared to a national average of 55 and a prospective pool of about 180 that are taxed one place or another – were the changes so conservative despite massive budget woes?
“It’s fear, really,” Stephen said. “The preference for known pain vs. the unknown is a great problem.”
The ongoing recession has further sapped appetite for fundamental reform, analysts say, because lawmakers are focusing on quick fixes.
“What makes it hard is that the last two years, the bottom has dropped out,” said Bill Raabe, a professor of taxation at Ohio State University. “It’s up to people in government to take the long view, and very few of them do. When times are good and there is extra money, the tendency of politicians is to cut the tax, when that is exactly the time to be socking money away. Otherwise, when the tide turns – like now – you’re sunk.”
Some take an even more dim view.
“You don’t see dramatic reform whether we’re in a recessionary environment or not,” said Matthew Murray, professor of economics at the University of Tennessee. “It’s extraordinarily rare. Oh, there’s nickel and diming out there. But every change creates winners and losers, so there is a great deal of resistance.”
Out-of-date tax policies
Because of the glacial pace of legislative change, economists say the tax codes no longer remotely reflect today’s service-dominated economy – so states are still reliant on personal and corporate income taxes that drive away talented segments of the labor force as well as prospective business tenants.
Meanwhile, burgeoning services – from pest control to Netflix to legal advice and veterinary care – are still tax free. And that’s not even getting into the third rail of taxing health care.
“The character of the tax code was formed in the Great Depression, and nothing much has changed since then,” said Stephen. “The tax code looks like the old economy, not the new economy.”
Most state tax systems were designed during the 1930s, when tangible property like real estate, buildings and equipment was the logical target for corporate levies, while sales taxes targeted the purchase of tangible goods. Depending on the state, some individual income taxes were established to tax wages. But back then, most people tended their own lawns, styled their own hair, and wielded fly swatters. Bill Gates hadn’t even been born yet.
Fast forward 75 years to present day, when households hire out pest control, day salons are proliferating and entrepreneurs will wheel up to clear yards of weeds and even pet waste. Books, music, periodicals and other media are downloadable at an instant’s notice and very few states reap revenue from any such transactions.
And aside from the foregone taxes, economists say, state sales taxes are taxing a larger bite from those who can afford it least, since poorer households use fewer services but pay sales tax on the clothing and other basics they do purchase.
“We have a very narrow sales tax base, and that’s very regressive when it comes to low-income people and young families,” said Stephen.
There is a downside to taxing services, Murray points out. For one thing, it’s cumbersome.
“Unlike the conveyance of a good, which the government can observe, it’s hard to monitor the provision of a service,” he said. The economist also warns that there would have to be exemptions for business-to-business services; otherwise commerce would be squelched and consumers ultimately would pay more. And then there’s the touchy question of which services should be exempt.
“Do we really want to be taxing doctor visits?” he asked.
New tax solutions
Some states are shaking off tax reform paralysis.
Maine this year made the most drastic changes, reducing property and income taxes for residents while shifting more of the revenue burden to its sales tax base and to taxes paid by tourists and cottagers. Starting in January, its 5 percent levy now will apply to admission at amusement venues ranging from cinemas to camps to mini golf. Services like dry cleaning, shoe repair and hair styling also will be subject to tax, among others.
Tourists and transients are expected to pick up the slack via a 1 percent rise in the prepared meals and lodging taxes, as well as steeper real estate taxes on non-primary residences. While the tax changes aren’t expected to have a large net effect on revenue, they are – by reducing dependence on income tax – expected to smooth out volatility.
Efforts elsewhere to raise rates and/or broaden the sales tax base, as in Rhode Island, were defeated.
“Virtually every service you could think about taxing has a lobby group ready to gear up,” said Carol Weissert, political science professor and director of the LeRoy Collins Institute at Florida State University. Florida’s lack of a personal income tax puts a great deal of pressure on sales tax revenue, Weissert said – especially with the state’s other main source of income, property taxes, being hurt by a prolonged real estate slump.
Still, a recent tax reform committee – mandated by state charter to meet every 20 years – failed to make comprehensive changes. Instead, Weissert said, Florida has tweaked traffic violation fines and other odds and ends. And this spring it boosted its cigarette tax $1 from 34 cents to $1.34 per pack, which the state hopes will garner about $900 million. The law also makes it illegal for non-tribe members to buy tax-free cigarettes on Indian reservations.
Due to term limits, “there is very little incentive for the legislatures to look long-term,” she said. “We had this once-in-a-generation opportunity to fix things, and no one stepped up. Nothing changed unless you happen to be a smoker.”
Corporate taxes questioned
A few state legislatures looked to corporate tax hikes to make up shortfalls despite recent years’ sentiment against business taxes, as battered states seek to attract new industry.
Oregon and North Carolina passed corporate tax hikes, while New Jersey extended what was intended to be a temporary 4 surcharge on businesses.
Economists shake their heads.
“If you were starting over, you wouldn’t tax corporations at all,” said Raabe, the Ohio State University professor. “It’s not a smart way to go, at all. The (business) tax is only passed along to consumers as higher prices or to workers as lower wages.”
Indeed, the state of Ohio has been forced to weather the recession just as the full effects of its sweeping 2005 tax reform are fully kicking in. The state scrapped archaic tangible property taxes – some dating back nearly a century – that essentially penalize firms, especially hardware-intensive manufacturers, for siting plants and equipment within the state. It also threw out its 1902 corporate franchise tax, which was based on profits, in favor of a “gross receipts” tax based on top line sales.
With an arcane set of deductions and credits, “the old way basically rewarded companies that could afford high-priced advisers,” said John Kohlstrand, spokesman for Ohio’s taxation department. He emphasized that the changes have been phased in at the pace of 20 percent a year since the new law took effect. “We’ve swept away a tax that was very complex and replaced it with something that was very simple. It has a broad base, but a very low rate.”
The Commercial Activity Tax (CAT) is a 0.26 percent levy on all companies’ gross receipts. While it’s not possible to do an apples-to-apples comparison with the old code – because of credits, deductions etc. that skewed actual rates paid – the nominal tax brackets under the franchise tax ranged up to 8.5 percent on profits above $50,000.
Unlike the old tax system, this one is not limited to larger “C corporations” but applies to anyone doing business in Ohio. That means more companies will be filing returns – numbers weren’t available – but dollar thresholds exempt small businesses. Those with gross receipts under $150,000 don’t need to prepare a return, while those with gross revenue up to $1 million pay a flat $150.
“Businesses love it. The tax return form is the size of a postcard,” Kohlstrand said.
Since Ohio also lowered its personal income tax in 2005, the revenue loss is stinging. Tax receipts in 2009 were off by 12 percent, and the state expects a 6.7 percent decline in the coming fiscal year.
“A lot of that is recession-driven,” Kohlstrand said. “It’s tough. Just as we were phasing it in, a lot of things happened that have nothing to do with Ohio. But it’s important not to lose sight that these are important changes that improve the long-term business climate in Ohio.”
Indeed, Site Selection magazine awarded the state its Governor’s Cup accolade in March, citing it as the state with the most new or expanded capital projects in 2008.
“It’s worked as it was designed to work,” said Raabe. “It’ll take 10 years to know if it was the right move, but at the moment it appears that it was.”
And while not everyone is happy with the Ohio changes – which tax companies whether or not they make a profit, and are especially tough on low-margin sectors like supermarket chains – the gutsy move should inspire more states to tackle overhauls aimed at broader, simpler systems, analysts say.
“States have fundamental long-term problems in terms of revenue,” Stephen said. “And yet we want to create a model where we maintain the amenities and offerings of the state – that’s the best recruitment tool you have since businesses now chase the talent instead of the other way around. The best incentive for businesses is not to have special dealings but to get the base as broad as possible, the tax as low as possible and all of it as transparent as possible.”
Raabe agreed. “In a crisis situation, everyone has to bite the bullet all at once. If we do that, it doesn’t have to be at a killer level.”
