Tax Reform Schools

If you think tax simplification is difficult in D.C., just try Albany, Annapolis, Atlanta, Austin...

George Bush delivered a big tax cut, and conservatives pummeled him for it. No, not that George Bush. I'm talking about Texas Gov. George W. Bush, son of the former president and (for wont of anyone else with star quality) the putative front-runner in the 2000 GOP presidential field. Last year, after months of testy debate with state lawmakers, he engineered a $1 billion property tax cut. Even for Texas, the nation's second most populous state, that's hefty tax relief. Yet the governor's notices, particularly among Republican power brokers and D.C.-based conservative activists, were terrible.

Bush's bad reviews shed light on the political dynamics of the national tax reform debate that Steve Forbes kicked off during his 1996 presidential run. The experience in Texas reflects the obstacles that tax reform has encountered in state capitals across the country. This year, tax cuts totaling $4 billion to $5 billion have been or will be considered in about 35 states. But tax reform has yet to gain any ground, and in many ways state and local tax codes are moving further from the neutrality, simplicity, and equality that reformers seek. The main problem is that fundamental tax reform inevitably means higher taxes for some. In a war between those seeking tax cuts and those protecting themselves from tax hikes, the latter will almost always win. To get past this obstacle, reformers may have to scale back their immediate goals.

The push for reform in Texas began with a tax system widely perceived as out of whack. Texas is one of five states without an individual or corporate income tax. The average state derives 40 percent of its revenue from income taxes, a third from sales taxes, and the remainder from levies such as business licenses and gasoline taxes. Texas, by contrast, gets half of its revenue from a sales tax, and it relies more than most states on local property taxes to pay for public education and other services. Its sales tax rate (6.25 percent) and its property tax burden are correspondingly high.

Lacking a corporate income tax, Texas imposes a disproportionate share of its business tax burden on capital-intensive industries, such as manufacturing, oil refining, and mining, that own a lot of taxable real property. According to a study by the governor's office, in 1997 the average property tax in the capital-intensive segment of Texas business was $5,300 per employee, compared to $595 per employee in labor-intensive businesses. "The bottom line is that the Texas economy has changed rather dramatically since the current structure was put into place," Austin attorney and tax reform activist Chris Shields told the Austin Business Journal in January of last year. "Asset-backed companies represent one-third of the economy but pay two-thirds of the school property taxes."

Elected governor in 1994, Bush started talking about the Texas tax code the day after the 1995 legislative session adjourned. The legislature had just adopted all four of Bush's key campaign promises: tougher juvenile justice laws, tort reform, welfare reform, and local control of schools. The governor was on a roll, and he decided to push on, into the tax thicket. Ruling out the adoption of income taxes, Bush put together a blue-ribbon panel to study ways to reduce property taxes and reform the financing of public schools.

In January 1997, Bush was ready to release his plan. It had four major components: 1) a big cut in school property tax rates in each of the state's 1,044 school districts; 2) a five-fold increase in the property tax homestead exemption, to $25,000 per home; 3) a half-cent increase in the motor vehicle tax and the statewide sales tax; and 4) a new 1.25 percent "business activity" tax to replace the state's franchise and property taxes on business. It would have applied only to companies with at least $500,000 in sales.

Overall, Bush's plan offered property-tax payers a projected $2.8 billion cut the first year and $6 billion over the budget biennium, translating into a 40 percent reduction of the average homeowner's tax bill as well as significant tax savings for businesses with lots of taxable property or inventories. All but about $1 billion of the initial tax relief, however, was offset by the increased tax rates on retail sales and motor vehicles and increased taxes on some service-sector businesses. In addition, the Bush plan would have shifted the main responsibility for funding schools to the state.

One can quibble with the details of Bush's plan. I wouldn't have structured it the way he did. But its fate at the hands of special interest lobbies in Austin should serve as a cautionary tale for flat taxers and sales taxers at the national level.

Keep in mind that Bush did a lot of things right. His plan offered a large net tax cut. And soon after announcing it in his 1997 State of the State address, the governor embarked on a speaking tour around Texas, generating significant public interest and media attention. The details of the plan were widely reported. For the first few weeks, both Democrats and Republicans in the state legislature were cautiously optimistic about the plan's prospects. But one prescient business lobbyist told the Abilene Reporter-News that Bush's pitch wasn't going to be easy. "I think tax reform is not a hard sell," he said. "But specific tax reform is a hard sell. The closer you get to specifics, the harder it becomes."

The state's business community quickly took sides. The Coalition for Property Tax Reform and trade associations for manufacturers, oil and gas companies, farmers, and ranchers all applauded the plan. Small-business groups, even those in retail and service industries, also liked the plan because of the $500,000 standard deduction from the new business activity tax. On the other hand, the Texas Retailers Association, the Texas Restaurant Association, and state associations of doctors, lawyers, and other professionals organized as partnerships announced their opposition. Some of these firms would have been subject to significant state taxation for the first time.

Another aspect of the new business activity tax that sparked opposition was the proposal to count employee compensation, including nonwage benefits and payroll taxes, as part of the tax base. Critics argued that taxing fringe benefits would reduce the likelihood that employers would offer them, and that imposing a state tax on Social Security, Medicare, and unemployment insurance contributions amounted to double taxation (of course, this already happens with the employee share of payroll taxes, which is included in a worker's income tax base).

To his credit, Bush attempted to defend his tax reform plan on the basis of treating taxpayers equally and minimizing state distortion of the economy. At an appearance in Amarillo in early February 1997, he was peppered with questions from doctors and lawyers. "An attorney might say that he shouldn't have to pay tax" for the legal services he dispenses, Bush said. "I say, why?" To exempt service industries from taxation, he continued, makes no sense in a modern economy where traditional manufacturing and extractive industries make up a smaller share of output.

This is a critical point. Most of what state governments do today--funding schools and colleges, for example, or paying for Medicaid and other social services--theoretically benefits taxpayers regardless of how much property they own. If taxes are designed as rough user fees, to be imposed according to a "benefit principle" that aims at neutrality and tries to minimize cross-subsidies, then these services (if provided by government at all) aren't properly funded by archaic property or franchise taxes that don't spread the burden equally. On the other hand, such functions as law enforcement and transportation especially benefit those with lots of land or expensive property and thus might still reasonably be supported by property taxes.

The governor made another point about neutrality. He noted that under the current Texas tax code, corporations are forced to pay extra taxes that partnerships and other business entities don't. "In today's world," Bush said, "multimillion-dollar partnerships compete for business with corporations, yet they escape tax liability." Income earned by corporations is often taxed two, three, or more times as it flows from the business to stockholders and eventually to their heirs. Income earned by other business forms usually is taxed only once or twice.

Two companies demonstrate the uneven impact that Bush's plan would have had. Southwestern Public Service Co., an electric utility, estimated that Bush's plan would cut its property tax liability by $4.2 million. On the other hand, Amarillo-based Wonderland Amusement Park projected a 27 percent increase in taxes. "A labor-intensive business, such as we are, will have a lot of problems with the proposals," said Wonderland President Paul Borchardt shortly after Bush announced his plan.

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