Tax Reform Schools

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

John Hood from the November 1998 issue

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That was putting it mildly. By the time the state legislature started working on the plan, Bush's business activity tax was already doomed. As the proposal worked its way through the legislative meat grinder, both chambers rewrote it. The majority-Democrat Texas House passed an even higher property tax cut than Bush had proposed but also approved more offsetting tax increases, including an attempt to widen the state sales tax base to include some services (Texas, like most states, has a narrow sales tax base that excludes most services and thus taxes lower-income families disproportionately). The Senate, with a 17-14 Republican majority, voted down this package. With the state GOP chairman criticizing Bush's approach as anti-business and pro-tax, the Senate fashioned its own plan, including smaller property tax cuts and little reform. Other ideas, such as extending the state franchise tax to partnerships and raising taxes on insurance premiums, were also floated.

Differences between the two chambers, the governor, and lobbyists for professionals and business interests led to stalemate by late May. With only days left in the 1997 legislative session, Bush and lawmakers settled for just one element of the governor's original plan: a constitutional amendment to increase the homestead exemption. Texas voters overwhelmingly approved the $1 billion tax cut amendment in a referendum two months later.

Again, I don't want to suggest that Bush's solution to the Texas tax morass was necessarily the best one. Some might argue against a shift of responsibility for school financing from local governments to the state (I happen to think that's a good idea). Others might question the wisdom of enacting what amounts to a value-added business tax and widening the tax base, both of which create the risk of government growth in future years because of the increased revenue that a relatively small rate hike can yield.

These concerns aside, however, the Texas experience illustrated virtually every political barrier that a flat tax or national sales tax would confront in Washington. Insurers and other providers of employee benefits went ballistic over Bush's proposal to tax nonwage compensation. Lawyers, doctors, and other professionals lobbied strenuously to keep their industries from being subjected to a new tax. Fiscal conservatives opposed the plan, despite the fact that it represented a net tax cut, because it raised rates in some areas and on some industries. Bush got awful national press in conservative media outlets such as The Wall Street Journal, which zeroed in on the part of the package that raised rates rather than recognizing it as a serious, albeit flawed, attempt to reform an outdated, complicated, and economically distorting tax system.

The fact is that sweeping tax reform would raise taxes on some individuals and companies. A flat tax would, and so would a national sales tax. Furthermore, both increase the potential revenue from future tax rate hikes by widening the tax base. Despite the differences in detail, if Bush's plan wouldn't fly in Austin, fundamental tax reform as currently envisioned won't fly in Washington, especially once a Republican Congress starts reading the fine print and getting phone calls and letters from irate doctors and insurance agents.

There's yet another reason to rethink the viability of comprehensive tax reform. Business lobbies have increasingly been abandoning any philosophical commitment they might once have had to a neutral tax code in favor of targeted breaks for specific industries or particular companies. These provisions, known as "economic incentives," are punching holes in state tax codes across the country and souring ordinary voters on the tax reform process.

Auto manufacturers such as Mercedes-Benz and BMW receive multimillion-dollar tax breaks to locate in Southeastern states. New York, New Jersey, and Connecticut play property tax tag with corporate headquarters. In August 1993, Illinois Gov. Jim Edgar helped put together a resolution against state relocation subsidies for corporations that was adopted by the National Governors' Association. Just before Edgar left Springfield for the NGA meeting to announce the truce, he approved an incentive deal with Tootsie Roll Industries that included $1.4 million in state and local tax exemptions. Right after he returned from the NGA meeting, Edgar offered a $30 million tax incentive package to woo a Nabisco plant.

As Edgar's behavior suggests, interstate agreements on corporate tax loopholes are about as effective as international agreements on arms. The incentive to cheat is high. Since the well-publicized multistate rivalry for new Nissan and Saturn auto plants in the mid-1980s, almost every state has offered or given special tax breaks, enacted general tax-incentive policies such as per-job corporate tax credits or enterprise zones, or both. Rather than moving in the direction of flatter, fairer, more neutral tax codes, states and localities are sprinting as hard as they can in the opposite direction.

Indeed, in some ways state tax codes are worse than the national system. The federal code has four income tax brackets. Of the 44 states with individual income taxes, 18 have five or more brackets, including Iowa and Ohio with nine and Missouri and Montana with 10. Some states have more than one corporate income tax bracket, not including the credits and exemptions that in effect create many more tax rates. States with retail sales taxes almost invariably exempt services from the tax base, and many have lower or no taxes on the retail sale of food, drugs, and other "necessities."

My own experience in North Carolina has been sobering. As much as business leaders in my state say they would like to see the overall corporate tax rate lowered, they spend far more time and money seeking incentive packages for specific companies (most recently for FedEx and Nucor Corp., both longtime heroes of free marketeers), along with general policies giving tax breaks to companies that locate in particular counties, pay certain minimum wages, and otherwise do what state politicians want them to do. This form of industrial policy should disturb anyone committed to tax reform or free enterprise.

The fact that there are political barriers to tax reform does not mean the cause is doomed. Rather, reformers will need to design discrete, incremental policies that are consistent with the principles of tax neutrality and simplicity yet salable to lawmakers and voters.

A good example is the reduction or elimination of taxes on cars. Jim Gilmore got elected governor of Virginia last year largely on this issue. Other sitting and would-be governors are following suit. In states where most or all car taxes go to dedicated highway funds, the issue is muddy at best, demagogic at worst. But in many states, money from property or use taxes on automobiles goes to the general fund, thus imposing an unjustified special tax on a single product. In these jurisdictions, eliminating car taxes, as well as special excise taxes on cigarettes and liquor, is both a popular campaign issue and a step toward neutrality.

Another example of incremental reform is giving the self-employed and those who work for small businesses the same tax breaks on their health insurance that people who get employer- provided coverage already enjoy. We had some success with this issue in North Carolina. In April, the state legislature passed a $65 million tax credit for families that buy health insurance for their kids. Lawmakers were persuaded that to do less was to continue to give breaks worth more than $1,000 per child in federal and state taxes to relatively affluent white-collar employees while denying them to self-employed plumbers and retail clerks. U.S. Rep. Bill Archer (R-Texas), chairman of the House Ways and Means Committee, has proposed a similar health care credit at the federal level. This change, of course, does not eliminate the special exemption for medical insurance; it just spreads the exemption more evenly across the population. But because it eliminates a bias in the tax base, it is consistent with tax reform.

Yet another step at the federal and state level would be creating and expanding tax-free savings accounts for medical care, education, unemployment compensation, and perhaps other purposes. Since the tax-reform argument for these policies is often misunderstood, let me explain a bit. First of all, a cardinal rule of neutral taxation is to stop punishing savings. For nonretirement accounts, we violate this rule by double-, triple-, or quadruple- taxing investment income, particularly that from corporate stocks. Taxing all forms of income or consumption only once means exempting either the principal or the earnings. Either a "front-ended" savings account that exempts deposits but taxes withdrawals or a "back-ended" account that taxes deposits but exempts withdrawals is consistent with tax neutrality.

For medical savings accounts, not just the deposits but also the withdrawals should be tax-free. That's because the current tax system makes health care consumption via insurance completely tax-free: Neither the premiums you pay insurers nor the services you receive are considered taxable income. Tax neutrality demands that medical savings, as an alternative to insurance, receive the same tax treatment.