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.

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.

The argument for tax-exempt educational savings accounts is a bit different. Education isn't just an alternative way to consume one's income. Often, it is an investment in skills and credentials that will yield a future return in higher (and taxable) wages. Just as the purchase of machinery or equipment should be tax-deductible, because it generates future taxable income, so should some training and education expenses paid by employers or employees. An educational savings account into which you can deposit several thousand dollars a year tax-free, and from which you can withdraw unlimited amounts tax-free, is defensible on tax policy grounds (as well as being an attractive means of enabling families to exercise school choice without the regulatory problems that vouchers might bring).

Other possible reforms include making payroll taxes deductible from income taxes (a must if Social Security privatization becomes feasible) and expanding the lower income tax brackets so more taxpayers pay the same rate (thus reducing the revenue loss from a subsequent elimination of the higher rates). The key is to pick ideas that generate strong political constituencies of their own while avoiding the mistake of raising taxes on other powerful constituencies.

Tax cutters fall along a continuum, from pure flat taxers and national sales taxers to corporate types who lobby for special rates, credits, and exemptions. Successful tax reformers will chart a middle course between these two poles, finding ways to promote ambitious ends through targeted means. As Bush discovered, how tax reform will be greeted by lobbies and perceived by voters is just as important as its theoretical underpinnings.

Contributing Editor John Hood (locke@interpath.com) is president of the John Locke Foundation, a state policy think tank based in Raleigh, North Carolina.