COMPETITION, COMPLEXITY AND CONSTRAINTS: THE EVOLVING NATURE OF STATE AND LOCAL TAX SYSTEMS
Matthew N. Murray Professor, Economics and Associate Director, Center for Business and Economic Research The University of Tennessee 100 Glocker Knoxville, TN 37996-4170 865-974-6084 (voice) 865-974-3100 (fax)
[email protected]
November 2002
Prepared for the National Tax Association’s 95th Annual Conference on Taxation, Orlando, Florida. Thanks to Don Bruce for comments on an earlier draft.
Introduction State and local tax systems are at risk from a variety of sources. There are growing concerns over the viability of the corporate income tax due to tax planning (Pomp, 1999), incentives (Fisher, 2002) and other factors like sales-dominated corporate income apportionment formulas and the introduction of limited liability companies (Fox and Luna, forthcoming). The sales tax continues to be threatened by mail order sales, the expanding service sector and remote sales through electronic commerce, as well as policy changes that narrow the base to support economic development and equity objectives. The local property tax is subject to base erosion through exempt properties, tax abatements and equity provisions like circuit breakers. The increasingly tenuous linkage between the property tax and education finance may increase taxpayer’s distaste for the tax and further limit its role in local government finance. The personal income tax does not appear to face immediate challenges of the same magnitude. But important pressures remain, including mounting concerns over the disincentive effects of progressive tax rates. Tannenwald (2001) surveys the overall landscape and asks whether our system of state and local finance has become obsolete. Brunori (2001) suggests the role played by local governments in our federalist system is in danger. The system of state and local government finance in the US is not broken. But there are serious problems and a concerted effort will need to be made to salvage this system for the future. It will not be easy. We are where we are today because of long-term economic forces and discretionary changes to tax structure that will be difficult if not impossible to reverse. This paper discusses some of the broad forces of influence on the evolution of state and local tax structure and speculates on the consequences for the future of subnational government finance.
2
Three factors have been instrumental in shaping the evolution of tax structure over time and the nature of tax burdens that individuals and firms now confront.1 First is the economic environment within which state and local tax systems operate. This environment, which influences heavily revenue productivity, has change markedly with the introduction of new technologies and increased competition arising from deregulation, globalization and freer trade. Potentially enhanced factor mobility coupled with tax planning opportunities facilitates the behavioral responses to taxation and increases avoidance and evasion opportunities. In some ways these changes threaten the viability of taxes that historically have been structured on either a destination or origin basis that reflects the traditional jurisdictional boundaries of state and local governments. But in another respect it simply changes who pays and how much is paid in taxes regardless of the basis for taxation. Second is the influence of political competition and the desire of elected officials to satisfy voter preferences on the level and mix of taxes. One consequence is that the structure of state and local taxation has become more and more complex with the passage of time, with tax burdens becoming more and more unique to specific taxpayers. While complexity can easily be criticized the revealed preferences of voters suggests it is a price taxpayers are willing to pay to achieve general policy objectives and more specifically define tax prices and tax burdens. Undoing complexity--broadening tax bases, eliminating exemptions, flattening rates--will face staunch political opposition. Finally there are constraints on tax policy options, both those emanating from long-standing constitutional limitations on taxing authority and others like Proposition 13 arising from choices made by voters and politicians. These constraints coupled with a competitive economic environment and
1
See Neubig and Poddar (2000) and Tannenwald (2001) for a discussion of similar issues.
3
an increasingly complex tax system that benefits individual taxpayers will necessarily limit options available to policymakers to finance services far into the future.
Competition, Technology and Mobility The environment within which state and local tax systems operate seems to be changing at an increasingly rapid pace. The environment has never been completely stable and state and local tax structure has frequently confronted challenging times, like the devastating recession of the early 1980s. But such events were largely temporary or cyclical in nature; they did not represent long-run changes in the fundamental tax structure environment nor did they have a direct and lasting impact on revenue productivity.2 Even the growth of the service sector did not compromise the sales tax as might have been expected some 20 years ago. Changes in economic structure (especially growth in intangibles) and greater market competition will mean relatively slower revenue growth. The situation seems radically different today. Technology has certainly increased competition and likely factor mobility as well. Many new technologies represent a problem for state and local tax systems since they support inputs or outputs that are inherently intangible. Technology may allow production to take place from multiple locations compromising originbased situsing of economic activity and tax bases. Similarly, consumption and use is easily obscured making it difficult to enforce destination-based taxes like the sales tax. Intangibles are not new but technologies like the Internet exacerbate the problem of observing the tax base and enforcing compliance with both direct and indirect taxes. Intangibles also are a potentially growing share of corporate value and may have consequences for the base of the local property
2
An important lesson was learned from the 1980s recession, the need for rainy day funds.
4
tax as well. The technology used in production and marketing has more locational options than has ever been the case before and is thus much more mobile than traditional brick and mortar inputs to business activity. At the same time business and household consumers have greater choice in purchasing productive inputs and consumption items. Greater urbanization (particularly along state borders) leads to more localized interjurisdictional consumption and residency options, while the Internet allows access to global markets. While hard evidence has yet to surface anecdotes and speculation together suggest an increasingly mobile and tax-sensitive population, particularly for higher income taxpayers. States are talking about how high tax rates, especially high nominal marginal tax rates, can discourage residency and economic development. An example is Montana which recently considered lowering its top bracket income tax rate of 11 percent to 6.9 percent to help overcome the perception problem. The ability to support progressive tax rates is being questioned and one must wonder if a race to the bottom is around the corner. Free trade in the global arena did not exist 20 years ago. Numerous formal and informal barriers to trade remain today, but markets are clearly less fettered than they used to be. Free trade agreements and the dissolution of the former Soviet Union have created new competitors for domestic business and the domestic labor force. Much of this reflects trade in good oldfashioned tangible goods. Nonetheless a result is that industry has less international pricing influence while at the same time domestic workers have less union influence on wages and compensation packages. Absent the same profit and rent-seeking opportunities in the now highly-competitive marketplace, agents will squeeze the margin they can. Today domestic taxes, particularly state and local business taxes, are subject to the big squeeze. The state corporate income tax offers the
5
best evidence through the rise of effective tax planning strategies including domestic and off shore tax havens and corporate tax inversions. Intangibles, including trademarks and corporate logos assigned to loose affiliates in tax haven states, are proving to be a critical element of the tax planning strategies. Few would argue that business taxes have ever represented benefit taxes. Historically they simply have been a convenient means of generating tax revenue, but competition will continue to erode the role business taxes play in state and local finances. The wave of deregulation in the US economy is also increasing competition and hence imparting a separate downward influence on taxes. Onerous property and gross receipts taxes, as well as discretionary diversions of revenue from state and local utility monopolies, no longer can be sustained under deregulation. This means a direct revenue loss for state and local governments and diminished opportunities for tax exporting. An important indirect behavioral effect may limit if not preclude revenue replacement in the face of deregulation, translating into still lower levels of spending. There is some evidence (e.g., Dowell, 2000) that taxation of regulated industries has given rise to a flypaper effect, with the monopoly revenue effect on government spending dominating the effect of own-income on spending. Thus deregulation of state-owned and state-regulated monopolies will reduce fiscal illusion, lead to lower expenditures and a relatively smaller public sector. Census data show that utility revenue was 7.3 percent of state and local general revenue in 1992/3, falling to 5.7 percent in 1998/99; public utility revenue fell from 2.4 percent of state and local tax revenue to 2.1 percent over the same period. Competition is increasing while at the same time some sources of fiscal illusion are in decline. Tax prices, especially for mobile taxpayers, are becoming clearer and clearer. For many businesses the excess of tax over benefits received is being reduced. So far there is no
6
evidence that competition is constraining state and local government spending programs, a trend easily masked by the strong economic and revenue growth of the last decade. Ultimately competition and less fiscal illusion will put downward pressure on the size of government. Independent of other trends and factors this should yield a better model of fiscal exchange.
Political Competition and Tax Structure Complexity We certainly ask a great deal of our tax system. Progressive personal and corporate income tax rates and targeted exemptions and deductions, tax incentives for business, preferential sales tax treatment of food and clothing, circuit breakers and homestead exemptions under the property tax are just a few examples. Some of these policies are pursued to benefit constituents and voters, as with the sales tax treatment of food, whereas others are in part a response to competition, as with tax incentives nominally implemented to promote economic development. Many struggle to understand why such policies are put in place as they often seem focused on narrow special interests and are far removed from more efficient alternatives that could support the same policy. Perhaps term limits have reduced legislative experience in understanding the issues and the tradeoffs, a view I have heard from state legislators. For example, how many elected officials (or students of public finance for that matter) understand the double-weighted sales factor for corporate income apportionment or know what a corporate inversion is? The fact is that policy is heavily driven by political considerations and vote seeking behavior rather than hard-headed reasoning. But over time one would hope that taxpayers and politicians have learned some important lessons about tax policy alternatives and their consequences. The question ultimately is whether voters are getting what they want through a system that yields
7
more and more tax structure complexity. If the answer is yes, reversing complexity will be exceedingly difficult. Some examples can illustrate the point. Consider first the sales tax and the pursuit of equity. Sales tax holidays and clothing and food sales tax exemptions are good examples of politics driving tax policy. The complexities and potential problems associated with sales tax holidays are now being documented (Hawkins and Mikesell, 2001). The typical holiday applies to specific categories of goods sold during a brief period of time, complicating compliance and enforcement, and potentially enabling manipulation by vendors. The loss in revenue for clothing and food exemptions far exceeds what would be needed under a targeted program focused on the needy. Administration and compliance costs can be increased substantially and in interesting ways. For example, with food exemptions decisions have to be made on the tax status of snacks like Twix bars and marshmallows, 1 donut versus 6 donuts, and so on. The seemingly obvious approach--target relief through a direct tax or another direct mechanism--falls on deaf ears. The public seems to like these programs. Another good example is the property tax, and a specific case of complexity arises in Maine. Property taxes in Maine are relatively high in part because of the absence of scale economies in service provision and the presence of service center communities that have high expenditure responsibilities relative to their revenue raising capacity. Property values have risen due to tourism, the re-location of retirees and the presence of temporary seasonal residents. So Maine has introduced a homestead exemption to benefit all taxpayers. Maine has always had a strong taste for equity, so additional property tax relief is offered under the circuit breaker program funded by the state. But neither of these programs provide relief to business. High property tax rates that fall on business personal property have created concerns over the
8
disincentive effects of the so-called local property tax. So the state has enabled local tax increment financing and has implemented the Business Equipment Tax Reimbursement (BETR) program to reduce the burden of the personal property tax. The irony is that businesses can double dip as Mainers say, i.e., firms can benefit from both programs at the same time. Some view BETR as an incentive whereas the reality is that it is an entitlement program as all firms in all sectors can enjoys its benefits. The net result is a complicated system that offers different taxpayer groups different degrees of property tax relief and different effective rates of taxation. Third are incentives often motivated by the need to promote economic development in the face of increased market and interjurisdictional fiscal competition. Some incentives, like the BETR program in Maine, are entitlement programs available to all firms, while some incentives are targeted to specific firms, sectors or types of economic activity. There is no good evidence that incentives come close to paying for themselves through economic development effects. Moreover, since programs are quickly mimicked by other states, as with the double-weighted sales corporate income tax apportionment formula and LLC enabling legislation, incentives simply lower the tax playing field and raise concerns of a different race to the bottom. Politicians chant the mantra that they are giving away something they never had when they grant an incentive to a newly locating firm. Because of all the influences on state and local budgets it is not easy to see the way in which incentives erode revenues, shift tax burdens to others and affect the spending side of the budget. But they do influence how much firms pay in tax. As Wilson’s (1999) survey shows, the net result of horizontal competition is likely a government that is too small. Political competition has increased the degree of complexity embedded in state and local tax structure. It is relatively painless to provide relief to a specific taxpayer group and benefit
9
from increased voter support through the electoral process a la Hettich and Winer (1984). If we place any trust in our political institutions it is possible that this is the tax system that voters--at least many voters--want. Overall the tax system may look very complicated from the outside, but individual taxpayers may know their own tax system quite well. Taxpayers commonly question relief programs extended to others but seldom question the appropriateness of relief targeted to themselves. Through mobility of residency and employment, and through non-wage earning choices, individual taxpayers can have a significant impact on the taxes they pay as well as the services they receive from states and localities. Through the political process within the jurisdiction of residency, taxpayers can further influence their tax mix and thus their overall tax burden. The same may be true of mobile capital and specific firms.3 With broad taxes and uniform rates effective tax rates depend on choices like hours worked and place of residency. With political competition tax bases and tax rates are also choice variables, yielding complexity and adding an additional source of tax burden variation across taxpayers. Taxpayers will not easily or willingly give up their tax preferences.
Constraints on Tax Policy Choice There are two important sources of constraints on the power of state and local governments to tax. First are those arising from federal and state constitutions and second are those that reflect the choices made by voters and elected officials, some of which may have formally modified pre-existing constitutional constraints. Implementation of new constraints is not moving forward at a pace commensurate with the evolution of market competition. But the cumulative effect of
3
Edmiston and Turnbull (2002) suggest that communities may structure different taxes for resident versus nonresident businesses, and even specific firms, through prevailing tax structure coupled with economic development incentives.
10
prior choices coupled with constitutional limits does seem to place tighter and tighter limits on the fiscal flexibility of states and localities. Voters certainly can broaden the power to tax as with discretionary changes made by their elected state officials that expand the scope of the sales tax to include enumerated services or Connecticut’s relatively recent adoption of a broad-based income tax. But numerous other choices continue to be made that restrict tax discretion on the part of state and local governments and these constraints will limit the growth and hence size of state and local governments in the years to come. There is an important element of vertical dominance in some of these choices, with higher levels of government exercising political control over the tax structure of lower levels of government. The efficiency properties of this trend towards increased constraints hinges on the efficiency of political markets framed by constitutional parameters. If the constraints legitimately rein in Leviathan, then efficiency is enhanced. If, on the other hand, they serve narrow self interests or fail to properly take into account vertical and horizontal externalities, then efficiency is compromised. Federal and state constitutions represent the framework within which tax policy operates, explicitly defining certain powers to tax on the part of federal and state governments. The federal constitution limits subnational taxing authority in numerous ways, notably through the commerce clause that limits interstate taxation and the assignment of nexus to remote sellers under the sales tax and generally to firms under the corporate income tax. Congress could choose to address the long-standing nexus problem associated with mail order sales, as well as the problem of nexus for vendors engaged in electronic commerce. But Congress has chosen a path of inaction as it does not want to be perceived as raising taxes. The latest nexus problem to emerge relates to business activity taxes. States now confront the risk of a congressionally imposed physical presence nexus test riddled with safe-harbor provisions that is inconsistent with
11
the structure of modern markets and would further threaten revenue streams.4 Again, Congress has nothing to gain by expanding the power of state and local governments to tax. The reticence to support the states became crystal clear in the recent debate over The Stanley Works’ proposed inversion and off-shore move. State constitutions also place significant restrictions on the ability to tax. States without common broad-based levies like sales or income taxes or without lotteries or gaming may confront constitutional constraints that are exceedingly difficult to overcome through the political process. States also control local taxing authority. Like Congressional behavior and the states, there is a vertical political economy problem as state officials see little to gain in broadening the local power to tax. Ultimately the power to tax is vested in voters and while constitutions can be changed, it is not an easy or common process. There are numerous other ways whereby voters can directly or indirectly enhance or place limits on government taxing authority. First are direct initiatives through the referendum process. This process has proven to be effective in limiting the power to tax, most notably in the form of the property tax limitation movements in California and Massachusetts. More generally tax policy constraints surface through the action (or inaction) of elected officials, in particular state legislatures. State legislatures have made a number of choices over time that increasingly limit their ability to adapt to changing economic fortunes. Some states have chosen to place limits on total revenue growth or on revenue growth from specific tax sources. Earmarking represents another constraint. While earmarking may facilitate legislative approval by linking revenue to popular
4
For a reaction see the recent Multistate Tax Commission proposal presented by Dan Bucks and Frank Katz and the response by Diann Smith of the Committee on State Taxation, State Tax Notes, September 30, 2002, 1037-1042 and
12
service programs like education it limits future fiscal discretion. A good guess is that earmarking has increased over time, but it is difficult to find objective evidence that this is the case from standard data sources and budget documents. Hold-harmless provisions are yet another example of a policy that hems in policymakers. Like earmarking, a good guess is that the amount of state revenue committed to holding harmless local governments has increased significantly over time. Other constraints arise when the state assumes local service financing responsibilities through intergovernmental grants. One example is state assumption of an increasing share of local education spending as has taken place in the past two decades. Once the state has committed to funding education, it is impossible to reverse course and funds are committed indefinitely.5 Whether dictated by an established constitution or through the actions of voters or elected officials, constraints on the power to tax are reducing the fiscal flexibility of states and localities. It is hard to imagine a significant shift in voter and politician sentiment that would alter this course. But states and localities nonetheless confront the practical need of financing services. The only practical option is to salvage, in some way, the structure that currently exists. Ultimately constraints will need to be relaxed and coupled with policy changes that can sustain the viability of reasonably autonomous state and local governments.
1043-1044. The proposal would trigger nexus if sales exceeded a de minimis threshold and would not necessarily require physical presence through payroll or property. 5 A different constraint on state and local taxation can arise through cooperation with other jurisdictions that culminates with codification of tax structure uniformity. One of the best examples is the Uniform Division of Income for Tax Purposes Act (UDITPA) that produced the uniform three-factor formula for corporate income tax apportionment. A more recent example is the sales tax streamlining initiative of the states. In these instances the states are willing to trade off some fiscal autonomy and independence in exchange for simplicity (through uniformity) and potentially less revenue erosion.
13
Discussion Tax economists probably have been concerned about the future of state and local taxation for as long as there has been state and local taxation. In the 1970s it was the tax limitation movement. In the 1980s it was services. In the 1990s it was incentives and the emergence of electronic commerce. Today it is tax planning and the corporate income tax. Tomorrow it will be a new problem. The fact is that state and local taxation has largely evolved to meet the needs of voters and consumers of government provided services. State and local tax structure may not have thrived but certainly it has survived. State and local tax systems in the US have reached an important stage of maturation. The primary taxes in use today--personal income and corporate income taxes, the sales tax and the property tax--have been in place for many decades. By and large taxpayers understand the way these taxes work, they understand their tax reporting requirements, and they know something about the importance of the taxes they pay in financing public services. Taxpayers have had ample time to make choices that influence the tax burden they will confront, including human capital investments, job and residency choices. They also have determined who their elected officials are through the political process, offering additional influence over the level and mix of state and local taxes. Heightened competition is putting downward pressure on revenue streams while deregulation is diminishing fiscal illusion. The tax system has become highly complex and tax burdens are becoming more and more person and firm specific like the fares we pay to fly. There are two broad perspectives on the consequences the evolutionary forces discussed above have for the viability of state and local tax structure and the size of government, and the nature of the taxes people pay. One perspective is that markets, including political markets,
14
work efficiently. Factors have better information, can respond more quickly to market forces and in Tieboutesque fashion choose communities that more closely offer the desired taxspending mix. Taxpayers within a given jurisdiction then use the political process to influence further their tax prices and impose constraints on government behavior to limit Leviathan (or more cynically simply limit taxes that otherwise might be imposed on themselves). But because of government’s preoccupation over mobile capital and the tax base, taxes are set at an inefficiently low level. The outcome is a smaller public sector and tax prices across taxpayers and tax instruments that in some sense mimic simple Lindahl tax prices. Tax structure survives but it is sharply constrained and highly complex. The alternative perspective is not so different. Political markets do not work so well in supporting the public interest, instead often serving the interests of the stylized bureaucrat or rent-seeking groups. Voter pressure nonetheless places important constraints on the power to tax. Competition, factor mobility and tax planning place further downward pressure on government size. The forces of competition and constraints on the power to tax may very well keep Leviathan at bay, again meaning a smaller public sector, or at least slower growth in state and local government activity. A complex tax system is sustained with very specific tax prices for people and firms. The options now available to policymakers are more restricted than they have ever been in modern history and efforts must be made to salvage the existing structure of taxation, a system that by and large has served state and local governments well. The introduction of new taxes like a state VAT is a possibility but it is unlikely that it would quickly supplant other primary means of generating tax revenue. Brunori (2001) has discussed ways to preserve the local property tax, but this will require reversing policy decisions or altering the very nature of the tax to emphasize land value taxation. Fox and Luna (forthcoming), Mazerov (2002) and Mcyntire (2002) explore
15
means of improving the productivity of the corporate income tax. These proposals also require political courage to limit tax breaks and incentives and close loopholes. The sales tax streamlining initiative offers some hope of sustaining the sales tax from further substantial erosion from remote sales. Optimistically, Congress or the Supreme Court will see much lower compliance costs and thus support a concept of nexus that relies more on market presence and less on physical presence. Reliance on the personal income tax as a resident-based tax will likely grow, perhaps with less nominal and effective progressivity, but certainly with a higher degree of complexity. It is impossible to reverse market forces. And it will prove difficult to rein in voters and politicians. But this is what will be needed to ensure that the structure of state and local taxation survives.
16
References Brunori, David. “To Preserve Local Government, Its Time to Save the Property Tax,” State Tax Notes September 10, 2001, 813-818. Dowell, Paula. “Electric Utilities, Fiscal Illusion and The Provision of Local Services,” Ph.D. dissertation, The University of Tennessee, Knoxville, December, 2000. Edmiston, Kelly and Geoffrey K. Turnbull. “Local Government Competition for Economic Development.” Georgia State University, September 2002. Fox, William F. and LeAnn Luna. “State Corporate Tax Revenue Trends: Causes and Possible Solutions,” National Tax Journal, forthcoming. Hettich, Walter and Stanley Winer. Democratic Choice and Taxation: A Theoretical and Empirical Analysis. Cambridge University Press, 1999. Hawkins, Richard R. and John L. Mikesell, “Six Reasons to Hate Your Sales Tax Holiday,” State Tax Notes, March 5, 2001, 801-803. Neubig, Thomas S. and Satya Poddar. “Blurred Tax Boundaries: The New Economy’s Implications for Tax Policy,” State Tax Notes, October 9, 2000, 965-972. Tannenwald, Robert. “Are State and Local Tax Systems Becoming Obsolete?” New England Economic Review, Issue 4, 2001, 27-43. Wilson, John Douglas. “Theories of Tax Competition.” National Tax Journal 52 (1999): 269304.
17
