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Monday, May 28, 2007

State Tax Studies

A common practice in state tax reform is to create a commission to study the problems and identify solutions. Often the commission is also required to get comments from the public. A recent example is Massachusetts where Governor Patrick and legislators formed a 15-member commission to study ways to improve the corporate income tax. This group has a short timeframe in that it was created on April 29, 2007 and the report is due June 15, 2007.

Apparently, the Governor believes there are loopholes in the state's corporate tax system and closing them could improve the business climate and possibly lead to a tax rate reduction.

For a list of some of the reports of various tax reform commissions created by states over the past few years, see the state reform link at:

A lot of person-hours and thought has been given to state tax reform in the past decade. The challenge is not only in identifying the best reform but also the implementation. It is difficult to change tax systems or rules because taxpayers are used to the existing rules and tend to view favorable deductions, exemptions and credits as entitlements that cannot be taken away. So, to "sell" tax reform, a rate reduction is often needed so that taxpayers can see that they will not be paying more taxes (if possible). Another drawback to reform, is the current low understanding most people have about taxes.

For example, most people don't know that their state has a use tax which they must self-report and self-assess when they purchase taxable items from a seller who was not required to collect sales tax on the transaction (see May 15, 2007 entry). Most people don't know how much it costs the government to provide certain tax preferences, such as a deduction for home mortgage interest. Most people also don't know how an entire tax rule works, but only how it applies to them. The home mortgage deduction is a good example. People who own a home likely know that they can deduct interest on the acquisition debt and on home equity debt. However, they may not know of the $1.1 million debt limit because most people don't have any possibility of having that much debt on their home because it isn't worth anything near $1.1 million (even in California). However, there are costs to the government of folks who have very high value, high debt houses (and perhaps 2 houses since the tax law allows for home mortgage deductions on a personal residence and a second residence). And, those homeowners tend to get more value from the deduction as they are likely to be in a higher income tax bracket (so they can afford to make the payments on their large mortage(s)). However, any talk of reducing this deduction tends to get picked up in the press as "legislature proposes to make it tougher to buy a home or stay in the one you have." (More on this topic of "tax expenditures" and "super-favorable" tax preferences later.)

Also, tax reform is difficult due to implementation. It is difficult to just terminate a tax or rule as of a certain date. However, transition is possible. For example, perhaps a new tax is brought in at a very low rate while the old tax is paid at a reduced amount (for example, 80% of what would normally be owed; then 60% next year, and so on). While it results in more tax compliance work in the transition period and perhaps some budget uncertainty for the government if less revenue is collected than expected, that may just be the price to pay and actions can be taken to reduce these concerns.

But, any change is hard because we tend to like what we know and not like what we don't know.

More later on these topics:
1. A look at the Massachusetts corporate tax reform commission suggestions when the report is issued on June 15. I'd guess that there will be a discussion on how best to determine how much of a corporation's total income should get allocated to Massachusetts and whether too many tax preferences (such as tax credits) are provided.

2. Suggestions for getting rid of ineffective taxes or tax rules and bringing in more effective taxes or tax rules (transition options).

3. Examples of what I would call ineffective tax deductions and exemptions that provide a benefit beyond the underlying policy or perhaps are even outdated because the problem that was being addressed decades ago when the rule was enacted no longer exists.

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