No Fooling - On April 1 California will have the highest and worst sales tax system!

March 31, 2008 is the last day for what will soon seem like a low sales tax rate in California even though it is one of the highest in the country. On April 1, 2009, the California state sales tax rate goes up 1 cent. In Santa Clara County, it will be 9.25%. In South Gate, it will be highest at 10.25%.

While temporary, this is still unfortunate. California does have some problems with its tax systems, but they can't be fixed with what may seem like the easy way out of a budget shortfall - raising tax rates. Instead, the harder work of broadening the base - removing special exemptions, deductions and exclusions, is needed. That is:

Most of California's tax problems must be solved by fixing the tax base - they cannot be solved with a rate increase. A rate increase makes most of the problems worse.

For the sales tax, the base should have been broadened years ago as our ways of living changed and we started consuming more services and entertainment and less tangible personal property (partly due to two-earner families and higher living standards than existed in the 1930s when the sales tax began).

Here are a few problems with California's sales tax that arguably makes it the worst sales tax system:

1. The rate is too high (even on March 31, 2008).
2. We make businesses pay sales tax when they purchase manufacturing and R&D equipment (and furniture and supplies). Most states exempt these purchases. Remember, when businesses pay sales tax, it becomes a cost of doing business and is reflected in prices that then also have sales tax charged. But that tax paid by the business is not apparent to the customers - that is poor tax system design.
3. The sales tax doesn't apply to a good amount of the higher end consumption of high income individuals. When a person buys a $15 music CD or $20 DVD, sales tax is owed. But if someone buys a $14.99 album from iTunes, or a $80 basketball game ticket or a $9 movie ticket or a $1,500 ticket to see Billy Joel and Elton John - no sales tax is owed on that consumption. Also, individuals earning over $150,000 tend to spend twice as much on food for home than those earning under $70,000 (groceries are generally exempt from the tax) - so the exemption is a better tax break for the high income individual. And this group of higher income individuals spends 5 times more on entertainment on average than lower income individuals and a lot of that entertainmen is not subject to sales tax. That's just wrong - exempting so much consumption of high income individuals - it makes the tax less equitable and fair.

The sales tax could be improved by lowering the rate and broadening the base to include more types of consumption such as personal services, entertainment and digital downloads. It should NOT be broadened to tax consumption by businesses. Some states are ahead of California on modernizing their tax base which means that they are making their tax system more fair and better enabling the state to make its business tax system more attractive to businesses.

I recently updated a report I wrote over a year ago on broadening California's sales tax base. It provides background on the sales tax, consumption trends, reasons for broadening the base, obstacles and how to overcome them, how a broader base satisfies the principles of good tax policy and I added an appendix on counterarguments to arguments often raised as to why we should not broaden the base. I hope you'll take a look and offer some comments:

http://www.cob.sjsu.edu/nellen_a/TaxReform/Report2a_21stCenturyTaxation_SUTBase.htm

Thanks.

President Obama's Task Force on Tax Reform to be Formed

On 3/25/09, Peter Orszag, Director of the White House Office of Management & Budget announced that the President's Economic Recovery Advisory Board (PERAB), chaired by Paul Volcker, will form a Task Force on Tax Reform with a report due 12/4/09. Per Orszag, PERAB's tax group will have 3 tasks:

"one is tax simplification; the second is closing tax loopholes and reducing tax evasion; and the third is reducing corporate welfare. And it's worth noting that with regard to that first category, one of the key things that the Volcker board will be examining is ways of unifying, streamlining, making more consistent the various credits that are out there: Making Work Pay, the Earned Income Tax Credit, the Child Tax Credit, and what have you. And in addition, with regard to the tax gap, there are hundreds of billions of dollars in uncollected taxes each year."

Further, "The Task Force on Tax Reform that will be formed by the Volcker board will be examining ways of being even more aggressive on reducing the tax gap, which could provide funding for tax provisions, including an extension of the Making Work Pay tax credit."

Orszag also noted that President Obama viewed these PERAB members are suitable for the task force: Laura Tyson, Bill Donaldson, and Marty Feldstein.

Well, certainly, the federal tax system is in need of reform - it is too complicated, has a large tax gap and does not necessarily tie to some of our nation's goals such as reducing GHG emissions and improving international competitiveness of US companies.

What can a task force do? Hopefully they will spend time with the thousands of pages of analyses and reports that have been created in recent years - much of it from government agencies, such as CBO, GAO and Joint Committee on Taxation. President Bush had his Federal Tax Advisory Panel - it's report, which is really quite good in the background data on the problems and bold solutions - but was shelved soon after issuance. They can get a good sense of the problems and proposed solutions from these reports to derive what is hopefully a cohesive set of proposals that meet the principles of good tax policy.

Comments on the 3 areas to be addressed:

Simplification:

• In 2001, at the request of Congress, the Joint Committee on Taxation released a simplification study that examined every Code section and made recommendations.
• The AICPA and ABA and others have offered many simplification proposals.
• The current budget proposals from the White House and Congress, as well as current tax proposals should be evaluated to be sure the law isn't made more even more complex while a task force attempts to craft proposals to simplify the tax law.
• How many different energy deductions and credits do we need? Same for education incentives. The desire to solve every problem with a tax provision needs to end or simplification is unlikely to be achieved.

Tax Gap:

• The IRS and GAO has done and continue to do extensive studies on reducing the tax gap. Just do a search at the GAO website on tax gap and you'll find about 3 decades of reports and recommendations. The GAO's January 2009 tax gap report focused on 1009-MISC.
• Information from the IRS can be found here.
• Recent efforts to address the tax gap, such as requiring basis reporting by securities dealers, are good steps, but they avoid the bigger aspects of the tax gap such as the 20% attributable to sole proprietorships (see data and links here). Here is a link to a short piece I wrote recently on the "slow pace" in closing the tax gap and reasons for that slow pace.

"Corporate Welfare":

• I use quotes because I find this term troublesome. Usually it prefers to provisions purposefully added to the tax law to provide a benefit or incentive. Many companies that legally use these rules also pay lots of taxes. If these provisions were not enacted as giveaways to corporations, they should not be labelled that way later when they might get repealed. Many of these provisions were enacted as permanent provisions and may no longer be appropriate. Or perhaps a majority have come to view a lower tax rate as a better (simpler and usually more efficient way), to reduce corporate taxes.
• Reform of the corporate tax rules including provisions pertaining to international transactions and entities sounds like a better label for this third area.
• Another matter to address in corporate tax reform is how other business entities should be taxed - should they all be taxed the same?

While the three areas identified for review are important - particularly simplification and the tax gap (it is hard to know what "corporate welfare" is), so are some additional areas, such as:

• Efforts to have a tax system that supports economic growth, a clean environment and social welfare - rather than running counter to these goals. Some provisions today do run counter to these goals, such as a gasoline excise tax that is too low, education tax incentives that don't help those most in need because they may not owe income tax, and that encourage savings.
• Corporate integration (for more info - click here)
• Improving worker classification rules

The Task Force has big job before it. They will need good ideas. What would you tell them?

A Better Way for California to Collect Use Tax

California individuals and businesses should notice a line on their California income tax form for reporting their use tax. The use tax is the complement to the sales tax and is owed when the seller of taxable goods is not required to collect the sales tax because they have no physical presence in the state.

A lot of people don't know what a use tax is and likely just skip that line. Some people think it is a joke and they are allowed to leave it blank (I have been at tax conferences where people - including some elected officials, have either said they just don't pay it or imply "who would ever keep track of records to pay that?")

It really isn't that hard for individuals to calculate how much use tax they owe. Most of these purchases on which people owe use tax - such as on items purchased from Amazon.com or on eBay, were purchased with a credit card. What I do every month is just put a * next to any charge on my credit card statement on which use tax is owed. At year end, I total the amounts and mutiply it by 8.25%.

I've advocated for a simpler option that several states use, that eliminates the need to keep any records. Under this alternative, the state creates a table where you look up your income amount and it tells you how much use tax to report. If you don't like this estimate, you could instead keep records to compute your actual liability. Last year, there was a legislative proposal to add the table option. For details, see "June 2008 update" here.

Some people, including some elected officials, are convinced that Congress is the only option for increasing use tax collection. Since the physical presence requirement is tied to the commerce clause of the U.S. Constitution, Congress could enact a law allowing states to require non-present (remote) vendors to have to collect sales tax when they sell to customers in the state. The physical presence requirement has been around for almost 20 years and Congress has not acted to modify that rule - it is unlikely they will do so soon.

Even if Congress does pass a law someday allowing states to collect sales tax from remote vendors, it will not help Califronia completely because:

1. It will be allowed only for states that have adopated the Streamlined Sales and Use Tax Agreement. California has not adopted this.
2. It will likely exempt small retailers, such as those with $5 million or less of gross receipts. Unless the state exempts the use tax on purchases from these small retailers, the buyers will still need to self-assess and remit the use tax.
3. It's a "flat world" - Californians might be buying taxable items from companies not even located in the US. The foreign sellers will not be liable to collect sales tax, so customers will still need to self assess and remit use tax.

An example of legislation to allow SSUTA-adopting states to collect sales tax from remote vendors is HR 3396 (110th Congress).

We need a public education campaign to encourage individuals and businesses to pay their use tax. The amount that goes uncollected annually is estimated at $1 billion! That would buy a lot of textbooks for K-12!

For more information - please see a report of mine with background data and suggestions for how to collect more use tax.

So Many Reports, So Little State Tax Reform

The National Conference of State Legislators (NCSL) notes that since 2000, a majority of states have had a study of their tax system and how to improve it. While we have seen several big changes in the past few years, such as a gross receipts tax in some states (such as Ohio) (although interestingly enough, some state tax reform reports note that this is something to be avoided), combined reporting and adoption of the Streamlined Sales & Use Tax Agreement. But, it is likely that most of these reports ended up just sitting on a shelf.

I've got a short article summarizing some of the focal points of these reports and noting why reform is needed in many states - click here.

While many of the commissions came about due to budget problems, it is difficult to enact good reforms in bad budget times - as proven by California recently increasing its already high sales tax rate 1 percentage point rather than broadening its shrinking tax base.

Most reports have looked at tax systems broadly while a few have been narrowly focused, such as Oregon's focus on the need to change the gas tax because drivers will be moving towards buying less gasoline, but using the roads just as much if not more.

What state tax reforms do you think are most crucial?

Let's Not Forget Simplification

Simplifying the federal tax law has been a focal point for the past several decades. Even the Tax Reform Act of 1986 which added several new and fairly complex provisions to the tax law was touted as simplification. Congress has had the Joint Committee on Taxation do studies on how to simplify the law. Every year, the National Taxpayer Advocate notes in the report to Congress that the biggest problem with the tax law is its complexity (for example, see page v of the 2008 report).

Yet, despite all of the talk, we always see more complexity added to the tax law, such as:

• The manufacturing deduction of IRC Section 199.
• More incentives and support for higher education tax breaks.
• A growing number of energy incentives with lots of definitions and special qualifications.

The latest complex proposal is the techniques used in President Obama's budget proposal to increase taxes on higher income individuals (defined as over $250,000 of AGI if married and over $200,000 if single). The budget proposal would increase taxes on this high income group in the following four ways to generate about $955 billion over 10 years. The estimated revenue effect for 2010 - 2019 in billions of dollars is shown in brackets.

• Reinstate the 36% and 39.6% top tax brackets. [$338.8]
• Tax capital gains and dividends at 20% (rather than 15%) [$118.1]
• Reinstate the phase-out of personal exemptions and itemized deductions. [$179.8]
• Cap itemized deductions such that they only provide a 28% benefit even if the individual is in a higher tax bracket. [$317.8]

The rate increases by themselves are NOT complex. Rate increases tend to be simple. It is easy to determine your marginal tax rate (what your next dollar of income is taxed at) and to calculate your tax (using a table or a rate calculator found online or in tax prep software).

It is the last two items listed above that will create complexity. There will be two different limitations on itemized deductions. That means the high income person really won't know how much of their state taxes, mortgage interest or charitable contributions are deductible until the tax return preparation software computes it. This also means that the law is not following the principle of transparency - it should be more clear what is deductible and what is taxable.

This level of complexity and lack of transparency is not needed and should be avoided. It can easily be avoided by either just eliminating some deductions completely (and keeping others without any limit). Another alternative would be to have additional higher tax brackets to raise the desired revenue. This is a more transparent approach than instead having one rule that allows a deduction and another that takes part of it away. The loss of part of the deduction increases the individual's taxes - but that could instead be done more transparently with a rate increase.

A complex tax law increase compliance costs and builds disrespect for the tax system. AND - it just isn't necessary - there are always simpler approaches and we all have to continue to remind Congress and the President to please use them.

There is a nice report from the AICPA on how to simplify the law and how to avoid making it more complex - click here.