State of the Union Speech Includes Tax and Budget Deception

President Obama's State of the Union address included some conflicting statements which I think he can easily get away with because most people don't think of tax credits and special tax deductions as being the equivalent of government spending. For example, the new tax credit he mentioned for creating jobs - any company that claims this will have a reduced tax liability. It is the same effect as if the government had issued a check to this employer.

So, when President Obama says he wants to freeze some spending categories starting in 2011 while at the same time adding new tax credits and tax deductions (although it sounded like he wanted to do this starting in 2010), spending is not frozen - it is likely going up. More specifically, the spending that is buried in the tax law increases.

Of course, he did also mention some tax reductions, such as for oil companies and companies that shift jobs outside of the US.

But, if you are going to freeze spending, you will not meet your goal if you create some new spending and bury it in the tax law. This would be like Jane saying she us going to cut down on her spending, but then asking her employer to send part of each of her paychecks to a travel agent to cover the cost of a vacation she is planning. While Jane might not be paying any increases in her cable or utility bills (because she is "freezing her spending"), she is spending more by diverting some of her paycheck to pay for a vacation. Even though her employer writes the check to the travel agent, it is Jane's spending. (Even though the government doesn't write a check for hiring the new employee, it has spent money because it collected less tax from that employer.) Let me know if you have a better analogy.

The Tax Foundation blog has a nice list of the tax cuts and increases noted in President Obama's address.

AMT Must Go

This month the Congressional Budget Office (CBO) released a report on the individual alternative minimum tax (AMT). The report points out how the number of individuals subject to AMT will increase dramatically in 2010 unless another "patch" is passed to increase the 1986-level exemption amounts and other adjustments.

Per the report: "Taxpayers with AGI between $200,000 and $500,000 will continue to be hit the hardest by the AMT. More than 77 percent of those taxpayers had AMT liability in 2009, and that share will grow to 98 percent in 2010. Those affected can expect to pay an additional $10,700 in tax, on average."

In his blog, CBO Director Elmendorf notes: "About 4.5 million taxpayers were affected by the AMT in 2009. That number has been kept relatively small by annual modifications to the AMT rules, but the most recent modifications expired at the end of calendar year 2009. Consequently, about 27 million taxpayers—one out of every six taxpayers—will be affected by the AMT in 2010, paying on average an additional $3,900 in tax. Nearly every married taxpayer with income between $100,000 and $500,000 will owe some alternative tax."

Clearly the individual AMT is out of control. When the AMT was broadened by the Tax Reform Act of 1986, it was not done so to reach the middle class. But the failure to adjust the exemption amounts and rate brackets for inflation have caused the AMT to just become a penalty. Also, the addition of more favorable tax deductions and credits for individuals means the AMT is more likely to kick in.

I've written about the need to repeal this tax before. I'm not the only one that has called for its repeal. The Joint Committee on Taxation, the AICPA and ABA have done the same. There should be only one minimum tax - the one we currently call the regular tax. If Congress believes that deductions and credits are allowing people to pay less than the minimum, then be more transparent about it all and just reduce or eliminate some of these numerous tax breaks that also are a source of complexity in the law.

Here is my op ed from 2007 where I call it a disgrace and point out the policy reasons why it should be repealed - Simplicity and transparency versus the dread AMT, Silicon Valley/San Jose Business Journal. The repeal will be scored as a revenue loser which is unfortunate because it would be counting dollars that never were expected back in 1986. Given the purpose of the AMT to cut back on the aggregate effect of preferential deductions and credits, Congress should cut back directly on some of these items AND stop adding new ones without getting rid of old ones!

What do you think?

Moving California's Tax System into the 21st Century

Governor Schwarzenegger has spoken a few times about the need to move the California tax system into the 21st century. This includes creating the Commission on the 21st Century Economy (COTCE) many months ago (their final report was issued in September 2009). Most recently, he mentioned tax reform in his State of the State address (1/6/2010).

A fact sheet accompanying the governor's State of the State address states:

"The Governor today encouraged the legislature to seize the opportunity to modernize and stabilize the tax structure while encouraging economic growth by taking up the bipartisan Commission on the 21st Century’s recommendations to restructure the way California funds state Government.

The current, outdated system produces dramatic fluctuations in revenue – these bust or boom cycles have made budgeting and funding of essential services year after year very difficult. The Commission’s recommendations are designed to broaden the tax base, making revenues less volatile while being fair and equitable for all Californians."

A few observations:

1. What is meant by the 21st century economy?

Well, this really wasn't discussed by the COTCE. Before the COTCE, California had the Commission on Tax Policy in the New Economy which issued a report in 2003. It engaged in discussion of what the new economy is. In addition, the statute that created the earlier commission described key elements of the "new economy." This included the following provision (I have highlighted terms that describe the 21st century economy).

"California’s current tax structure is largely based on a 20th century industrial economy that produced most of its wealth from manufacturing and agriculture. California’s 21st century technology-dependent economy is already based largely on information and services, part of a new global economy that is built on the rapid development of ideas and the exchange of information using multiple communications media. It is characterized by rapid restructuring of business-to-business and business-to-customer relationships in the state and across the world and a shift from production and consumption of tangible goods to use of intangible goods and services."

2. What elements of California's tax structure reflect the 20th century rather than the 21st century?

Here are a few:

• Consumption has changed: Consumption patterns began changing a few decades ago as people's consumption of services increased (likely tied to the increase in dual-worker households and increased wealth). The patterns continue to change due to technology which enables consumption of digital goods and more services (such as web hosting and consulting). California's consumption tax - the sales tax, is very much stuck in the 20th century because it only taxes consumption of tangible personal property. That is, buy your music on a CD and you owe sales tax, but download it onto your mp3 player and you owe no sales tax. The 2003 report of the New Economy commission recommended: "Broaden the sales tax base to include selected services, while lowering the state rate to retain revenue neutrality." I think this is the most obvious modernization needed. Why let the sales tax continue to just apply to 20th century consumption rather than 21st century forms of consumption? (I've written about this one a lot - here)
• Business models have changed: E-commerce enables businesses to have customers in all states even without a physical presence in the customer's state. This challenges 20th century tax models where physical presence and borders were more important. One issue it causes is that consumers have a growing amount of use tax they need to self assess. The New Economy Commission recommended that the Board of Equalization make greater efforts to collect use tax. This is an area where today's technology can help in addition to simplified compliance approaches. (I've written on this one too - here) California should also look into joining the Streamlined Sales and Use Tax Project as that will likely lead to the ability for the state to have remote vendors collect sales tax (rather than rely on consumers to self-report use tax).
• More fierce business and interstate competition for business: All states compete to keep high quality jobs in the US. To that end, lots of incentives are offered. This is often described as a "race to the bottom." The 21st Century Tax Reform Commission in Minnesota, which issued a report in February 2009, recognized this issue as well as the growing complexity of applying the state income tax to multistate corporations. They recommended repealing the corporate income tax. I think that is an idea worth considering. It simplifies the tax system (all of the incentives and efforts to create new ones goes away) and it ends tax planning efforts to move operations around to minimize state income tax. The state would still collect payroll taxes, property taxes, excise taxes and sales taxes.
• Growing income gaps: This seems to be a continuing reality. The California Budget Project has a nice overview of the issue in a June 2009 report. I think this means that overall equity in a tax system needs to be reviewed. This overlaps partly with the need noted above to broaden the base of the sales tax. Much of the consumption that is currently exempt is that of high-income individuals which makes the system inequitable. In addition, income tax structures should be reviewed to see if the income groups makes sense. For example, perhaps those with $100,000 of income should not be in the same bracket as those making over $500,000 (or even more).
• Greater attention being paid to climate change: California probably has the most ambitious targets for reducing greenhouse gas emissions among the states. Some type of polluter-pays tax to encourage people to reduce emissions makes sense, and will generate revenue allowing for some other tax rate to be reduced.

3. Do the COTCE recommendations move California's tax system into the 21st century?

I don't think so. For example, instead of recognizing growing income gaps, the COTCE recommended a significant income tax reduction to very high income individuals with most of that being replaced with a consumption tax which would fall upon middle- and low-income individuals disproportionately (in terms of the percentage of their income being used to pay the tax).

The COTCE's business net receipts tax (BNRT) proposal would likely encourage employers to purchase goods and labor from outside of the state and to try to get more employees to become contractors. The BNRT also relies on the ability to get out-of-state businesses to pay the tax on sales into California. However, a bill before Congress that I think will get enacted sometime in the next few years, would say that California could only collect BNRT if the business has a physical presence in California exceeding 15 days during the year. That would be a big blow to state revenues if the state general sales tax and corporate income tax had already been repealed and replaced with the BNRT. The BNRT has several issues that make it unlikely to be the vehicle to promote 21st century business activity and growth in California. (I've got more on this here and you can do a search using BNRT and economy and find many reasons why this would not be good for California).

The COTCE makes no mention of a polluter pays tax even though there were suggestions from at least one commissioner and public comment.

I hope the legislature will discuss how the existing tax structure both supports and hinders the 21st century ways of living and doing business so it can find the right ways to modernize our tax system so that it can promote a strong economy, society and environment.

What do you think?

Some Kentucky legislators looking at expanding sales tax

Two Kentucky newspapers have detailed articles in today's papers (1/17/2010) on efforts of some lawmakers to reduce the regressivity of the state sales by expanding it to cover more personal services and lowering the 6% rate.

The Courier-Journal: "Regressive tax system needs reform" by Al Cross (University of Kentucky) - points out that the sales tax base, which includes very few services, "has failed to keep up with changes in the economy and has become too volatile." He also notes, based on income, that the middle 60% of individuals devote a greater percentage of their income to taxes than do the top 20%. This is probably true in most states and typically due to the many transaction taxes states have, such as sales and excise taxes, that represent a good portion of a low-income person's income but a smaller portion of a higher income individual's income because they have more income to easily cover these taxes that do not tend to increase as one's income goes up - particularly when many types of high-end consumption (such as personal services and entertainment) is tax-exempt.

Note: Data from the US Census Bureau for 2007 indicates the following percentages of income used for state and local taxes for a family of three living in Los Angeles (Table 435):

• Under $20,000 10.8%
• Over $150,000 9.3%

The higher income individuals are paying more total tax dollars, particularly if the state also has an income tax, but the percentages shown above indicate the overall progressivity or regressivity of the state tax system.

Al Cross also notes that the University of Kentucky held a symposium on tax reform on 1/13/2010 (“An Economic Perspective on Kentucky’s Tax Structure”). You can find the presentations here.

Lexington Herald-Leader: "Tax-code reform: service to the state? Economy has changed, goods-only sales tax hasn't kept pace in Ky." by Linda Blackford - also notes the overly regressive nature of the Kentucky sales tax. She notes that State Rep. Jim Wayne wants to educate the public about the need for tax reform. He notes that the Kentucky sales tax base is tied to the 1960s and doesn't address today's consumption which includes a lot of personal services. The story indicates that a possible reform package would not only expand the sales tax to personal services but also lower the rate and perhaps add an Earned Income Tax Credit for low-income workers and reduce the income tax rate on the middle class.

These are just the type of reforms that should be considered in California. The sales tax is growing in inadequacy because we are only taxing consumption of tangible personal property when people, particularly higher income individuals with money to spend, are consuming services, digital items and entertainment which is tax-exempt. That's an odd way to maintain a tax base that is so important to state and local governments. It is also an odd group to provide tax exemptions to. Expansion of the base should be accompanied by a rate reduction for everyone, and depending on what is added (if, for example, it also includes some "necessities of life" such as utilities), a refundable income tax credit for low-income individuals could also be added. While there are reasons to exempt some necessities of life, the reality is that higher-income individuals spend more on these necessities than do lower income individuals and thus get a boon from the exemption (such as no tax on a $30 block of gourmet cheese or the utilities to heat and cool a 6,000 square foot home).

I've written about this many times as have others. For more information, please click here.

I hope that California pursues this tax system modernization effort which could be aided as other states do the same (and some states have already begun bringing their tax systems into the 21st century). One of the presenters (Wildasin) at the Kentucky symposium compared the Kentucky tax system to California's to highlight just how problematic it is!

What do you think?

Tax Policy Overlooked in First Decade of the 21st Century

I'd say that the first decade of the 21st century (2000 - 2009), was not a good one for tax policy. We are still talking about issues left unresolved from the 1990s (and even earlier), such as international tax reform, reducing the tax gap, and simplification. Meanwhile, the tax law continues to grow in complexity.

I've got a short article in the January AICPA Tax Insider - Overlooking Tax Policy: A Decade in Review - here. I hope you enjoy it.

How would you assess the past decade in terms of improving our tax system and do you think this new decade will be better?

Alternatives to the COTCE Recommendations

Today (1/13/2010), the California Assembly Revenue & Taxation Committee held an informational hearing on alternatives to the recommendations of the CA Commission on the 21st Century Economy (COTCE). The schedule included testimony from:

• Paul Warren - Legislative Analyst's Office (LAO) - testimony
• Richard Pomp - law professor at University of Connecticut Law School and a member of the COTCE
• Annette Nellen (me!)
• Fred Keeley - Santa Cruz County Treasurer-Tax Collection and a member of the COTCE

It was very interesting, particularly to hear from the two COTCE members (neither endorsed the COTCE recommendations). They pointed out some unfortunate aspects of the process of the COTCE including that they never really talked about what the 21st century economy is and what tax system features made sense for it; the revenue estimate for the BNRT was generated before there was statutory language; and the BNRT basically just appeared one day without any discussion.

The hearing was webcast - you might find it posted at the Assembly page (see link above).

The LAO has run some estimates of the revenue potential and affect on volatility of the BNRT. They found that it is not revenue neutral at a 4% rate (which many already view as too high for this type of tax). LAO projects a $10 billion annual drop in state revenues from the proposals. Also, they found little improvement in volatility under the COTCE proposals.

Professor Pomp noted several concerns with the BNRT and COTCE process and offered alternatives. He stated that most of what he said was in the four letters he had shared with fellow commissioners - but were not included in the final report (the final report does not include any statements from those who did not endorse the recommendations (9 or 14 commissioners endorsed the final report)).

Here are links to three of his letters (can't find the 4th on the COTCE website):

• 9/25/09
• 9/14/09
• 9/4/09

Ive got my testimony posted at the 21st Century Taxation website - see link towards top of page. The alternatives I suggested are almost all discussed at the 21st Century Taxation website, including expanding the sales tax base to include personal services, digital items and entertainment while also lowering the rate and hopefully using some of the funds to start to reduce pyramiding in the sales tax such as by creating a sales tax exemption for R&D equipment. I also note the need to apply accountability measures to all tax expenditures and phase-out ones that do not meet an important purpose (such as subsidizing one's mortgage on their second home). Something we don't hear mentioned too often, I noted that the legislature should encourage and work with Congress to reduce the tax gap because the state would also be a beneficiary of this initiative. You can read the rest (here). The testimony also compares the sales tax to the BNRT which really then highlights some significant problems with the BNRT.

I have more on the COTCE proposals on this blog (search for COTCE). Also see links at top of this page on California tax reform.

Comments?

Income tax for California Cities?

One of the bills on the agenda for the January 11, 2010 hearing of the California Revenue & Taxation Committee is AB 1342 which includes a law change to allow local governments to impose a personal income tax. Currently, R&T Section 17041.5 prohibits local governments from imposing an income tax. The personal income tax to be allowed under AB 1342 would be based on a percentage of the state personal income tax a person owes and administered by the Franchise Tax Board. A vote of residents would be needed to create the tax.

Is this a good idea? Well, there are a few cities outside of California that impose income taxes, such as New York City and Philadelphia. It would enable cities to have a progressive tax (sales tax is regressive) and would enable cities to generate additional revenues without having to try to get voters to increase an already too high sales tax rate or attract a big-box retailer into the city.

A city income tax would better align state and city goals. Today, the state would like to have high wage jobs in the state. However, local governments are not as eager because high wage workers are more likely to live in their own home and have higher infrastructure needs than would someone who works for a big-box retailer. Local government revenue bases are not adequate to attract high earners because their high income does not necessarily turn into high sales tax collections.

So, wouldn't it be better to find a way for all cities to be aligned with state interests in attracting and creating high wage jobs? If yes, why not have a tax system where the state government shares a portion of its personal income tax base (and perhaps the corporate income tax base as well) with local governments?

What do you think?

Call for 21st century tax system by Georgia State Senator

Georgia State Senator Doug Stoner (D-Smyrna) had an op ed in The Atlanta Journal Constitution on 1/7/2010 entitled, "State suffers from revenue problem." I think he did a nice job explaining that tax systems need to be modernized and clarifying some misconceptions that can lead to continued weaknesses such as inequities and lack of transparency and accountability in tax systems.

He reminds readers that tax cuts for some mean tax increases for others. Consideration should be given to what the effect of such cuts is on overall equity in the system. He also notes that too often, tax breaks enacted under the guise of job creation, do not have any accountability measures associated with them so it is not known if the goal was reached. I'd add to this that such credits also are often enacted without any "clawback" provision that requires taxpayers to repay the tax if they ultimately do not create and keep the jobs created. Senator Stoner reminds us that no one would run a business this way. [Note: Tax Notes' blog has a post on 1/8/2010 about the lack of any proof that Georgia's tax credits for job creation are working.]

Senator Stoner concludes with a statement applicable to all states: "Georgia needs fundamental tax reform, linking our budget needs to a 21st century tax system. We must develop a fair and adequate tax structure that enables us to fund high-quality services and make long-term infrastructure investments in education, transportation and water resources, if Georgia is to prosper in the global economy."

Accountability - Growing Attention, More Needed

An Associated Press story of January 2 (Babwin, "Cities, counties take back corporate tax breaks") notes how some cities are making use of "clawbacks" to reclaim tax breaks that did not yield the expected benefits for the jurisdiction.

I think this is part of what will be a growing trend amongst lawmakers and the public to ask questions about both direct spending and indirect spending that exists in the tax law (such as via special deductions, credits and exemptions).

There is another current article (1/3/10) in The Lexington-Herald Leader in Kentucky - "Tax breaks are budget loophole" by Blackford and Cheves. This story raises the question why consumers pay sales tax on DVDs but none is paid on the purchase of horses and coal. Per the article: The "state's General Fund is expected to collect about $3 billion in sales taxes during fiscal year 2010, compared to about $2.4 billion the state will forgo in sales tax breaks for horses, coal and dozens of other items."

The Kentucky article notes that a study on tax exemptions was authorized by the legislature in 2005, but never completed. It also notes that in 2008 the legislature failed to pass a bill that would have imposed sunset dates on exemptions and required public discussion on the provisions. The article notes that the dollar amount of exemptions is growing: "The money lost to tax breaks is rising about 7 percent a year as the General Assembly -- often at lobbyists' urging -- creates new loopholes in the tax laws without closing old ones."

Some states are considering or taking actions. I noted some actions in Oregon, Missouri and Florida in a 11/27/09 post. Oregon imposed sunset dates on many of its tax breaks which will require some discussion as to whether or not they should be renewed. Unfortunately, the legislators might not have the data they need to make such determinations because there was no specific call to either identify the objectives of particular breaks or call for collection of data needed to evaluate them.

Tax expenditures - deductions, credits and exemptions in a tax system that are not there for fundamental design reasons, but to provide some special benefit, are mostly hidden from lawmakers and the public. If there is no sunset date, they can remain in the tax law forever unlike line item spending that is likely to get reviewed each year. Also, these expenditures are rarely capped. Thus, unlike a budget line item, the tax expenditure can easily grow each year without offsetting revenues to cover the spending.

Ideally, special tax breaks should not be used. A tax with a broad base and lower rate best meets the principles of good tax policy. If a jurisdiction believes its economic, social and environmental health warrants some type of encouragement to some activity, it can be handled via a direct grant of funds. That allows for specific criteria for the award to be created, a dollar limit set and the public to have access to who received the funds. The tax law won't have to suffer the burden of the added complexity of special rules or their typical inequity (that is, a tax break to some is paid for by higher taxes for others).

It is great to see the news stories because that may cause the public to not only ask their elected representatives about spending in agency budgets, but also the spending that exists in the tax law. There are many puzzling tax expenditures in most tax systems and with rising budget shortfalls, it is past time to look at where that unnecessary spending can also be cut.

For more:

• Nellen, CA Sales Tax Base is Too Narrow
• Nellen, CA Personal Income Tax - Too Many Unneeded Breaks
• Nellen, Op ed in SF Chronicle - 'Spending problem?' - some of it's hidden in our tax laws" (2/08)
• Nellen, "Calls for Accountability: Will It Help the Overall Incentives Process?," Journal of Multistate Taxation and Incentives (6/09) (available through RIA)
• Congressional Research Service, Tax Expenditures: Compendium of Background Material on Individual Provisions (12/08)
• Joint Committee on Taxation, Tax Expenditure reports
• Urban Institute, How Big Are Total Individual Income Tax Expenditures and Who Benefits from Them? (12/08)

What do you think? Should tax expenditures be addressed in some way? How? Which ones? How can accountability be built into the tax and law-making systems?

Happy New Year 2010! Time to address tax problems.

Thank you for reading this blog in 2009 and I hope you'll continue and that you'll post replies. Also, if you have a short paper on a realistic idea for improving and modernizing federal or state tax systems or one that describes a tax problem, that you'd like me to post on the blog - please let me know.

If we look at the past decade (2000 - 2009), there have really been more problems for tax systems than improvements. This leaves a lot of work for the next decade. Consider:

• Congress is not ready to deal with expiration of the 2001 and 2003 tax cuts as evidenced by not acting to keep some version of the estate tax for 2010.
• The tax gap continues to be a serious problem (over $345 billion goes uncollected at the federal level annually). Yet, solutions are typically only enacted as revenue raisers for other bills. And these solutions do not address the biggest parts of the gap - sole proprietors and complexity. [see 2008 article on this]
• Complexity grows. The temporary provisions of the American Recovery and Reinvestment Act of 2009, some of which may become permanent just add more rules, definitions and effective dates. Nothing has been truly simplified.
• Who should pay? Lately, it seems that we want millionaires to pay for everything. The Tax Foundation issued a report in 2009 that notes that tripling everyone's tax rate still won't solve the federal deficit problems. I think that growing income gaps should lead to governments to analyze whether more brackets in the higher levels of the income tax rate structure make sense (for example, lumping together the group over $150,000 is likely too low of a point to lump high earners), but it won't solve all problems. Also, such high rates are unattractive to businesses. There are other ways to get higher income taxpayers to pay "their share" (such as reduce unnecessary tax subsidies (such as $1.1 million dollar mortgage deductions) and stop exempting utilities from sales tax)).
• Growing and continuing state budget deficits. Tough times often lead to unfortunate tax changes such as rate increases which may make tax systems more inequitable (such as the sales tax rate increase in California which only taxes tangible personal property so omits most types of consumption). Tax systems usually are more likely to meet principles of good tax policy if bases are broad and rates are low.

What do you think legislators need to do to improve tax systems for 2010?