States need to get ready for federal tax reform

There is lots of talk about federal tax reform. We are likely to see some legislative language from the House in spring, according to Speaker of the House Paul Ryan (see Jeremy Quittner, "Paul Ryan Says Tax Reform Won't Happen Any Time Soon," Fortune, 2/2/17).

Federal tax reform presents opportunities and challenges for states. I've got an article in State Tax Notes on suggestions for state governments to consider.  For example, to lower federal tax rates, the base will be broadened and most credits will go away.  One of those credits is the low-income housing credit. State and local governments are indirect beneficiaries of this credit.  State governments should consider asking Congress to give some of those dollars to the states rather than using them all for rate reductions.

I hope you'll take a look - Time to Really Get Ready for Federal Tax Reform.

What do you think?

Tell me - hot state tax issue of 2015?

In preparation for a State Tax Notes article I'm working on for publication later this year, I'd appreciate your input on what you think are one or two of the most meaningful state tax issues for 2015?  For example, perhaps it is the Wynne decision, Justice Kennedy's comment about Quill in the DMA case, the revised Marketplace Fairness legislation (H.R. 2775), accountability measures, some states trying to reduce income tax and increase sales tax, expiration of the Internet Tax Freedom Act, taxes on short-term rentals, worker classification, marijuana taxes, something else?

Please post a comment here or if you don't want to do that, you can email me at annette.nellen@sjsu.edu.

Thank you!

Some governors talk of ditching their income tax

1-25-13

Tonight I participated in a HuffingtonPost Live session* on the calls by some governors to end their income tax. For example, Louisiana Governor Jindal has called for such a change (see Reuters article of 1/10/13 by Finn and NYT article of 1/24/13 by Stevenson).

This is a drastic move. Certain more drastic than a few states ending or greatly diminishing their car taxes a few years ago.  The income tax brings in a fair amount of revenue. Per data from the Federation of Tax Administrators, in 2011, Louisiana received 27% of its revenue from the individual income tax, 2% from the corporate income ta and 32% from the sales tax. To make up that revenue, it would seem that they almost need to double their sales tax. They also would increase the volatility of revenue. With a mix of revenues, states are better able to keep a somewhat stable base regardless of economic changes.

The sales tax is also regressive. That is, it represents a larger portion of a low-income person's income than it does for a higher income person. Also, most states have a narrow sales tax base that only covers tangible personal property even though today, more personal consumption consists of services, entertainment and digital goods.

Why not look at repealing their corporate income tax? Why should Louisiana and corporations doing business there spend so much time to generate 2% of the state's revenue base?

Better yet, state tax reform should focus on each tax and where it can be improved. The current system should be analyzed against principles of good tax policy and the state's economic, societal and environmental goals. That will help identify what improvements are needed.

What do you think?

* Hosted by James Poulos and Alyona Minkovski; other commentators Nick Gillespie and Dave Johnson.

The Fiscal Cliff and the States

A report by the Pew Center on the States on 11/15/12 notes that the fiscal cliff the federal government is facing also affects the states. They note that with state tax systems usually tied closely to the federal tax rules, expiration of federal tax cuts will also result in higher state taxes for taxpayers and greater collections for the states. But it will also result in a larger contraction of the economy than we are hearing about when only the federal picture is considered. Pew also notes though that six states allow for a deduction of federal taxes and they would see a reduction in state taxes because of the impending higher amount of federal taxes many people will have in 2013.

Sequestration at the federal level may reduce certain grants and other funds that states receive.

Also see "Without a Cliff Deal, States Will Bleed Red Ink, by Pianin and Ehley in The Fiscal Times, 11/16/12.

I encourage you to review the Pew report to learn what the possible impact of the federal fiscal cliff is for your state. The federal-state fiscal cliff connection is also a reminder that there is a connection between federal and state tax rules and systems that is relevant for tax reform.

For example, in discussing base broadening at the federal level to allow for continued lower rates, a few of the items will have direct and indirect impacts on state budgets. For example, if some portion of tax-exempt interest income becomes taxable, state and local governments will most likely find they need to offer higher interest rates.  Also, cut back of the low-income housing credit or new markets credit will have indirect unfavorable effects on state and local governments who are indirect beneficiaries of these federal rules.

Ideally we'll see Congress reach out to the state and vice versa as tax reform activities ramp up in the 113th Congress.

What do you think?   

California State-Local Fiscal Relationship

This month, the Legislative Analyst's Office issued a report - Ten Events That Shaped California State-Local Fiscal Relations (12/15/09) for a hearing of the Senate and Assembly Select Committees on Improving State Government (Assembly page + Senate page). The 10 events:

1. 1910 Separation of Sources Act
2. 1930s New Deal
3. 1952 Proposition 18
4. 1972 SB 90
5. 1978 Proposition 13
6. 1979 AB 8
7. 1991 Realignment
8. 1992 and 1993 ERAF Shifts
9. 2004 Triple Flip/Swap
10. 2004 Proposition 1A

It's a bit of a cryptic list without the brief explanation of each event offered by the LAO (you can find that here). It also sounds like an odd list with words like "realignment," "shift," "flip" and "swap." The word "proposition" also showing up three times indicates that the voters rather than elected officials created some of the events.

As some of the words used in the list of events indicates, there are oddities in the California-local government relations. While Number 1 on the list - separation of sources, sounds like authority and accountability at each level of government (a good thing), such separation is limited and has been modified since enacted in 1910. Per the LAO report, the Act called for the state to tax railroads, telegraph and telephones while the local governments would tax property and set the rate.

While the bulk of property taxes are collected and used at the local level, the system for how they are allocated among local governments is controlled by the state (Numbers 5 & 6 on the list above - Prop 13 & AB 8). This makes it difficult for local governments to do their job - they can't necessarily allocate revenues to their best need.

Another problem in the state-local fiscal relationship is lack of transparency. Taxpayers don't really know where their taxes go and how they are spent. Part of this is due to oddities in the flow of some tax funds. For example, Event Number 8 on the LAO list - the Triple Flip. To help fund state bond payments, 0.25% of the local sales and use tax was shifted to the state for the Fiscal Recovery Fund. To replace the lost sales tax, cities and counties received funds from the Education Revenue Augmentation Fund (ERAF). The State then uses General Fund monies to replace the ERAF dollars. [ABX1 7 (2003) and Prop 57 (2004)]

Another problem in the state-local fiscal relationship is the sometimes opposing strategies that exist due to flaws in the tax system. For example, cities seeking revenues might aim to get a "big box" retailer to locate inside city borders. This generates sales tax revenues. However, these are not high wage/high skill jobs that would be more advantageous to the state's income tax base and prospects of attracting manufacturing and R&D businesses to the state.

A final problem I'll note is that while the state has a fair amount of control over local revenues (and some expenditures) locals are often forgotten at the state level. A recent example is the final report of the California Commission on the 21st Century Economy. One of the recommendations was a Business Net Receipts Tax (BNRT). This would replace the corporate income tax and the state-level general sales tax. One reason for this proposal was to use a more administratively simple approach to extending the sales tax to services (the BNRT is a type of subtraction method VAT making it similar in collections to a sales tax). However, no comment or effort was made to find a way to update the sales tax base for local governments or to have them share in the BNRT revenues.

It is important for any state level fiscal discussion or action to consider the effect on local governments. The National Conference on State Legislatures (NCSL) includes this in their 9 principles of a high-quality state revenue system - "A high-quality revenue system comprises elements that are complementary, including the finances of both state and local governments."

What do you think of the LAO top 10 list? What do you think are key problems with the California-local government fiscal relationship?

Bottled water tax proposed in Michigan

The Lt. Governor of Michigan has proposed a 10 cent per bottle tax on water to help fund education (Lt. Governor John Cherry press release of 12/14/09). Per Lt. Governor Cherry, it makes sense to tax one resource to fund another (Mlive.com 12/14/09). Is this a good idea? Based on principles of good tax policy and budgeting - no.

Equity - why a tax on bottled water and not other bottles or other acquisitions of water?

Economy in collection - there will be costs to both businesses and the government of collecting and auditing this new tax.

Neutrality - the tax will affect taxpayer decisions on whether to buy bottled water and where to buy it.

Appropriate government revenues - while the government should be able to estimate how much it will generate from a new bottle tax, the fact that the tax is tied to a specific use and one that is unrelated to bottled waters (education), makes this earmark a problem for the budget process. I've written about the problems of earmarking before (San Jose Mercury News, 3/21/08).

Complexity - as a new tax, new forms and processes would be needed. It might also be difficult to define bottled water - does that mean pure water? What if a few vitamins are added or flavoring?

Minimum tax gap - people will be encouraged to buy water outside of the state if convenient to do so (they live on the border of another state).

The tax does meet the transparency principle assuming the tax would be added to a buyer's bill.

Constitutionality - it is not unusual for state constitutions to have a variety of prohibitions that will defeat some taxes unless the Constitution is first changed. The likely unconstitutionality of a Michigan water bottle tax has been noted by The Tax Foundation (12/17/09 blog post) and others.

This is not the first time states have suggested or enacted odd taxes:

• Chicago's bottled water tax
• New Mexico TV/video game tax

While Michigan, like other states, is facing budget shortfalls, desperate measures, such as a bottled water tax, are not the best way to go. They should look more broadly at reform, which should include consideration of polluter pays taxes. A polluter pays tax on all plastic bottles might make sense. If Michigan already imposes a deposit on plastic bottles, a system is already in place to assess such a tax. Also, it is likely that general fund dollars today are being used for waste disposal including plastic bottles. But, this still seems like a small measure in light of larger tax and budget problems.

What would you suggest for Michigan?

Uniformity of State Tax Laws - Possible? Desired?

When businesses operate in more than one state, the question arises as to how to determine how much of its income should be subject to tax in each state in which it is subject to tax. This is a matter that has been argued at the Supreme Court level numerous times and states have modified their approaches over the years.

Decades ago (1957), the National Conference of Commissioners on Uniform State Laws (NCCUSL) drafted the Uniform Division of Income for Tax Purposes Act (UDITPA). It was last amended in 1966. UDITPA provides rules on apportionment and allocation of multistate business income among states.

In 2007, NCCUSL decided to form a committee to look at changes to update UDITPA. Section 17 of UDITPA which deals with sourcing of sales that are not of tangible property was to be a focal point, but other areas could be looked at as well. Section 17 was clearly outdated. UDITPA provides that sales of tangible personal property are sourced to the destination state. Section 17 uses a costs of performance sourcing rule meaning that typically, sales of services and intangibles are sourced to the origin state. Several states including California have modified their laws to source services to the market (destination) state.

The Committee held its first meeting in late May 2008. There were protests by some businesses urging NCCUSL to terminate the project (see letter submitted by COST and a business coalition). Yet, others supported the project (see, for example, letter from Utah).

Uniformity among states cannot be guaranteed through a UDITPA revision though because states are not required to adopt the Act.

Well, on June 30, the committee voted to recommend termination of the project. Basically, it doesn't meet the goals for a uniform law if it is unlikely that any state is going to adopt the model law.

So, does this mean that Congress might step in?

I doubt it. If Congress took on how to source and apportion income among the states, there would be long debate among members of Congress, the business community and state governments (and some academics, of course) as to what the uniform rule should be. I think Congress is well aware that the states are struggling with how much to tax businesses versus how much to incentivize them to locate or stay in their state. While there has been some concern expressed in the press (Business Week, 7/1/09) as to whether federal stimulus dollars are being spent on state corporate tax breaks, I don't think Congress is going to step in.

Congress already has multistate issues on its plate that it has not be able to resolve in the past 6+ years - (1) updating PL 86-272 and (2) legislation to allow states to collect sales tax from remote vendors.

Perhaps states will move to uniformity given that more are moving to a single sales factor and sourcing sales of services to the market state (which makes sense to do along with a single sales factor if the state is trying to encourage businesses to locate property and payroll in the state). But, when (if) all states have these rules, the economic development aspect of it will be diminished - because all states are then offering the same incentive. So states will then have to find some other incentive to keep and attract businesses. It could be lower rates, more tax credits (such as hiring credits and R&D credits) or even repeal of the corporate income tax.

So, let's see what happens next. What do you think?

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?