New Realities in State Finance
Executive Summary
This book deals with state tax policy and how well state taxes perform in the
early 21st century. It examines the major state taxes and the ways
that changes in the American economy and society have affected taxes, as well as
alternatives to taxes and how the federal government's tax policies affect
states. The book considers the productivity of taxes, their fairness, and the
reasons tax policy must be considered not only in the long-term, but also in the
immediate present.
These topics are independent of the amount of money that taxes raise. They
should be considered whether policymakers' goals are to cut taxes and spending
or to raise them. Sound tax policy is concerned with how taxes are designed and
administered, how they affect the taxpayer, and how they affect the economy.
High or low, taxes can be well-designed or badly designed. The quality of tax
policy should be a concern for both the hardiest anti-tax advocates and the most
fervent proponents of income redistribution.
General sales and personal income taxes are the main sources of state tax
revenue--they have grown from 36 percent of state tax revenue in 1970 to 70
percent in 2001. The increased use of these taxes is explained by their capacity
to capture growth in the national economy as no other state tax can do. Other
taxes have lost relative importance over time because of their inability to
capture growth. Excise taxes, for example, usually are set at a specific rate
per amount of something sold, so it requires a specific legislative act to
adjust an excise tax for inflation or other cost changes. The third major state
tax, the corporate income tax, has failed in recent years to capture national
economic growth as it once did.
State tax policy faces challenges because its three major taxes have not kept
pace either with changing patterns of productivity and consumption in the
American economy or the changing American demography. Base erosion of the
corporate income tax, in particular, has reached a point where its continued
existence can be questioned.
Besides productivity and responsiveness to economic change, other
requirements for a sound state tax system are that it should:
- Distribute burdens equitably;
- Provide appropriate and timely revenues;
- Promote economic efficiency and growth;
- Be easy to comply with and administer; and
- Ensure accountability.
Such principles are not easy to apply in practice because they can conflict
with each other and with other policy goals. They are intended to raise
questions policymakers will want to consider, not to provide guidelines that
bind decisions. It is important to think of these principles as being more
applicable to a state tax system than to individual taxes because the strengths
and shortcomings of various individual taxes can offset each other.
Economic and demographic changes in the United States have distorted the
workings of the major state taxes, which have not been adjusted fully to take
into account those changes. Among the principal changes is the shift of
American economic activity from the production of goods to the production of
services. The latter, which surpassed the production of goods in economic
importance in 1975, represents 35 percent of gross domestic product (GDP), far
below the 57 percent reached immediately after World War II. Changes in personal
consumption have followed the same trend, with important consequences for both
sales and income taxes.
Low birthrates and increases in longevity have produced a long-term trend
toward an aging population, which has consequences not only for Social Security,
Medicare and Medicaid programs, but also for state tax collections. Another
long-term trend, a shift in the nature of American personal income from wages
and salaries toward compensation in benefits and transfer payments, has
unfavorable implications for state income taxes.
State sales tax collections have long been affected by these trends, which
have shrunk the base upon which the sales tax is levied. Sales tax revenues have
been sustained only by rate increases. If present consumption patterns hold as
the population ages, the sales tax base will continue to shrink because the
elderly tend to spend a larger share of their incomes on non-taxed services such
as health care and prescription drugs than younger people do; the elderly also
have less to spend overall. Changing consumption patterns also are diminishing
the sales tax base, as consumption continues to shift from taxable goods to
untaxed services.
Policy decisions have speeded this process by exempting from the sales tax
base some consumer goods, food and many products business uses in the productive
process. The economic and social advantages of those exemptions are very
important, but they represent significant reduction of the potential sales tax
base. Under current law, some mail order and Internet sales can legally avoid
sales taxes, a further erosion of the base.
Whether expanding sales taxes to more services is a potential solution to
these problems is open to question. Besides political resistance to doing so, it
would be difficult to avoid undesirable taxation of business's use of services
and it is very difficult to deal with the issue of the sales of services across
state lines. In addition, there is the broader issue whether it is desirable to
address the problems of an already regressive tax by extending it to a broader
base.
The personal income tax has responded more smoothly to a changing economy and
demographics than have state sales taxes. Issues of over-responsiveness in the
course of the business cycle--meaning rapid revenue growth in good times and
sharp reductions in collections in bad times--can be addressed in the design of
the tax. An eventual reduction in the proportion of Americans who are employed,
as the population ages, will mean that more income is sheltered from taxes
because of present income protections states have given people age 65 and older.
Federal tax policies are sometimes changed without regard for their effect on
state income tax collections. Despite these issues, the personal income tax is
likely to continue in its role as the single most important source of state tax
revenue.
Business tax payments play a significant role in state finance, contributing
as much as 42 percent of state tax collections. Most of this is from sales taxes
paid on business inputs and a wide range of other business taxes. The corporate
income tax, the best-known business tax, has declined in relative importance for
decades and now produces only about 5 percent of state tax collections. Given
the complicated nature of the tax, the costs of compliance and administration,
and the extent to which state policy decisions and economic change have reduced
its base, the question arises as to whether the tax should be continued at all.
It currently represents only about 10 percent of total business tax payments to
state and local government.
The value-added tax (VAT) is sometimes suggested as a replacement business
tax or as a replacement for business taxes and state sales taxes. VAT is widely
used in other industrialized nations, and it has theoretical advantages for the
states. VAT operates differently from the taxes most American policymakers are
familiar with, and has been adopted as a business tax in only two states, one of
which is phasing it out. Not all forms of VAT are workable as a state tax.
States have made wide use of other alternatives to broad-based taxation. Two
important examples are user charges and gambling. Both are important state
revenue sources, but inherently are limited in their revenue potential. User
charges in many ways are better suited to local governments than to state
governments because of the different kinds of services states and localities
provide. The recent round of state increases in user charges may represent their
highest state use to date.
Gambling is another resource to which states have increasingly turned in
recent years, despite charges that it is immoral and exploits low-income people.
As a state revenue source, in most states gambling will remain a niche revenue
with uncertain potential to respond to economic growth over time.
State policymakers will want to keep the role of the local property tax in
mind when reviewing state revenue systems. Not only do local property taxes
sustain the independence of local decision-making, they also provide more tax
revenues than any other state or local source. State policymakers, responsible
for general control and oversight of property taxes, have made significant
changes in how property taxes operate to address public opposition to the tax in
recent decades. Renewed interest in statewide property taxes and the stability
and productivity of the tax will preserve its role in state-local finance for
some time to come.
All state taxes are, to some extent, subject to federal limits, even though
state taxing powers are independent of the federal constitution. The federal
government and the states share tax bases, and constitutional scholars assert
that the federal government can legislate on state tax issues. This power has
been sparingly used in the past, although there now is more federal involvement
than ever before in areas that traditionally have been under state control. An
independent revenue stream is key if states are to maintain their role in the
American federal system, and state policymakers will want to remain alert to
federal challenges to their independent authority.
Preface and Acknowledgments
Executive Summary
Introduction
1. What States Tax
State Taxes
State Taxes as Part of Total State Revenues
State Revenues in a National Context
State Taxes Under Siege
2. Ground Rules for Evaluating Taxes
A State Tax System Should Distribute Burdens Equitably
The Benefit Principle
The Principle of Ability-to-Pay
The Principle of Horizontal Equity
A State Tax System Should Provide Appropriate and Timely Revenues
A State Tax System Should Promote Economic Efficiency and Growth
A State Tax System Should Make Compliance and Administration Simple
A State Tax System Should Ensure Accountability
Conclusion
3. Economy, Population and Income
A Service Economy in a Greater World
Americans Are Growing Older
The Shift Away from Taxable Income
Conclusion
4. State Sales Tax Issues
The Viability of the Sales Tax
Narrowing the Sales Tax Base
Mail Order and Internet Sales
The Streamlined Sales Tax Project
Should States Extend Sales Taxes to More Services?
Then Why Don't States Tax Most Services?
Regressivity of the Sales Tax
Conclusion
5. Personal Income Tax Issues
The Shift to a Service Economy
Demographics and the Income Tax
Federal Policy and the State Income Tax
Business Organization and Personal Income Taxes
Conclusion
6. Taxes on Business
Sales Taxes on Business Purchases
The Corporate Income Tax
The Diminished Role of Corporate Income Taxes
The Corporate Income Tax as an Economic Development Tool
Apportionment Formulas
Cracks in the Corporate Tax Base
Conclusion
7. The Value-Added Tax
Operational VAT
Transaction-based VAT
Conclusion
8. Alternatives to Taxes: User Charges and Gambling
User Charges
Why Collect User Charges?
Are User Charges Regressive?
Gambling
Revenues from Gambling
Is Gambling an Efficient Way to Raise State Revenues?
9. Property Taxes
Property Taxes in the State-Local Revenue System
Property Tax Reform and Preservation
The Property Tax as a State Tax
Conclusion
10. The Federal Government and State Taxes
Linked Tax Bases
Interstate Commerce
Preemption
Conclusion
Published April 2004; posted June 2004.
Email statebudget-info@ncsl.org
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