Our Outmoded Tax System

Balancing Acts: Tax Cuts and Public Policy in Arizona

Our Outmoded Tax Systems

by Ronald K. Snell
© Reprinted by permission of the National Conference of State Legislatures from State Legislatures, August 1994
Ronald K. Snell is director of NCSL's fiscal affairs program.

Now that state tax collections have improved, Medicaid cost increases are no longer burning like a prairie fire through state budgets, and sustained economic growth seems likely, can legislators put tax issues out of their minds?

If state finances are improving, why even raise the issue? "If it ain't broke, don't fix it." Why should state officials subject themselves to the stress and misery of talking about taxes, let alone the fundamental reconsideration of state tax policy?

States' tax policy may not be broken. But it's chugging along like a '39 Studebaker on 1990s expressway: getting somewhere, in a manner of speaking, but not efficiently, not reliably, not in a very satisfactory way.

From 1989 through 1993, budget shortfalls and tax increases dominated legislative sessions. Legislators debated countless changes designed to give larger shares of shrinking resources to corrections, education and health care while revenue stalled. Time and again, unhappy legislators voted to increase taxes to sustain state spending while constituents' incomes were stagnant or shrinking. Legislators, governors and taxpayers alike are ready to put the subject of taxes aside—except for the possibility of tax cuts, which occupied many legislatures in 1994.

But the time to stop thinking about taxes has not yet come. The issue that needs attention, however, is not revenue raising in the short term. For now, most states appear to be in solid fiscal health—with the exception of northern New England and California, places where the recession of 1990 has never ended.

It's Time to Remodel
It is time to consider more fundamental questions of how well state tax systems in the 1990s reflect the American economy of the 1990s. That is the subject of the book Financing State Government in the 1990s, published jointly by the National Conference of State Legislatures and the National Governors' Association. Three other formidable 50-state policy associations—the Federation of Tax Administrators, the Multistate Tax Commission and the National Association of State Budget Officers—provided much of the policy discussion in the book. The result, according to Hal Hovey of State Policy Research Inc., is "the new conventional wisdom among state officials." Conventional wisdom or not, the book asks legislators and governors to consider remodeling a structure of state taxation that has developed haphazardly for over half a century.

To see why this is necessary, consider the the general nature of state tax policy—the kind of taxes state governments rely upon, what they tax and how the taxes operate. Then consider how America has changed since the foundations of current state tax policy were laid.

States Tax Alike
It's possible to talk about tax systems in terms of the 50 states, despite the great differences in individual policies, because states have tended to make their policies resemble those of their neighbors. The 50 state governments have two major sources of tax revenue—the general sales tax and the personal income tax.. The third state tax source is the corporate income tax, which in terms of revenue is far less important than either of the two mainstays. And all 50 states mandate that local governments impose property taxes, usually to finance a substantial chunk of elementary and secondary education as well as to pay for local administrative expenses.

Every state, except New Hampshire and Alaska, has either a general sales tax or a broad-based personal income tax and most have both. Only five states (Alaska, Delaware, Montana, New Hampshire and Oregon) do not impose a general sales tax. Seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) have no personal income tax, and two more (New Hampshire and Tennessee) tax only investment income.

States rely heavily on sales and personal income taxes. In FY 1992 state governments collected $328 billion in taxes (not including any local government taxes). Of that amount, $108 billion or 33 percent came from the general sales tax and $104 billion or 32 percent from personal income taxes. The corporate income tax (collected by 45 states) produced $21.5 billion, a little under 7 percent of total state tax collections.

Local property taxes produce more revenue than any state tax. Figures for FY 1992 are not yet available, but in the year before local property tax collections were more than half as large as total state tax collections. For that reason, any substantial reduction in local property taxes, such as the one the Michigan Legislature approved in 1993 or the one Oregon voters approved in 1990, forces major revisions in finances if state government makes up for the revenue forgone.

This basic picture of heavy reliance upon general sales taxes and personal income taxes, supplemented by a corporate income tax at the state level and by property taxes at the local level, has characterized state government since 1971. From 1961 through 1971, income taxes were enacted in 10 states and sales taxes in 10 states (for 19 states in all—Nebraska double-dipped). Only two states have added either tax since 1971, so that the general outline of state tax systems has been stable for 20 years. But the roots of the current tax systems go back much further, to the years of the Great Depression.

Replacing State Property Taxes
The current system was invented in the 1930s to replace old state property taxes. As late as 1932, state governments collected more revenue from property taxes than from their sales, personal income and corporate income taxes combined. During the Depression, the failure of property taxes to produce revenue and their potential for destroying the assets of farmers and homeowners led 16 states to adopt individual income taxes from 1931 to 1937. Even more states—23 from 1933 to 1938—followed Mississippi's lead in trying out the newly invented general sales tax. Although the nation's economy has enjoyed a sea of change since the dismal 1930s, these taxes remain much as they were designed to be in the days of dust bowls and Hoovervilles.

The state adoption of sales and income taxes in the 1930s represented modernization. Basing state taxes on wages, salaries and consumption instead of real estate recognized that the United States had become a nation of factory and office workers instead of farmers. That was, of course, a belated discovery for state policymakers in the 1930s—in 1929, nonfarm personal income was 10 times as great as farm income in the United States. It took an economic crisis of previously unknown proportions to bring the discovery home.

System Outmoded Again
Over the past 50 years, economic changes of similar magnitude have again outmoded state tax systems. The economy of smokestack industries they were designed for no longer exists. The way Americans generate wealth and the way they spend their income has changed dramatically since the 1930s.

Manufacturing is in decline relative to other areas of the economy. In the 1930s, services accounted for about one-third of GNP; the share fell briefly because of wartime manufacturing growth, but has grown steadily since the late 1940s. The share of GNP attributable to the production of goods has declined steadily since the mid-1940s. In 1975, the production of services became a larger share of GNP than that of goods, and the services sector has continued to grow in relative as well as absolute terms.

An equally important change has occurred in how Americans spend their money. We eat at MacDonald's instead of buying groceries, and we rent videos instead of buying books. Consumers in 1990 spent smaller proportions of their money on durable and nondurable goods than in 1960, much less on groceries and about the same share on housing. But expenditures on services (which include restaurant and take-out meals and explain how Americans manage to eat) grew from 25 percent to 42 percent of consumer expenditures.

The trend toward producing and consuming more services and fewer manufactured goods is likely to continue. The services sector is the fastest-growing and healthiest part of the economy. In the 1980s, the goods-producing sector of the economy grew at a rate of 0.2 percent a year while services grew at 3.8 percent a year.

Two other kinds of changes deserve notice because they are also significant in the structure of state tax policy. Americans are growing older. In 1940, less than 7 percent of Americans were over age 65. By 1990, their share had grown to 12.5 percent. The share of the population that has reached what we consider to be retirement age will continue to grow for the next 50 years.

Finally, not only has the nature of business production changed, but so has the scope. The most dramatic signs have been the rapidity with which the latest round of the General Agreement on Tariffs and Trade (GATT) followed the North American Free Trade Agreement—international business is more and more a visible, everyday fact. Exports of goods and services grew from 5.6 percent of gross national product in 1970 to 10.5 percent in 1991; imports have grown even faster.

Within the United States, a steadily increasing share of business transactions crosses state lines. Millions of homeowners send their mortgage payments to a bank in another state. Mail-order catalog sales have grown enormously. More and more businesses operate in more than one state. The local department store may exist in name, but it is likely to belong to a national conglomerate. National franchises have replaced mom-and-pop operations.

So far this is a familiar story. Its relevance for state tax policy is this: All three of the most important state taxes—the general sales tax, the personal income tax and the corporate income tax—have, to some extent, been made obsolete by economic and demographic change. States have tended to overlook the need for fundamental tax reform while the national economy has changed. States have tended to overlook the need for fundamental tax reform while the national economy has changed. State tax systems have been revised, updated and reformed to an extent that would be admirable if the American economy were still what it was in 1972. But tax policy has fallen behind the times.

What a Good System Is
It matters because the fundamental changes just described have distorted the workings of state taxes so that they no longer comport with reasonable expectations of what ought to characterize a state tax system:

Equity—Taxpayers who are in similar circumstances should be treated similarly, and dissimilar treatment should be reserved for taxpayers whose situations are dissimilar.
Promoting economic efficiency—As a rule, it is desirable to design taxes to have as little impact on individual and business decisions as possible. When taxes are intended to discourage or encourage specific behavior, they should be carefully targeted to their intended purpose.
Broad bases—Broad bases help to distribute tax burdens, and, by contributing to low rates, minimize the effect of taxation on the private sector's economic decisions.
Productivity—How much revenue a goverment should collect is a political issue, but whatever the decision is, a tax system should predictably produce that amount in order to prevent frequent changes to bases and rates to preserve the revenue stream.

The economic and demographic changes listed above have had specific consequences for state taxes.

State Sales Taxes
Sales taxes are a good example of how states have failed to adapt their tax systems to changes in the economy. In almost every state, sales tax bases remain, as they were in the 1930s, focused on tangible goods; in most states, they exdude most services. The shift toward production and consumption of services and away from manufactured goods has prevented the sales tax base from growing in proportaion to the national economy, requiring rate increases to maintain the relative productivity of the tax. Purchases of services are favored over purchases of goods, since goods are taxed and services are not. The tax is less stable and more regressive than a broader based sales tax would be.

Because more than half of the states enacted their current sales tax statutes during the 1930s, the tax base reflects the U.S. economy during the Great Depression. Most personal consumption at that time consisted of purchases of tangible property. Such services as existed (other than housing, education and utilities) were generally from manual labor. As a result, most sales tax systems became taxes on retail sales of tangible property, and they mostly excluded purchases of services.

Despite recent attempts in some states to broaden the sales tax base, service transactions still are generally untaxed. Because a growing share of consumer money is spent on services, this explains the fact that sales tax collections fail to grow in proportion to the economy. The average state sales tax rate grew from 3.54 percent in 1970 to 5.07 percent in 1992. Yet due to the narrowing of the tax base through enacted exemptions and increased service consumption, the substantial rate increase succeeded only in holding collections at a constant share of GNP. State sales tax collections were 2.7 percent of GNP in 1970, and they remained at 2.7 percent in 1990.

Excluding services from state and local sales and use tax bases raises policy issues beyond that of revenue productivity. Exclusion affects the neutrality of the tax by treating similar transactions in dissimilar fashion. A system that taxes the purchase of new items, but does not tax repairs, favors repairs over purchases. Exclusion of services also affects the stability of the tax during the economic cycle. A tax structure that includes only purchases of tangible personal property (especially one that exempts food for home consumption) is more sensitive to downturns in the economy than a more broadly based tax. Finally, the expansion of a sales tax to services can make the sales tax less regressive.

Personal Income Taxes
Changes in the U.S. economy and demographic patterns pose growing problems for the base and wquity of the state personal income tax as well as its responsiveness to personal income growth. A growing proportion of personal income goes untaxed because of specific federal and state decisions to give it preference.

The same is true of American workers' pay. Untaxed fringe benefits are increasing—health insurance, pre-tax contributions to pension plans, various forms of deferred compensation for retirement savings and flexible spending accounts. Since state income tax bases generally conform to the federal tax base, this income goes largely untaxed at the state level as well.

These benefits affect the equity of the tax because two workers can receive similar total compensation, but substantially different untaxed benefits. They will be treated differently because one worker enjoys more tax-exempt income than the other. Since there is a tendency for higher paid workers to receive more fringe benefits than lower paid workers, the exclusion of fringe benefits from income taxation reduces the progressivity of the income tax.

Exempting fringe benefits from income taxation while more compensation is made in the form of fringe benefits also reduces the responsiveness of income taxes to economic growth in the United States. The reason is that a greater proportion of that growth is used for nontaxable compensation.

In addition, many states provide special tax credits, deductions, exemptions and exclusions for certain kinds of income received by people over age 65, often without means testing. Such preferences pose a number of policy problems. Households headed by people over 65 are less likely than any other age group to be below the poverty line; 6.5 percent of such households were below the poverty line in 1992, as opposed to 11.5 percent of all American households.

Age-specific tax breaks, therefore, benefit a relatively prosperous group of people. They also benefit a growing number of people, as the American population ages. Such policies are not only inequitable, if equity requires similar treatment for people whose incomes are similar, but they will also be increasingly expensive as more of the population becomes able to take advantage of them.

In general, the proportion of American personal income subject to taxes is shrinking (although the dollar amount continues to grow). Tax-protected income such as social security, pension payments, welfare benefits and untaxed fringe benefits have grown from 14.3 percent of personal income in 1970 to 20.5 percent in 1990. Earnings and investment income have fallen as a percent of national personal income, while the kinds of income that are not so fully taxed have grown as a percentage of national income. Thus, state personal income taxes are being levied on a smaller proportion of total personal income than in the past.

Without changes in tax policy or patterns of compensating workers, the responsiveness of the personal income tax to growth in national personal income will steadily decline.

Taxes on Business
A third area in which change in the economy has outstripped state policy is the taxation of business. Current corporate income taxes were written largely with manufacturers in mind and are not as effective in reaching businesses that produce services. One reason springs from the difficulty of determining where provision of a service can be said to occur for tax purposes. Take an imaginary example: A New York advertising agency develops a TV ad campaign for a company in Chicago. The agency uses data stored in a computer in Massachusetts, and it has a design studio and some offices in Connecticut. As the campaign progresses, presentations sometimes are done by teleconference using a rented satellite uplink studio in Connecticut and sometimes in the client's Chicago office. So diffuse a set of activities was not envisioned in corporate tax law as it exists in most states.

Even for more traditional forms of production, the increase in interstate and international activity has created situations state business tax law was not designed to handle. Inconsistencies among the states allow for loopholes that interstate corporations can legitimately use to protect income from taxation. The rapid growth in interstate and international commerce confronts the states with questions about their authority to tax multi-jurisdictional transactions and businesses, the preservation of tax bases, and the distribution of the tax burden between companies that operate in only one state and those that operate across state lines.

Policies Create Problems
Finally, policies of the federal government and of state governments themselves have created problems. Federal preemption through statutes is one threat, a good example being the way that the Railroad Revitalization and Regulatory Reform Act preempted some aspects of state control of taxation and created a privileged position for railroads vis-a-vis other transportation industries. Federal courts also can limit state freedom to act, as the Supreme Court did in the Bellas Hess case, which limits states' authority to require out-of-state vendors to collect sales tax on items shipped into the state. The possibility exists that GATT may infringe upon state powers of taxation. State governments themselves can damage their tax systems with economic incentive packages that erode tax bases and shift tax burderns, thus raising issues of fairness.

What's To Be Done?
Given all these ways that state tax systems have failed to keep pace with economic change, what will happen? And what will legislators do?

Two things seem likely if states fail to modernize their taxes. Tax bases will become even less equitable, as the winds of change benefit some groups in the population and some kinds of business. Equity matters; taxpayers notice unfairness and have never been very patient with it.

Second, with tax bases becoming narrower, taxes will not grow in proportion to economic growth without repeated rate increases. State expenditures in recent years have tended to grow as fast as the economy or faster, driven by education and health spending. Proponents of higher education, welfare reform and more aid to local governments are likely to exert pressure for greater state spending and will push for tax increases. Proponents of smaller government could welcome taxes that produce slow revenue growth as a brake on government growth.

If state governments see these issues as problems to be solved, what can be done? Good analysis of state tax policy is the first step, since in some cases the statement of a problem suggests a solution. Financing State Government in the 1990s has some general recommendations:

Review the ways that changing economic conditions affect a state's tax structure. The kinds of structural issues discussed in this article have received little attention in state tax reform in recent years, a point made very clear in a recent report by Steven D. Gold and Jennifer McCormick, State Tax Reform in the Early 1990s. Although states continue to make personal income taxes somewhat more progressive and sales tax bases a little broader, they have ignored fundamental issues.
Consider state tax policy systemically, not as a set of unrelated components. State and local tax policy are intertwined; the progressivity of one tax can offset regressivity of another; scant use of one tax can require high rates from another.
Carefully evaluate the impact of economic development incentives upon state tax policy. Interstate competition for economic development can force states to grant incentives or shape tax policy in ways that may not be cost effective overall.
Cooperate with other states. States have preferred to go it alone, but the complexities of the modern economy, the pressures to grant economic development incentives and the dangers of federal preemption increase the value of cooperative efforts, state compacts and uniform state laws.

Specific Taxes
Recommendations with regard to specific taxes are harder to make since they have to be adjusted to individual situations in the states, but here are potential courses of action for policymakers to consider:

Expand sales taxes to more sales. Expanding sales tax bases to reflect economic change means expanding them to services. Florida and Massachusetts both did so on a large scale and then repeated most of them. There are a number of objections to extending sales taxes to business services: The sales tax is a tax on consumers and should not be levied on components of production; it could cause "pyramiding" since the taxes would likely be passed on through sales to ultimate consumers; and it could affect interstate competitiveness.
Sales taxes on consumer services are less likely to involve such disadvantages. In many states, substantial numbers of consumer goods have been excluded from sales tax bases over the years, and those exemptions can cost more than they are worth. For example, some tax experts point out that the exclusion of groceries from sales tax is an expensive way to benefit the poor since affluent people receive a greater gain.
Expand personal income taxes. Again, legislators should review exemptions, deductions and exclusions of income, asking whether the advantages offered to some are worth their cost in terms of equity and the higher tax burden that others must bear. Tax breaks for the elderly without adjustment for income levels need reconsideration. They will pose increasingly difficult questions of fairness across age groups as the number of elderly increases, and they will be more and more expensive in terms of lost revenue.

Reform for Reform's Sake
Legislators hardly ever attempt tax reform for its own sake. Reforms are more likely to accompany changes in tax rates because the change in rates conceals the shifting tax incidence that reforms produce. Reform for its own sake has high political costs and few friends. Anyone whose taxes will increase because of reform will doubt its value, and people who are promised tax relief through reform will be skeptical of the promise. A recent study that found some sort of tax reform in 39 states from 1990 through 1993 found only one state in which the reform was intended to be revenue neutral. Change for the sake of improving the system is rarely ventured.

But the accumulated distortions that a generation of structural economic change has caused in state tax systems require such efforts. If policymakers are to avoid continual patching and tinkering with state taxes, they need to look at fundamental issues and assumptions, and make fundamental revisions.

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