COMPETITION, COMPLEXITY AND CONSTRAINTS:
THE EVOLVING NATURE OF STATE AND LOCAL TAX SYSTEMS
Matthew N. Murray
Professor, Economics and
Associate Director, Center for Business and Economic Research
The University of Tennessee
100 Glocker
Knoxville, TN 37996-4170
865-974-6084 (voice)
865-974-3100 (fax)
November 2002
Prepared for the National Tax Association’s 95th Annual Conference on Taxation, Orlando, Florida. Thanks to Don Bruce for comments on an earlier draft.
Introduction
State and local tax systems are at risk from a variety of sources. There are growing concerns over the viability of the corporate income tax due to tax planning (Pomp, 1999), incentives (Fisher, 2002) and other factors like sales-dominated corporate income apportionment formulas and the introduction of limited liability companies (Fox and Luna, forthcoming). The sales tax continues to be threatened by mail order sales, the expanding service sector and remote sales through electronic commerce, as well as policy changes that narrow the base to support economic development and equity objectives. The local property tax is subject to base erosion through exempt properties, tax abatements and equity provisions like circuit breakers. The increasingly tenuous linkage between the property tax and education finance may increase taxpayer’s distaste for the tax and further limit its role in local government finance. The personal income tax does not appear to face immediate challenges of the same magnitude. But important pressures remain, including mounting concerns over the disincentive effects of progressive tax rates. Tannenwald (2001) surveys the overall landscape and asks whether our system of state and local finance has become obsolete. Brunori (2001) suggests the role played by local governments in our federalist system is in danger.
The system of state and local government finance in the US is not broken. But there are serious problems and a concerted effort will need to be made to salvage this system for the future. It will not be easy. We are where we are today because of long-term economic forces and discretionary changes to tax structure that will be difficult if not impossible to reverse. This paper discusses some of the broad forces of influence on the evolution of state and local tax structure and speculates on the consequences for the future of subnational government finance.
Three factors have been instrumental in shaping the evolution of tax structure over time and the nature of tax burdens that individuals and firms now confront.[1] First is the economic environment within which state and local tax systems operate. This environment, which influences heavily revenue productivity, has change markedly with the introduction of new technologies and increased competition arising from deregulation, globalization and freer trade. Potentially enhanced factor mobility coupled with tax planning opportunities facilitates the behavioral responses to taxation and increases avoidance and evasion opportunities. In some ways these changes threaten the viability of taxes that historically have been structured on either a destination or origin basis that reflects the traditional jurisdictional boundaries of state and local governments. But in another respect it simply changes who pays and how much is paid in taxes regardless of the basis for taxation. Second is the influence of political competition and the desire of elected officials to satisfy voter preferences on the level and mix of taxes. One consequence is that the structure of state and local taxation has become more and more complex with the passage of time, with tax burdens becoming more and more unique to specific taxpayers. While complexity can easily be criticized the revealed preferences of voters suggests it is a price taxpayers are willing to pay to achieve general policy objectives and more specifically define tax prices and tax burdens. Undoing complexity--broadening tax bases, eliminating exemptions, flattening rates--will face staunch political opposition. Finally there are constraints on tax policy options, both those emanating from long-standing constitutional limitations on taxing authority and others like Proposition 13 arising from choices made by voters and politicians. These constraints coupled with a competitive economic environment and an increasingly complex tax system that benefits individual taxpayers will necessarily limit options available to policymakers to finance services far into the future.
Competition, Technology and Mobility
The environment within which state and local tax systems operate seems to be changing at an increasingly rapid pace. The environment has never been completely stable and state and local tax structure has frequently confronted challenging times, like the devastating recession of the early 1980s. But such events were largely temporary or cyclical in nature; they did not represent long-run changes in the fundamental tax structure environment nor did they have a direct and lasting impact on revenue productivity.[2] Even the growth of the service sector did not compromise the sales tax as might have been expected some 20 years ago. Changes in economic structure (especially growth in intangibles) and greater market competition will mean relatively slower revenue growth.
The situation seems radically different today. Technology has certainly increased competition and likely factor mobility as well. Many new technologies represent a problem for state and local tax systems since they support inputs or outputs that are inherently intangible. Technology may allow production to take place from multiple locations compromising origin-based situsing of economic activity and tax bases. Similarly, consumption and use is easily obscured making it difficult to enforce destination-based taxes like the sales tax. Intangibles are not new but technologies like the Internet exacerbate the problem of observing the tax base and enforcing compliance with both direct and indirect taxes. Intangibles also are a potentially growing share of corporate value and may have consequences for the base of the local property tax as well. The technology used in production and marketing has more locational options than has ever been the case before and is thus much more mobile than traditional brick and mortar inputs to business activity. At the same time business and household consumers have greater choice in purchasing productive inputs and consumption items. Greater urbanization (particularly along state borders) leads to more localized interjurisdictional consumption and residency options, while the Internet allows access to global markets.
While hard evidence has yet to surface anecdotes and speculation together suggest an increasingly mobile and tax-sensitive population, particularly for higher income taxpayers. States are talking about how high tax rates, especially high nominal marginal tax rates, can discourage residency and economic development. An example is Montana which recently considered lowering its top bracket income tax rate of 11 percent to 6.9 percent to help overcome the perception problem. The ability to support progressive tax rates is being questioned and one must wonder if a race to the bottom is around the corner.
Free trade in the global arena did not exist 20 years ago. Numerous formal and informal barriers to trade remain today, but markets are clearly less fettered than they used to be. Free trade agreements and the dissolution of the former Soviet Union have created new competitors for domestic business and the domestic labor force. Much of this reflects trade in good old-fashioned tangible goods. Nonetheless a result is that industry has less international pricing influence while at the same time domestic workers have less union influence on wages and compensation packages.
Absent the same profit and rent-seeking opportunities in the now highly-competitive marketplace, agents will squeeze the margin they can. Today domestic taxes, particularly state and local business taxes, are subject to the big squeeze. The state corporate income tax offers the best evidence through the rise of effective tax planning strategies including domestic and off shore tax havens and corporate tax inversions. Intangibles, including trademarks and corporate logos assigned to loose affiliates in tax haven states, are proving to be a critical element of the tax planning strategies. Few would argue that business taxes have ever represented benefit taxes. Historically they simply have been a convenient means of generating tax revenue, but competition will continue to erode the role business taxes play in state and local finances.
The wave of deregulation in the US economy is also increasing competition and hence imparting a separate downward influence on taxes. Onerous property and gross receipts taxes, as well as discretionary diversions of revenue from state and local utility monopolies, no longer can be sustained under deregulation. This means a direct revenue loss for state and local governments and diminished opportunities for tax exporting. An important indirect behavioral effect may limit if not preclude revenue replacement in the face of deregulation, translating into still lower levels of spending. There is some evidence (e.g., Dowell, 2000) that taxation of regulated industries has given rise to a flypaper effect, with the monopoly revenue effect on government spending dominating the effect of own-income on spending. Thus deregulation of state-owned and state-regulated monopolies will reduce fiscal illusion, lead to lower expenditures and a relatively smaller public sector. Census data show that utility revenue was 7.3 percent of state and local general revenue in 1992/3, falling to 5.7 percent in 1998/99; public utility revenue fell from 2.4 percent of state and local tax revenue to 2.1 percent over the same period.
Competition is increasing while at the same time some sources of fiscal illusion are in decline. Tax prices, especially for mobile taxpayers, are becoming clearer and clearer. For many businesses the excess of tax over benefits received is being reduced. So far there is no evidence that competition is constraining state and local government spending programs, a trend easily masked by the strong economic and revenue growth of the last decade. Ultimately competition and less fiscal illusion will put downward pressure on the size of government. Independent of other trends and factors this should yield a better model of fiscal exchange.
Political Competition and Tax Structure Complexity
We certainly ask a great deal of our tax system. Progressive personal and corporate income tax rates and targeted exemptions and deductions, tax incentives for business, preferential sales tax treatment of food and clothing, circuit breakers and homestead exemptions under the property tax are just a few examples. Some of these policies are pursued to benefit constituents and voters, as with the sales tax treatment of food, whereas others are in part a response to competition, as with tax incentives nominally implemented to promote economic development. Many struggle to understand why such policies are put in place as they often seem focused on narrow special interests and are far removed from more efficient alternatives that could support the same policy. Perhaps term limits have reduced legislative experience in understanding the issues and the tradeoffs, a view I have heard from state legislators. For example, how many elected officials (or students of public finance for that matter) understand the double-weighted sales factor for corporate income apportionment or know what a corporate inversion is? The fact is that policy is heavily driven by political considerations and vote seeking behavior rather than hard-headed reasoning. But over time one would hope that taxpayers and politicians have learned some important lessons about tax policy alternatives and their consequences. The question ultimately is whether voters are getting what they want through a system that yields more and more tax structure complexity. If the answer is yes, reversing complexity will be exceedingly difficult.
Some examples can illustrate the point. Consider first the sales tax and the pursuit of equity. Sales tax holidays and clothing and food sales tax exemptions are good examples of politics driving tax policy. The complexities and potential problems associated with sales tax holidays are now being documented (Hawkins and Mikesell, 2001). The typical holiday applies to specific categories of goods sold during a brief period of time, complicating compliance and enforcement, and potentially enabling manipulation by vendors. The loss in revenue for clothing and food exemptions far exceeds what would be needed under a targeted program focused on the needy. Administration and compliance costs can be increased substantially and in interesting ways. For example, with food exemptions decisions have to be made on the tax status of snacks like Twix bars and marshmallows, 1 donut versus 6 donuts, and so on. The seemingly obvious approach--target relief through a direct tax or another direct mechanism--falls on deaf ears. The public seems to like these programs.
Another good example is the property tax, and a specific case of complexity arises in Maine. Property taxes in Maine are relatively high in part because of the absence of scale economies in service provision and the presence of service center communities that have high expenditure responsibilities relative to their revenue raising capacity. Property values have risen due to tourism, the re-location of retirees and the presence of temporary seasonal residents. So Maine has introduced a homestead exemption to benefit all taxpayers. Maine has always had a strong taste for equity, so additional property tax relief is offered under the circuit breaker program funded by the state. But neither of these programs provide relief to business. High property tax rates that fall on business personal property have created concerns over the disincentive effects of the so-called local property tax. So the state has enabled local tax increment financing and has implemented the Business Equipment Tax Reimbursement (BETR) program to reduce the burden of the personal property tax. The irony is that businesses can double dip as Mainers say, i.e., firms can benefit from both programs at the same time. Some view BETR as an incentive whereas the reality is that it is an entitlement program as all firms in all sectors can enjoys its benefits. The net result is a complicated system that offers different taxpayer groups different degrees of property tax relief and different effective rates of taxation.
Third are incentives often motivated by the need to promote economic development in the face of increased market and interjurisdictional fiscal competition. Some incentives, like the BETR program in Maine, are entitlement programs available to all firms, while some incentives are targeted to specific firms, sectors or types of economic activity. There is no good evidence that incentives come close to paying for themselves through economic development effects. Moreover, since programs are quickly mimicked by other states, as with the double-weighted sales corporate income tax apportionment formula and LLC enabling legislation, incentives simply lower the tax playing field and raise concerns of a different race to the bottom. Politicians chant the mantra that they are giving away something they never had when they grant an incentive to a newly locating firm. Because of all the influences on state and local budgets it is not easy to see the way in which incentives erode revenues, shift tax burdens to others and affect the spending side of the budget. But they do influence how much firms pay in tax. As Wilson’s (1999) survey shows, the net result of horizontal competition is likely a government that is too small.