State tax systems are in trouble. Revenue collecting methods developed more than a half century ago are straining to deal with 21st century economies. Globalization and e-commerce are changing the way people work and purchase goods; devolution has steadily shifted responsibility from the federal government to the states; tax incentives have become the weapon of choice in the battle to attract business investment. All of this, in an environment where antitax messages have become a staple of political campaigns, have made creating tax policy more challenging than ever before. In the updated third edition of State Tax Policy: A Political Perspective, David Brunori analyzes these and other critical challenges facing state governments. He identifies the important issues, and examines possible solutions in formulating and implementing state tax policy.
About the Author
David Brunori is a journalist, author, educator, and lawyer who specializes in tax and government issues. He is the Deputy Publisher at Tax Analysts. In addition he serves as contributing editor to State Tax Notes magazine for which he writes the Politics of State Taxation, a weekly column focusing on state and local tax and budget politics. He is a Research Professor at the Trachtenberg School of Public Policy and Public Administration at The George Washington University where he teaches courses in state and local public finance and fiscal federalism. He also teaches state and local tax law at the George Washington University Law School. He has published numerous books and articles on state and local tax policy. His book State Tax Policy: a Political Perspective, won the 2001 Choice Award. He served as an appellate trial attorney with the Tax Division of the United States Department of Justice and practiced with a Washington DC law firm. He served as a David C. Lincoln Fellow at the Lincoln Institute of Land Policy from 2001 - 2004.
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The Importance of State Taxation
The ability of existing tax systems to adequately finance state governments has been the subject of considerable debate and discussion over the past three decades. Indeed, volumesincluding the first two editions of this bookhave been written describing the serious problems facing state taxation (Brunori 1998; Murray and Fox 1997; Sjoquist 2003; Snell 2004; Wallace 2010; Zodrow and Mieszkowski 2008). Many of these works warn of an impending crisis (Gold 1986, chapter 2), question the viability and in some cases the "survivability" of a particular tax (Fox 1998; Mikesell 1998; Pomp 1998), and suggest courses of action for saving the state tax system (Hellerstein 1998). The issue of state tax adequacy was heightened during the recession of 2008, the effects of which linger as this book goes to print.
That scholars and policymakers have weighed in on the fragile condition of state taxation is not surprising. The state tax systems in use today, after all, were implemented over 70 years ago. Their fundamental structure, however, has remained largely unchanged. The sales and personal income taxes, the two dominant sources of revenue available to the states, were developed during a different time to raise revenue in a vastly different economy. The sales and use tax began as a temporary revenue measure during the Great Depression. The personal income tax was implemented more than a generation before that. The other taxes levied by state governments (corporate income, excise, inheritance, and property) are just as old as, or in some cases older than, the sales and use tax. In many respects, the tax systems used by state governments today reflect the economy of the 19th century more than that of the 21st century.
New Challenges for State Tax Systems
There is an old shibboleth among tax lawyers that an old tax is a good tax. Unfortunately, the tax systems constructed by state governments in the past are often inadequate for raising revenue today. While state taxes have remained essentially unchanged, the economy has moved from a manufacturing base to one dominated by services and intellectual property. In this new economy, businesses, even small companies, no longer produce and sell products in one or in a few states, but throughout the nation and the world.
Electronic commerce has revolutionized how people work, play, and communicate. The economy in which people primarily bought locally manufactured goods no longer exists. In today's high-technology, global economy, the ability to purchase services or products from anywhere in the world is just a few keystrokes away.
To be sure, states are still collecting revenue. But state tax systems are not as efficient as they should be. The prosperity of the late 1990s led to record budget surpluses in most states. The recession at the end of the first decade of the 2000s in turn led to record budget deficits. State tax structures are incapable of dealing with economic swings.
Questions about the systems' efficiency are pressing, as state taxes have never been as important as they are today. State governments are providing more public services than ever. In addition to traditional services (e.g., state police, prisons, higher education, and highway maintenance), states are delivering many services once supplied and paid for almost exclusively by the federal and local governments. It is not surprising, then, that state governments have been raising unprecedented amounts of money. This growth in the importance of state taxation largely reflects several political and economic developments.
Devolution of Responsibility to the State Level
Since the 1980s, the federal government has been steadily shifting more responsibilities to the states, a phenomenon commonly called devolution in academic circles. States have been asked (or, in many cases, required) to administer and pay for many programs that traditionally were the responsibility of the federal government. Welfare, Medicaid, and highway maintenance are a few examples in which the states have replaced the federal government as the administrative body responsible for providing services. The war against terrorism has further complicated subnational finances, requiring state and local governments to spend more on public security than ever before. Although the costs of assuming many of these programs have been offset by increased federal funding and protections against unfunded mandates, devolution has contributed significantly to the recent growth in state government budgets.
Along with this shift in responsibility, political pressure and a flood of legal challenges have prompted state governments to take on an increasingly greater share of the cost of public education. While the federal government was traditionally responsible for elementary and secondary education, state governments have paid a decidedly greater percentage of school finance costs over the past two decades. Some states, such as Michigan, finance virtually all elementary and secondary education.
Two primary developments explain the increased state funding of public education. First, the property tax revolts of the late 1970s and early 1980s seriously curtailed the ability of local governments to raise revenue. Thus, many state governments were forced to provide additional financial assistance to local school districts laboring under tax limitations.
Second, and perhaps more significant, legal and political challenges to the constitutionality and fairness of how local governments fund schools became increasingly common in the 1970s and 1980s. Wealthier school districts with larger tax bases could provide more money for educating their students than could poorer school districts. In many states, the wide gap between per pupil spending by rich and poor school districts led to political protest and legal challenges. Many state supreme courts ordered their state governments to distribute school spending equally between rich and poor districts. No other development has burdened state budgets more than the shift in public education financing.
The Politics of Antitaxation
In addition to the pressures of shifting financial responsibilities, states have experienced what can be called the politics of antitaxation. Since the late 1970s, a concerted effort to politicize, even demonize, taxation has been under way. This often-fervent antitax sentiment is evident at all levels of government. Antitax politics fueled the passage of Proposition 13 in California and spurred property tax revolts around the country. Presidential and congressional candidates from both parties began to use taxes as a central part of their campaigns. Tax cuts became a regular theme for gubernatorial and legislative candidates seeking election in virtually every state. These developments helped spawn the initiative and referendum movement, which has traditionally been dominated by antitax crusaders (Brunori 1999k).
The politics of antitaxation have limited state governments' ability to raise revenue precisely when the demand for services and education spending has increased. This paradox has forced state revenue departments to squeeze more from the existing tax laws. State revenue departments have by all accounts become more aggressive in their auditing and litigation. This vigilance, in turn, has led businesses to increase spending on state tax lawyers and accountants for auditing and planning purposes.
Another reason for the increased importance (from both the taxpayers' and the government's perspectives) in state and local taxation is that many corporations now pay more in combined state and local taxes than in federal taxes. This trend began in 1981, the first year many corporations paid greater state taxes than federal taxes, and has continued throughout the 1990s and 2000s. As a result, the business community is spending more resources on lobbying, auditing, planning, and litigating state tax issues. The increased attention to state taxation by the business community is illustrated by the often-contentious debates over the taxability of electronic commerce, corporate profits, and business inputs.
Concern with Economic Development
State tax policy has also grown in importance because of its use as an instrument to foster economic development. Over the past 40 years, state governments have wastefully competed against each other for business investment and jobs. In particular, political leaders have used their tax laws to encourage companies to relocate to (or to remain in) their states. The use of tax incentives to encourage economic activity generally violates the principles of sound tax policy (see Brunori 1997). This interstate competition (well documented in the academic and professional literature) has had undesirable effects. In addition to shrinking the tax base, it has pitted states against each other in the endless quest for economic development and job growth.
The Continuing Importance of State Taxation
The political and economic pressures on state revenue systems have not changed the fundamental purpose of state taxation. State governments need revenue to fund the services sought by their constituents. This statement may appear obvious, but a surprising disconnect between providing public services and raising the revenue to pay for those services has plagued the government sector. The political rhetoric criticizing taxes and government spending masks a simple truth: services cannot continue without proper funding. For example, even the most ardent antitax advocate would agree not only that public safety must be maintained, but also that roads must be constructed and repaired. Moreover, the majority of citizens would concur that state police officers and other essential government employees must be paid, and that important government services such as higher education must be funded. These obligations need to be met along with federal mandates, the challenges of devolution, and increased public school financing responsibilities. Not surprisingly, given the importance of such services, the nation's legislators and governors have broad support for their efforts to ensure that state governments are adequately funded to meet the public's demands.
Just as citizens will continue to demand services, state governments as they have throughout historywill need to find the revenue to pay for these programs. In the past, state political leaders have proved resourceful in financing government services despite the often-significant political and economic challenges to state tax systems.
Thus, the question is not whether states will raise the necessary money, but from which groups the funds will be collected. State and local governments generally impose taxes on consumption, income, and property. Each of these tax categories has different effects on various segments of society. Some taxes fall more heavily on the wealthy (progressive income taxes), while others fall more heavily on the poor (regressive sales and use taxes). In addition, some taxes are perceived to harm business and economic development (corporate income taxes). Determining who bears the burden of paying for government is an important political question.
Public leaders face a difficult task: They must raise the requisite revenue, often by overcoming political opposition to taxes in general. In setting tax policy, they must weigh various concerns from constituents, business interests, and a myriad of organizations representing the poor, unions, and environmentalists. They must deal with interstate competition, economic development, and tax relief for politically sympathetic groups such as veterans, the elderly, and children. While state taxation has never been more important, formulating state tax policy has never been more difficult.
A Look at State Tax Policy
The purpose of this book is to examine the issues political leaders face when developing and implementing state tax policy. It will discuss the basic concepts of state taxation, including the theoretical underpinnings of policy and its real-world applications. This book will not turn the reader into an expert in state public finance; no single work can. Nor does it address every issue involved in state taxation. Again, no single work can accomplish that. Rather, the goal is to analyze the critical tax policy issues facing state governments. Each chapter addresses a particular tax issue, the problems it has posed, and ideas on possible solutions in formulating and implementing state tax policy.
One of the most important questions facing state tax policymakers and political leaders is identifying the benchmarks against which the merits of a particular tax system can be measured. This question goes to the heart of what citizens, by electing particular officials, hope to achieve through their state tax laws.
Chapter 2 discusses what is widely referred to as classic tax policy. Classic tax policy sets forth certain principles that can lead to viable revenue systems for all levels of government, including states. These principles, which hold that tax systems should be fair, efficient, stable, and accountable, have long been advocated by economists, political theorists, and state tax administrators.
Interstate Competition and Taxation
One of the greatest threats to a fair and efficient tax system is the inexorable quest for economic development. Chapter 3 addresses the relationship of economic development and the formation of state tax policy, a topic long debated in academic and policy circles. The chapter argues that state tax competition for economic development is a worthwhile public policy objective because it leads to innovation, experimentation, and efficiency. Such competition, however, must be conducted within a principled approach to ensure accountability. Interstate competition that aims to lower the burden for all taxpayers while ensuring the provision of necessary public services can have long-term, beneficial effects on a state's economy.
Significantly, chapter 3 also examines the less desirable forms of interstate tax competition that have proliferated over the past 30 years namely, targeted tax incentives aimed at particular industries or individual companies. Targeted tax incentives are portrayed as an unthinking response to the perceived political pressure to create jobs and spur economic development. The chapter concludes that targeted tax incentives violate the principles of sound tax policy.
Chapter 4 explores the political interests that influence tax policymaking in the states. Tax policy plays a role in both electoral and legislative politics. It has been an integral part of state elections over the past 30 years. Numerous governors and legislators have captured or lost public offices because of their position on how states should tax citizens. Virtually every election cycle features at least one statewide campaign in which taxes are the dominant issue.
Tax policy plays an even greater role in the legislative process. Business, public interest, labor, and education organizations routinely lobby state legislators on tax issues. The influence of large corporations (which employ many people), campaign contributors, and constituents on state tax policy is enormous.
Citizens, however, have also become an increasingly powerful force in the tax policymaking arena. Nearly half the states allow citizens to initiate and directly vote on tax policy issues. Over the past 30 years, policymakers have increasingly used this practice, known as direct democracy, to set tax policy. Since the 1990s alone, citizens have been asked to vote on more than 250 tax-related issues. And the number of tax-related ballot issues increases every year. The use of initiatives and referendums to set tax policy raises many questions for state governments. In particular, should state tax policy be determined through a popular vote? Do citizens possess enough information to make educated decisions? Are taxrelated initiatives more vulnerable to the demands of special interests than are tax policies set by legislation? As chapter 4 indicates, the implications of such initiatives for state governments are far reaching.
Pressure on State Taxes
Beginning with chapter 5, the book examines policy issues presented by specific types of taxes. Although the analysis provides some information on the policy design of these taxes, the focus is on the economic, political, and social issues that arise in levying these particular taxes.
Sales and Use Tax
Chapter 5 reviews one of the mainstays of state revenue systems, the sales and use tax. An important component of most state tax systems for more than 60 years, the sales and use tax accounts for nearly a third of state tax revenue. In today's demanding economy, however, the sales tax is under intense pressure.
In 1998, for the first time since the Great Depression, the personal income tax replaced the sales tax as the single most important source of state revenue. The continuing pressure on the sales tax is the result of electronic commerce, the shift to a service-based economy, and the political pressure to exempt broad categories of products traditionally considered taxable. Many observers also view the sales and use tax as the most unfair of all state taxes.
Personal Income Tax
Another important source of revenue is the personal income tax, which accounts for about a third of state tax revenue. Unlike the sales and use tax, which is under constant pressure, the personal income tax is enjoying unprecedented growth. It also has widespread public support. As discussed in chapter 6, the personal income tax raises a tremendous amount of revenue and is perceived by many as the fairest of all state levies. Nonetheless, imposing state personal income taxes raises several important policy issues.
Corporate Income Tax
Chapter 7 looks at the corporate income tax, perhaps the most controversial of the state taxes. The corporate income tax accounts for less than 6 percent of state tax revenue. State governments and taxpayers, however, spend considerable resources administering and complying with the tax. Although experts cite several important reasons for taxing corporate income, the tax has continued to shrink as a source of revenue. This decline is partly a result of more professionals dedicated to tax law and more advanced planning by businesses to avoid corporate tax liabilities. It can also be attributed to the significant political pressure for states to grant tax breaks to corporations. Several factorsincluding the relatively small amount of revenue collected, the considerable cost of collecting the revenue, and the draconian steps required to revive the taxhave led many to question the tax's long-term viability.
Other State Taxes
Chapter 8 describes the other categories of taxes imposed by states. Of these categories, state property taxes and death taxes generate very little revenue (less than 5 percent of total state revenue). Yet these taxes consume considerable compliance and administrative resources. In addition, they often create political problems for elected leaders.
Specialized excise taxes, one of the oldest sources of state revenue, account for approximately 20 percent of total state tax revenue. Many economic and political questions surround the use of various excises. Unlike income and sales taxes, excise taxes can promote social policy objectives while raising substantial revenue. For example, excise taxes on alcohol and tobacco could limit consumption of those substances. Excise taxes at the gas pumps will likely encourage fuel conservation. These kinds of social policy objectives, however, conflict with the notion that taxation should have a neutral effect on the market. These taxes are also widely regarded as regressive and offering little potential for sustained revenue growth.
Nontax Revenue Sources
The states collect only about 40 percent of their total revenue through taxes. As explained in chapter 9, the nontax revenue sources used by state governments include intergovernmental aid, lottery revenue, and fees and licenses. These sources of nontax revenue are important to discussions of tax policy. The availability of such revenue enables states to devise shortterm funding strategies as they consider ways to address long-term problems. For example, states can postpone implementing the politically difficult measures necessary to strengthen consumption and business taxes. But as discussed in chapter 9, the states' ability to rely on alternative revenue sources is inherently limited.
The concluding chapter addresses the policy issues presented by the two most important economic developments since the Industrial Revolution: the globalization of markets and the advent of electronic commerce. Together, these developments will continue to affect all aspects of society. State policy and political leaders are well aware of the threats the new economy presents to their revenue systems. State governments have already lost considerable tax revenue as a result of electronic commerce; they could lose much more.
Less understood are the effects of international trade and global commerce on tax systems. The removal of governmental trade barriers, the mobility of capital, and the expansion of emerging economies will continue to hasten the growth of global trade. National borders will cease to be relevant. This increase in global trade will challenge state taxation systems in unprecedented ways. For example, international trade agreements may limit state taxation of foreign commerce, particularly corporate taxes. In addition, the rapid flow of goods across borders and the mobility of capital will make identifying the source of transactions and, thus, sales and income taxes, more difficult. The mobility of world capital will also increase pressure on states to compete with foreign national governments. Chapter 10 contains five commonsense policy recommendations for states to consider as they address the issues facing their beleaguered tax systems. These policy recommendations do not involve significant tax reform or large costs. Although substantial tax reform may ultimately be necessary, these modest policy recommendations offer legislators and policymakers a broad framework for considering state tax policy. The recommendations can be implemented without cost or controversy and could help lead to more effective, and more equitable, state tax systems.
Table of Contents
1 The Importance of State Taxation
2 Principles of Sound Tax Policy
3 Interstate Competition for Economic Development
4 The Politics of State Taxation
5 Sales and Use Taxes
6 State Personal Income Taxes
7 Corporate Income Taxes
8 Other State Taxes
9 Other Sources of State Revenue
10 Policy Recommendations for State Policymakers
About the Author