1

Lessons from Recent State and Local Tax Reforms

Presentation to Connecticut Legislative Program Review & Investigations CommitteeState and Local Tax Policy Forum

Robert Cline, National Director,State & Local Tax Policy EconomicsErnst & Young LLP, Washington, DC

October 26, 2005

2

Overview of CT Business Taxes

Business Tax FY2004 ($mil) % of TotalProperty Tax $2,204 36.9%Sales Tax on Business Inputs 1,524 25.5%Unemployment Insurance Taxes 621 10.4%Gross Receipts Taxes 421 7.1%Ind. Income Tax on Business Income 397 6.7%Corporate Income 338 5.7%License and Other 242 4.1%Excise and Selective Sales Taxes 220 3.7%Total Business Taxes $5,966 100.0%

3

CIT: A Very Unstable Tax (US)

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Year

Percent Change (Year-over-year)

Total State-Local Taxes

Corporate Taxes

4

Business Tax Bases

Revenues $1,000,000

Less: Cost of Goods Sold Labor (1) $400,000 Purchases from other firms $100,000 Total costs of goods sold $500,000

Gross Profits $500,000

Less: Other Expenses Labor (2) $100,000 Purchases from other firms $300,000 Total other costs $400,000

Net Income (3) $100,000

Value Added Labor (labor #1 plus #2) $500,000 Capital (net income #3) $100,000 Total payments to factors $600,000

Corporate income tax

Income Statement Concept

MI SBT, NH BET

Amount

OH CAT, NJ AMA, Sales Tax

NJ AMA alternative

Wage tax

Wage tax

Type of Tax

5

Case Study: Ohio Tax Reform Objectives• Number one objective: grow the economy by

improving business tax competitiveness • Reduce the tax burden on capital investments,

increase taxes on consumption• Impose more uniform (and stable) taxes on all

industries and forms of doing business• Reduce out-of-line personal income taxes (top

state + local marginal rate of almost 11%)• Deal with an expiring 1% temporary sales tax

increase -- $1.5b problem

6

Ohio Tax Reform Features• Phases out corporate franchise tax (income & net worth

components) -- 5 yrs.

• 5-yr. phase out of business tangible personal property tax (immediate elimination for new machinery & equipment purchases).

• Uniform 21% reduction in personal income tax rates

• Permanent 0.5% increase in sales tax

• Phases in new 0.26% CAT on sales over $1m for most businesses (excluding financial services and insurance); min. fee of $150 (sales from $150,000 to $1m); no gross receipts cap

7

Commercial Activity Tax (CAT)• CAT applies to both C-corps and pass-through entities• Destination-based tax: exempts exports but taxes

imports – no P.L. 86-272 nexus protection • Excluded from base: interest and dividends• Partial pyramiding relief by eliminating intercompany

sales among firms in a consolidated group (elected)• Addressed balance sheet impacts of changes by

allowing limited carryover of unused NOLs • Brightline nexus test (MTC): at least $50,000 of property

or $50,000 of payroll or $500,000 of taxable receipts• Solves the Cuno problem – converts tax credits to grants

8

Why Did Reform Happen in Ohio?• Terrible economy: loss of 200,000 manufacturing jobs• Long-running public debate over tax reform &

business competitiveness – “system is broken”• Proactive role of the business community: lead by

Ohio Business Roundtable and sharply focused on growing the economy – evaluated options for reform

• Leadership of Governor and legislature• Need to replace temporary 1% sales tax revenue• No balanced-budget constraint – $3.7b tax cut by

2010 (financed by spending constraints & econ. rebound); no tax-expenditure limits

9

Tax Reform in Other States• Kentucky Reforms

– New law adopts a corporate AMT equal to smaller of .95 mills times gross receipts or 7.5 mills times gross profits (NJ AMA-type tax); firms pay higher of regular, AMT or min. fee ($175)

– Mandatory consolidated returns; extends tax to pass-thru entities; top rate lowered to 6% (from 8.25%)

• Texas Proposals – Looking at alterative business tax bases: payroll, gross

receipts, value added, net worth and profits– Or all of the above?

• Michigan Governor’s Proposal– Provide a 35% SBT tax credit for manufacturing personal

property, increase profit component of the tax, go to a 100% sales factor, broaden the base and shift insur. to GRT

10

Tax Reform in Other States (cont.)• Pennsylvania Proposal

– Lower CIT rate from 9.99 to 6.99%, accelerate phase out the capital stock and franchise, 100% sales factor

– Focus on creating jobs (dynamic feedback effects)

• Indiana Reforms (2002)– Repealed gross income and supplemental inc. taxes;

expanded ITC and R&D credits– 60% reduction in school real property taxes; phase-

out of inventory tax

• Tax studies in progress: NY, OK, Utah• MD debating AMA and combined reporting

11

Property Taxes• Revolt on the near horizon?

– Possible proposition 13 in Idaho; KS & TX court rulings; reductions debated in Iowa

– Reduction in FL intangibles tax; IN 60% cut in school real prop. taxes; Ohio eliminates business tangible per. prop. tax

• CT Urban Rankings (MN Taxpayers Assoc.)– Homesteads: 2nd highest (84% above ave.)– Commercial: 14th highest (33% above ave.)– Industrial: 9th highest (35% above ave.)

• State vs. local property tax relief

12

Value-Added Taxes: MI’s SBT

• 44-yr. “experiment” with a modified VAT• Pluses:

– Broad-base, low-rate tax (1.9%, no increases)– Very stable, base falls 1/5 as much as profits – Uniform tax on all forms of doing business– Encourages capital investment (CAD)– No pyramiding (does not tax bus. purchases)– Indirect way to tax services– Replaced other taxes: inventory,net worth,CIT

13

Value-Added Taxes: MI’s SBT (cont.)• Minuses:

– What is it? Consumption or business tax?– A destination-based VAT may be borne by

consumers in higher prices (STN,12/25/95)– Uniform tax on all forms of doing business:

heavier taxes on non-corp., low-profit, labor-intensive businesses (services & retail)

– Issues related to apportionment (90% sales) and nexus (P.L. 86-272 does not apply)

See: “Should States Adopt a VAT?” in Unfinished Agenda for State Tax Reform, Steve Gold, ed.,1988

14

Lessons Learned

• There is no “best practice” tax system that CT can copy from another state, but trends are evident– Reduce taxes on mobile capital– Increase importance of consumption taxes– Reduce volatility of tax bases

• Reform needs to address specific CT issues• Reform must look at the system of taxes

– State and local taxes

– Business taxes

15

Lessons Learned (cont.)• If economic development is a key

objective, evaluate the impacts of different alternatives on CT’s competitiveness– Dynamic feedback analysis: Ohio, KY, MN,

MA, PA– Focus on benefits to private sector

• Appreciate the difficulty in expanding sales tax bases to include services – primarily a bus. tax (See Cline et al., STN, Feb. 14, 2005)

• Business pays almost 50% of CT sales taxes (COST study, STN, May 9, 2005)

16

Lessons Learned (cont.)

• Need to look more closely at economic (“final) incidence – who ultimately bears the tax burden– Who pays the corporate income tax?– Who pays the gross receipts tax?

• Need to recognize tax convergence– 100% sales factor apportionment of CIT– GRTs vs. sales taxes – Nexus considerations: sales tax and CIT

17

Where Are Business Taxes Headed?• State reforms are reducing taxes on capital

investment (corporate income, net worth, property, input sales taxes) making states more competitive – focus is on economic development

• Will Congress intervene? ITFA, BAT bill, remote sales tax collection, Cuno

• States should consider using stronger revenue growth as an opportunity for longer-run reform or, at least, to unwind recent anti-business tax policy decisions

• Business and government should work closely in developing business tax reform proposals