September 5, 2007
How should states tax business?
As much of the Midwest economy struggles to boost its economic performance and as Midwest governments try to maintain funding for public services, the subject of state and local business taxes arises. This summer, the state of Michigan replaced its innovative but contentious “single business tax” with two lesser taxes, one on business income and the other on business gross receipts. Meanwhile, Illinois’ Governor Blagojevich proposed a hefty tax on business gross receipts that was to begin in 2008. That tax proposal was defeated even as the Governor railed against the interests of high-powered lobbyists “who eat fancy steaks” and “shuffle around in Gucci loafers.” These and other new developments in state–local business taxation will be discussed and analyzed by some of the nation’s leading tax experts at a Bank conference this coming September 17.
What are business taxes, and how should they be viewed? By definition, and in accounting for them, business taxes are any taxes collected from businesses and legally imposed on business revenue, property, assets, sales, right to do business and inputs to production. Measured in this way, business taxes are estimated in a recent study by Ernst & Young to have been $554 billion in 2006, accounting for 45 percent of state–local government tax collections. By this reckoning, their share of these tax collections has fallen by only a couple of percentage points since 1990.
The table below, drawn from the same study, displays business tax collections by type for Seventh District states and the U.S. The following graph allocates property taxes by type into shares of the total collection. Property taxes, which are largely administered and collected by local governments, comprise almost 50 percent of business taxes. Seventh District states have historically drawn on these sources since local governments tend to be prominent here and because the Midwest economy has historically concentrated in property-rich sectors, namely agriculture and manufacturing.
It may surprise many to find that “retail” sales taxes on business transactions rank second in business tax share. Though it is often thought of as a tax primarily levied on consumers at the point of final sale, many intermediate purchases of goods and services between businesses (B to B) are not exempted from it. By one estimate, as much as 40 percent of retail sales tax collections in the U.S. may be collected from B to B sales.
In fashioning business-type taxes, policymakers seem to be motivated in two primary ways. First, business taxes are often seen as a popular and expedient way of raising revenue for public services and do so at the expense of the business owners. There is a common notion that such taxes are “progressive” and are drawn from the wealth of well-to-do individuals. However, business-type taxes are imposed on certain transactions and not people per se. For example, a particular tax may be called a “retail” tax if it is imposed on telephone or electricity consumption, implying that the consumer is bearing the burden. But, the same tax may be called a “gross receipts” tax when levied directly on the public utility, implying that unidentified “business owners” are bearing the burden of the tax. Yet, in every action in collecting either tax, they are identical. “Who puts the nickel in tax collection box” makes no difference in real impact.
Similarly, while a business tax may be legally written to fall on the purchase of a business input or on the income of a corporation, behavioral adjustments take place in response to the tax that ultimately shift the final burden of the tax. Most commonly, excessive taxes are shifted forward into the prices of goods purchased by consumers—rich and poor alike; or taxes may be shifted backwards onto people who own the factors of production—laborers as well as nonworking households of various income strata.
If it is true that business taxes are shifted, why do we see that business organizations and business owners vigorously fight business tax hikes in state legislatures and in local city councils? Part of the answer is that taxes are only shifted in the long run. In the meantime, because business operators and owners cannot quickly adjust their behavior in response to tax hikes, the tax burdens may indeed fall heavily on them personally. Only after varying periods of time may businesses fully take offsetting actions, such as reducing investment and labor, retrenching production, or moving to other locales. And looking forward, many opportunities for business expansion may be nullified because of disincentives that are attendant to the expanded taxation.
In this light, the other major consideration of policymakers comes to the fore. State and local policymakers worry about their competitiveness in setting business tax policy. In the United States, “tax competition” is highly active among state and local governments. As localities compete for both jobs and tax revenues, taxes do not generally stray too far out of line. Outwardly, states keep their general business tax structures in line with their neighbors so as not to discourage business investment. So too, states and localities often offer generous and other selective tax abatements.
Tax competition serves not only to keep business taxes from being punitive, but in the competition for local investment, localities are often forthcoming in allowing commercial use of land and providing public services to business. In fact, because businesses do directly use public services such as roads, refuse disposal and public safety services, it is clear that business taxes should seldom or never be reduced to zero but should rather cover related costs. Other similar “business generating” costs that have been advanced in this regard include pollution-type taxes, which are more common in Europe, and the business benefits of allowing “limited liability” organization, which may impose costs on governments if businesses fail catastrophically or in unanticipated ways.
Some observers and analysts believe that local governments do not manage well the negotiations with savvy business firms for selective tax subsidies. For this and other reasons related to tax competition, insufficient revenues will be raised to fund basic services to households, such as public education. Accordingly, efforts to limit competition by statute have been advocated, along with proposals to assist governments in bargaining more effectively with arbiters of mobile capital investment.
Is the limiting of tax competition necessary to save governments from themselves? The answers are not yet clear. However, it can be said that local governments are competing on more than the basis of tax competition alone. Several studies have indicated that the quality of life and other household amenities are increasingly the determinants of metropolitan area growth. Local leaders, and especially big city mayors, have responded to this trend by building infrastructure and offering amenities to attract workers—especially educated and skilled work force—to their cities. Such efforts range from festivals and parks to school reform and public safety. Younger people are often the focus, since they are more mobile in their migration patterns. In tandem, cities often couple amenity initiatives with employment strategies such as college internship programs with local firms, recruitment fairs and regional marketing.
Governments also compete in providing public services to business, and they also construct the regulatory and legal environment in which businesses operate. In considering where and whether to invest, businesses must often look to an uncertain future. In choosing where to invest, they accordingly prefer to have some certainty with respect to state and local government behavior toward business activity. They may ask themselves: Do the state and local governments seem to be committed to standing as an attentive and steady partner in providing services as businesses’ needs change over time? Or has the past record of state and local government been punitive and myopic in expanding business taxation when revenue shortfalls arise?
Posted by Testa at September 5, 2007 11:01 AM
Taxing business is nothing more than making that business a collector of taxes from the consumer (as end-user of a business's products or service, directly through higher price, or otherwise an indirect beneficiary - e.g., costlier public works).
Taxing business, therefore, constitutes a “hidden tax” to the consumer. It, combined with a socially-driven, constantly changing tax code, are what have widely become seen as tools of mischief that politicians, lobbyists, and special interests depend on to continue excessive spending; citizens cannot make politicians accountable for taxes they cannot see that they’re paying.
The national FairTax initiative (bills HR 25 / S 1025 in Congress, as championed by Americans for Fair Taxation - FairTax.org) seeks to make all taxes visible by taxing the consumer on new goods and all services “at the cash register” and showing the tax amount on the receipt.
The considerable research on the national bill makes a persuasive case for the pro's over the con's. And it would seem that, for the same reasons - states would stand to benefit, proportionally. Four states, including Michigan - one of the worst economic performers, are now undertaking legislative and/or ballot initiatives to scrap business income and payroll taxes, as well as personal income - and other - taxes in favor of shifting to a "progressive consumption tax."
The sales tax is made "progressive" through a direct, advance cash return, or "prebate," of likely tax expenditures on poverty-level spending by families (of 1, or greater, as per Dept. of HHS).
Nationally, the scheme would seem to be workable if, as Prof.'s Kotlikoff and Rapson (10/06) contend,
"...the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.
"Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax."
Further, per Jokischa and Kotlikoff (circa 2006?) ...
"...once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there's a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent."
Should the national initiative succeed, it's certainly plausible that the states would soon follow suit.
Posted by: Ian, Ann Arbor at September 12, 2007 12:10 AM
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