Introduction
by David Brunori
State and local taxation has generally not changed much in the last half-century. To be sure, there have been innovations with respect to collection, periodic Supreme Court pronouncements on state taxing power, and the trauma of the property tax revolt movement. But the structure of state and local tax systems has remained the same. States are still levying sales, income, and corporate taxes in much the same way. Nor has the relative importance of those taxes changed dramatically. The sales tax remains the single most important source of tax revenue for state governments, with the individual income tax a close second. The state corporate income tax is a smaller but still substantial source of revenue for state governments. The property tax remains the most significant source of local government revenue—as it has been for most of the nation's history—accounting for 95 percent of local revenue.
History will note, indeed perhaps marvel at, the endurance of these tax structures. For they have remained in place for decades despite being designed in a different era and for a vastly different economy. The modern sales tax began in the throes of the Great Depression; the modern income tax was put in place slightly earlier. Both systems were developed in and for an economy dominated by the manufacturing sector. People bought food (from family farms) and manufactured goods. And they bought them from American businesses.
Yet the sales, income, and property tax systems in the nation have endured, despite the tremendous political and economic changes experienced in the last half-century. The economy has moved from a manufacturing base to one dominated by the service sector. Business began to evolve, even while these tax systems were in their infancy, into multi-state, indeed multi-national, enterprises. What Americans buy and from whom and from where they buy products is far different today than in the 1930s or even the 1970s. The political climate, too, has changed dramatically. The burdens of taxation, real or perceived, and the weariness of governments have changed the dynamics of state and local politics. The "anti-tax" rhetoric that dominates all levels of politics has incited nationwide tax revolts, shortened political careers, and resulted in tighter state budgets. Paradoxically, the federal government, itself the target of downsizing pressures, has shifted many of its responsibilities to the states. This "devolution" has resulted in more and more governmental functions being transferred from Washington to state capitals.
The political and economic changes experienced in the last decades have accelerated in recent years. European and Asian countries have emerged as economic giants, challenging and in many cases surpassing American productivity. Today much of what is sold in America is produced overseas. Emerging democracies and expanding markets, spurred by the end of the Cold War, have changed the political and economic landscape in which we live. The world has never known greater political freedom or economic opportunity than it does today. Unprecedented technological advances—computers, satellite communications, and the ubiquitous Internet—are influencing all aspects of society.
The political, economic, and technological changes that the world is experiencing are affecting how the world works, plays, shops, and communicates. These changes, one would think, are bound to affect the traditional methods of how states levy and collect taxes. After all, state and local governments collect taxes from people and businesses; if the ways in which people behave and businesses operate change, it stands to reason that state tax collection structures will also change.
But as we stand on the threshold of a new century, it does not appear likely that state tax systems are in fact going to change very drastically. Whatever the problems, and there are many, with existing state tax collection procedures, there is no public outcry for reform of existing tax systems. State legislatures are not busily preparing elaborate contingency plans to cope with current and future societal and economic changes. Nor is there a groundswell of citizen dissatisfaction, similar to California's Proposition 13, that might produce dramatic changes in state and local tax systems.
With no wholesale reform on the horizon, however, what will be the results when the political, economic, and technological changes occurring throughout the world eventually collide with enduring but often archaic state revenue systems? What will the states do when their predepression era income tax systems are forced to operate in a world of unprecedented global trade and often unimaginable technological developments? Assembled in the pages that follow are the thoughts of the nation's leading academics on the future of state taxation as we enter the new millennium. The contributors have vast academic and practical experience in the political, legal, and economic aspects of how states raise revenue. They are the preeminent scholars in the field.
The purpose of the book is to foster public debate on the future of state and local government finance and taxation. The contributors were asked to provide their opinions on the future of various aspects of state taxation. They were given wide latitude in determining what topics to address. Some present new research to support their views on what lies ahead, while others offer novel arguments and fresh approaches to age-old problems. They all offer provocative essays on the future of state taxation.
While the contributors have noted what they think works—and what doesn't—the goal was not to provide solutions to all of the potential challenges to the ways state and local governments collect revenue. Rather, the book is designed to highlight issues for consideration by policymakers, practitioners, and community leaders. The hope is that the essays contained herein will provide the basis for future discussions on the serious challenges facing state and local governments.
The work begins with two essays on the future of the sales tax, the single most important source of state government revenue. Forty-five states and the District of Columbia impose a tax on sales, and it accounts for about 34 percent of total tax revenue collected by state governments. (That percentage is even greater in states such as Texas and Florida that do not impose personal income taxes.) In most state revenue systems the tax is levied on the sale of tangible personal property; sales of services are usually exempt from the tax. The sales tax has been accepted by the public—at least to the extent that any tax is or can be "acceptable" to the public. The relatively low rates and ease of compliance generally reduce the sales tax to an afterthought for consumers. And because sales tax is collected by the vendor, states are generally not burdened by it. Administrative and enforcement costs are relatively low compared with those for other taxes. The drawback, from a political and policy perspective, is that sales tax is regressive.
In chapter 2, then, University of Indiana professor John Mikesell highlights the critical challenges to the sales tax as we reach the end of the century. The sales taxes consumption, and Mikesell believes that the assignment of government costs according to how much a person chooses to spend coincides with fundamental notions of consumer sovereignty and private markets. Mikesell maintains that the logic of the sales tax is rooted in its special advantages in terms of economic efficiency (the tax is levied independent of timing) and transparency (the consumer witnesses the imposition of the tax at the time of the sale and is aware of the costs of government). That logic helps explain why the tax has endured for more than half a century.
But, as Mikesell points out, several trends are converging to challenge the logic, and hence the efficiency and efficacy, of the sales tax. As those who have studied this subject are well aware, subjecting production inputs to a tax has been a problem since the inception of the sales tax. According to Mikesell, that problem has become acute. He notes that 41 percent of the sales tax now falls on business purchases. The results, he warns, are increasingly greater costs of business expansion and a system that creates barriers to growth. The other trend threatening the logic of the tax is the unprecedented movement toward exempting household goods. There are strong political and policy reasons for exempting from the sales tax household goods such as food, clothing, and medicine. But, notes Mikesell, despite the good intentions behind such exemptions, they have the undesirable effects of making the sales tax more regressive, while at the same time costing states millions of dollars.
Mikesell cites the continued exclusion of services from the sales tax as the last, converging threat to the logic of the tax. For largely political reasons, states have been reluctant to expand the sales tax base to include services. Besides costing states enormous amounts of potential revenue, however, the exclusion of services from the tax base greatly complicates both taxpayer compliance and state administration of the tax. Mikesell says that these trends defeat the logic of the tax, reducing the economic efficiencies of the tax and placing future acceptance of the tax in jeopardy. In order for the sales tax to survive, he argues, it is critical for states to stem these converging trends. Because it is unclear whether states will take the necessary steps, Mikesell concludes that the continued survival of the sales tax as the dominant source of state revenue is uncertain.
University of Tennessee economist William Fox takes an even more pessimistic view of the future of the sales tax in chapter 3. He cites two trends that severely threaten the entire sales tax regime. First, Fox cites the continuing change in consumption patterns: Purchases of durable and nondurable goods are declining, while purchases of services are increasing. Moreover, Fox notes, there is a greater propensity to purchase both goods and services from outside the state. The former threatens the sales tax because the tax is still aimed primarily at tangible personal property. The latter complicates administration of the tax because of now well-established constitutional limitations on the states' ability to impose collection responsibility on out-of-state vendors. If vendors have no collection responsibility, the sales and use tax regime, at least as we know it, collapses.
Second, policy decisions have continually narrowed the sales tax base, as politicians manage to grant exemptions to more and more types of goods and services. From a tax policy standpoint, Fox argues that the shifting tax base dangerously increases compliance and administration costs and distorts consumption decisions. These trends, asserts Fox, have resulted in a stunning loss of one-fourth of the tax base as a share of personal income in the last seventeen years. Even assuming that states refrain from further depleting the sales tax base, Fox predicts that states may have to increase tax rates beyond acceptable levels for the tax to remain the dominant source of state revenue. At a minimum, predicts Fox, the sales tax will be replaced as the largest source of state tax revenue in the near future. Unless states take a more aggressive approach to the taxation of services, obtain jurisdiction over out-of-state vendors, or exhibit some political fortitude to stem the exemption bonanza, the demise of the sales tax may occur even more quickly.
While the taxation of business inputs reduces the efficiency and efficacy of the sales tax, state taxation of business income faces many more profound challenges in the years ahead. Taxation of corporate income comprises only 7 percent of total state revenue, yet corporate income comprises over $28 billion dollars of tax revenue. Over the years, corporate income taxation has been the subject of much debate and litigation as taxpayers and state governments have contended with the seemingly nonstop growth in multi-state business.
In chapter 4, University of Connecticut law professor Richard Pomp provides a critical examination of the problems inherent in levying a state tax on corporate income. In a spirited essay, Pomp explains that the weaknesses of the corporate tax system are well known and exploited by tax practitioners. He argues that the intellectual firepower that the private sector brings to bear on the corporate income tax results in legal yet undesirable avoidance of the tax. Practitioners, says Pomp, are continually developing new ways to shift income away from corporate tax liability. Essentially, state revenue departments, understaffed and under funded, are losing the battle over state corporate taxation. Next, Pomp argues that the obsession with tax incentives has cost the states dearly—nearly half a billion dollars in New York alone. Incentives cause other states to adopt retaliatory incentive measures, further shrinking the aggregate tax base. And, says Pomp, incentives don't work.
The corporate tax is threatened by its very structure. The traditional apportionment formulas do not work well in our modern economy. But the alternatives adopted by the states, particularly the use of double-weighted and single-factor sales formulas, have magnified the structural deficiencies of the tax. Other serious problems with the structure and administration of the tax include the failure of most states to require combined reporting and the relative ease with which corporations can convert business income into nonbusiness income. These problems, says Pomp, leave states vulnerable to aggressive planning, transfer pricing, and the use of holding companies to shift income. Pomp does not argue that the corporate tax should expire. But he warns that the tax requires constant vigilance. The problems are predictable, and fixable. States can adopt combined reporting rules, curtail the use of incentives, and broaden the definition of business income. He predicts, however, that given the political climate, the necessary reforms are unlikely of enactment. In the future, he notes, the corporate tax will be a minor player that consumes a disproportionate amount of intellectual capital.
Pomp's criticism of incentives is, of course, consistent with most scholars' views on the subject. Commentators generally agree that incentives violate the most basic principles of sound tax policy. Incentives result in tax systems that are less accountable, less efficient, and less fair. Moreover, there is more than ample evidence that incentives do not work. Still, the use of tax incentives has increased primarily because political leaders lack the will to reject them. The political benefits of new jobs and increased economic activity are attractive inducements for offering incentives. Northeastern University Law professor Peter Enrich asserts in chapter 5 that in the light of the political realities there is only one way to stop the proliferation—legal challenges to tax incentive programs under the Commerce Clause. In an innovative argument, Enrich asserts that for political reasons it is virtually impossible to end the practice of granting generous tax incentives to entice a business to relocate to or remain in a jurisdiction. Moreover, while states have instituted safeguards to ensure that companies receiving incentives produce the requisite measures of jobs and economic development, these safeguards actually increase the likelihood of continued incentives. It is not illogical to think that with such safeguards in place, the granting of incentives then appears much less risky politically.
Given the politics of tax incentives, Enrich asserts that the only plausible means of halting the spread of incentives is through judicial challenges under the Commerce Clause. He argues that the Commerce Clause's anti-discrimination principle is "straightforwardly" applicable. Enrich explains that established judicial precedent provides that a tax measure discriminates against interstate commerce if it provides an advantage to local commerce over out-of-state competitors. And measures that forestall tax-neutral decisions about where to do business while favoring local commerce are discriminatory. Tax incentives offered by state governments, particularly investment tax credits and targeted job credits, would often meet the criteria of being unconstitutional under the tests enunciated bu the Supreme Court, argues Enrich. He asserts that the likely plaintiffs in such constitutional challenges are in-state businesses placed at a competitive disadvantage by incentives, public employee unions, and maybe even state governments themselves. Because there are no reasonable alternatives, Enrich predicts that legal challenges—perhaps successful legal challenges—will inevitably arise in the coming years.
In chapter 6, Thomas Pogue, professor of economics at the University of Iowa, offers his insights into the future of state taxation of business. While Pogue recognizes that taxes on business are indirect taxes on consumers—i.e., they are ultimately passed on in the form of higher process—he puts forth a compelling argument for the continued taxation of business entities. He says that businesses should be charged for the costs they generate, but would otherwise ignore, when determining when, where, and how to produce products. Indeed, Pogue asserts that business taxes reflect nonmarket costs of production and are necessary in a market economy to ensure the efficient allocation of resources. Such taxes, he argues, equitably distribute the external costs—which would otherwise be borne by the public—of production. Pogue calls this the "social cost rationale" for business taxation. But, Pogue contends, current revenue systems, with their widespread use of business exemptions and tax incentives, fail to distribute nonmarket costs fairly. Pogue recognizes that political pressures lead to tax competition among states and that competition inevitably leads to more exemptions and incentives. But., he argues, the social cost rationale for taxing business must be widely understood and accepted by the public. Without such understanding and acceptance, the states will continue to reduce overall taxation of business and thus further distort the external costs of production.
While concerns about how and why states tax, or in the case of incentives, don't tax, business will be an important topic of discussion in the coming years, the question of the future of property tax has immediate ramifications that directly affect nearly all Americans. The property tax, of course, is an old tax. Its longevity can be attributed to the fact that it is easy to administer (you cannot hide land) and generally results in growing revenue because of appreciation. It has endured despite being regularly identified as the most disliked of all taxes. While transparent, the tax results in severe "sticker shock" as property owners receive their bills during the year. Moreover, the property tax has an adverse effect on those with fixed incomes, since their property usually appreciates at a rate faster than the rate of growth in their income. These problems gave rise to California's Proposition 13 in 1978 and the many similar, albeit quieter, revolts in other states.
In chapter 7 , Lincoln Land Institute Fellow Joan Youngman provides a fresh perspective on the problems faced by this age-old source of income. She recounts the profound paradoxes of the tax. It has a long history yet has been under incessant attack; it commands approval from economists (as efficient) and political theorists (as transparent) but remains vilified by the public. Within those paradoxes, Youngman identifies several challenges to the continued survival of the tax as the dominant source of local revenue. She explains that the problems associated with the tax include long-time, but still fundamental, questions of value and valuation. The assignment of value, she points out, touches on deeper social questions that themselves involve value judgments. Those value judgments are at the heart of the political debate about the property tax; they affect everything from determining what should be included in the tax base to the relative value of diverse property such as farmland, forests, historic sites, family residences, and commercial buildings. Youngman pays particular attention to the issues of which property should be exempt from tax and to the tension between valuing appreciating, but underdeveloped, land and the costly preferences provided to farmland and open space. She claims that it is easy to predict that the ambiguity concerning valuation, and thus the political debate about the tax, will continue. She concludes, however, that despite the often heated debate, the property tax will survive. Experience has shown that there are no viable alternatives to it.
University of California professor Steve Sheffrin predicts in chapter 8 that the property tax will remain the primary source of revenue for local governments. It will not, however, be the same system long idealized by economists and political theorists. Sheffrin predicts four trends that will fundamentally change the property tax in the next several decades; these trends will inevitably reduce the significance of the tax as a source of local government revenue. First, he contends that the ongoing, and successful, legal challenges to the use of the property tax to finance public schools severely undercut the political rationale for the tax—for no other local government expenditure has the appeal of education. A second, but related, trend is the unrelenting political pressure to limit overall property taxation. Many such limitations, spurred by Proposition 13, are already in place, and only six states are free of limitations on imposition of the tax. The public, predicts Sheffrin, will keep sharp limits on the tax in effect. Third, local governments have begun to adopt alternatives to ad valorem taxation that sharply reduce reliance on the traditional property tax. Fees, charges, exactions, and special assessment districts have sharply increased as a result of property tax limitations. Finally, Sheffrin predicts increased "direct democracy" in local government, by which voters and property owners will have a greater voice in public finance policy decisions. Correspondingly, he believes there will be a decrease in the discretion of elected officials to set fiscal policy.
According to Sheffrin, these trends will reduce the significance of the property tax considerably but will not signal the complete demise of the tax. The property tax will remain an important source of revenue as we enter the next century. Because it is a proven revenue raiser, easily administered and without viable alternatives, the tax will continue to provide local governments with funding well into the future. The real change, says Sheffrin, will be property tax systems capped at lower rates and under little practical local autonomy.
As both Youngman and Sheffrin note in their essays, much of the debate surrounding the property tax arises in the context of school finance. Public school systems have traditionally relied on the property tax for the bulk to their revenue. In chapter 9, Georgia State University professor William Waugh provides an insightful look at our changing approaches to funding public education as we reach the end of the century. Waugh describes the many legal and fiscal challenges that have forced an examination of public school financing and predicts that the way schools finance their operations in the future will be far different than today. He predicts that school districts will continue their efforts to reduce their reliance on the property tax, partly as a result of legal challenges to such financing and partly owing to the general public dislike of the tax. He predicts an increase in the use of local option and special-purpose sales taxes dedicated to particular education-related programs, such as school construction. He also notes that states are now granting more direct aid to local school districts. State funding was originally intended to equalize spending among school districts but more often is used to alleviate the financial burdens on local systems. And it will, Waugh predicts, increasingly be tied to state-mandated performance standards.
State aid was traditionally allocated from state general funds, but states are also experimenting with using revenue from their lotteries as a dedicated source of state education funding. In turn, predicts Waugh, the school districts will also experiment with imposing student participation fees, obtaining contributions from the public and private sectors, and even entering into profit-making joint venture agreements with business. All of these new modes of revenue raising will reduce reliance on the property tax and lead to a more eclectic system of education financing.
The essays set forth in chapters 10 and 11 explore the difficult question of how equitable tax systems of the future will be. This is, of course, no minor matter, for public attitudes about taxes are directly related to whether taxes are perceived to be fair. Andrew Reschovsky, professor of economics at the University of Wisconsin, examines the distribution of state and local tax burdens. He notes initially that most states have attempted to achieve some measure of progressivity with respect to their income and sales taxes. But he offers a critical examination of the published research, explaining the flaws inherent in some of the methods used to determine the progressivity of tax systems. He estimates that for a majority of states the incidence of the three main sources of tax revenue (sales, income, property) is clearly regressive.
When discussing the future of relative tax burdens, Reschovsky points out two trends that will affect the progressivity of state systems. First, states will be under extrordinary pressures to raise revenue as a result of federal budget cuts and the simultaneous increase in service demands on state governments; the latter will be fueled by the continuing devolution of fiscal responsibilities from the federal government to the state and local governments. Second, Reschovsky argues that despite the looming budget crises, the continued intense competition among the states for economic development will affect how states distribute their tax burdens. If the competition for capital (or the appearance of it) remains fierce, states will continue to lower their tax rates and reduce their tax base. This will lead inevitably to more regressive state revenue systems.
In chapter 11, I offer my own thoughts on the future of the personal income tax, long a dominant source of revenue for state governments. (Only the sales tax rivals it in importance.) The success of the personal income tax is attributable in part to its adherence to widely accepted principles of sound tax policy. That is, the personal income tax is effective, efficient, and most importantly, fair. Its effectiveness as a revenue source is unquestionable: Nearly a third of all state tax revenue is collected from the taxation of personal income. In 1996, states collected over $130 billion dollars of personal income taxes. Conformity with the federal tax system has resulted in a method of collecting revenue that is efficient for both taxpayers and the government. Taxpayers incur few administrative burdens beyond those experienced as part of the federal income tax system. State governments, for their part, have found the personal income tax to be a cost-effective method of collecting revenue. The state personal income tax has long been thought of as the most fair of all forms of taxation. Its perceived fairness is due in part to its status as the least regressive of all forms of taxation.
My conclusion is simply that, barring a radical change in the federal income tax system, the state income tax will remain a dominant source of revenue in the future. Neither technological nor economic developments will change the structure of the tax. The advent of electronic commerce will not have the detrimental effects on the personal income tax that it is likely to have on corporate or sales taxes. The ever-growing dependence on international trade also has little effect on personal income taxation. For nearly half a century the public has considered the state personal income tax to be an acceptable means of raising revenue. That public acceptance has led in turn to continuous growth of the tax. There is nothing in the future that will likely change that trend.
The book concludes with a discussion of what may have the most widespread effect on state taxation in the future: In chapter 12, University of Georgia law professor Walter Hellerstein discusses the challenges state revenue systems face in the age of electronic commerce. The nation, indeed the world, has already experienced the dramatic changes brought on by new technology. Today over a third of American families own a personal computer. Millions of people access the Internet on a regular basis. People are using the Internet to communicate, to retrieve information, and, with increasing regularity, to purchase products and services. By all accounts, electronic commerce—the selling of goods and services through the Internet, intranets, or on-line services—will dramatically increase in the coming years. Conservative estimates of total Internet sales of goods and services range from $7 to $150 billion by the year 2000.
Electronic commerce poses profound, and by now well-documented, challenges to the way states have traditionally raised revenue. That is not surprising considering that state revenue systems were developed in an era when it was impossible to imagine a world in which goods and services would be sold via computers.
Hellerstein steps back from present-day discussions and considers the challenges electronic commerce brings to our conventional modes of thinking about state taxation. He maintains that before policymakers can discuss the effects of electronic commerce on state taxation, several fundamental quesitions need to be addressed. First, is the current constitutional and statutory framework adequate to deal with electronic commerce? If the answer is no, and Hellerstein certainly implies as much, how might the framework be altered to provide a sound tax policy in the electronic age? For example, jurisdiction to impose state taxes on electronic commerce has been defined by traditional nexus criteria. Yet nexus is rooted in the concepts of territoriality and physical presence. Basing jurisdictional decisions on such concepts makes little sense in cyberspace. Hellerstein says that a fresh approach that "reverse engineers" the nexus issue is needed. Rather than asking how electronic commerce should be treated under traditional nexus criteria, we should be asking what kind of tax regime will allow customers and businesses engaged in electronic commerce to pay taxes in an efficient manner to states with legitimate claims to obtain revenue and collect taxes therein.
According to Hellerstein, states will have to take a fresh approach to many traditional areas of taxation. He cites, as an example, definitional issues surrounding the administration of sales and use taxes. Because much of electronic commerce involves the sale of services, transactions are likely to be characterized as nontaxable unless those services are deemed to fall into the category of taxable services. The problem, maintains Hellerstein, is that the definitions we are using were not designed with electronic commerce in mind. Similarly, the concept of sale for resale and the determination of where a sale takes place (a particularly acute problem in the age of electronic commerce) should not be addressed in terms of traditional thinking.
Hellerstein points out that our approach to imposing income taxes must undergo similar revisions in order to cope with the structure of electronic transactions. In particular, he notes that the delineation of the sales or receipts factor in traditional apportionment formulas raises difficult issues. Whether electronic or commercial transactions should be treated as sales of property or of services—and if the latter, where those services are deemed to have been performed—are daunting questions, without clear answers under current thinking.
The problems posed by state taxation of electronic commerce are significant. Hellerstein's warning for the future is that efforts to resolve those problems within traditional state tax structures are unlikely to succeed.
The coming century will require policymakers to focus on political, economic, and technological changes occurring thoughout the world. These changes will inevitably influence state tax systems that were designed long ago. State lawmakers will need to examine not only the mechanics of how their revenue systems work, but also the underlying rationales for those systems. In the end, reform of state tax systems is likely. Whether such reforms are relatively mild or dramatic, they will certainly be marked by heated debate and controversy. Adopting state tax systems for the next century will require input from tax practitioners, business, community leaders, and academia. Hopefully, this work will lead to more discussion on the pressing challenges facing state and local governments in the years ahead.
