Unmasking the Debate: Perspectives of Public Finance Experts on State Tax Reform

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State Tax Reform
Options, Challenges & Creativity

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The February/March 2013 edition of ABFM’s newsletter, Line Item, features several articles on the pertinent topic of State Tax Reform. Click here to check out the rest of this special issue, and click here for information on a special webinar featuring contributors to this issue, hosted by AABPA on Wednesday, March 13th (1PM Eastern).

Several members of ABFM, including past winners of our Aaron Wildavsky Award, were asked to share their thoughts on State Tax Reform. The group reflects decades of experience in public sector finance practice and research within local and state government. Several are also involved in writing and editing three of the principal texts for the today’s study of public financial administration.

Dall Forsythe, Adjunct Professor of Finance, NYU Wagner Graduate School of Public Service, and former Budget Director, State of New York
Justin Marlowe, Associate Professor of Public Affairs, Evans School of Public Affairs, University of Washington, and Co-Editor, Management Policies in Local Government (2012, ICMA Press)
John Mikesell, Chancellor’s Professor, School of Public & Environmental Affairs, Indiana University, Author, Fiscal Administration: Analysis and Applications for the Public Sector (2010, Wadsworth), and immediate past Editor-in-Chief, Public Budgeting & Finance
Dan Smith, Assistant Professor of Public Budgeting & Financial Management, NYU Wagner Graduate School of Public Service, and Co-Author, Financial Management for Public, Health, and Not-for-Profit Organizations (2012, Prentice Hall)

What is often overlooked with “tax reform?”

Forsythe: The linkage between reform and fairness is important, although defining “fairness” is not simple. In our public finance courses, we often speak of horizontal and vertical equity. Horizontal equity, which requires that equally situated people should be treated equally, is often violated by tax loopholes. Vertical equity, which requires that people with higher taxes be taxed more, calls for either progressive or at least proportional tax systems. Many state and local tax systems are regressive. Moreover, citizens in most states have no readily available benchmarks to judge whether their tax systems meet their standards of equity.

Mikesell: Politicians get so excited about “reform” they forget that tax systems exist to produce revenue to cover the cost of government services.”

Marlowe: Most states are talking about scaling back tax expenditures. One of the most important issues in tax reform is that most states don’t have the capacity weigh the trade-offs around tax expenditures. In most cases the central question becomes “is this preference necessary?” That discussion usually goes nowhere because every tax expenditure is “vital” or “essential” to some important group of voters.

Smith: While state personal income taxes generally are not as progressive as the federal personal income tax, they are (in most cases) less regressive than consumption taxes, particularly when essentials such as food and medication are subject to taxation. In terms of adequacy, these proposals are explicitly revenue-neutral; the shifts from income-based taxation to consumption-based taxation are being promoted as economic efficiency enhancing (and they may well be). They also have the air of true “fairness,” as flat taxes are in keeping with horizontal equity. The disproportionate impact on lower-income households is being overlooked, however.

How does tax structure potentially-impact credit ratings?

Forsythe: If we could devise reforms that also provided more stable funding platforms for government, we might be able to reduce the need for pro-cyclical budget cuts and tax rate increases when the economy turns down. However, we can also look outside the tax system for counter-cyclical strategies, improving rainy day funds and other tools for management in recessions and slowdowns of the economy. Over the long run, income-based taxes usually grow faster than consumption taxes, which is a positive feature in credit quality.

Smith: All else equal, income-based tax systems are more stable and more amenable to revenue growth over the long term. “All else equal” is an important caveat because some states rely on volatile sectors for income tax revenues. Nonetheless, a stable tax system, particularly one that promotes revenue growth over the long term, enhances a state’s credit quality and debt refinancing capabilities. A consumption-based tax system, all else equal, is less favorable in terms of credit quality and the capacity to refinance debt in the future.

What should states keep in mind with respect to tax reform and its impact on tax administration?

Forsythe: Like taxpayers, tax administrators work much harder when the revenue-raising systems they administer are more complex. Reducing loopholes by frequent review of tax expenditures can reduce complexity. It is also true that the more a state tax code resembles and conforms to the federal tax code, the easier it is to administer.

Mikesell: States with individual incomes taxes closely linked to Federal Law have a big advantage in administration. They can ride on the IRS coattails and get high levels of compliance with their income tax without much administrative effort on their part. States need to be prepared to boost their enforcement activities as they start increasing their sales tax rates.

Can “tax reform” seriously help states administer structural deficiencies with respect to their finances?

Forsythe: The choice is political, not technical. However, we also need to remember that some tax reform proposals at the federal level, like elimination of the deduction for state and local taxes, can exacerbate state and local budget problems. In states that rely heavily on income and property taxes, the burden of those taxes on many citizens would be significantly higher without an offset from federal deductions.

Marlowe: It’s interesting that a few states are taking a different approach and instead asking “is this preference working?” Washington State is trying out this approach. The state legislative auditor recently began to review the state’s largest 500 or so tax preferences. The key question is: does this preference meet its intended policy goal? That’s a difficult question to answer, but it’s much more tractable than questions of necessity or fairness. So far this process has identified 19 (out of about 160) tax expenditures that should be allowed to expire.

Smith: At the state level, proposals are explicitly revenue-neutral. Absent willingness to cut expenditures, which many of these states have already done over the past several fiscal years, the shifts from income-based taxation to consumption-based taxation have the potential to exacerbate structural deficiencies.