Individual Income Insights: Singing The Georgia Blues: A Lesson in Base Erosion (Part 2 of 3)—Q&A with the Tax Foundation’s Joseph Henchman

Joseph Henchman; Tax Foundation

Individual Income Insights: Singing The Georgia Blues: A Lesson in Base Erosion (Part 2 of 3)—Q&A with the Tax Foundation’s Joseph Henchman

In Part 1 of Individual Income Insights’ state tax base erosion series, we highlighted states struggling to adapt their tax policy to changing economic realities. This week, Bloomberg BNA spoke with Joseph Henchman to get his views on state tax base erosion and policy responses such as a universal minimum tax and new taxes on e-commerce. In short, he believes in widening the base and dropping the tax rate, which results in a more efficient tax system and stabilizes tax revenue streams. According to Henchman, outdated tax codes contribute to slowing job and economic growth and states need to formulate policy responses to this pressing issue.

Bloomberg BNA: Tell us a little about yourself, and your role at the Tax Foundation.

Henchman: I’ve been at the Tax Foundation for 12 years now. My role as vice president here is overseeing our state and legal programs, analyzing state tax proposals and filing amicus briefs. I’ve written a book on the difference between taxes and fees and testified in about 36 states.

Bloomberg BNA: What is state tax base erosion?

Henchman: Tax codes are created taking into account the economy of the time. As the economy changes and the competitive environment changes, the tax code should as well. Before the 1930s, states taxed agriculture, property and banks heavily because that was all that existed to be taxed. All those revenue sources plummeted in the 1930s, so states created taxes on capital investment, sales taxes on goods, broader business taxes and income taxes. As we’ve become a more technological, mobile and service-based economy, those taxes in turn are eroding.

Bloomberg BNA: What effect does state tax base erosion have on state budgets?

Henchman: As the tax code applies to less of the economy each year, the taxes bring in less revenue than they could. So, while revenue grows, it’s not as fast as the economy as a whole. This creates pressure because state spending often grows at, or faster than, the rate of inflation.

Bloomberg BNA: What can states do in response?

Henchman: State sales taxes, for instance, apply primarily to goods, not to services. As services grow faster in the economy than goods, the response has been to raise sales tax rates. Sales taxes used to be three or four percent; today they’re six, seven or eight percent. Other taxes, like franchise or capital investment taxes, put a state at such a harmful competitive disadvantage that they’ve mostly been repealed.

Bloomberg BNA: Some states have proposed to tax new goods and services as a way to stabilize budgets or to fund new government initiatives. What balance should states strike between attracting business through low taxes and strengthening fiscal stability?

Henchman: There absolutely can be a balance. Thinking carefully about which taxes you want, and making sure they all have broad bases and low rates, helps both competitiveness and stability. The state with the most stable revenue in the country is South Dakota, even though all they have is a sales tax. It’s because their tax is a broad-based one that applies to all goods and services. California has one of the most volatile revenues in the country because all their many taxes are high-rate and narrow-base.

Bloomberg BNA: The Georgia Budget and Policy Institute, a nonprofit organization focusing on tax policy, released a report entitled “A Tax Blueprint to Strengthen Georgia.” The Institute recommends a “bottom-up” tax cut designed to be progressive up to $10,000, with a $10,000 standard deduction for those making under $50,000 per year, while those at the top end of the income spectrum would pay more. The Institute rejects H.B. 329, a bill instituting a slightly lower flat personal income tax with the loss of revenue being made up by H.B. 61, legislation introducing an e-commerce sales tax. Which plan would strengthen Georgia’s finances and lead to higher growth?

Henchman: Again, the goal ought to be broader bases and lower rates. The first proposal sounds like it raises rates and narrows the base, while the second proposal broadens the base a bit and lowers the rate a bit. So, the second [proposal, H.B. 329] sounds more likely to have a positive impact.

Bloomberg BNA: Focusing on the issue of an online sales tax levy, what do states need to do to ensure compliance?

Henchman: There needs to be a solution at the federal level. If someone in New York is changing planes in Chicago and buys an app from a company in Arizona, using the California-based app store, routed through a server in Nebraska and then used in Wisconsin when the person lands, every state would try to tax that transaction without clear federal rules. [The same situation applies] for a book bought from a Washington-based website via a Nebraska-based server, delivered by truck over several states.

Massachusetts just announced that they’ll begin taxing any website capable of putting a “cookie” on a Massachusetts computer, which is probably every website on the planet. States promised in 1959–1959!–that they would come up with rules ensuring tax coordination on interstate commerce, and we’re still waiting. States that have so far refused to join the Streamlined Sales Tax Project should join, and Congress or the courts should help create a simplified and uniform sales tax system. I don’t think the states will, or can, do it on their own.

Bloomberg BNA: Are the efforts to ensure compliance with online sales tax worth the revenue the taxes will create?

Henchman: It’s a few billion dollars a year nationwide, although it’s growing quickly because internet commerce is growing quickly. Drastic measures, like auditing consumers, probably cost more money than they bring in.

Bloomberg BNA: A relatively low state tax burden nationwide or compared to its neighbors has been used as an argument to increase taxes in response to falling revenue. Do you believe a lower relative tax burden to be a sound reason to raise taxes?

Henchman: U.S. Supreme Court Justice Brandeis referred to our 50 states as the “laboratories of democracy.” We have high-cost, high-service states, like Vermont. We have low-tax, low-service states, like Wyoming. And everything in between. What you want to avoid is high-tax, low-service [states].

If legislators or voters are considering raising taxes, I’d think of it in those terms: what’s the added value you’ll get from the spending, and does it outweigh any negative effect you’ll get from the higher tax burden? Does it put you out of line with your neighbors or regional competitors? Does it undermine a strength or exacerbate a weakness?

Bloomberg BNA: Will an increase in taxes, though lower relative to the nation, be a burden on business and employment growth in the state?

Henchman: Depends on the state and the type of tax. A small increase to a gross receipts tax can be incredibly damaging because of how such a tax operates. New Jersey’s recent big increase in its gas tax probably will do little economic damage just because the alternatives were much worse and it avoids a transportation work halt.

Bloomberg BNA: Despite Oklahoma’s low-tax environment, economic activity within the state has stagnated at, or below, the national average for the last ten years, according to the Oklahoma Employment Security Commission’s report entitled “Oklahoma Economic Indicators.” Are market forces, policy or execution of the policy to blame for the state’s current fiscal issues?

Henchman: State and local tax burdens, which are the amounts paid by Oklahomans, are about 8.6 percent of personal income. That’s about $3,515 per capita, compared to $4,420 per capita nationwide. The Tax Foundation’s “State Business Tax Climate Index” ranks Oklahoma 31st out of 50 states, so in a way, Oklahoma has a fairly complex tax system that succeeds in raising a less-than-average amount of revenue.

Part of the solution ought to be tackling some of the archaic, poorly designed or just plain punitive on job creation features of the Oklahoma tax code: sales taxes on manufacturing machinery, taxes on equipment and inventory, a corporate throwback rule, lack of tax rate inflation-adjusting and outdated sales tax. Low tax rates make up for some of these flaws but, if you raise the tax rates, you’ll end up with the worst of both worlds.

Bloomberg BNA: Returning to the Feb. 21 article you wrote about tax reform in Kansas, it stated that you supported the proposed changes to the tax code, including the addition of a top tax bracket and the raising of the rate of a middle-income bracket, as a way to secure the state’s fiscal condition. The bill was vetoed by Gov. Sam Brownback (R) and override attempts failed. What is the next step for Kansas legislators in this process?

Henchman: The key element of that bill was the elimination of a total exemption of pass-through income, which has been law there for a few years. When they first passed that [exemption], we warned that carve-out was unjustifiable policy and would be problematic for revenue. Legislators seem to acknowledge that, and I think they’ll repeal it. The question is what other elements will be part of the bill.

Bloomberg BNA: Are there any points of common ground for Kansas lawmakers to compromise on future tax reform?

Henchman: Some legislators want spending cuts, although they have trouble pointing to specific programs. Some legislators want to raise every tax they can find. Most of the legislators are in the middle: they want the state government to be fiscally responsible but not reckless. I think they’ll find a solution. Many of them were elected to help clean up the mess and find a solution.

Check in next month for Part Three of the series, an interview with Institute on Taxation and Economic Policy to read their perspective on tax base erosion issues facing the states.

Continue the discussion on the BBNA State Tax Group on LinkedIn: Should states expand their revenue base or increase tax rates to make up lost revenue?

Get a free trial to the Premier State Tax Library, a comprehensive research service that delivers deep, unique analysis and time-saving practice tools to help practitioners make well-informed decisions.

Interviewed by Kevin Thayer