It is early winter, the time when, as the poet said, “young legislators’ fancies turn lightly to thoughts of revenue forecasts.” OK, no poet ever said that! But a comparison to lovestruck youth is an apt way to describe the way legislators from many states, including Minnesota, are responding to the revenue numbers they are getting from state forecasters.
Eight or 10 years ago, many legislatures were wrestling with budget cuts and tax revenue shortfalls. The decisions were painful ones: which programs to limit or ax.
Now, thanks to a booming economy, many states are looking at surpluses, and our elected leaders face the much more pleasant task of deciding what to do with piles of lucre. As for the federal budget, it shows that while a rising tide may not lift all boats, it surely is preferable to a falling one.
Some people already await next year’s legislative sessions with lists for increased spending for roads, education, health, state parks and so forth. But the size of the surpluses in Minnesota and several other states is such that tax cuts are also under discussion. As we look at changing state and local taxation, it is a good time to review some basic tax issues.
Virtually all states get most of their revenue from sales taxes or state income taxes. An increasing number use both. And most states set the rules by which cities, counties and school districts raise their funds through taxes on real estate. Legislatures will be hashing over all three of these tax types in just a few weeks.
Real estate taxes have long been used, not because of any economic theory, but because they are relatively easy to administer and understand. The value of land and buildings has always been easier to ascertain than income. Once- or twice-a-year billing involves less administrative cost for society as a whole than sales taxes, which require merchants to calculate the tax on every transaction and make detained tabulations.
Real estate taxes involve a strong element of local control. A property owner can go to a local board to protest an unfair appraisal.
Unfortunately, real estate taxes are often unfair in how they affect different individuals and different counties, cities or districts. The value of real property, especially in an age of easy credit and rising housing costs, is only tenuously related to either wealth or income.
A highly leveraged young couple can pay the same tax as a mid-career couple with higher income and greater net worth but a comparable house. Retired people, for whom a house may represent most of their net worth, can pay taxes that are extremely high relative to their limited, often fixed, incomes. This is particularly harsh for those retirees whose homes appreciate markedly in value after their retirement while their income remains stable.
Another problem: disparities between different municipalities in the value of taxable real estate compared to population. A school district with a given number of students that has a major power plant or corporate headquarters located within its limits can spend much more money per pupil that one with the same student count but only low-income residences. Minnesota and other states have adopted a variety of measures to cushion such disparities, but they are an inherent feature of the tax.
Sales and use taxes are similarly transparent. You know when you are paying the tax, and you know that everyone else buying the same products is paying an equal tax. But they are costly to administer, at least for merchants if not for the state, and they are regressive. That is, they take a proportionately bigger chunk out of poor people’s income that that of rich people.
Exempting “necessities,” such as food and clothing, as Minnesota does, can reduce this regressivity but not eliminate it. And, as mail order and e-commerce take an increasing proportion of retail purchases, devising a sales tax system that does not discriminate against brick-and-mortar stores physically located in the state may be impossible. Some analysts argue that e-commerce virtually dooms sales taxes at the state level.
Sale taxes appeal to some economists because they discourage consumption and hence indirectly encourage savings and investment. But their regressivity must be offset in some other way, such as a high “zero bracket amount” in a complementary income tax, or the poor end up carrying a higher tax burden than the rich.
The income tax has many virtues, some of which can also be vices. It can be structured to provide any degree of progressivity desired. Whenever it is too progressive, however, some conservatives and high-income people will invoke the claim of “class warfare.”
Using special deductions or credits, it can be structured to subsidize desired behaviors such as buying a home, getting a college degree or educating children. It can also serve as a vehicle for a general income transfer to poor households through programs such as the federal Earned Income tax credit.
To this, critics respond with charges of “social engineering.” While a simple income tax that closely piggybacks on the federal one is relatively inexpensive to administer, the more bells and whistles are added, the costlier compliance becomes and the murkier its effects on households of different incomes.
Many legislatures will be looking at taxes in the sessions that will begin in the new year. Now is the time for citizens to express their concerns and priorities.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.