Tax Talk in Midwest's Capitols

Stateline Midwest ~ April 2013

Plans in 2013 include expanding sales tax base, raising severance tax, cutting income taxes and adding tax brackets

Sen. Beau McCoy calls it a once-in-a-generation opportunity for himself and other Nebraska policymakers: the chance to pore over the state’s entire tax structure, and reform and modernize it.

But as he has already found after introducing an overhaul this year, there are reasons why major shifts in tax policy sometimes occur only once every few decades.

“The more we, or at least I, spend on this, the more you realize how difficult it is for states to make big changes to their tax structures,” he says. “There are so many moving parts.”

In Nebraska, for instance, the proposal he introduced earlier this year called for a “revenue neutral” tax swap: abolish or dramatically reduce income taxes in exchange for the elimination of some of the state’s $5 billion in sales tax exemptions.
Many of those exemptions — which McCoy says now include everything from bull semen to energy and fuel costs — first became part of state law in the late 1960s, when lawmakers instituted a sales and income tax. 
This year, it didn’t take long for various groups in Nebraska to point out the negative economic consequences of removing those exemptions, particularly changes that would impact business-to-business sales.
In response, the tax legislation in Nebraska was put on hold and instead replaced with a study bill, but McCoy isn’t losing hope that significant changes will eventually be made.
“Right now, we’re losing young people and we’re losing retirees,” he says about the need for a tax restructuring. “That is a bad combination, and the time to address it is now.”
Since the start of this year, several tax-reform proposals have been introduced in the 11 Midwestern states, a sign of improved budget conditions and of the belief among many lawmakers that their current tax systems are antiquated, uncompetitive or both.
“If we were starting a tax system from scratch, we would not build one that is so heavily reliant on personal income taxes,” says Timothy Keen, director of the Ohio Office of Budget and Management. “That’s where Ohio is at the biggest competitive disadvantage.”
In response, Republican Gov. John Kasich has proposed an across-the-board cut of 20 percent in income tax rates (which already have been cut 21 percent over the past decade), a major tax reduction for the state’s small businesses, and a drop in the sales tax rate from 5.5 percent to 5 percent.
Part, but not all, of that lost revenue would be made up by increasing Ohio’s severance tax and expanding the state’s sales tax to include services. Ohio, like most states (with South Dakota being a notable exception; see table on taxation of services), currently taxes goods but leaves many services untouched.
“Our view is to shift a little bit away from income taxation to consumption taxation,” Keen says.
The changes would not only allow for deeper income tax cuts, he says, but would also make the state’s sales-tax structure less regressive.
“How many lower-income people are buying [the services of] architects?” Keen notes as one example. 
This type of sales-tax “modernization” — capturing tax revenue from services, which due to decades-long changes in the U.S. economy now account for a greater portion of state economic activity than goods — is often floated as a policy idea. Getting it through the legislature, though, has often proved politically problematic. 
Already this year in Minnesota, Democratic Gov. Mark Dayton chose to pull back a proposal to expand the sales tax base in exchange for lowering the overall rate (from 6.875 percent to 5.5 percent). 
He instead is focusing on other parts of his tax restructuring plan, which includes adding a fourth, higher-rate income tax bracket. Under his plan, the rate on income above $150,000 (for single filers) would be taxed at 9.85 percent, rather than the current level of 7.85 percent.
Minnesota is one of seven Midwestern states with a graduated-income tax structure (see map on income taxes). If the Legislature follows through on Dayton’s plan, it would be following in the footsteps of neighboring Wisconsin, which added an additional bracket to its income tax code in 2009. (The highest rate in that state is now 7.75 percent.)
Illinois also raised its flat income tax rate from 3 percent to 5 percent in 2011.
But it is not tax increases that have dominated discussions in most of the Midwest’s state capitols so far this year. Instead, proposals to cut taxes — particularly reductions in the income tax — have been most prominent in the region. They include: 
• a proposal by Indiana Gov. Mike Pence to cut the state’s income tax by 10 percent;
• measures in Kansas to further cut the state income tax (rates were already dropped in 2012), with one idea being to keep in place a temporary increase in the sales tax in order to make up for the lost revenue; and
• a proposal by Wisconsin Republican Gov. Scott Walker to cut income taxes paid in the state’s lower three brackets by 2 to 3 percent. (Rates in the two higher-income brackets would be unchanged.)
Economic impact of income tax cuts

These plans are often touted not only as way to help taxpayers, but also as a way for a state to grow its economy and make it a more attractive place to live and do business. Republican Gov. Sam Brownback, for example, has said another round of tax cuts would provide the Kansas economy with a “shot of adrenaline.”

Scott Drenkard, an economist for the Tax Foundation’s Center for Tax Policy, says numerous studies back up this line of thinking. Higher taxes stunt economic growth, he says, with corporate and personal income taxes (in that order) being “the most destructive” (followed by sales taxes and property taxes).
Keen echoes those concerns about the current tax structure in Ohio, where he says income taxes are discouraging savings and investment.
But policy analysts at the Center on Budget and Policy Priorities say the academic literature and recent state experiences show no evidence that income tax cuts yield greater economic growth for states.
In a study released earlier this year, the center found that of the six states that enacted large income tax cuts before the most recent national recession, half grew faster and half grew more slowly than the national economy. Similarly, income tax cuts enacted in the 1990s had no effect on subsequent economic growth of individual states, says Michael Leachman, the center’s director of state fiscal research.
“In a vacuum, a cut in the personal income tax would have an economic impact,” Leachman says. “But it’s a zero-sum game. States have to balance their budgets, so tax cuts have to be paid for. They pay for them by cutting services or raising other taxes, or some combination. Those actions slow the economy.”
He adds that other factors — an educated state workforce, a state’s natural resources and the ability of businesses to access major consumer markets — play a much larger role in a state’s economy.
“You don’t want your tax levels to be outrageously out of line with your competing states, but tax levels are not the only thing,” he says. “And in the big picture, they are a minor thing.”
‘Modernizing’ sales tax, severance tax
As much as Drenkard and Leachman disagree on many aspects of state tax policy, they both support the idea of modernizing sales-tax systems to include more services.
“Almost all states do not tax services in a comprehensive way,” Drenkard says. “Instead, states have gone in the opposite direction and just raised the rates. So you’re preferencing the services sector at the expense of the goods sector.”
Leachman calls this “a serious structural problem that makes it harder to keep up public services.” Drenkard, on the other hand, prefers the idea of using the additional revenue to cut taxes in other areas.
Adding services to the tax base would be a major new source of revenue in nearly every Midwestern state. In Ohio, for example, Keen says sales tax receipts would increase by as much as 40 percent (if the overall sales tax rate were not cut at the same time).
In Nebraska, McCoy says, the state currently taxes fewer than half of the various types of services. Capturing more of this economic activity in the tax base would be one way to raise more revenue in order to cut income taxes while also lowering the sales tax rate and retaining many existing exemptions on business-to-business sales.
Kasich, meanwhile, is also seeking another type of modernization of Ohio’s tax code: a change in the severance tax on oil and natural gas extraction.
“The current severance tax does not generate revenue for state government,” Keen says. “It was put in place just to pay for the regulatory responsibilities of state government.
“Given the volume of [hydraulic fracturing] activity we expect, this is an opportunity to take advantage of our natural resources, generate some additional general-fund revenues and reduce the personal income tax.”
Leachman expects other states to look more closely at modernizing their severance taxes as well. He suggests, too, that policymakers take a close look at what is often a long list of credits, incentives and exemptions in their tax codes.
“What are they costing us and are they helping our economy?” Leachman says. “Those are important questions, and states are increasingly doing a better job of addressing them.”