Ohio Tax Reform Package Keeps Getting Worse

June 20, 2013

This afternoon, I learned of new changes to the tax reform proposal being considered in Ohio. Back in February, we gave a middle of the road reaction to the original plan being pushed by Governor Kasich, and two weeks ago, we admonished the Senate for scrapping some of the good elements of the original plan and retaining some of the bad elements. According to new details from the Columbus Dispatch, it looks like the plan just got worse. The new plan would:

  • Increase the statewide sales tax from 5.5 percent to 5.75 percent
  • Lower the exemption on the state’s gross receipts tax from $1 million to $500,000; meaning more businesses will be subject to it
  • Reduce income tax rates across the board by 10 percent over three years
  • Create a new earned income tax credit
  • Allow pass-through entities to deduct their income below $250,000 by 50 percent
  • Subject digital products like music downloads to the sales tax
  • Tighten up the homestead exemption in the income tax so it can only be taken by low income seniors

The biggest problem with this new plan is that it pays for income tax cuts by increasing the state’s reliance on the highly distortive Commercial Activities Tax (CAT), which is easily the worst part of Ohio’s tax code. The CAT is a gross receipts tax, which are like sales taxes, except they are levied at every point along the production chain. This is problematic because if you were to make a car under a gross receipts tax regime, the firm that turns rubber into tires would be subject to a tax, then the firm that adds the tire to the car would pay a tax on the final car, then the car would be subject to a tax when sold to the dealership, and finally the car would be taxed again when sold to the final consumer.

These taxes create a host of economic problems, one of which is that the true tax burden is disguised, as the tax is baked into the price of the product as it moves through the production process. So while the CAT’s 0.26 percent statutory rate may seem paltry, the tax is levied so many times that the effective rate is much higher.

Another problem is that gross receipts taxes disproportionately harm industries with more production stages. At their worst, gross receipts taxes can even encourage businesses to vertically integrate to avoid the tax, even if doing so doesn’t make any business sense. The new plan being considered in Ohio just increases this distortionary effect by subjecting more business revenue to a tax that pyramids throughout the economy.

The plan also increases the sales tax rate and uses the revenue to lower income tax rates (usually a good reform), but most of the revenue actually goes to a small business gimmick where passthrough entities like LLCs and S-corps are allowed to deduct half of their income that falls below a $250,000 threshold. As I commented two weeks ago:

This is bad policy, and many supporters are errantly pushing it under the guise of putting more money in the hands of “job-creators.” But this is based on a flawed understanding of what creates jobs. The businesses that actually create jobs are not small businesses or big businesses; they are businesses that are growing. And that type of business is virtually impossible to target with a tax incentive.

Finally, this plan lacks any semblance of cohesion. While the special carve out for passthroughs will be pushed under the guise of helping small businesses create jobs, the lowering of the exemption on the Commercial Activity Tax (CAT) will force low-revenue companies to pay more taxes. While raising sales tax rates and lowering income tax rates moves the code toward more of a consumption base, the plan doesn’t expand the sales tax base to services, so the tax still disproportionately harms the goods sector of the economy, while the services sector is not subject to sales taxes. While income tax rates are cut, the state still has nine brackets.

So even though this plan cuts revenues by $2.6 billion over three years, you really can’t call it tax reform; it’s just a mishmash of tax changes with no central theme.

More on Ohio.

Follow Scott Drenkard on Twitter.

PS- As I mentioned two weeks ago, there actually is some good tax reform legislation being considered in Ohio right now; it would reform the state’s highly unusual municipal income taxes.

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