This post originally appeared as an op-ed on Forbes here.
Ohio’s state budget has been in negotiation since January. Governor Kasich’s (R) original budget plan came in at a large fiscal cost because of hefty individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. cuts, but multiple structural components of the proposal—like a hike in the state’s Commercial Activity TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. —would prevent the plan from delivering on economic growth in the way income tax cuts normally would.
The House of Representatives responded by making several discernible improvementsin their proposed budget, mostly turning the tax plan into a slightly smaller individual income tax cut while scrapping the damaging revenue offsets. Though the House plan is still not perfect, the changes were a significant step in the right direction. In recent weeks, the Ohio Senate has countered with a bill that reincorporates some of the damaging parts of Gov. Kasich’s original proposal.
Excluding Pass-Through Income: It’s Foolhardy
One of these damaging elements is the Senate’s proposal to allow pass-through businesses like LLCs, S-corps, and sole proprietorships to deduct 100 percent of their income up to the first $250,000 in gross receipts and cap the tax rate of any additional revenues at a flat 3 percent.
While tax breaks for small businesses might play well in politics, the way this policy is structured just incentivizes wage-earners to reclassify themselves as contractor businesses in order to take advantage of the tax break. As one of us explained in testimony to the Ohio Committee on Ways and Means and in previous op-eds, if the District of Columbia, where we live, were to adopt the same policy, we could simply ask our employer to rehire us as a contractor, then file taxes as a sole proprietor, voiding our tax liability. The result? We wouldn’t add additional value or create any new jobs, but we would receive a huge tax break in return thanks to our new business classification.
Admittedly, this isn’t possible for every worker, but it does work for a lot of people on the margin. When Kansas enacted a similar pass-through exclusion (for all pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. income), the state estimated that 191,000 workers would receive the tax break. The result was almost twice as high – 330,000 Kansans took advantage and the state lost $207 million in revenues.
Swapping Income Tax Cuts for Cigarette Tax Hikes: Won’t Work for Long
The Senate’s bill does enact the same House-proposed broad-based personal income tax cuts of 6.3 percent, reducing the top rate from 5.33 percent to 4.99 percent, but would also increase the state’s cigarette tax from $1.25 to $1.65 a pack. This would move Ohio’s cigarette tax rate from the 28th highest in the nation to the 21st highest.
High cigarette taxes have the unintended consequence of leading to cigarette smuggling and tax evasion. This problem, coupled with the fact that cigarette taxes also represent a declining source of revenue, makes it very difficult to use cigarette taxes as a robust funding mechanism for important functions of government. These vital projects would be better funded by broad, predictable revenue sources, not unreliable, concentrated, and consequence-heavy sin taxes.
Again, this compromise is weaker than the House’s bill, which resisted Gov. Kasich’s $1 cigarette tax hike and new e-cigarette tax proposals. The Senate’s bill will not tax e-cigarettes, but does concede to a cigarette tax increase.
Reforming Ohio’s Gross Receipts TaxA gross receipts tax, also known as a turnover tax, is applied to a company’s gross sales, without deductions for a firm’s business expenses, like costs of goods sold and compensation. Unlike a sales tax, a gross receipts tax is assessed on businesses and apply to business-to-business transactions in addition to final consumer purchases, leading to tax pyramiding. : It’s Overdue
So what should Ohio do? If the goal is to cut business costs, a more effective growth plan is to lower, or better yet, eliminate the state’s Commercial Activities Tax (CAT). Ohio employs the CAT, a gross receipts tax, as their form of corporate tax. The tax is structured such that it results in tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action. , a damaging process where products and services are taxed multiple times throughout the production chain. Ohio is one of only five states to tax corporations in this way, and economists have denounced gross receipts taxes for centuries.
Gov. Kasich’s plan troubling suggested increasing the CAT, but the House and Senate proposals keep the rate at its current 0.26 percent. In the long-run, comprehensively revisiting the CAT will be necessary to bring the state in line with more competitive corporate tax structures.
Going Forward
In whole, the changes by the Ohio House and Senate to the original proposal put forward by Governor Kasich are welcomed, but there are still improvements to be made. The Senate is scheduled to vote on the bill on Wednesday, and it will be interesting to see how the House and Senate compromise their plans.
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