New Mexico “Hard Reboot” Offers Exciting Vision, Potential Dangers in Details

February 11, 2013

Two New Mexico legislators, Sen. Bill Sharer (R) and Rep. Tom Taylor, have pitched a plan to clean out all the deductions, credits, and exemptions in the tax code and replace it all with one simple tax. In their words:

"We have 51 bills just in the Senate just this year asking for more deductions, more credits, more exemptions," Sharer said.

“It will just be easier to understand and compute. You know what you buy, sell and rent. Simply add 2 percent for the state’s cut rather than the over 8 percent tax that is charged now in some cities. We don’t need to charge those high taxes once the special interest credits, deductions and exemptions are eliminated.”

Sharer and Taylor concede their idea (dubbed a “Hard Reboot” of the tax system) is a work in progress, but the outline at present is this: repeal the state’s corporate income tax, individual income tax, franchise tax, estate tax, and car tax. The $4 billion in revenue would be made up by expanding the sales tax base and lowering the rate.

Here’s where the danger lurks: from my best reading of the 207-page proposal, the proposed 2 percent tax (plus 1 percent for localities) would apply to all transactions, including business-to-business transactions. To structure a sales tax to minimize economic distortions, it should exclude business-to-business transactions. This is not because businesses deserve special treatment, but because all final retail services should be taxed the same. If business-to-business transactions are also taxed, some final goods and services will be taxed multiple times. This problem with these so-called turnover or gross receipts taxes led to many European countries abandoning them and shifting to value-added taxes. (The tax also famously led to the economic collapse of the Spanish Empire.) Only a few U.S. states still have these types of taxes, and aside from Hawaii and Washington state, they are a minimal revenue source.

Transaction taxes come up quite often because they appear to be low taxes on a broad base, what economists usually recommend. However, the base is broader than the economy, since it encompasses more than just final transactions. We publicly sparred with Rep. Chaka Fattah (D-PA) over his federal transactions tax proposal, by which he proposed replaced all federal taxes with a 1% transactions tax. We noted that there are about $445 trillion worth of transactions annually in the U.S., over 30 times the economy. A 1% tax on every transaction would be, on average, a ~37% tax on final transactions, but just hidden in the prices.

The primary problem with this system is that intermediate business inputs would be taxed multiple times, what economists call "tax pyramiding." As we have noted, "This repeated taxing at each link in the production chain results in punitively high effective tax rates on complex products produced in stages by more than one company, and low rates on products with few production stages or that are produced entirely in-house." This creates massive discrimination in the tax code, with some products largely unscathed (particularly imports), and other items taxed into oblivion. On the issue of transparency, consumers would be unable to ascertain tax effects on prices. Sales tax reform should expand the tax, at maximum, to all final retail purchases. It should not encompass prior, non-final, transactions.

New Mexico’s existing sales-like Gross Receipts Tax (not to be confused with the concept of gross receipts taxes) is already pretty broad. Professor Mikesell estimates it as the second broadest in the United States, and it is the only state to subject all eleven major services to the tax. (Hawaii taxes just ten, letting off financial services.) I’m curious as to what the fiscal note says, as I’d be surprised that this proposal could be revenue-neutral without wrecking the state economy with pyramiding.

That said, the core idea is a good one: clean out exemptions and credits (and the bill gets rid of a lot of them besides business-to-business transactions) and use the revenue to pay down tax rates. It's especially do-able in New Mexico, given how relatively little the state raises from individual income taxes. Paul Gessing adds that, done right, it could also make the state tax system less volatile and more attractive to investment. It’s a proposal to watch.


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