Ohio Tax Plan Broadens Sales Tax, Lowers Income Tax, Includes “Small Business” Gimmick

February 11, 2013

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Governor Kasich last week rolled out specifics for a plan on Ohio that would broaden the state’s sales tax base to services and lower the rate from 5.5 percent to 5 percent. The plan uses the additional revenue from this move to phase in lower individual income tax rates across the board by 20 percent by 2015. The current top marginal rate is 5.925 percent, and would fall to 4.74 percent by 2015. Finally, the plan also includes a generous 50 percent exclusion for income below $750,000 earned by pass-through entities like LLCs and S-corps that file through the individual code.

Severance taxes (which the Kasich administration unsuccessfully attempted to hike last year) would also be restructured and hiked, raising $415 million in revenue by 2017.

Ohio Individual Income Tax Rates Under Kasich Plan

Proposed Reductions
Brackets Current Law 2013 2014 2015
$0-$5,000 0.587% 0.543% 0.499% 0.470%
$5,000-$10,000 1.174% 1.086% 0.998% 0.939%
$10,000-15,000 2.348% 2.172% 1.996% 1.878%
$15,000-$20,000 2.935% 2.715% 2.495% 2.348%
$20,000-$40,000 3.521% 3.257% 2.993% 2.817%
$40,000-$80,000 4.109% 3.801% 3.493% 3.287%
$80,000-$100,000 4.695% 4.343% 3.991% 3.756%
$100,000-$200,000 5.451% 5.042% 4.633% 4.361%
$200,000-over 5.925% 5.481% 5.036% 4.740%

Note: Brackets do not reflect inflation indexing.

The heart of this plan is in the right place, but there is certainly some room for improving. The general idea of swapping a base expansion of the sales tax with a rate reduction for the individual income tax is a one that is rooted in the principles of sound tax policy. Economic theory indicates that income taxes are more destructive to the economic growth because they disincentivize wealth creation. Empirical evidence shows that this intuition bears out in the real world. Sales taxes, by contrast, are less destructive to growth because they encourage saving, which is linked to long term growth.

The plan also takes a wide approach to taxing services, which I’ve argued elsewhere is the best way to tackle that type of reform. In fact, the only reason most states do not tax services is because the statutes (most written in the 1930s) were originally only applied to sales of “tangible personal property.” While this worked well enough back then when goods composed two-thirds of the economy, that base has been shrinking every year, and services now compose two-thirds of the economy. This subjects the goods sector of the economy to an undue tax burden, which is economically equivalent to a subsidy for the services sector.

Kasich’s plan deserves kudos for proposing to expand the sales tax base to politically powerful groups like attorneys and financial planners—they should pay sales taxes like everyone else, but often lobby to keep their exemptions (I’ve attached the full list of sales tax base changes from the Ohio Treasury below).

However, some elements of Kasich's plan deserve more scrutiny. Raising severance taxes can create public administration problems, as these costs are exported to taxpayers across state lines and in-state residents end up getting more in government services than they actually pay for.

The income tax portion of the plan—which looks a bit like what ended up getting accidentally passed in Kansas last year—has a 50 percent exclusion available for "small business" income up to $750,000, a provision which has little public policy justification other than being appealing from a messaging standpoint. The biggest concern is that this creates a substantial incentive to structure one's personal income as business income, even when there is no other economic reason to do so.

Proponents of this provision will talk about how this tax preference for small businesses is designed to spur job growth, and to some extent they are correct in that income taxes are negatively correlated with economic growth. However, the real businesses that "create jobs" are not firms that stay small forever, they are the ones that grow from small firms into medium or large firms. These businesses are exceptionally hard to target with tax preferences and Kasich’s plan even phases out the small business deduction after the firm reaches an arbitrary size.

The plan would do better to use the revenue that the sales tax base-broadening would bring in to lower the income tax rate on all taxpayers. By my back of the envelope calculation, this means the top rate could end up around 4.4 percent, not 4.7 percent. Ideally, the state would also start looking at eliminating at least a few of their nine tax brackets to move toward a flatter treatment of income.

More on Ohio here.

Follow Scott Drenkard on Twitter @ScottDrenkard.

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