Ohio Tax Reform in 2014: Framing the Conversation

Download FISCAL FACT No. 424: Ohio Tax Reform in 2014: Framing the Conversation

Key Findings

• Governor Kasich’s 2014 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. proposal decreases individual income taxes, but pays for those tax decreases with hikes in taxes on tobacco, energy, and businesses.
• Overall, tax policy in Ohio over the last several years has been a mixed bag, but there are many ways to move Ohio down a path to fundamental reform.
• Ways policymakers should consider to improve corporate taxes would be to repeal the Commercial Activities Tax, eliminate special credits for businesses, and bring down the overall rate.
• Ways policymakers should consider to improve individual income taxes would be to overhaul Ohio’s local income tax system, repeal last year’s 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. carve out, consolidate income tax brackets, and eliminate the marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples. .
• Ways policymakers should consider to improve sales taxes would be to eliminate taxes on business inputs, while expanding the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. base to services.

Introduction

Tax policy changes in Ohio over the last few years have been a mixed bag. While income tax rates were cut during the 2013 legislative session, policymakers also enacted an increase in the state sales tax and a problematic small business carve-out that distorts the 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. base. Most harmfully, the 2013 tax package increased the state’s reliance on the Commercial Activities Tax (CAT),[1] a tax which is routinely the subject of scrutiny from tax scholars.[2]

Governor Kasich recently called for further tax changes in his 2014 State of the State address. These proposals, too, are a somewhat disjointed attempt at tax reform that lacks principle or a unifying theme. In an effort to provide a menu of options for sound tax reform, this report lists the current proposals being considered in 2014 and options for improving them.

Governor Kasich’s 2014 Tax Plan

In mid-March, Governor Kasich unveiled the specifics of his State of the State promise to cut taxes in 2014. They are listed in detail on the Mid-Biennium Review website[3] and in House Bill 472.[4] Major changes include:

Tax Changes	Revenue Impact (FY 2015-17)
Individual Income Tax
Reduce rates across the board by 8.5 percent over the next three years	$2.639 billion tax cut
Increase Earned Income Tax Credit (EITC) from 5 percent of federal credit to 15 percent
Increase state’s personal exemption from $1,700 to $2,700, with phase downs at incomes of $40,000 and $80,000
Excise Taxes
Increase cigarette excise tax rate from $1.25 to $1.85 per pack	$848 million tax hike
Implement new tax on electronic cigarettes (49 percent of wholesale price by July 2015)
Energy Taxes
Increase state’s severance tax rate to 2.75 percent of all gross receipts	$874 million tax hike
Implement new $8 million per new well drilled (applicable for three years)
Implement exclusion from all severance taxes for small conventional gas producers
Distribute 25 percent of new oil revenues to local governments in oil and gas producing regions
Gross Receipts Taxes
Increase Commercial Activities Tax (CAT) rate by 15 percent from 0.26 percent to 0.30 percent	$743 million tax hike
Total Revenue Impact (FY 2015-17)	$174 million cut

While income tax rate cuts are beneficial fiscal policy, there is little here in the way of base reform. For example, the state would retain all nine of its income tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s (see Table 1). Additionally, while the formula for sound tax reform would be to offset rate cuts with base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. that improves neutrality, this proposal exclusively relies on opaque and politically expedient tax hikes to make the ledger add up.

Table 1: Proposed Ohio Income Tax Bracket Changes

	Current Rate	Proposed Rate
Bracket	2014	2014	2015	2016
$0	0.534%	0.515%	0.491%	0.483%
$5,200	1.068%	1.031%	0.983%	0.967%
$10,400	2.137%	2.062%	1.965%	1.933%
$15,650	2.671%	2.578%	2.457%	2.417%
$20,900	3.204%	3.092%	2.947%	2.900%
$41,700	3.739%	3.608%	3.439%	3.384%
$83,350	4.272%	4.122%	3.930%	3.867%
$104,250	4.960%	4.786%	4.563%	4.489%
$208,500	5.392%	5.203%	4.960%	4.880%

Note: Brackets adjusted for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. each year.

The most damaging of these offsets is the increase in the state’s Commercial Activities Tax (CAT). While the tax rate of 0.26 percent seems small, gross receipts taxes like the CAT are levied so many times along the production process that effective rates are many times higher. Ohio is one of just five states with gross receipts taxes like this, and of those states, Virginia, Texas, and Washington have all seen calls for reform in the last year.[5]

Placing additional weight on tobacco taxes to fund government services is another poor budget strategy. Because cigarette consumption has decreased steadily since the 1960s, tobacco revenues cannot be used as a long-term funding source.[6] New taxes on electronic cigarettes are also misguided, as research often finds them to be less harmful than incinerated tobacco.[7]

Moving the Discussion Forward

While the above proposals leave much to be desired, an appetite for tax reform appears to be present in Ohio. As such, the list below details recommendations for policymakers, journalists, and taxpayers as they start conversations about how Ohio can improve Governor Kasich’s 2014 plan to make it more competitive and pro-growth. Many of these suggestions could be done in a revenue-neutral fashion, and all suggestions are sourced to larger works for further study.

Corporate Taxes

• Repeal the CAT: Ohio is one of just five states to levy a 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. , which they call the Commercial Activities Tax (CAT). Gross receipts taxes are widely criticized by economists because they result 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. ,” the double and triple taxation of business inputs as they move through a production chain.[8] As a component of 2013 tax changes, the state lowered the exemption of the tax, meaning more of the Ohio economy is subject to it, amplifying its distortive effects.
  Instead of increasing the CAT rate as the 2014 plan proposes, a prudent change would be to move to taxing services through the sales tax instead of gross receipts (detailed below), as this would remove tax pyramiding concerns and not unduly burden businesses with cyclical income or low profit margins.
• Eliminate Credits and Lower Rates: The Ohio tax code has generous credits for all three generally-applicable categories: jobs, research and development, and investment. While these credits lower the tax burden of select businesses engaging in favorable activity, they also mean the overall tax rate must be higher to bring in revenue. Sound tax reform would mean eliminating these privileges to broaden the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and then lowering tax rates to make the state more competitive.[9]
• Repeal Local Corporate Income Taxes: Ohio is one of very few states that allows municipalities to levy corporate income taxes, which stack on top of the already problematic statewide CAT. Revenue from these taxes is highly volatile, which means municipal planning is very difficult, and compliance with corporate income taxes is incredibly arduous.[10] Municipalities should lean on more traditional local revenue streams like property taxes to fund essential government functions.

Individual Taxes

• Reform Local Individual Income Taxes: Ohio has the most complex and unnecessarily burdensome local income tax system in the country.[11] In the long run, the system needs to be entirely restructured to comport with standards of other states that levy such taxes (which are few).[12] The state considered H.B. 5 in 2013 which proposed some of these simplifications, but the bill has since been largely stripped of many of the beneficial elements included in proposals.[13] While comprehensive simplification is needed (e.g., making local taxes easy enough to include on the state’s tax return, as Maryland does), moderate reforms are also possible in the interim:
• Require local income calculations to start with taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. as defined on the Ohio state tax return (Localities currently define their own income base)
• Establish a statewide standard mandating that income may not be subject to taxation in more than one jurisdiction (fixing what is referred to as the cross-credit problem)
• Establish a strong, bright-line visitor’s exemption (30 days) before which no income tax is due
• Repeal Last Year’s Pass-Through Carve Out: A hallmark element of Governor Kasich’s 2014 tax package is getting the top income tax rate below 5 percent. Further income tax rate cuts would be easier from a revenue perspective if policymakers repealed last year’s generous exclusion for pass-through income and applied that revenue to rate cuts.[14]
• Consolidate Income Tax Brackets: While income tax rate cuts have been a component of both last year and this year’s proposals, policymakers could increase simplicity and decrease labor distortions by consolidating brackets and considering a move to a single tax rate structure. Standard deductions could be adjusted to retain progressivity of the code.[15]

Sales Taxes

• Eliminate Tax on Business Inputs: Ohio currently applies its sales tax to many business-to-business transactions, meaning that businesses have to pass on the costs of those sales taxes to final consumers. A well-structured sales tax would apply only to final consumer transactions.[16] In 2012, Ohio businesses paid $4.3 billion dollars in sales taxes on business inputs.[17]
• Expand Sales Tax Base to Services: Ohio currently does not tax many services in its sales tax, and this means that the goods sector of the economy bears a disproportionate burden from the sales tax and that the overall sales tax rate has to be much higher to bring in necessary revenue. As a component of overall tax reform, expanding the sales tax base to services is a neutrality-enhancing offset that can make rate cuts possible.[18]

Conclusion

2014 represents an opportunity for Ohio to tackle tough tax code problems that have been a drag on the state’s fiscal structure for years. Governor Kasich’s goal of enacting income tax cuts with revenue offsets is possible, but relying on tax gimmicks to close the revenue gap is not sensible tax policy. The proposals presented here, or any elements of them, would start Ohio down a path to fundamental reforms to the state’s tax structure instead of tinkering at the edges.

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