Pennsylvania Governor Proposes Major Tax Overhaul

March 6, 2015

“See, we can agree on certain things,” Pennsylvania Governor Tom Wolf (D) quipped during his State of the State Address, when members of both parties applauded his proposal to phase out the Commonwealth’s Capital Stock and Franchise Tax. It may be one of the few areas of agreement the Governor can find with a Republican-controlled legislature as he pushes his a budget containing $4.7 billion in new and higher taxes, which the Harrisburg-based Commonwealth Foundation estimates would cost an average family of four an additional $1,450 a year.

In broad strokes, Wolf’s plan involves reductions in property taxes and corporate taxes, but these are more than offset by increases in the individual income tax, the sales tax, and a proposed severance tax on the state’s booming natural gas industry.

Corporate Taxes

At 9.99 percent, Pennsylvania’s Corporate Net Income Tax (CNIT) is the second-highest state corporate income tax in the nation, and it's an enormous factor in Pennsylvania's abysmal 46th place ranking on the corporate tax component of our 2015 State Business Tax Climate Index. Only Iowa has higher corporate income tax rates, and then only on corporate income above $100,000, whereas Pennsylvania’s 9.99 percent corporate tax falls on all income, from the very first dollar. There is much to be said for a flat rate, but one this high has a substantial adverse effect on economic growth. The Wolf budget proposed halving the rate over three years, reducing the rate to 5.99 percent for 2016 and 2017, then to 4.99 percent after that.

Wolf also proposes the phase-out of the state’s Capital Stock and Franchise Tax—or rather, the completion of a phase-out begun by then-Governor Tom Ridge seventeen years ago, one that has been delayed again and again. The Wolf budget would eliminate the tax effective January 1, 2016. As we noted last week, eighteen states levy some sort of capital stock tax, though several are in the process of eliminating them. As a tax on net worth, franchise taxes penalize business growth, with companies that invest in capital expansion experiencing a higher tax burden than those that do not.

At the same time, Wolf proposes limiting the ability of corporations to write off losses in two ways. Firstly, he proposes a reduction in the cap on net operating losses, from $5 million or 30 percent of income to $3 million or 12.5 percent of income. Pennsylvania is one of only three states to cap NOL carryforwards, and the Governor’s budget represents further retrenchment on that issue. Doing so penalizes companies with greater volatility across the business cycle. Secondly, the budget includes “combined reporting,” which entails calculating a business’s profits, for Pennsylvania tax purposes, by adding up the profits and losses of all of its subsidiaries, even if those subsidiaries operate outside of and lack nexus with Pennsylvania. This is arguably a means of broadening the corporate tax base by ensuring that all business income is taxed, but it adds a great deal of complexity and can lead to multiple taxation of business income.

Severance Taxes

Pennsylvania is the largest natural gas-producing state without a severance tax, and as the state continues to experience a boom in hydraulic fracturing of the Marcellus Shale layer, levying one has been a source of continued controversy. In his budget address, Wolf declared, “Natural gas production is growing faster in Pennsylvania than anywhere else in the country. Yet, we are the only major producer of natural gas that does not ask drillers to pay their fair share or provide a return on our resources.” The choice of conjunction might be disputed; perhaps the lack of a severance tax is a contributing factor in the growth of the industry in Pennsylvania. In any event, it has helped offset the impact of the state’s extremely high corporate tax, although Wolf’s proposal does include rate reductions to the Corporate Net Income Tax, as discussed above.

Sales Taxes

Sales tax expansion is one of the key revenue drivers in Wolf’s budget, which proposes both eliminating 45 existing exemptions and raising the state sales tax rate from 6.0 to 6.6 percent. The base would be broadened to include currently exempted goods such as candy, newspapers and magazines, personal hygiene products, non-prescription drugs, textbooks, investment coins, cable television, and horses. The latter is no small matter; Pennsylvania is, after all, a state where the state supreme court declared unconstitutional a section of the Vehicle Code that addressed animals and animal-drawn vehicles, notwithstanding the lyrical dissent of Justice Eakin (“A horse is a horse, of course, of course, but the Vehicle Code does not divorce its application from, perforce, a steed, as my colleagues said”).

The expanded sales tax base would also include a wide range of services, including legal, accounting, and professional services; finance and real estate; business support and employment services; home health care, nursing, and ambulatory services; transportation; the performing arts, spectator sports, and entertainment venues; and personal care and personal services, among others. Exemptions for food, clothing, and prescription drugs are maintained. The one percent dealer discount would be capped at $300 a year. Consistent with good tax policy, business inputs would remain exempt, which avoids tax pyramiding.

Personal Income Tax

Wolf campaigned on a progressive income tax, but in an attempt to comply with the Uniformity Clause of the state’s constitution, settled on a twenty percent increase in the flat rate, from 3.07 to 3.7 percent, coupled with exemptions for low-income taxpayers. There may be some question about the constitutionality of even his revised proposal, however; the Pennsylvania Supreme Court struck a progressive income tax in 1935, then in 1971 struck down a flat-rate income tax on the grounds that its deductions and exemptions “offend[ed] the constitutional requirement of uniformity.” A 1968 amendment to the state constitution waives the uniformity requirement for exemptions specifically targeted the impoverished or disabled; whether Wolf’s proposal exceeds those limitations is disputed.

Property Taxes

As part of his budget, Wolf proposes $3.8 billion in property tax relief, though it is more accurate to say that he proposes increasing the state’s share of public education funding to hypothetically reduce the pressure on localities to raise revenues through local property taxes, with different impacts across the Commonwealth. In Philadelphia, for instance, most of the reduction would actually come through the city’s wage tax, not property taxes as such. In Pennsylvania, counties, school districts, and municipalities all have the power to levy property taxes. Wolf also proposes a rent rebate for renters with annual incomes less than $50,000.

Overall Tax Plan

Wolf’s tax plan has positive elements. Expanding the sales tax base is good policy; so is reducing the corporate income tax and eliminating the outmoded capital stock tax. A $4.7 billion tax increase, however, is a bitter pill to swallow, and several of the Governor’s proposals increase tax complexity and further burden economic activity. The Governor says that Pennsylvania needs a “bold and ambitious” budget; that’s definitely one way to describe a 16 percent increase in the size of the state budget. But fights about taxes are nothing new for Pennsylvanians; Ben Franklin’s famous bon mot about liberty and security was, in fact, about the “liberty” of the legislature to impose property taxes. What bears following is whether Tom Wolf can write a new chapter on Keystone State tax policy, or whether this proposal, like so many that preceded it, will be consigned to the bonfire of the vanities.

Check out our recent testimony to the Pennsylvania House Majority Policy Commitee.

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