May 11, 2006

Reforming Property Taxes in the Lone Star State

On March 31st, the Texas Tax Reform Commission (chaired by former Comptroller John Sharp) released its tax reform recommendations. The Commission’s plan includes several major changes, including a new business gross receipts tax.

We understand that compliance with the Supreme Court’s ruling means that local property taxes must be reformed. While it is unfortunate that so many states entangle themselves in local fiscal affairs—often substituting worse taxes in lieu of local property levies—legal and political reality in Austin demands that something be done.

If Texas lawmakers have to cut local property taxes, they should pick replacement taxes that will minimize the damage to Texas’ sterling business tax climate—ranked 7th best in the Tax Foundation’s State Business Tax Climate Index.

The core of the Sharp Commission’s plan would replace Texas’ franchise tax with a gross receipts tax. Texas lawmakers should be cautious about this proposal. Gross receipts taxes are great for governments (because they raise lots of revenue) but they are generally hated by taxpayers. One need only look to Michigan’s example to see why.

In Michigan, many business owners are struggling under the Single Business Tax (SBT)—a gross receipts tax hybrid—and efforts to repeal the tax are gaining momentum. Michigan’s SBT is the nation’s most uncompetitive business tax because it extracts a tax burden even when a Michigan company fails to earn a profit.

Most states tax corporations on their profits: receipts minus costs. Gross receipts taxes, however, tax a company on its revenues with no deduction for costs. While the Texas gross receipts proposal does allow some deductions for wages or the cost of goods sold, this could benefit some companies more than others. For example, companies that purchase lots of machinery or other capital will not be able to deduct capital costs, while those deductions are available in other states with a corporate income tax. This will harm the competitiveness of Texas’ business tax system.

Putting aside the issue of competitiveness, the gross receipts tax proposal has another flaw. For instance, while corporations and partnerships would generally be taxed, sole proprietorships and small businesses with under $300,000 in revenue would pay no gross receipts taxes. One of the core principles of sound tax policy is that all businesses should be treated equally. Therefore, all forms of business, including C-corporations, S-corporations, partnerships and sole proprietorships, should pay the gross receipts tax. This is a flaw that the current franchise tax also suffers from.

Unequal tax treatment of businesses (through exclusions from the tax, credits against tax liability, or unjustifiable deductions from income) creates an economically inefficient system, where the winners and losers are determined by government tax policy instead of the marketplace. It also requires those without special exemptions to pay higher taxes. This means that Texas will experience lower economic growth than it would under a neutral tax system.

The next pitfall in the Sharp Commission’s report is the proposal to raise the cigarette tax by $1 per pack. An increase to $1.41 per pack would rank Texas’ cigarette tax 11th highest in the nation—just behind New York and Massachusetts. With the ever increasing prominence of cigarette sales via the Internet, the projected $800 million in expected revenue from the cigarette tax increase is questionable at best.

Finally, the Commission’s plan would indeed lower local property taxes for homeowners throughout Texas and impose a lower cap on taxes. However, unless there are accompanying measures that restrain the growth in government spending, there is no adequate protection against higher property taxes in the future. It will only be a matter of time before localities reach their new property tax caps—and constitutionality would again be a major question.

Even though we do have some sympathy for the plight of Texas lawmakers, it should not serve as a license to increase taxes or institute policies that favor one industry or business form over another. Texas has a reputation as a low-tax state with a competitive business tax climate. Many of the proposals currently on the table would harm that reputation.

Chris Atkins is staff attorney and Jonathan Williams is an economist at the Tax Foundation in Washington, D.C.