June 21, 2005

Revenue Neutrality: Taxing Peter to Give Tax Cuts to Paul?

When President Bush created his Advisory Panel on Federal Tax Reform, he required that any proposal crafted by these experts must be “revenue neutral” – meaning, the new tax system must raise the same amount of tax revenue as the old system.

Considering the size of the federal deficit and his plan to reform Social Security, this is an understandable goal. But, this restriction opens the door to many bad tax policies, where politically powerful groups will get lower taxes that have to be made up by raising other people’s taxes — robbing Peter to pay Paul. As we’ll see, this type of redistributionist reform plan is very popular in the states – especially among Republican Governors, who want credit for reforming their tax systems without violating their pledge not to “raise taxes.”

We should start from the premise that a good tax code, whether at the federal or state level, distributes the tax burden evenly throughout the economy, leaving all redistributionist policies to the spending side. The tax code should simply be a means of raising sufficient monies to fund government programs, not a tool for social engineering or political patronage. Thus, the goal of tax reform is to make the tax code simple, fair, and economically efficient by getting rid of all the special tax breaks and applying the lowest possible tax rate on the widest possible tax base. In other words, “plucking the goose as to obtain the largest possible amount of feathers with the smallest amount of hissing” as Jean Baptiste Colbert wrote some 250 years ago.

Unfortunately, our federal and state tax codes are so far from this ideal that true tax reform will require shifting the tax burden considerably, creating lots of winners and losers. That’s why it’s so politically difficult, but the rewards in economic prosperity are worth the pain. And the pain in this case would distribute the tax burden in a more economically efficient way, allow the private economy to create jobs more easily, boost earnings, and promote savings and investment.

Sadly, many states are actually moving away from this ideal with proposals that shift the tax burden to politically unpopular constituents such as smokers or “big business.”

For example, the Texas House of Representatives recently passed a bill that would cut local property taxes but increase state sales and corporate taxes so as to make the plan revenue neutral. The problem, they say, is that property taxes are too high. That may well be true, but raising taxes on consumers and businesses does not right the wrong.

Indiana lawmakers pulled the same trick a few years ago, raising the state sales tax to provide local property tax relief. This is not tax reform (there’s another word for it: redistribution) and it merely shifts the tax burden from property owners to consumers and businesses.

Kentucky Governor Ernie Fletcher recently signed a major piece of tax legislation that repealed the state’s corporate license tax, reduced the tax rates on personal and corporate income, and enacted a new low-income tax credit. Sounds good so far. But to make the plan revenue neutral, he also raised taxes on cigarettes and other tobacco products, and made a host of changes to the corporate income tax law that amount to a tax hike. These new measures actually make Kentucky less attractive to business investment. From an accounting perspective, the plan was “revenue neutral.” As a reform plan, however, it did little to address the complexity or efficiency of Kentucky’s tax system.

Governor Bob Taft in Ohio is pushing his version of tax reform. Taft’s plan, contained in Ohio House Bill 1 and Senate Bill 1, would lower personal income taxes, eliminate some business taxes, raise the state sales tax rate, institute a new commercial activity tax on business gross receipts, and raise a host of state excise taxes. While it’s admirable that Taft wants to make the state’s tax code more “competitive”, the insistence on revenue neutrality will be counterproductive to the Governor’s goal.

The Kentucky and Ohio plans illustrate one of the worst aspects of so-called state tax reform: the shift from broad-based to narrow-based taxes. Both Fletcher and Taft’s plans lower income taxes while raising excise taxes on things like cigarettes and alcohol. Do Fletcher and Taft really think it is prudent to make the state’s education and health spending dependent on the sale of Marlboros and six packs?

One can hope that tax reform at the federal level will be different. If recent history is any indication, however, we best not get our hopes up. The 1986 tax reform, even with all its benefits, had many disastrous side effects for American business, all of which resulted from an insistence on revenue neutrality. If President Bush and the Congress want to truly reform the tax code, they should avoid the temptation to use revenue neutrality as an excuse to redistribute the tax burden among Americans.

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