Texas Considering Drastic Modifications to Margin Tax
March 12, 2013
While Nevada legislators consider mimicking the Texas margin tax, no less than 99 bills are under consideration in Texas to modify or repeal the tax. Most relate to credits, exemptions, and other carve-outs, but others permanently increase the exemption level or alter the constitutional requirements for raising rates. Five bills call for the phase-out or direct repeal of the tax. Because of the way tax overhaul’s design shifted the burden of the tax from certain entities to others, the tax has mixed reviews among the business community. A few companies have attempted to challenge the constitutionality of the tax, and there’s even a petition for its repeal.
We’ve criticized this particular Texas tax a few times (here and here), despite the state’s merits in other areas of taxation. There are two compelling economic reasons why this is a poorly-designed tax. First, it’s complicated to calculate and drains economic resources due to high compliance and administrative costs. Second, it isn’t neutral, treating certain business types, industries, and operations differently. Both of these lead to economic distortions that would not be present in the absence of such a tax.
Overly complicated tax calculations create compliance and administrative costs that are a loss to society. The calculation of a business’s margin tax liability is far from simple. Businesses subject to the tax must choose one of three bases. The definitions used in determining these tax bases are statutorily defined and different from definitions set by the federal government. Since calculations are so complicated, compliance and administrative costs are high. In a 2010 interim report of the House Committee on Ways and Means, one taxpayer, represented by the National Federation of Independent Business (NFIB), reported an increase from $400 to $2,500 in compliance costs after the margin tax was implemented. Economic resources wasted on complying with a complicated tax could be utilized more efficiently elsewhere in the economy. Further, when a tax treats different activities differently, it implicitly favors certain practices and operations over others. This generates economic distortions that would not be present in the absence of the tax. The less economic decisions that are created due to a tax, the better.
Taxes should be neutral, and the margin tax favors certain industries, practices, and business types by design. The margin tax isn’t neutral for a variety of reasons. First of all, there are two separate rates—0.5 percent for businesses “primarily engaged in wholesale or retail trade” and 1.0 percent for everyone else. Businesses with sufficiently low revenues have another separate rate. Second, it isn’t horizontally equitable, meaning that businesses that are similarly situated don’t face the same liability. For example, as described by the Texas Taxpayers and Research Association (TTARA):
[T]he retail outlet of a manufacturer may be taxed at one percent because the combined group of companies may be classified as a manufacturer. In contrast, an independently-owned retail store is classified as a retailer and pays a half percent tax rate…A company that hires its own employees may deduct salaries as compensation; however, a company engaged in the same line of business that chooses to use independent contractors to conduct its operations may not. Companies in the business of renting equipment may not deduct the cost of their equipment as cost of goods sold, while companies that sell that same equipment may. As a retailer, the company selling equipment will also qualify for a lower tax rate, while the rental company will not because they are considered to be engaged in providing services.
(Note that these observations are based on the law as of October 2011.) The tax treats businesses differently based on the industry in which they operate, how they are organized, and on minute operating and organizational details. Again, this implicitly favors certain activities over others—something the tax code shouldn’t do.
Back to Square One. Unfortunately, Texas is right back where it began. Last month, the school financing system was again deemed unconstitutional by the same District Judge that ruled on the system in 2005. (This had been the impetus for enacting the tax in the first place.) The decision will likely be appealed to the Texas Supreme Court, which could result in more than a year of additional litigation time. In the meantime, perhaps this will provide the needed impetus for Texas to find a more efficient way to fund state operations, rather than relying on a tax that is complicated and confusing, generates wasteful costs, and creates economic distortions.