Some states don’t have any 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. overhaul plans on the agenda this year. West Virginia has at least three. Facing a revenue shortfall and a widely-held conviction that reforming the state’s tax code could increase the state’s economic competitiveness, legislators and the governor are exploring options to cover the current revenue gap while also adopting long-term revisions to the state’s tax code. Easily the most ambitious of these proposals is Senate Bill 335, which recently reported from a Finance subcommittee.
The bill, cosponsored by most of the Republican Senate delegation, represents a complete overhaul of the state tax code, with the ultimate aim of replacing 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. , the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. , and the current 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. with a new, broad-based consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. at a rate of 8 percent. The new consumption tax would take effect in October, while the taxes it replaces would phase out over time. It is designed in part to provide a short-term revenue boost to cover the current shortfall, but also to bridge a revenue gap created by the new consumption tax unless and until the state economy grows to the point that revenue from the holdover taxes is unnecessary.
Offsetting the cost of three major taxes with one consumption tax, even at a high rate, requires a broad base—arguably too broad a base. An ideal sales 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. includes all final consumer transactions, both goods and services, but exempts business inputs to avoid what is known as “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. ,” where the tax is imposed at several points along the production process and thus ultimately falls on more than 100 percent of the final transaction price. To raise enough revenue, the consumption tax envisioned under SB 335 necessarily falls on a range of business inputs.
While it maintains the exemption for some business-to-business transactions, like raw materials and machinery and parts used in manufacturing, it explicitly includes certain other business inputs in the base. One practical result would be that a business which contracts out for various services would see a higher level of taxation embedded in its products than businesses which are more vertically integrated. Nevertheless, as the bill has gone through its revisions, the treatment of business inputs has vastly improved. As introduced, the bill would have taxed almost all professional services, but the most recent substitute reinstates the exemption for many professional services (including architecture, engineering, advertising, data processing, employment services, legal services, and accounting) when purchased by those holding a business certificate, a marked improvement from the original draft.
The current substitute bill language would replace the current graduated-rate individual income tax with a 2.5 percent flat income tax, reducing the rate by a further 0.1 percent for each $50 million of consumption tax revenue in excess of $2.5 billion, provided revenue reserves remained at appropriate levels. The language presently available includes a mandatory phasedown by 2032 should the triggers not be met, but committee revisions eliminate this provision, only reducing the rate of the income tax subject to revenue availability. If and when the individual income tax is eliminated, a similar phasedown of the corporate income tax would commence.
Here’s everything the bill does, in brief:
- Replaces the existing 6 percent sales tax with a revised sales tax with a rate of 8 percent and a broader base which includes groceries, a range of services purchased by consumers (with a $10,000 cap on the value of construction services), and some additional business inputs, effective October 1, 2017.
- Converts the current graduated-rate individual income tax into a single rate 2.5 percent income tax effective January 1, 2018. It then reduces the rate each year by 0.1 percent for every $50 million over the prior year’s revenue from the new sales tax that exceeds $2.4 billion, provided the rainy day fund balance exceeds 15 percent of the value of the general fund budget.
- While the income tax remains in place, exempts Social Security income and lifts the cap on the amount of retired military pay exempted.
- After the complete revenue-contingent (triggered) phaseout of the individual income tax, sets the corporate income tax on a track to decline by 1 percent per year, subject to an adequate rainy day fund balance, until the tax is repealed—but only if voters ratify a constitutional amendment, which provides for reserve deposits necessary to facilitate the reductions.
- Creates an earned income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. and a credit for senior citizens on fixed incomes, again only subject to ratification of the amendment.
- Adjusts severance tax rates, such that coal severance taxes, which currently range from 1 to 5 percent (the lower rates applying to thin seam coal), would be set uniformly at 2.5 percent, and after the repeal of the corporate income tax, reduces the rate on other natural resources from 5 to 3 percent.
- Replaces the current excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. on electronic cigarettes with a surcharge on the sales tax, bringing the sales tax rate on vapor products to 11 percent.
- Increases excise taxes on beer and soft drinks, along with the state’s wholesale “markup” on liquor sales.
Senate Bill 335’s boldness is its best attribute but also its greatest liability. Such dramatic overhauls of the tax code are rare, and more typically begin with the executive branch. Refining such a plan within the constraints of the session calendar is a daunting task. (All bills must receive a floor vote in their chamber of origin by March 29th, though language can continue to be revised in the opposite chamber, and in a committee of conference, after that.) When the fiscal note for the introduced version—which featured a much more robust schedule of tax phaseouts—projected revenues well short of the mark, senators worked hard to revise the bill, modifying the proposed consumption tax base, adjusting the phaseout provisions for the individual and corporate income tax, and incorporating excise tax increases (on soda and alcohol) to address the revenue gap.
With each revision, however, the simplicity of the original plan eroded, and even now there may be doubts about the plan’s ability to raise enough revenue to ever trigger the planned reductions in the individual and corporate income taxes, particularly if the state also adopted the constitutional amendment-contingent relief for senior citizens and low-income households.
An 8 percent consumption tax rate is viable, even with localities imposing their own sales taxes—Tennessee, which foregoes an individual income tax, features a 7 percent sales tax with high local option sales taxes atop it. However, with 28 of West Virginia’s 55 counties bordering another state, policymakers must be cognizant of the potential for cross-border shopping to avoid the higher rate. This would be of particular concern if the rate were allowed to creep any higher than 8 percent should revenues prove inadequate.
The great advantage of SB 335 is that it relies more heavily on consumption taxes, which are more pro-growth than income taxes because they do not fall on saving, investment, or (doubly) on future consumption. The challenges include revenue certainty and the necessity of adopting expedients to make the numbers work, including higher soda and alcohol taxes (which are regressive, somewhat arbitrary, a declining revenue source, and particularly conducive to cross-border shopping). This is coupled with the reality that some additional business inputs would be subject to taxation on top of the existing system of a corporate income tax (for at least the foreseeable future), tangible personal property taxes, and a local 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. . Securing ratification of a constitutional amendment as a precondition of significant elements of a reform package, moreover, is a daunting requirement.
There are sound economic arguments for greater reliance on consumption-based taxation, which tends to be more pro-growth than taxing either corporate or individual income. The individual income tax is, essentially, a tax on consumption and savings (or, more precisely, the change in savings). Whatever income an individual earns is either spent or saved, and savings and investment are more growth-oriented activities, so a tax that falls only on the portion of income that is consumed will tend to favor growth. Savings, moreover, can be understood as deferred consumption: we save, after all, for the purchase of consuming. When our savings are taxed, and then we are taxed again at the point of consumption, that delayed consumption is effectively double-taxed.
The comparative effects of corporate income taxes and other business taxes that fall heavily on capital are well-established. While it may be a simplification, it is still the case that whatever you tax, you get less of—whether that’s capital investment, labor, or consumption. A consumption tax, like the current general sales tax or the proposed revised sales tax, represents a more neutral and economically productive approach to taxation overall. Taxes on capital accumulation or labor force participation have larger ramifications for the broader economy. It is instructive that seven of the nine states that forego an individual income tax grew faster than the national average during the last census period, and the remaining two still experienced the fastest growth in their regions.
In its direction and intention, therefore, SB 335 represents a bold plan to jump-start West Virginia’s economy. The plan’s complexity, however, and the uncertainty surrounding it, justly give one pause. The West Virginia House of Delegates has its own, more modest tax reform plan (more on that soon). The good news is that both chambers seem serious about tax reform. The bad news is that the time to reconcile their distinct approaches is running short this session. There is much to admire in SB 335—but also a good deal to be wary of. No tax reform package of this magnitude could possibly please everyone in all its particulars, but as the bill continues to wend its way through the Senate, perhaps with further revisions ahead, the tradeoffs associated with the legislation will merit close attention.
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