Tuesday, February 06, 2007

The Governor's New Budget, Part 1: Making Pennsylvania Less Competitive

Governor Rendell announced his proposed 2007-08 State Budget today. Although it's hard to summarize the many changes in the $28 billion budget, the biggest (and worst) news for economic development is that, if enacted, the state's tax structure would become even less competitive than it is today.

It's particularly disappointing that despite a proposed $1 billion increase in state general fund taxes, no reduction whatsover was proposed for the state's Corporate Net Income (CNI) tax, which still stands as the nation's second highest at 9.99%. Pennsylvania continues to send a "take your business elsewhere" message by preserving this obvious red flag for business development, which in turn undercuts the impact of all of the other valuable economic development initiatives the state has undertaken.

As noted after the current year's budget passed with no reduction in the CNI, Pennsylvania could have moved out of the #2 position at a first year cost of about $33 million in the budget, or a mere 3% of the new revenues from the proposed sales tax increase. But the Governor didn't propose budging the CNI rate at all. It's good news that the state is continuing to phase out the Capital Stock and Franchise Tax (CSFT) -- the other big uncompetitive business tax -- but without changing the CNI, Pennsylvania won't reap the kinds of economic benefits it might otherwise enjoy from reducing the CSFT.

It's bad enough that Pennsylvania will continue to have the second highest Corporate Net Income Tax in the country. But the proposed Sales Tax increase would give Pennsylvania the highest Sales Tax rate in the country. Pennsylvania would move from having the 11th highest sales tax to join a group of only 4 other states with 7% statewide rates. Pennsylvania's sales tax burden would not be as onerous as other states because it exempts clothing, food, and prescription drugs from taxation. However, on the items it does tax, it would tax at a higher rate than 45 other states do. The only other major state with a sales tax as high as Pennsylvania's would be is New Jersey.

The message that businesses considering locating in the state will hear is that not only is Pennsylvania the least competitive of the major states in terms of the explicit corporate taxes, but it will now also be the least competitive of any state in terms of the sales tax.

The Sales Tax is not only regressive on individuals, it's regressive on businesses. Businesses will pay 16.7% more for most of their purchases regardless of whether they are profitable or not. One of the reasons why it's so important for Pennsylvania to phase out the Capital Stock and Franchise Tax is that it's a tax businesses pay regardless of whether they are profitable. But while Pennsylvania is reducing one tax that's unrelated to income, it will be increasing another.

But what about property tax reductions -- that's a tax on businesses and individuals that's not related to income, too, and isn't that what the Sales Tax increase is paying for? True, but only half of the proposed Sales Tax increase is going to property tax reductions, so there's still a net increase in taxes in the end. And as the Governor notes in the budget, Pennsylvania ranks in the middle of states on per capita property taxes. So while the reduction in property taxes will be welcomed by most, making Pennsylvania uncompetitive on another tax isn't the way to do it.

Let's suppose that everyone agreed that we needed $500 million more in state funds for property tax relief and/or reducing the Corporate Net Income tax, and that one needed to raise another tax to get it. Which tax should it be?

One option is similar to what the Governor proposed -- a half-percent increase in the Sales Tax, to 6.5%. That would give Pennsylvania the fifth highest rate in the country, tied with Minnesota, Nevada, and Washington, still making it look uncompetitive.

A second option would require raising the Personal Income Tax from 3.07% to 3.22%. Would that be uncompetitive? Interestingly, the answer is no. Pennsylvania currently has the second lowest Personal Income Tax (PIT) among the states that have such a tax, and only 6 states don't have a personal income tax, so Pennsylvania has the 8th lowest PIT. (Most states have graduated PIT rates, so it's hard to rank PIT rates, precisely, but we'll use the lowest rate on income over $25,000 for comparison purposes.) An increase to 3.22% would not change Pennsylvania's rank at all.

Of course, an increase in the PIT not only affects individuals, it affects small businesses organized under Subchapter S. But they already have a significant competitive advantage, both because they don't pay Pennsylvania's onerous 9.99% CNI tax, and because they pay the second lowest PIT rate in the country.

Increasing one tax to reduce another is a legitimate thing to think about in terms of making Pennsylvania more competitive -- as long as we don't substitute one uncompetitive tax for another. Unfortunately, the Governor is proposing to leave the most uncompetitive tax uncompetitive, and make a moderately uncompetitive tax even more uncompetitive. That's not a prescription for economic growth.

More on other aspects of the budget in future posts.


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