Sunday, March 07, 2010

State Tax Changes Would Hurt Economic Development

Governor Rendell has proposed dramatic changes in two of the state’s primary sources of tax revenue – the sales tax and the corporate net income tax. Both changes are touted as making the tax system fairer, which is certainly a desirable goal. But would the Governor’s proposals make Pennsylvania more or less competitive with other states for attracting and retaining businesses and jobs?

The Governor has proposed cutting the sales tax rate by one-third, from 6% to 4%, and expanding the tax to 74 categories of products and services that are currently exempt. These categories are so large that taxing them would not only offset what would otherwise be a $3 billion loss from the lower tax rate, but increase total revenues from the sales tax by 10%.

A number of examples have been given to illustrate the unfairness of the current sales tax exemptions, such as the fact that laundry detergent is taxed, while dry cleaning is not, and popcorn at a movie theater is taxed, while candy is not. However, these are not the exemptions that affect revenues the most. The majority of the new sales tax revenues would come from extending the sales tax to business and professional services such as accounting, architecture, computer programming, law, and public relations. Those industries would be subject to over $2 billion in new sales taxes.

Only five other states (Delaware, Hawaii, New Mexico, South Dakota, and Washington) have a sales tax on major business and professional services, and only three of those have taxes of the magnitude the Governor is proposing. (A few additional states tax advertising agency fees and testing laboratories.) Although the Governor suggests that these exemptions exist because of the influence of powerful lobbyists, the fact is that most states don’t tax these services because it’s viewed as double taxation on consumers, who will pay tax again on the final product the services were used to create. For example, if a manufacturer pays tax on legal services, it has to increase the price of its product to cover the cost of that tax, and then consumers pay more sales tax when they buy the product at the higher price.

Only 13 states tax custom computer programming services as the Governor is proposing to do. In fact, Pennsylvania’s exemption was enacted in 1997 specifically to make the state more competitive in attracting and retaining businesses in the information technology industry.

Consequently, expanding the sales tax to business services, computer services, and professional services would make the Pittsburgh Region dramatically less competitive in attracting and retaining businesses and jobs. Moreover, lowering the sales tax rate on currently taxable items seems to give up revenue unnecessarily; only 5 states that exempt food from sales tax as Pennsylvania does have a tax rate as low as the 4% rate the Governor has proposed (an additional 5 states have no sales tax at all). (It’s worth noting that although the Governor wants to close loopholes for accountants and lawyers, he doesn’t want to close them for doctors, hospitals, and universities; taxing health care and college tuition would raise $2 billion, almost as much as taxing business and professional services.)

The Governor has also proposed several significant and desirable changes in the corporate net income tax, including lowering the 9.99% rate (currently the second highest in the country) to 8.99% (still leaving the state with the 7th highest rate) and eliminating the cap on net operating loss carryforwards (which would help startup businesses and manufacturing firms).

To pay for this, the Governor has proposed to institute “combined reporting,” which would force national companies to pay Pennsylvania’s high taxes on all of their businesses, not just the ones located in Pennsylvania. As evidence that many large corporations are escaping Pennsylvania taxes by shifting profits to businesses located in other states, the Governor cites the fact that 71% of corporations in the state don’t pay any state corporate income tax. However, he fails to point out that the reason most corporations don’t pay corporate taxes is that they have no income to tax. In fact, a study by the U.S. General Accountability Office showed that 67% of corporations in the country had no federal tax liability, so the 71% figure in Pennsylvania does not suggest a major tax avoidance problem in the state. Moreover, there is no evidence that states which have instituted combined reporting or used other methods of closing tax loopholes have a higher percentage of their businesses paying taxes than Pennsylvania currently does.

Most worrisome is the fact that combined reporting would dramatically increase taxes on the sector the state needs to compete for most aggressively – manufacturing. A study done by the Pennsylvania Department of Revenue showed that even with the other changes proposed by the Governor, combined reporting would increase taxes on manufacturers by over 21%, which could well result in thousands of high-paying manufacturing jobs leaving the state.

Balancing the state budget is clearly a challenging task in these difficult economic times. However, the best way to increase state revenues is not to increase taxes, but to stimulate economic growth. National studies have shown that Pennsylvania spends more and taxes more than the majority of states, so the first priority should be to reduce expenditures. Any tax changes should be evaluated not by how much money they raise, but how they affect the state’s competitiveness.

(A shorter version of this post appeared as the Regional Insights column in the Sunday, March 7 Pittsburgh Post-Gazette.)


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