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1 6-7 Martin Chren, President, F.A. Hayek Foundation, Slovakia Fundamental Tax Reform in Central Europe FRONT & CENTER In this issue: Tax Cuts and Deficits 1 Uncle Sam’s Dollar 3 Surveying Unemployment 5 New Flat Tax in Slovakia 6 State Tax Collections 8 Virginia Tax Reform 10 New Background Papers 10 Foundation Message 11 Giving to the Foundation 12 TAX FEATURES www.taxfoundation.org January/February 2004 Volume 48, Number 1 See Tax Cuts on page 2 Tax Cuts Promise To Be Major Domestic Issue of Presidential Election Bush Pushes for Permanence; Kerry Wants Repeal of High-Income Tax Cuts, Promising New Tax Credits and Spending Programs As members of Congress debate the budget resolution for the FY 2005 federal budget, many lawmakers are claiming that the 2001 and 2003 Bush tax cuts — especially for high-income taxpayers — are the principal cause of today’s high tide of red ink: $477 billion according to the Congressional Bud- get Office (CBO) but $521 billion according to the Office of Management and Budget. President Bush believes the high deficit is primarily caused by an economy that’s recovering slowly from a series of jolts in 2001: a normal cyclical recession, the attacks of September 11 and the popping of the internet bubble which revealed outrageous corporate criminality. On the subject of ex- cessive federal spending, he has called on the Congress to restrain itself. To maximize the chances of full recovery, the President believes the tax cuts should be made permanent at their highest levels in- stead of rising and falling in value over the next several years and finally expiring com- pletely at the end of 2010. Meanwhile, others assert that repealing all of the tax cuts for upper-income Ameri- cans would make a significant dent in the deficit. For example, Senator John Kerry considers all the tax cuts that benefitted couples making $200,000 or more to be unjustified. He does not focus on federal overspending; indeed, he has proposed hun- dreds of billions of dollars worth of new government spending. These are the essential tax policy posi- tions that voters will be assessing in the presi- dential election come November. Sen. Kerry says the Bush tax cuts, especially for high-income taxpayers, have created the huge federal deficit. ... President Bush believes the deficit is caused by an economy that’s only now recovering from 2001, when a normal recession was worsened by the attacks of September 11th, the internet bubble, and corporate criminality. 2 How Much Revenue Is There In Tax Cut Repeal? There has been some dispute over which provisions of the Bush tax cuts Kerry would target for repeal. After all, high-income people benefit from many of the same tax cuts that mid- dle-income taxpayers do. Using an individual tax model similar to the one used by Congress’s Joint Committee on Taxation, Tax Foundation economists estimated how much revenue could theoretical- ly be raised in 2004 if provisions of the Bush tax cuts were retroactively repealed. The table above compares those amounts to the CBO deficit estimate, showing what fraction of the deficit is caused by tax cuts, or could be elimi- nated by repealing tax cuts. Tax Cuts at the High End of the Income Spectrum Our first step was to return the top two income tax rates to their 2000 levels (the 35 percent rate back up to 39.6 percent, and the 33 per- cent rate back to 36 percent) and repeal the preferential 15 percent tax rate on dividend income for these taxpayers. This repeal would raise $27 bil- lion, only 6 percent of the current deficit, most of which would come from the roughly 700,000 taxpayers earning more than $500,000 per year. Unfortunately, this would only lower our current year deficit to $450 bil- lion, a very long way from balance. Keep in mind that our estimates here are “static,” by which we mean that we ignore any changes people would make in their earning, saving and spending habits when their tax rates change. In real life, people (espe- cially high-income people) certainly do respond to higher tax rates in ways that lower tax revenue. And because that isn’t taken into account in these estimates, they likely overstate the amount of new revenue that tax cut repeal could generate. We next repealed the new 15 percent rate on dividend income for taxpayers in all other tax brackets and reset the capital gains tax rate to 20 percent. Restoring these rates to their 2000 levels would raise $20 billion, cutting the deficit to $430 billion. That wraps up the “tax cuts for the rich,” and yet the deficit is re- duced by only 10 percent. From here on down, the tax cuts overwhelmingly benefit middle-income people, and Sen. Kerry has consistently defended those cuts. In fact he recently told the AFL-CIO in Florida that he wants new tax credits for health care and college tuition. But if he changed his mind, adopting the Dean-Gephardt position of total tax cut repeal, and resisted the temptation to spend the extra tax revenue, how much more could he cut the deficit? Middle- and Low-Income Tax Cuts Too few in Washington recognize that a sizeable majority of the 2001 and 2003 tax cuts benefited millions of working families across the country by lowering their income tax rates, lifting the so-called marriage penalty, and raising the value of the child cred- it to $1,000 from $500. We found that restoring all of the old individual tax rates, as well as eliminating the new 10 percent brack- et, would raise $70 billion and, thus, lower the deficit to $360 billion. Re- pealing even more “middle-class” tax cuts, such as the marriage penalty and the adjustment to the Alternative Mini- mum Tax, would raise an additional $26 billion and cut the deficit to $334 billion, still miles away from balance. Lastly, we returned the value of the child tax credit to its old level of $500 per child. It is important to note that few tax measures in history have had such a profound impact on the tax burden of working families as the child credit. By our estimates, the increased value of the child credit knocked at least 3.6 million families from the tax rolls. Currently, more than 44 million taxpayers (one-third of all filers) file tax returns but pay no income taxes after all of their credits and deduc- tions are taken into account. This is up from 29.9 million no-tax filers in 2000. Restoring the child credit to its old level would raise another $21 Tax Cuts from page 1 Can the Deficit Be Eliminated by Repealing Tax Cuts? New Taxes Deficit Raised Remaining ($billions) ($billions) CBO Estimate for This Year’s Deficit $ 477 Step 1: Return top two tax rates to 36% and 39.6% — and apply those rates to dividend income $ 27 $ 450 Step 2: Restore the higher tax rates on dividend and capital gains income for remaining tax brackets $ 20 $ 430 Step 3: Restore all other tax rates to 2000 levels and repeal the 10% bracket $ 70 $ 360 Step 4: Restore Marriage Penalty and eliminate the EITC and AMT adjustments $ 26 $ 334 Step 5: Return the value of the child credit to $500 from $1,000 $ 21 $ 313 To borrow and amend an old Clintonian slogan, the cause of today’s deficits is not a lack of tax revenue, “It’s the spending stupid.” 3 How does President Bush propose to spend your federal tax dollar in FY2005? A lot differently than it was spent in FY1995, ’85, ’75 or ’65, ac- cording to the Tax Foundation’s annual comparison. Assuming that Congress makes no dramatic changes in the President’s FY2005 Budget, 59¢ out of every tax dollar spent will go to three areas — Social Security, health and medical, and income security (see Chart 1). These program areas are “mandatory,” so the federal government automatically spends a legally determined amount of money. Compared to previous budgets Social Security 21¢ Where Your Federal Tax Dollar Will Go, FY 2005 Notes: “Income Security” includes General Retirement and Disability, Federal Employee Retirement and Disability, Unemployment Compensation, Food and Nutrition Assistance, Supplemental Security Income, Family and Other Support Assistance, Earned Income Tax Credit, Offsetting Receipts, and Housing Assistance. “Other” includes Energy, Natural Resources and Environment, Commerce and Housing Credit, Community and Regional Development, International Affairs, General Science, Space and Technology, Agriculture, Administration of Justice, General Government, Allowances and Undistributed Offsetting Receipts. Source: Tax Foundation calculations based on OMB projections. Veterans 3¢ Other 3¢ Education, Training 4¢ National Defense 19¢ Net Interest 8¢ Income Security 15¢ Health & Medical 23¢ Transportation 4¢ How the Federal Government Plans to Spend Your Tax Dollar In Fiscal Year 2005 billion, leaving Uncle Sam $313 billion in the red. Adding It All Up Repealing all of the major Bush tax cuts would raise about $164 bil- lion in “new” tax revenues, roughly one-third of what is needed to erase the deficit. When all is said and done, if our goal is to cut the deficit through higher taxes, there is very little blood left in the stone of individ- ual income to find new revenues. To put the $477 billion deficit forecast in perspective, it is well in excess of the $404 billion in income taxes that will be collected from every taxpayer making more than $200,000 this year. Thus, to balance the budget on the backs of these upper-income Americans would require effective tax rates more than double what they are today, a level far beyond what they have ever been in our history. When Bill Clinton ran for presi- dent, one of his campaign slogans was, “It’s the economy, stupid.” He used it whenever some other issue threat- ened to distract people from what he considered to the issue that mattered the most. In the current debate over why the government is spending so much more than it is bringing in, pushing the federal deficit up to about a half a trillion dollars, an appropriate version of that slogan would be, “It’s the spending stupid.” Truth be told, repealing the tax cuts won’t lower the deficit much, and neither party seems to want a balanced budget enough to cut spending. (see pie charts on page 4), the biggest changes in the last four decades can be found in how much Uncle Sam spends on health-related programs and on national defense. In FY 1965, Uncle Sam spent only 1¢ out of every tax dollar on health, and even after Medi- care and Medicaid had been enacted, that cost only rose to 8¢ on the dollar in 1975 and 10¢ in 1985. Those are small slices of the national pie com- pared to the 23¢ that is planned for 2005. On the other hand, the portion of federal spending devoted to national Truth be told, repealing the tax cuts won’t lower the deficit much, and neither party seems to want a balanced budget enough to cut spending. See Budget Dollar on page 4 4 defense has fallen from 43¢ out of ev- ery tax dollar in FY 1965, to 27¢ in FY 1985, to a proposed 19¢ in FY 2005. Net interest payments on the fed- eral debt are projected to fall signifi- cantly in FY 2005 compared to ten years ago, from almost 15¢ on a dollar in 1995 to 8¢ in the coming fiscal year. The FY 2005 budget shows that “discretionary” spending — such as defense, education, agriculture and transportation — now plays a compara- tively minor role — only about 33¢ on a dollar. Mandatory spending and net interest now account for 67¢. In con- trast, back in FY 1965, the portions were reversed: discretionary spending was roughly 69¢ out of every federal tax dollar while entitlements and net interest payments took up about 31¢. FY 1975 FY 1965 How Uncle Sam Has Sliced Up the Federal Pie in the Past FY 1995 FY 1985 Budget Dollar from page 3 Other 12¢ Transportation 7¢ Veterans 5¢ Education, Training 2¢ Income Security 8¢ Net Interest 7¢ Social Security 15¢ Health & Medical 1¢ National Defense 43¢ Other 5¢ Transportation 4¢ Veterans 3¢ Education, Training 3¢ Income Security 14¢ Net Interest 14¢ Social Security 20¢ Health & Medical 10¢ National Defense 27¢ Other 7¢ Transportation 8¢ Veterans 5¢ Education, Training 5¢ Income Security 15¢ Net Interest 7¢ Social Security 19¢ Health & Medical 8¢ National Defense 26¢ Other 4¢ Transportation 2¢ Net Interest 15¢ Education, Training 3¢ Income Security 15¢ Veterans 3¢ Social Security 22¢ Health & Medical 18¢ National Defense 18¢ 5 There is a growing but erroneous con- sensus that U.S. job growth is anemic. The source of the story is consistently pessimistic results from the Bureau of Labor Statistics’ payroll survey, but a closer look at other evidence on job creation and employment gives a dif- ferent impression. On one hand, the payroll survey shows payroll employment is growing so slowly that recent average gains of less than 60,000 jobs per month would not offer a full recovery for over a de- cade. On the other hand, February’s unemployment rate fell to 5.6 percent of the civilian labor force, down from a peak of 6.3 percent eight months earlier. Some commentators suggest that the reduction in the unemployment rate did not signify job gains. According to this view, the dip only meant that job seekers had dropped out of the labor force and therefore were no long- er counted. This notion is contradicted by several statistical observations. In February the civilian labor force did decline, but so did employment and the number unemployed (see ta- ble at right). These declines reflect the month-to-month volatility of the house- hold survey data used to measure em- ployment and the unemployment rate. Something as simple as unusual slow- ness in the normal seasonal pattern of post-Christmas lay-offs and labor force exit could account for the vagaries of these data. The evidence over two months supports this notion, as em- ployment shows a strong gain, match- ing a sharp drop in the number of unemployed. Over the past eight months the gains in employment are even stronger. The number of unemployed dropped by more than a million, or about 125,000 per month, and this was matched by nearly the same rise in civilian employment. Looking back even further, civilian employment in February was 1.9 mil- lion workers greater than at the end of the recession in November 2001, after adjusting the numbers for breaks due to changing population controls. It even exceeds the level of employment at the business cycle peak in March 2001 by almost 400,000 workers. On this basis the economy’s employment recovered over three months ago and employment is expanding briskly, a radically different picture than that provided by the non-farm private jobs count that gets so much attention. If unemployment keeps falling at this rate, which would be fully consis- tent with widespread forecasts of ac- celerating output, the unemployment rate could reach 5.2 percent by mid- summer, generally considered to the lowest sustainable or “natural” rate of unemployment. What will the policy debate look like this summer if growth has pushed the economy into boom territory, with accelerating inflation, but the falsely dismal impression of employment is still being perpetuated? The normal monetary policy action — raising inter- est rates — will certainly be much more difficult to sell. The manufacturing jobs count, part of the dismal payroll employment sur- vey, has gotten the most attention. Over the last 4 months, the survey shows manufacturing jobs declining 0.9 per- cent annually. Yet the Institute of Sup- ply Management’s reliable index shows that net job creation in manufacturing began 4 months ago. Since then, the number of manufacturing jobs has risen at a 3.6 percent annual clip. Similarly, sharp declines in initial claims for unemployment insurance, continuing claims and in mass lay-offs in the past nine to twelve months sug- gest that the number of jobs are ex- panding at the rapid pace suggested by civilian employment. While Alan Greenspan strongly endorsed the payroll jobs count re- cently as a reliable indicator, there are many reasons for doubting it. The jobs count is not intended to measure overall employment, it counts jobs and even then it excludes large numbers of jobs. It counts each job held by multiple jobholders, but it ex- cludes government and farm workers. Most importantly, it excludes the self-employed and has a biased sample excluding new firms just when em- ployment at such small firms is ex- panding rapidly. This is usually fixed by revisions but only many months later. That is exactly what happened after the last recession. Dismal data from the non-farm payroll jobs count were big news from June 1991 until June 1992, but those stories of a “job- less recovery” were ultimately proven wrong by revised data. A similar sce- nario is likely this year. U.S. Jobs Picture Brighter than Reported Civilian Employment Is Improving Number Change in Change in of Months From To Employment Unemployed 1 Jan. 2004 Feb. 2004 –265,000 –127,000 2 Dec. 2003 Feb. 2004 +230,000 –204,000 8 June 2003 Feb. 2004 +1,034,000 –1,047,000 Source: Bureau of Labor Statistics household survey, adjusted for break due to population controls. The economy’s employment recovered over 3 months ago and employment is expanding briskly, a radically different picture than that provided by the non-farm private jobs count that gets so much attention. 6 FRONT & CENTER Martin Chren is President of the F.A. Hayek Foundation in Brataslava, Slovakia by Martin Chren Fundamental Tax Reform in Central Europe Slovakia, a small country of five and a half million people in Central Europe still hasn’t been discovered by many American travelers and businessmen. Those who have already visited it, or who have at least heard about it, know that it is a young country, born after the split-up of former Czechoslovakia just a dozen years ago. Some may even know it as the “Heart of Europe” — a nickname given to Slovakia thanks to its favor- able geographical location, numer- ous historical sightseeing spots and picturesque countryside. However, it seems that now the day has come for Slovakia to attract the attention of economists, busi- ness people and politicians from the world over. The reason is a compre- hensive tax reform enacted in the last week of October. Pursuing the main goals of fair- ness, simplicity and no double taxa- tion, the Slovakian government has adopted major changes to the cur- rent tax system, based on the idea of the flat tax as the best option for the Slovak economy. The flat rate we decided on is 19 percent, and that one rate replac- es a typical structure of income tax rates that started at 10 percent and went progressively higher, up to 38 percent. In addition, the 19 percent rate replaces the 25 percent rate that had been levied on corporate income. This will decrease the income and profit tax burden for both indi- viduals and businesses. Slovakia was already offering multinational firms a tempting combination of central location and a skilled but relatively cheap labor force. Now that we have added a tax code that is un- questionably one of the most com- petitive in Europe, if not the world, we should be able to attract the foreign investment that will be the lifeblood of the Slovak economy in the final stages of its transition to the free market. Although enactment of a single income tax rate will possibly have the most evident impact on Slovak taxpayers’ wallets, it is not the most important change in the Income Tax Act. The flat tax simplifies the whole tax code. Just as in most of the world’s developed countries, the income tax code in Slovakia used to be a mess of different exemptions, various specially treated income sources, different tax rates for differ- ent subjects, and many other special rules tailored for narrow interest groups. There were more than two hundred departures from the rules before the reform. Most of them are to be eliminated, and this will cer- tainly make the tax system more transparent for all types of taxpay- ers, from wage-earners to large firms. I would not go so far as to say the tax system will be “user friend- ly.” A tax return will still not fit on a postcard, but let us not hold the standard up so high that no im- provement seems enough. This is truly a dramatic, fundamental tax reform. Aside from individual income taxes, the biggest tax in most Euro- pean countries is the Value Added Tax (VAT). This European version of the American sales tax is levied on I would not go so far as to say the tax system will be “user friendly.” A tax return will still not fit on a postcard, but let us not hold the standard up so high that no improvement seems enough. This is truly a dramatic, fundamental tax reform. Main Features of the Tax Reform in Slovakia Flat income tax A single, flat, 19-percent tax on personal and corporate income VAT A single, 19-percent tax on purchases Tax simplification Elimination of most exceptions and special treatments from the tax code No double taxation Abolition of tax on dividends No death tax Elimination of the inheritance tax No taxation of goodwill Elimination of the gift tax No real estate transfer tax To become effective in 2005 7 The Tax Foundation invites national leaders from all perspectives to con- tribute columns to Tax Features. The opinions expressed are not always those of the Tax Foundation. everything that businesses buy, and then subtracted when they sell, so that the tax burden is passed down the chain of production until it gets to the retail consumer, the one who can’t pass it on to someone else. Slovakia’s VAT had a basic rate of 20 per cent, and a special reduced rate of 14 percent for some products. They are now unified to one rate of 19 percent, the same as the rates on individual and corporate income. Another rule that guided the reformers when designing the new tax laws was the no-double-taxation approach. Therefore, every type of income should be taxed in the same way regardless of its source, and no type of income should be taxed more than once. This had been the case, for example, on dividend in- come which was taxed first as the profit of a company, and then a sec- ond time as individual income when the firm sent out the dividend. Cor- porate income will continue to be taxed, but the second level of taxa- tion on individuals’ dividends has been eliminated. And there is more good news for Slovak taxpayers, such as the elimination of one of the most un- fair and meaningless taxes — the inheritance tax, better known as the death tax. After a strong and long- lasting campaign led by the Slovak Taxpayers Association, tax on inher- itance for close relatives was abol- ished in Slovakia two years ago. Now, after the tax reform, the death tax will be totally abolished, and the same fate awaits the gift tax. There will be no taxation of goodwill in Slovakia any more. Moreover, begin- ning in 2005, the real estate transfer tax is scheduled to disappear as well. I am truly convinced that such a fundamental reform warms the heart of any reasonable economist, but the first question that comes to their minds is: “Okay, sounds great, but where’s the hitch?” Well, there really is a hitch. The necessary precondition for passing such a tax reform through the political process was making it fiscally neutral. In layman’s terms, the state will collect just as much in taxes as it used to. If predictions of revenue-neutrality fall short, a drop in income tax revenues will be re- placed by an expansion in excise taxes, such as taxes on gas and to- bacco products. Replacement of the 14 percent VAT on some products with the 19 percent rate will raise significant revenue, and this will affect almost all the products most commonly used in daily life. Many people feel the flat tax rate on income could have been significantly lower than Steve Forbes, perhaps the best-known promoter of the flat tax concept, visited Slovakia at our invitation. Coming back from the three-day visit, he published a full page article about the reforms going on there, headlined “Investors’ Paradise” in Forbes. 19 percent. Reliable estimations show that if the income tax rate dropped to 16 or even 15 percent, the government budget would not be hurt seriously. However, though there certainly is still a lot of work to do, the Slo- vak tax reform is a real step towards a fairer, more economically efficient tax system. It could perhaps be said that the newly adopted Slovak flat tax is more consistent with the gen- eral principles of academic flat tax proposals than in any other country where this kind of reform has been introduced. Much of this is a credit to a few free market institutes that originally came up with this idea in Slovakia and promoted them. In June this year, Steve Forbes, perhaps the best-known promoter of the flat tax concept, visited Slova- kia at our invitation. Coming back from the three-day visit, he pub- lished a full page article about the reforms going on there, headlined “Investors’ Paradise” in Forbes. Well, of course paradise doesn’t happen overnight, even in Slovakia, but we are doing everything we can to grow our nation’s economy. 8 Table 1: State Tax Collections and Distribution by Source Fiscal Year 2002 Distribution Total General Individual Corporate Motor All ($Thousands) Sales & Use Income Income Fuels Licenses Other All States (a) $ 533,432,378 33.5% 34.7% 4.9% 6.0% 6.6% 14.3% Alabama $ 6,878,923 25.4% 34.9% 4.7% 7.4% 5.7% 21.8% Alaska 1,089,504 0.0 0.0 24.7 3.7 6.8 64.8 Arizona 8,477,001 50.6 24.7 4.1 7.4 3.2 10.1 Arkansas 5,034,109 38.1 29.6 3.2 8.2 4.7 16.2 California 77,755,376 30.6 42.5 6.9 4.2 7.3 8.4 Colorado $ 6,923,171 27.5% 50.2% 3.0% 8.2% 4.0% 7.1% Connecticut 9,032,787 33.7 40.8 1.7 4.7 4.5 14.7 Delaware 2,173,600 0.0 33.0 11.6 5.0 35.9 14.6 Florida 24,815,964 58.1 0.0 4.9 7.3 6.3 23.5 Georgia 13,772,147 35.1 47.1 4.1 4.7 3.6 5.4 Hawaii $ 3,420,671 47.1% 32.5% 1.5% 2.3% 3.3% 13.3% Idaho 2,271,075 35.0 37.1 3.4 9.4 9.8 5.3 Illinois 22,460,190 28.6 30.9 9.2 6.1 8.5 16.7 Indiana 9,994,595 38.0 35.4 6.7 6.7 3.0 10.2 Iowa 5,006,251 34.9 35.3 1.8 6.9 10.4 10.8 Kansas $ 4,808,361 37.4% 38.6% 2.5% 7.8% 4.8% 8.9% Kentucky 7,974,690 29.0 33.6 3.8 5.8 6.8 21.1 Louisiana 7,345,994 31.7 24.2 3.6 7.6 7.0 25.9 Maine 2,626,830 31.8 40.8 2.9 7.3 5.7 11.4 Maryland 10,821,276 24.9 43.5 3.3 6.5 4.0 17.8 Massachusetts $ 14,819,794 24.9% 53.4% 5.5% 4.5% 3.4% 8.3% Michigan 21,864,052 35.6 28.0 9.4 5.0 5.9 16.0 Minnesota 12,936,369 28.9 42.1 4.2 4.8 6.7 13.3 Mississippi 4,728,905 49.5 20.8 4.1 8.7 6.4 10.5 Missouri 8,678,611 32.9 41.7 3.5 8.0 5.4 8.6 Montana $ 1,442,731 0.0% 35.9% 4.7% 13.3% 13.8% 32.3% Nebraska 2,992,522 35.7 38.5 3.6 10.3 6.5 5.3 Nevada 3,945,329 52.5 0.0 0.0 6.7 11.1 29.7 New Hampshire 1,883,924 0.0 3.8 20.0 6.4 9.1 60.7 New Jersey 18,328,814 32.7 37.3 6.0 2.9 5.2 15.9 New Mexico $ 3,628,055 36.9% 27.1% 3.4% 5.5% 4.7% 22.4% New York 43,262,137 19.9 59.1 5.2 1.1 2.4 12.2 North Carolina 15,535,277 20.7 46.8 4.3 7.8 5.7 14.8 North Dakota 1,117,299 30.0 17.9 4.5 9.9 9.2 28.5 Ohio 19,616,569 32.6 42.5 3.9 7.0 8.0 6.1 Oklahoma $ 6,052,680 25.3% 37.8% 2.9% 6.8% 13.6% 13.7% Oregon 5,139,322 0.0 71.5 3.8 7.8 9.7 7.3 Pennsylvania 22,135,537 33.1 30.4 5.4 7.9 9.4 13.7 Rhode Island 2,127,609 34.4 38.7 1.3 6.1 4.3 15.1 South Carolina 5,748,585 40.6 34.0 3.8 7.2 5.4 9.1 South Dakota 976,596 53.6% 0.0% 4.2% 12.6% 13.6% 16.0% Tennessee 7,797,681 60.0 1.9 6.5 10.4 10.7 10.6 Texas 28,662,395 50.8 0.0 0.0 9.9 13.2 26.1 Utah 3,925,382 38.2 40.9 2.8 8.6 3.8 5.7 Vermont 1,533,982 14.0 24.4 2.4 5.6 4.5 49.0 Virginia 12,781,149 21.9% 52.5% 2.4% 6.6% 4.2% 12.3% Washington 12,628,567 62.6 0.0 0.0 5.9 5.0 26.5 West Virginia 3,551,756 27.1 29.1 6.2 8.4 4.9 24.2 Wisconsin 11,813,832 31.3 42.1 4.4 8.1 5.5 8.6 Wyoming 1,094,402 40.7 0.0 0.0 6.9 8.7 43.7 Dist. of Columbia (b) 3,215,289 20.3% 30.5% 3.6% 1.0% 0.7% 43.9% (a) Does not include the District of Columbia. (b) Based on quarterly data. (c) The “all other” category is a subtraction of the 5 other sources of revenue from “Total.” Source: Tax Foundation, based on data from the Department of Commerce, Bureau of the Census. State government officials are still complaining mightily about insuffi- cient tax revenue, but looking back at the Census Bureau’s final data for fiscal year 2002 should make them feel a bit better. The worst year for state coffers for at least a decade, FY’02 (July 2001 through June 2002) saw state tax and fee collections drop 4.7 percent from FY’01 levels (6.1 percent adjusted for inflation), according to a new Tax Foundation Special Report, “State Tax Collections and Rates” by Foundation economist Sumeet Sagoo. “The principal culprit is capital gains taxes,” explains Sagoo. “In FY’01 tax collections on capital gains flooded state coffers. When the bubble popped, states that had foolishly counted on the same amount in FY’02 were left in the red. Some responded the next year by raising taxes, but not as much as after earlier recessions.” The final income data for that period show growth of 2.1 percent, primarily because the Bureau of Eco- nomic Analysis does not count capital gains in income. Nevertheless a re- markably good figure considering that the year included the recessionary months of July-November 2001. Combined with the drop in tax collections, income grew 6.8 percent faster than taxes, a remarkable dispari- ty. This actually tilted the 10-year com- parison of income growth to tax growth in favor of income. After adjust- ing for inflation, the annual growth rate of state governments’ tax collec- tions was 0.1 percent slower than the growth rate of their taxpayers’ income between FY’92 and FY’02. The fastest falling category of state collections between FY’01 and ’02 was severance taxes on mineral extraction, down 34 percent, hurting Alaska and several other states. Corporate income tax receipts also fell dramatically, down 18.3 percent. More problematic nationwide was the 11.1 percent fall-off in individual income taxes. Sales tax collections held steady, dropping just 0.2 percent. Meanwhile, taxes on tobacco, alcohol, licenses, public utilities, insurance and motor fuels were all up. State Tax Revenue by Source The three staples of state finance continue to be individual income taxes (34.7 percent of revenue), general sales and use taxes (33.5 percent), and a combination of business and excise taxes, including corporate income taxes (4.9 percent) and licenses (6.6 percent). See Table 1. Five states do not tax sales: Alaska, Delaware, Montana, New Hampshire and Oregon. Meanwhile, Florida, Neva- State Governments Look Back in Relief at Fiscal 2002 9 Table 2: State Tax Collections Per Capita and Per $ 1,000 of Income With Corresponding Ranks, Fiscal Year 2002 Rank Total Per Per $ 1,000 Per Per $ 1,000 ($ Thousands) Capita (c) of Income (c) Capita of Income All States (a) $ 533,432,378 $ 1,863 $ 59.56 - - Alabama $ 6,878,923 $ 1,536 $ 60.84 42 25 Alaska 1,089,504 1,705 53.37 34 40 Arizona 8,477,001 1,575 59.35 40 30 Arkansas 5,034,109 1,863 79.21 21 6 California 77,755,376 2,231 66.75 8 18 Colorado $ 6,923,171 $ 1,549 $ 45.64 41 49 Connecticut 9,032,787 2,620 60.32 3 28 Delaware 2,173,600 2,710 82.38 2 4 Florida 24,815,964 1,500 49.91 44 45 Georgia 13,772,147 1,623 55.76 38 36 Hawaii $ 3,420,671 $ 2,768 $ 91.85 1 1 Idaho 2,271,075 1,706 67.56 32 16 Illinois 22,460,190 1,788 52.83 24 42 Indiana 9,994,595 1,627 57.26 37 34 Iowa 5,006,251 1,706 60.36 33 27 Kansas $ 4,808,361 $ 1,775 $ 60.73 25 26 Kentucky 7,974,690 1,954 75.92 19 7 Louisiana 7,345,994 1,641 64.73 36 20 Maine 2,626,830 2,038 73.08 14 10 Maryland 10,821,276 1,996 54.84 16 38 Massachusetts $ 14,819,794 $ 2,310 $ 58.19 6 31 Michigan 21,864,052 2,180 71.50 10 13 Minnesota 12,936,369 2,586 75.66 4 8 Mississippi 4,728,905 1,650 73.71 35 9 Missouri 8,678,611 1,535 52.73 43 43 Montana $ 1,442,731 $ 1,591 $ 63.48 39 23 Nebraska 2,992,522 1,735 58.14 29 33 Nevada 3,945,329 1,847 59.99 22 29 New Hampshire 1,883,924 1,487 42.75 45 50 New Jersey 18,328,814 2,144 53.79 12 39 New Mexico $ 3,628,055 $ 1,969 $ 82.27 18 5 New York 43,262,137 2,263 62.02 7 24 North Carolina 15,535,277 1,880 67.23 20 17 North Dakota 1,117,299 1,758 65.74 27 19 Ohio 19,616,569 1,720 58.16 30 32 Oklahoma $ 6,052,680 $ 1,738 $ 68.16 28 15 Oregon 5,139,322 1,469 50.68 46 44 Pennsylvania 22,135,537 1,797 56.49 23 35 Rhode Island 2,127,609 1,998 63.89 15 21 South Carolina 5,748,585 1,407 55.00 47 37 South Dakota $ 976,596 $ 1,286 $ 47.16 50 47 Tennessee 7,797,681 1,351 49.03 48 46 Texas 28,662,395 1,328 45.98 49 48 Utah 3,925,382 1,709 69.69 31 14 Vermont 1,533,982 2,494 83.92 5 2 Virginia $ 12,781,149 $ 1,764 $ 53.26 26 41 Washington 12,628,567 2,094 63.54 13 22 West Virginia 3,551,756 1,972 83.32 17 3 Wisconsin 11,813,832 2,178 72.12 11 11 Wyoming 1,094,402 2,204 71.54 9 12 District of Columbia $ 3,215,289 $ 5,621 $ 131.29 - - (a) Does not include the District of Columbia. (b) Based on quarterly data. (c) Population and personal income figures adjusted into fiscal years. Source: Tax Foundation, based on data from Department of Commerce, Bureau of the Census, and Bureau of Economic Analysis. Publication Summary General: Special Report No. 128; ISSN 1527-0408; 12pp.; $10 or $50/yr. for 10 issues on varied fiscal topics Title: State Tax Collections and Rates Author: Sumeet Sagoo Date: March 2004 Subject: State tax collections for FY2002 and selected tax rates as of December 31, 2003 Tables: State Tax Collections by Type, FY’92–’02; State Tax Collections and Distribution by Source, FY’02; State Tax Growth Compared to Income Growth, FY’92–’02; State Tax Collections Per Capita and Per $1,000 of Income, FY’02; Individual Income Tax Rates; Corporate Income Tax Rates; Various State Tax Rates da, South Dakota, Tennessee, Texas and Washington derived over half of their tax revenue from sales taxes. Seven states have no individual income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Two more, New Hampshire and Tennessee, tax only interest and dividend income. On the other hand, five states depended on the individual income tax for over half of their tax revenue in FY’02: Colorado, Massachu- setts, New York, Oregon and Virginia. Ranking the States Nationwide, the average per capita collection was $1,863 in FY’02, and the average amount of tax collected per $1,000 of income was $59.56. Hawaii collected the most by ei- ther measure, $2,768 per capita and $91.85 per $1,000 of income. Dela- ware collected the second most per capita ($2,710), and Vermont collected the second most per $1,000 of income ($83.92). South Dakota collected the least per capita ($1,286) while New Hamp- shire collected the smallest share of income, $42.75 per $1,000. States without income taxes gener- ally collected less, but Wyoming and Washington collected more than aver- age by both measures. Some states ranked near the top by one measure but near the bottom by the other. The widest disparities can be seen in New Jersey (12th per capita but 39th as a share of income) and Mississippi (35th per capita but 9th as a share of income). State Tax Rate Changes in 2003 Aside from routine adjustments for inflation, no state raised income taxes during 2003. The only state to enact a rate cut was New Mexico, and Utah widened its brackets modestly. Three states—Alabama, Indiana and Tennessee—and the District of Columbia raised their tax rates on all corporate income. North Dakota raised its tax on financial institutions. Six states—Idaho, Kansas, Nebras- ka, Ohio, Tennessee and Vermont— raised general sales taxes, and numer- ous states raised excises on alcohol and tobacco. 10 New Studies from the Tax Foundation on Manufacturing Employment, Cross-Border Beer Purchases and the Impact of Alcohol Taxes Publication Summary General: Background Paper No. 43; ISSN 1527-0408; 16pp.; $25 or $60/yr. for 4 issues on varied fiscal topics Title: A Critique of the National Re- search Council and Institute of Medicine’s Recommendations to Raise Alcohol Excises to Curb Underage Drinking Author: Patrick Fleenor Date: March 2004 Subject: Asserts that higher alcohol taxes would hurt a large, low-wage population of legal drinkers, but provide no effective deterrent to underage drinking. Contends that enforcement measures targeted at alcohol abusers are more effective and practical. Publication Summary General: Background Paper No. 42; ISSN 1527-0408; 16pp.; $25 or $60/yr. for 4 issues on varied fiscal topics Title: Manufacturing Employment, Productivity and the Business Cycle Author: John A. Tatom Date: February 2004 Subject: Recent U.S. manufacturing job loss is consistent with the historical pattern of secular decline, with steep losses during recessions as well as during the months immediately before the business cycle peak and after the trough. Manufacturing jobs have de- clined worldwide for at least 20 years as manufacturers have found new ways to produce more with fewer employees. Publication Summary General: Background Paper No. 44; ISSN 1527-0408; 16pp.; $25 or $60/yr. for 4 issues on varied fiscal topics Title: How Tax Competition Affects Cross-Border Sales of Beer in the United States Authors: J. Scott Moody, M.A. and Wendy P. Warcholik, Ph.D. Date: March 2004 Subject: Shows how often beer taxes induce customers to shop in adjacent low-tax jurisdictions. High taxes in Illinois, New York and Alabama cause residents to buy the most beer out of state. Low-tax shopping destinations include Delaware, New Hampshire, New Jersey and Oregon. Publication Summary General: Special Report No. 127; ISSN 1527-0408; 12pp.; $10 or $50/yr. for 10 issues on varied fiscal topics Title: The Path to Reforming Virginia’s Tax Code Authors: Steve Slivinski & Scott Moody Date: February 2004 Web: taxfoundation.org/virginia Subject: Reaction to the tax plans of- fered by legislators and the governor in Virginia, with a suggestion for more fundamental reform. Tables: How Virginia Stacks Up – Tax Burdens in the Region; How Virginia Stacks Up – Statutory Tax Rates in the Region; Impact of Tax Reform Proposals on Two-Earner Families of Four Who Take the Standard Deduction; Impact of Tax Reform Proposals on Two-Earner Families of Four Who Itemize Deductions A new Tax Foundation report proposes that Virginia repeal its sales tax and make up the revenue by enacting a flat 6-percent tax on individual income, matching the rate on corporate income. Writing on the op-ed page of the Richmond Times-Dispatch on March 8, Tax Foundation President Scott Hodge called for a clean departure from the plans that have led to the current stale- mate, asserting they would all stunt Virginia’s economic growth. “As shoppers from Maryland, Vir- ginia and Pennsylvania prove every day,” Hodge wrote, “Delaware’s zero tax rate on sales is a magnetic draw. Virgin- ia retailing could enjoy the same ad- vantage, but Gov. Warner and the Sen- ate would go the other way, giving neighboring states a competitive edge.” The Tax Foundation report is criti- cal of the current legislative proposals because they raise the sales tax, a tax that is hard to enforce, hard on lower- income people and hard on the econo- my in general. Sales taxes hit low-income people harder because they spend most of their money on basic, taxable products rather than untaxed services. The plan from the House of Delegates to rectify this problem by taxing more services would create “tax pyramiding.” That happens when businesses pay sales tax on materials that they resell with tax, effectively charging tax on tax. The sales tax is hard to enforce and hard on the economy because catalogs, the internet and nearby low- tax jurisdictions offer easy avoidance. The Foundation’s revenue-neutral plan makes up lost revenue by elimi- nating many deductions from the flat 6-percent state income tax, preserving only a per-person allowance of $3,700. As a by-product of relying more heavi- ly on state income taxes, Virginia’s taxpayers could deduct $3 billion more on their federal tax returns, saving about $390 million annually. Extra revenue from a flat income tax would also allow Virginia to repeal Virginia Tax Reform Plan Pushes Sales Tax Repeal Flat Income Tax Would Make up Revenue, Save on Federal Taxes its estate tax and its gross receipts tax, a tax on business known locally as the business and professional organization license tax, or BPOL. 11 FOUNDATION MESSAGE Scott A. Hodge President Tax Foundation Reforming Virginia’s Tax Code Considering the anti-tax reputation of Virginia voters, it is not surprising that most state officeholders take a pledge not to raise taxes when they’re up for re-election. Governor Mark Warner (D) was no exception, nor was Republican State Senator John Chichester. By late 2003 those promises were forgotten as Gov. Warner submitted a budget that included $1 billion in tax hikes under the banner of “tax reform,” and Senator Chichester responded with a tax hike almost 4 times bigger. So far the truly anti-tax House of Delegates has opposed both tax hike plans, but even the House eventually passed a budget that raised some taxes. Our concern is not with party, or even so much with revenue-raising. Our concern is with tax policy. Not one of the announced plans deserves the name of tax reform, and not one will improve the business tax climate. In our annual ranking of the states’ business tax climates, Virginia ranked 21st, which though respectable is low for a state with a comparatively low state-local tax burden. Gov. Warner was right that Virginia needs tax reform, but he is wrong to think that his plan is real tax reform. The General Assembly needs a distinctly different plan that can raise needed revenue and deliver honest-to- goodness tax reform. We have devised such a plan (see Tax Foundation Special Report, No. 127, described on page 10). It follows the principles of fairness and simplici- ty, and it would give Virginia one of the most economically competitive tax systems in the country. It is revenue neutral, as all tax reform should be, to put aside any suspicion that the ulteri- or motive is to raise or lower revenue. Of course, the same sound principles could be adapted to a higher or lower revenue stream. The “6 and 6” Plan We call our proposal the “6 and 6 plan” because it relies heavily on flat 6% taxes on individual and corporate income. Mean- while, it tar- gets for repeal the sales tax, the estate tax and the busi- ness and professional organization license tax (BPOL). Scrap the Sales Tax Sales tax collection has become a nightmare and will probably continue shrinking nationwide as a share of state revenue. Internet-shoppers have joined cross-border travelers and cata- log users in avoiding the tax. Raising the rate just creates a vicious cycle, punishing “brick-and-mortar” retail and giving shoppers even more reason to avoid the tax. Virginia legislators should reverse the flow of shoppers and bring their business in state. On the fairness front, sales taxes generally hit low-income people hard- er because they spend most of their money on basic, taxable products. Meanwhile, higher-income people spend a lot on untaxed services. Attempts to make the sales tax fairer by extending it from basic prod- ucts to tax exempt services—the House plan does this—causes “tax pyramiding.” That’s what happens when businesses pay sales tax on equipment and services, then resell their products with another sales tax, effectively charging tax on tax. Flatten the Income Tax Virginia should replacing its 4- bracket income tax structure with a flat 6% rate, allowing no deductions except for a generous exemption of $3,700 per person. This higher tax with no deduc- tions for interest or charitable giving would collect a lot more revenue. By itself, this would be a hardship, but as part of the whole package, it’s worth it. Keeping popular deductions would force the rate up into uncompetitive territory. One major bonus of this heavy reliance on the state income tax is federal deductibility. Virginians would deduct almost $3 billion more every year on their federal 1040s, saving $390 million in taxes. That savings alone could almost finance Gov. Warn- er’s plans for higher spending. Match Income Tax Rates for Individuals and Corporations When tax time rolls around, many businesses can guide income into ei- ther the “corporate income” column or the “individual income” column. It’s wise, therefore, for the state to keep the individual and corporate rates the same, and with as few deductions and exemptions as possible on both sides. In the matter of tax avoidance schemes, an ounce of prevention is worth a pound of audits. Raise the Gas Tax 7 Cents Currently, a half-cent of the sales tax is devoted to transportation. This would make up that revenue. Repeal the Estate Tax Virginia can keep its wealthy retir- ees and foster small business growth. Warner’s plan comes so close to elimi- nating the estate tax that one wonders why he can’t pull the trigger. Why keep that monstrous administrative super- structure in law for so little revenue? Repeal the Business License Tax The obscure business and profes- sional occupation license tax (BPOL) is a job-killer because unlike a corporate income tax that varies with profitabili- ty, this gross receipts tax hits even during economic slumps. Adopting the Tax Foundation’s “6 and 6” plan would greatly improve Virginia’s business tax climate, and save on federal taxes to boot. Raising taxes isn’t what tax reform is about, but the General Assembly could do the state a world of good by focusing on true tax reform while it does its revenue business. 12 1 9 0 0 M S tre e t , N W S u ite 5 5 0 W a s h in g to n , D C 2 0 0 3 6 -3 5 0 8 N o n -P ro f it O rg . U S P o s ta g e P A ID W a sh in g to n , D C P e rm it N o . 5 2 2 9 TAX FEATURES© Tax Features© (ISSN 1069- 711X) is published bi-monthly by the Tax Foundation, an independent 501(c)(3) organization chartered in the District of Columbia. Annual subscriptions are $15. Joseph O. Luby, Jr. Chairman, Program Committee Michael P. Boyle Vice Chairman, Program Committee Scott A. Hodge President Bill Ahern Editor & Communications Director Alicia Hansen Staff Writer J. Scott Moody Senior Economist Steve Slivinski Senior Economist Sumeet Sagoo Economist Tax Foundation (202) 464-6200 (202) 464-6201 Fax www.TaxFoundation.org TF@TaxFoundation.org Multiply Your Investment in the Tax Foundation! Many corporations (both large and small) have a matching gift program for their employees, which means that your contribution to the Tax Foundation could be doubled, at no cost to you. For instance, your gift of $500 could mean $1,000 to the Tax Foundation. If your company has this program, usually, you will only need to send us a matching gift form (usually available through your company’s personnel department) with your contribution, and we’ll do all the follow-up work. Please ask your company if they offer this program. The Tax Foundation is a 501(c)(3) organization, and both individual and company contributions are tax- deductible to the extent allowed by law. 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