Tax Reform in California
An extremely important new report was issued yesterday by the State of California on reforming its tax system. The arguments it makes and the reforms it proposes are very much applicable to the national tax system as well.
The main point the report makes is that the nature of the economy and the nature of income have changed over the years, but the tax system has not changed to deal with them.
First, income has become more volatile as people receive less of it in the form of relatively stable wages and more in the form of capital gains, bonuses and stock options that may vary significantly from year to year.
Second, services are much bigger as a share of both production and consumption. By their nature, services are harder to tax than goods.
Third, technology and globalization make it easier for people to purchase goods and services across state and national borders, and to move capital and income to other jurisdictions where they are taxed at lower rates or not taxed at all.
As it has become harder for the state to tax certain forms of income and output, it has had to raise rates on those that it can still tax. This has led to very high marginal rates that impede economic growth and create unfairness.
The proposed tax reform would broaden the tax base by replacing the corporate income tax with a business net receipts tax that would be very similar to a value-added tax. It would also replace the state sales tax and significantly reduce the personal income tax.
The state believes that the new tax would be less volatile than the taxes it replaces and would improve its revenue-raising capacity to pay for spending that the state’s taxpayers are unwilling to cut. Here and here are links to some commentaries on the California initiative.
At least on paper, this appears to be an excellent proposal that is in line with a growing body of economic research. For example, a recent NBER study by Lawrence Summers and James Hines argues that globalization makes it harder for national governments to tax income and recommends that taxes be shifted more towards a consumption base. Summers is, of course, director of the National Economic Council in the White House.
A Wall Street Journal report from this morning indicates that a group with close White House ties, the Center for American Progress, will be recommending a VAT as part of a fiscal reform initiative to reduce budget deficits. It will be opposed by the usual right-wing suspects. But as I have explained on many occasions, they are fools because if we don’t raise revenues through a consumption tax they will inevitably be raised by soak-the-rich taxes that will be far more harmful to the economy. (See here, here, here, here, and here.)
Note that a group of top tax
Note that a group of top tax experts -- Charlie McLure, Steven Sheffrin, Arnold Hargerger, Walter Hellerstein, James Hines, George Zodrow, etc. -- have written a stong negative analysis of the plan, particularly the business net receipts tax. It is variously on the web and in State Tax Notes, September 28, 2009. While state, local, and federal tax systems need a heavy dose of reform, the California proposal does NOT show the way.
Reply
Don't have access to State Tax Notes, but John Cogan and Michael Boskin are supporting the reform in today's Wall Street Journal.
That letter re the California tax reform
Re the proposed California tax reform, here's that critical letter. (It's a .pdf)
I'll try posting their letter of concern
September 5, 2009
Sent by Regular Mail and E-Mail
comment@cotce.ca.gov
Mr. Gerald Parsky, Chair
Commission on the 21st Century Economy
c/o State of California Department of Finance
915 L Street, 8th Floor
Sacramento, CA 95814
Dear Commissioner Parsky,
The undersigned, all experts in tax policy, are writing to share our views regarding the
proposal for a new “business net receipts tax” (BNRT), as well as possible reforms to the
California’s retail sales tax (RST). It is our understanding that the Commission on the 21st
Century Economy will be deciding how to proceed on these and other matters in the next few
weeks. The purpose of this letter is not to comment on the full range of the Commission’s
recommendations, but rather to address the specific BNRT/RST options the Commission now
faces. In our view, the most advisable course of action at this stage would be to recommend
several key reforms to the RST but not to recommend adopting the BNRT. Among the
signatories to this letter, we differ on whether the BNRT idea is sufficiently promising to
warrant further consideration in future tax reform efforts. We all agree, however, that
recommending the adoption of the BNRT at this stage would be highly imprudent.
1. Proposed Business Net Receipts Tax
Our concerns regarding the BNRT arise primarily from the numerous uncertainties
relating to administration, compliance, legal challenges, and economic distortions of such a
tax. As you know, there is almost no experience—in the United States or abroad—with an
apportioned business net receipts tax of the sort under consideration by the Commission.
What little experience there is with similar taxes (e.g., the “Single Business Tax” in effect in
Michigan from 1976 to 2007) is not positive. This fact alone is not reason to reject the
proposal outright, but the lack of practical experience with the BNRT necessarily limits our
ability to evaluate the proposal according to standard tax policy criteria, especially within the
time constraints your Commission faces. In most cases, fundamental tax reform is preceded
by years of study, not months. To go forward with so little information and such minimal
analysis significantly increases the likelihood of negative unintended consequences. Based on
our understanding of the core design features of the BNRT, we have several specific
reservations. We do not purport to offer an exhaustive analysis in this letter, but a few
examples will give some sense of the nature of our concerns.
First, the BNRT purports to be a consumption-type “value-added tax,” but it is likely to
have economic effects that are far different from those of a conventional VAT of the type
used in most countries. The typical VAT features border tax adjustments (i.e., the tax is
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imposed on imports and rebated on exports) and thus burdens only consumption occurring in
the taxing jurisdiction. By contrast, the proposed BNRT apportions the tax base according to
the share of each firm’s sales into California, including sales to other businesses. The
practical effect of this difference is that firms exporting goods and services produced in
California will, to the extent that they purchase inputs from firms subject to the tax, have a
BNRT cost embedded in their production process. As with the current RST, a firm’s ability
to pass this cost on to its non-California consumers will be limited. This illustrates a
fundamental design flaw with the BNRT concept—apportionment (even single-factor sales
apportionment) is not an adequate substitute for the type of border tax adjustments used in
typical cross-border VAT designs.
In addition to the foregoing, the treatment of capital expenditures under the BNRT is
likely to be a fertile source of administrative complexity and potential economic distortions.
The most recent materials available from the Commission’s website suggest that capital
expenditures will be either (a) immediately expensed in the year in which the asset is placed
in the service, or (b) subject to a cost recovery regime based on federal law, coupled with an
interest payment designed to replicate the effects of expensing. We understand the dilemma
the Commission faces on this important design feature of the BNRT. If expensing is allowed,
taxpayers may attempt to manipulate the timing of their investments so as to minimize their
BNRT liability—for example, by making year-end purchases to reduce their net receipts tax
base. The depreciation-with-interest alternative seems intended to limit such game-playing but
comes with its own problems, chief among them the considerable complexity such a provision
would add to the proposal. Special problems may arise with regard to multistate firms,
especially if the state seeks to limit the benefits of expensing to California investments. As
discussed further below, any such limitation would likely be challenged on federal
constitutional grounds. These lurking issues suggest that the BNRT’s treatment of capital
expenditures is likely to be one of the least stable features of the new regime, exacerbating
uncertainty regarding business investment decisions. It bears noting that controversy
surrounding the treatment of capital expenditures dogged Michigan’s Single Business Tax
from the outset and played no small role in the eventual repeal of the tax in 2007. It is not the
sort of experience that California should replicate.
Yet another set of uncertainties relates to potential legal challenges to the proposed
BNRT. Principal among these is the litigation that is likely to ensue if the BNRT incorporates
an “economic nexus” requirement as suggested by the materials posted on the Commission’s
website. As you know, there has been substantial litigation over the past several years
relating to the scope of the U.S. Supreme Court’s 1992 decision in Quill v. North Dakota.
That decision prohibited the states from imposing a use tax collection obligation on vendors
without a physical presence in the state. Litigation in state courts since Quill has focused on
whether the Court’s prohibition extends to taxes other than the sales/use tax. Because this
issue has not been resolved, firms subject to the BNRT but without a physical presence in
California (e.g., Amazon) would likely challenge the tax on federal constitutional grounds.
Another unresolved legal issue concerns the differential treatment of in-state and out-of-state
investment. As noted in the previous paragraph, any attempt to limit the benefits of expensing
(or its present value equivalent) to California investments would also likely result in federal
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constitutional challenges. As you know, this issue was raised in the DaimlerChrysler v. Cuno
litigation before the U.S. Supreme Court, but was not resolved since the Court dismissed the
case on standing grounds. As a result, any attempt to provide for differential treatment of instate
and out-of-state investments remains open to legal challenge. Finally, we note that, to
the extent that BNRT is structured to look more like an income tax than a sales tax (e.g., by
using depreciation instead of expensing), the state could face challenges under federal Public
Law 86-272, which limits the state’s ability to impose net income taxes on out-of-state firms.
There is also some risk that a BNRT with income tax features could be challenged under the
GATT. Of course the outcome of these legal challenges is by no means certain, but the costs
and lingering uncertainty associated with protracted litigation are virtually guaranteed.
Moreover, the state would be putting itself at risk for massive BNRT refunds in the event that
lawsuits challenging the tax are successful. In our view, these legal risks counsel against the
BNRT in favor a more cautious approach, including perhaps a recommendation for further
study of the BNRT proposal.
Finally, it bears noting that any new tax, especially one with which there is so little
practical experience, will be subject to aggressive tax planning in the early years, as taxpayers
exploit as yet unidentified opportunities to minimize their tax liability. Some of these issues
have already come to light in testimony before the Commission. For example, as several
commentators have noted, the BNRT would create an incentive for firms to outsource work to
independent contractors (for which a deduction is allowed) instead of hiring employees (for
which a deduction is not allowed). This incentive is mitigated to the extent that firms to
which the work is outsourced are subject to the BNRT; however, the $500,000 exemption
reintroduces the incentive, encouraging firms subject to the BNRT to outsource work to firms
not subject to the tax. (Japan has experienced precisely such a problem because of its smallbusiness
exemption in its subtraction-method VAT.) This example illustrates the difficulty of
crafting a new tax regime from scratch. It may be possible to anticipate the most obvious tax
avoidance strategies and address them in the initial legislation. Experience shows, however,
that it is simply impossible to predict the many and varied strategies that taxpayers and their
advisors will devise to minimize their taxes. Moreover, even if the most obvious strategies
are anticipated, statutory fixes to address them may generate further planning and distortions
in taxpayer behavior. Thus, adoption of the BNRT proposal should be thought of as the
opening of a new front in the state’s ongoing tax compliance efforts, along with a concomitant
increase in planning costs and tax litigation. These are wasted resources and should be
minimized in any effort at tax reform.
In summary, the BNRT is an intriguing proposal, perhaps worthy of consideration in
future tax reform efforts, but there are numerous reasons to believe that this is the wrong
course for the state to take at this stage.
2. Proposed Reforms to the Retail Sales Tax
Rather than recommending the BNRT, we believe the Commission should endorse three
key reforms to the RST: (1) extension of the tax to cover selected retail services,
(2) exemption for business purchases, subject to provisions to prevent avoidance for nonP
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business purchases, and (3) continued efforts to include cross-border retail purchases in the
tax base to the extent allowable under federal law. We will not rehearse here the rationale for
each of these reforms, nor do we mean to opine on the revenue consequences of this particular
combination of proposals. These issues have been vetted at length in expert testimony before
your Commission. We note simply that, unlike the BNRT, these are familiar, longstanding
reform proposals about which there is nearly universal consensus among tax policy experts.
Moreover, because of their familiarity, these reforms are suitable for immediate legislative
consideration during the special session the Governor has said he will call to take up the
Commission’s recommendations.
* * *
We are mindful of the numerous administrative, legal, and political obstacles involved in
any effort to reform the state’s tax system, and we understand the instinct to work from a
clean slate. That said, we are skeptical that the BNRT would, as some have suggested, allow
the state to accomplish indirectly reforms that cannot be accomplished directly. We believe
that the best and most direct path to a broad-based personal consumption tax for California is
to reform the RST in the manner described above. A fully modernized retail sales tax—one
that reaches all personal consumption and eliminates the existing tax burden on business
inputs—would represent a landmark reform of California’s tax structure consistent with the
principles set forth in the Governor’s Executive Order establishing the Commission.
Sincerely,
Joseph Bankman, Stanford Law School
Arnold C. Harberger, UCLA Economics Department
Walter Hellerstein, University of Georgia School of Law
James R. Hines, Jr., University of Michigan Economics Department
Charles McLure, Hoover Institution/Stanford University
Steven M. Sheffrin, UC Davis Economics Department
Kirk Stark, UCLA School of Law
John Swain, University of Arizona College of Law
George R. Zodrow, Rice University Economics Department
Thanks
Thanks