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Hard Numbers on Obamas Redistribution Plan

Wed, 25 Jun 2008 00:00:00 EDT

Fiscal Fact No. 132

The Tax Policy Center's recent analysis of the presidential tax plans has received a considerable amount of attention in the press. While much of the focus has been on how much or how little each plan benefits "middle-class" taxpayers, little attention has been paid to how each plan affects the overall distribution of the nation's tax burden.

On this account, the plans are vastly different. Under the McCain plan, since every taxpayer gets a tax cut, the overall distribution of the federal tax burden remains roughly the same as it is today. Under the Obama plan, because some taxpayers get a tax cut and others get a substantial tax increase, the overall distribution of the federal tax burden changes quite considerably.

In short, the Obama plan would redistribute more than $131 billion per year from the top 1 percent of taxpayers to all other taxpayers. In 2009, for example, Tax Policy Center figures show that after the income-shifting in the Obama plan, the top 1 percent of taxpayers would pay a greater share of the total federal tax burden than the bottom 80 percent of Americans combined. In other words, 1.13 million Americans would pay more in all federal taxes than 128 million of their fellow citizens combined.

These figures do not include the impact of Obama's proposal to apply Social Security payroll taxes on incomes above $250,000. According to Tax Policy Center estimates, this plan would increase the tax burden of top earners by an additional $40 billion in 2009 alone and more than $629 billion over the next ten years. By itself, the $40 billion tax hike is twice as much as all the federal taxes paid by people in the bottom quintile combined.

To put the Obama plan in context, it is important to understand how divided America's tax burden already is between a large group of Americans who pay little or nothing and a shrinking group of upper-income taxpayers who shoulder the lion's share of the burden. For example:

In 1999, about 30 million tax filers had no income tax liability after taking advantage of their credits and deductions. By 2006, the number of non-payers had grown to nearly 44 million, one-third of all income tax filers.
According to the Congressional Budget Office, in 2005, the top 20 percent of households paid 86.3 percent of income taxes while the bottom 80 percent paid a collective 13.7 percent of the income tax burden. The top 1 percent of households paid 38.8 percent of income taxes.
Looking at all federal taxes, in 1990, the bottom 80 percent of households paid 42 percent of the tax burden while the top 1 percent of households paid about 16 percent. By 2005, the share of all federal taxes paid by the bottom 80 percent of households had fallen to 31 percent, while the share paid by the wealthiest households had risen to nearly 28 percent.
A recent Tax Foundation study found that in 2004, the nation's tax and spending policies redistributed more than $1 trillion in income from the top 40 percent of American households to the bottom 60 percent of households.

The chart below shows the tax changes that would result from Obama's plan in 2009, in raw dollar amounts, for taxpayers separated into income quintiles, or fifths. The top quintile has been split into smaller income bands to illustrate the amount of income shifting between the groups. The top 1 percent of taxpayers would see a tax hike of $131 billion while the other groups would see a tax cut of $155 billion. Presumably, the residual tax cut of $24 billion would be deficit financed.

While the majority of the redistribution is targeted to taxpayers in the middle three quintiles, a surprising large amount—$40 billion—would flow to taxpayers in the 80th to 95th percentile (those earning roughly $93,000 to $192,000 per year). This is largely due to the extension of the AMT patch.

Figure 1
Tax Increases or Decreases Faced by Different Income Groups under Obama's Plan

Source: Tax Policy Center

Table 1 presents the share of total federal taxes currently borne by each income group compared to the changes that would occur under the Obama plan. A couple of figures jump out. First, the table illustrates how few taxes are paid by Americans at the bottom end of the income scale and, thus, how difficult it is to give them tax relief.

According to Tax Policy Center tables, there are roughly 72 million tax units in the bottom two quintiles, representing 48 percent of all tax units. Under current policies, these people pay just 4.8 percent of all federal taxes. Those in the lowest quintile would receive $22 billion in various tax credits under the Obama plan, which would reduce their overall federal tax liability by an average of $567. However, since these 39 million people currently pay an average of only $489 in federal taxes, they would see their federal tax liability fall below zero, meaning they would get money back from the government in excess of any taxes paid. For those in the second quintile, the Obama plan would cut their current average tax liability of $2,995 by 30 percent, or $892.

At the other end of the scale, the Obama plan would boost the average tax bill for the top 1 percent of taxpayers by $115,974, from $559,181 to $675,155. The overall tax burden on the top 1 percent would climb from 25.7 percent of all federal taxes to 31.3 percent. Thus, the top 1 percent of taxpayers would shoulder a greater burden of all federal taxes than the bottom 80 percent combined. Again, these figures do not include Obama's proposed increase in payroll taxes on high earners.

Table 1
Impact of Obama Plan on Federal Taxes Paid by Income Quintile

	Tax Units*		Share of Federal Taxes
Cash Income Percentile*	Number (thousands)	Percent of Total	Current Share of Total	Change Under Obama's Proposal	New Shares Under Obama's Proposal
Lowest Quintile	39,102	26.0%	0.8%	-0.90%	-0.12%
Second Quintile	32,942	21.9%	4.0%	-1.16%	2.84%
Middle Quintile	30,075	20.0%	10.7%	-1.18%	9.53%
Fourth Quintile	25,152	16.7%	17.9%	-1.15%	16.75%
Top Quintile	22,287	14.8%	66.5%	4.39%	70.88%
All	150,241	100.0%	100.0%	0%	100%

Addendum
80-90	11,264	7.5%	14.1%	-0.88%	13.23%
90-95	5,439	3.6%	10.4%	-0.52%	9.88%
95-99	4,454	3.0%	16.3%	0.16%	16.48%
Top 1 Percent	1,131	0.8%	25.7%	5.63%	31.29%
Source: http://www.taxpolicycenter.org/numbers/Content/Excel/T08-0114.xls.
* Quintiles have equal numbers of people but unequal numbers of tax units

While many Americans may cheer this outcome as just or equitable, this sort of direct redistribution raises some important questions that should be part of a larger national discussion:

What is the long-term effect on the economy of so few households shouldering such a large share of the tax burden?
What are the consequences for our democratic system when a majority of Americans are disconnected from the full cost of government? Will that majority demand more from the government because they bear little of the cost?
Should the tax system be used as a means of redistributing income or simply as a neutral mechanism for raising money for government services? Can a tax system premised on redistribution also be compatible with economic growth?
The Obama plan assumes little behavioral change from such a large tax hike on high-income workers. Is this realistic or will the higher rates encourage tax minimization strategies and reduced work effort, which will lead to lower tax revenues?

The Tax Policy Center has done the public a service by putting hard numbers on the candidates' tax plans and bringing a dose of reality to the political rhetoric. While it is easy for the press and voters to consider only "What's in it for me?," there are larger issues raised by these findings that deserve more public discussion.

Testimony on H.R. 5267, the Business Activity Tax Simplification Act of 2008

Tue, 24 Jun 2008 00:00:00 EDT

Prepared Statement of

Joseph Henchman, Tax Counsel,

Tax Foundation

Before the

Subcommittee on Commercial and Administrative Law

Committee on the Judiciary

United States House of Representatives

June 24, 2008

Hearing on

H.R. 5267, the Business Activity

Tax Simplification Act of 2008

Madam Chairwoman, Ranking Member Cannon and members of the Committee:

On behalf of the Tax Foundation, I appreciate the opportunity to submit this statement of testimony regarding H.R. 5267, the Business Activity Tax Simplification Act of 2008.

The Tax Foundation is a non-partisan, non-profit research institution founded in 1937 to educate taxpayers about sound tax policy. Based in Washington, D.C., our economic and policy analysis is guided by the principles of neutrality, simplicity, transparency, and stability. We aim to make information about government finance understandable, such as with our annual calculation of "Tax Freedom Day," the day of the year when taxpayers have earned enough to pay for the nation's tax burden and begin earning for themselves.

While we, as an institution, take no position on the bill itself, we believe that retaining a physical presence nexus standard for state taxation of business activity is an essential part of a neutral, simple, transparent, and stable tax system. State efforts to move away from a physical presence standard undermine these principles and threaten to do long-term harm to economic growth.

In 2007, Americans spent $175 billion in online retail transactions, up 21 percent from the year before and accounting for six percent of total sales.¹ Although the proportion is still small, it is growing quickly.

Economic transformation and integration have always been features of the American economy, even back to the period of the Founding. Similarly, it is not new for states to seek revenues by shifting tax burdens away from the majority of voting residents, such as with changing nexus rules. Because economic integration is greater now than it has ever been before, the economic costs of nexus uncertainty are also greater today and can ripple through the economy much more quickly.

For example, if a New York company sells a product on its website to a California purchaser via servers in Ohio and Colorado, is the transaction everywhere, nowhere, or always somewhere at a given point in time? A physical presence rule provides an easy and logical answer to where the transaction is located, identical to the answer given for brick-and-mortar businesses: New York, where the company's property and payroll are located.

Proponents of economic nexus are mostly unanimous in rejecting that choice, but they would substitute only uncertainty about the ultimate answer. Inflicting this uncertainty on our economy, as states have begun doing in absence of a uniform physical presence standard, would be disastrous.² As long as state tax systems are defined by geographical lines, consistency requires that taxes be imposed only on individuals and businesses within those geographical lines.

Our written testimony makes two broad points. First, the physical presence standard limits destructive and likely unconstitutional state efforts to export tax burdens, efforts that stifle interstate commerce and harm economic growth. Second, a uniform physical presence standard would decrease transaction costs for interstate commerce, especially small businesses using mail and the Internet.

A Uniform Physical Presence Standard Limits Destructive and Likely Unconstitutional State Efforts to Export Tax Burdens

The U.S. Constitution came about in large part because the federal government initially had no power to stop states from setting up trade barriers between each other. Many states sought, as they do today, to protect domestic enterprises by burdening or discouraging out-of-state competitors with heavy taxes and import restrictions, harming these businesses and the economy as a whole. This race to the bottom directly led to granting Congress the power to regulate interstate commerce.³

State officials still have every incentive to pursue beggar-thy-neighbor tax policies designed to shift tax burdens from voting in-state residents to out-of-state residents and businesses unable to resort to the ballot box. Not only does democracy not prevent harmful tax exporting from occurring, it actually worsens it, since services can be provided to a majority of voters, paid for by non-voters.

As scholar Daniel Shaviro put it, "Perceived tax exportation is a valuable political tool for state legislators, permitting them to claim that they provide government services for free."⁴ The Supreme Court, using its dormant commerce clause jurisprudence, has intervened to stop some of the more egregious state actions; but its scope and power in this regard is limited.⁵ It is thus up to Congress to exercise its power to protect interstate commerce.

The Tax Foundation has catalogued the growth in state tax exporting. Increasingly, states have imposed higher, non-neutral taxes on products and services more likely to be used by non-residents, such as hotel rooms and rental cars; they have enacted subsidies and tax credits to favored in-state activities but not out-of-state activities; and they have shifted corporate tax burdens by changing apportionment and nexus rules. States are trying to tax whatever they can reach-hardly a new or innovative development.

Contrary to the assertions of the Streamlined Sales Tax Project and others, states are moving away from harmonization. Beginning in 1959, for example, states adopted uniform rules for apportioning income earned by interstate corporations between states for tax purposes. The apportionment formula was one-third based on the location of property, one-third on the location of payroll, and one-third on the location of sales. Many interstate businesses, of course, conduct sales in more states than they have property and employees, and states with poorer business tax climates began to insist that sales count for more than a third of the apportionment formula. Today, only 14 states still have an evenly weighted three-factor formula, with other states having moved to double weighting sales or even only counting sales. As these states reached out for a larger share of taxes that would otherwise go to other states, they reduced neutrality in the tax system, burdened interstate transactions with uncertainty, increased compliance costs, and threatened multiple taxation of the same business income by different states.

A recent nexus case involved West Virginia's levy of a quarter million dollars in state taxes on a company (MBNA, now FIA Card Services) whose only connection to West Virginia is that some of its customers now live there.⁶ Although MBNA had property and 28,000 employees around the world, none of them were in West Virginia. And although a quarter million dollars may not be considered much for a company with profits of over $1 billion per year, MBNA had tax liability on those profits in the state where its employees and property were: Delaware. If every state were to impose similar taxes on every company, the negative impact on the economy would be serious.

A business with property and employees in a state is properly subject to state taxation, as the Supreme Court emphasized in its famous Complete Auto Transit case in 1977.⁷ Known as the "benefit principle," liability to state taxation is usually described as a form of payment for enjoying police protection, access to courts, and state-maintained roads. This idea, that a company pays taxes in return for benefits derived from being physically present in a state, is reflected in the test adopted in Complete Auto, which requires that "the tax must be fairly related to services provided to the taxpayer by the state," as well as requiring that there must be "a sufficient connection between the taxpayer and the state."⁸

Proponents of economic nexus argue that out-of-state businesses must be subject to tax since their sales into the state enjoy the benefit of a functioning economy. If a business does not have property or payroll in a state, true application of the benefit principle makes these arguments less compelling. Sales over the Internet or through the mail that happen to pass through a state, or terminate in a state, do not use state services to the extent of physically present companies and in-state residents, if they do at all.

At some point states must accept that the benefit of a functioning economy, which results in large part from good property rights and court systems, accrues primarily to in-state residents and businesses, and it is ultimately their responsibility to maintain and finance. (States are also unlikely to waive taxes on out-of-state residents when the economy is functioning poorly.) To allow interstate transactions to be nickel-and-dimed by state taxing authorities as they make their way across the continent would impose, and has imposed, a huge burden on interstate commerce.

In Quill v. North Dakota (1992), the U.S. Supreme Court reaffirmed the rule that a state cannot impose tax collection obligations on a business unless that business is physically present in the state.⁹ The Court broadly recognized that states seek to impose greater tax burdens on businesses not physically present in the state, which by definition are taxes on activity occurring out-of-state. The only way to ensure that states are not burdening activity out of state more than activity in state is to limit state tax collections solely to businesses with a physical presence.

A Uniform Physical Presence Standard Would Decrease Transaction Costs for Interstate Business Activity

Businesses throughout our nation's history have plied their trade across state lines. Today, with new technologies, even the smallest businesses can sell their products and services in all fifty states through the Internet and through the mail. If such sales can now expose these businesses to tax compliance and liability risks in states where they merely have customers, they will be less likely to expand their reach into those states. Unless a single nexus standard is established, the conflicting standards will impede the desire and the ability of businesses to expand, which harms the nation's economic growth potential.

We here at the Tax Foundation track the myriad rates, bases, exemptions, credits, adjustments, phaseouts, exclusions, and deductions that litter our federal and state tax codes. The federal income tax code in 2006 stood at 7 million words in 236 code sections, up from 718,000 words in 103 code sections in 1955. In 2005, the estimated time and money cost of complying with the federal income tax code was 6 billion man-hours, worth $265 billion.¹⁰

Frequent and ambiguous alterations of tax codes and the confusion they cause are a key source of the growing tax compliance burden. These costs are especially relevant for interstate businesses, both large and small. In the United States, there are over 7,400 sales-taxing jurisdictions, many with their own tax rates, tax bases, and lists of exemptions. The Streamlined Sales Tax Project has been making little progress in its effort to align sales tax jurisdiction boundaries with 9-digit zip codes (of which there are 38,547,080), and it has no intention of trying 5-digit zip codes.¹¹ So even if an Internet retailer knows the nine-digit zip code of his customer, that doesn't mean he or she will know the correct tax rate.

Retailers are stuck between a rock and a hard place. If they "play it safe" and end up overcharging the customer on sales tax, they are subject to a class action lawsuit. If they undercharge, they are subject to tax penalties and prosecution by the state. Here at the Tax Foundation, we have several staffers as well as computer-based and publication subscriptions dedicated to being up to date and accurate on the frequent changes to the many taxes in our country, but even we have trouble doing it. It would be extremely difficult for retailers who are in business to sell a good or service, not to conduct tax policy research.

Under either physical presence or economic nexus, brick-and-mortar stores need to worry only about the tax system where they are physically present. The same would be the case for online retailers under a physical presence standard. But under an economic nexus standard, online retailers would have to pay taxes based on where their customers are located. This would burden e-commerce more than brick-and-mortar business, and effectively impose an exit toll on outbound commerce.

I live in Virginia but work in the District of Columbia. Say I go down the street to buy lunch from a retailer here in the District. The retailer earns money and ultimately pays income tax on the revenue to D.C., which makes sense since that's where the retailer's property and employees are. Under economic nexus, however, the retailer would have to pay income taxes on earnings from the sale to me based on where I live—in this case, Virginia—with the money going to Virginia. Income taxes derived from each transaction would go to a different state, based on where the customer lives. This real-world application of economic nexus demonstrates that besides the compliance problems, the complexity, and the administrative burden, economic nexus just doesn't make sense. Under the benefit principle, D.C. should get this money, not Virginia.

There is a high likelihood that e-commerce would become subject to multiple taxation under an economic nexus standard. Under physical presence, only one state may claim a certain share of business income at a time. It's easy to do-one just looks to see where employees and property are.

An economic nexus rule, by contrast, complicates matters. In the MBNA case, West Virginia sought to tax income that is already subject to Delaware taxation. Even though Complete Auto says that a state cannot tax beyond its fair share, multiple states would assert that they are entitled to tax the income. States are unlikely to smooth out such agreements for the same reason that rules for divvying up state corporate income have become less uniform. Without a uniform standard, multiple taxation and substantial litigation surrounding it could arise.

States' adoption of economic nexus also raises questions of temporal limitations. How far in space and time does economic nexus go? States vary widely on how long nexus lasts after in-state activity occurs: three states say twelve months, the State of Washington says five years, two states say it ends on the day the physical presence ends, and in Indiana, nexus apparently lasts forever.¹² Only a uniform federal standard can provide a rational and comprehensive answer to the question of how far is too far and how long is too long.

These problems—tracking state tax rates and bases in 7,400+ jurisdictions, litigation, inequity, multiple taxation, and unpredictability—are associated with economic nexus. A uniform physical presence standard would avoid most or even all of them.

Conclusion

The Internet has seen an increased amount of commerce, but some seem to view it as a golden goose that can be squeezed without adverse effects on economic growth. It must be understood that the availability of many items in electronic commerce could be hindered if states are permitted to adopt economic nexus standards. States will reach for as much revenue as they can, if they believe that it can benefit them even at the expense of other states and the nation as a whole. A uniform physical presence standard would restrain these efforts, maintain a level playing field for all types of businesses, and reduce costs and burdens to interstate commerce.

The Supreme Court is not well-equipped to move beyond the broad outlines of its past Commerce Clause cases. Courts can only develop doctrine in a case-by-case fashion, based on the facts of the particular case before them. (Additionally, the Court seems to have an aversion to tax cases.) Congress, by contrast, can obtain evidence from interested stakeholders and take political and economic factors into consideration when developing new rules of taxation. This is why congressional action, which can be more comprehensive and accountable than judicial action, and can also better address issues of transition, retroactivity, and de minimis exemptions, may now be the best vehicle for preventing burdens to interstate commerce by adopting a uniform physical presence standard. It is thus up to Congress to exercise its power to protect interstate commerce.

We now live in a world with iPods and Amazon.com. It is a testament to the Framers that their warnings about the incentives for states to hinder the national economy remain true today. Some academics argue that faster roads and powerful computers mean that states should now be able to tax everything everywhere. While some constitutional principles surely must be revisited to apply them to new circumstances, the idea that parochial state interests should be prevented from burdening interstate commerce remains a timeless principle regardless of how sophisticated technology may be.

Endnotes

1. See "Online Sales Spike 19 Percent," CNN (May 14, 2007), available at http://tinyurl.com/2ox935.

2. Replacing a physical presence standard with a "modern" one has caused uncertainty and economic dislocation before. See Joseph Henchman, "Why the Quill Physical Presence Rule Shouldn't Go the Way of Personal Jurisdiction," State Tax Notes (Nov. 5, 2007), available at http://tinyurl.com/5jsykb.

3. See, e.g., Gibbons v. Ogden, 22 U.S. 1, 224 (opinion of Johnson, J.) ("[States,] guided by inexperience and jealousy, began to show itself in iniquitous laws and impolitic measures . . ., destructive to the harmony of the States, and fatal to their commercial interests abroad. This was the immediate cause that led to the forming of a convention.").

4. Daniel Shaviro, "An Economic and Political Look at Federalism in Taxation," 90 Mich. L. Rev. 895, 957 (1992).

5. For a discussion of past cases, see Joseph Henchman, Defending Competitive Neutrality Before the Supreme Court, Tax Foundation Special Rep. No. 158 (Nov. 2007).

6. See Tax Comm'r of State v. MBNA America Bank, N.A., 640 S.E.2d 226 (W.V. 2006), cert. denied, 75 U.S.L.W. 3676 (U.S. Jun. 18, 2007) (No. 06-1228).

7. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

8. Id. at 279.

9. Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

10. See Scott A. Hodge, J. Scott Moody & Wendy P. Warcholik, "The Rising Cost of Complying with the Federal Income Tax," Tax Foundation Special Report, No. 138 (Jan. 2006).

11. See Douglas L. Lindholm, "Old Economy" Tax Systems On A "New Economy" Stage: The Continuing Vitality of the "Physical Presence" Nexus Requirement, Council on State Taxation (Feb. 27, 2003), at 20-26, available at http://tinyurl.com/59v6yw.

12. See H. Beau Beaz III, The Rush to the Goblin Market: The Blurring of Quill's Two Nexus Tests, 29 Seattle U. L. Rev. 581, 622 (2006).

Arizona's Special Interest Laundry List

Tue, 24 Jun 2008 00:00:00 EDT

Fiscal Fact No. 131

Last week, Arizona state representatives unveiled a raft of proposed subsidies and special tax breaks for favored industries. Typically, with packages of lobbyist-driven handouts such as these, the actual value to state residents is inversely proportional to the sponsors' soaring language regarding their benefits. So when Arizonans are told that the package's effects will be "bringing in new manufacturing jobs, revitalizing urban areas, attracting tourists, maintaining or expanding the Cactus League and stabilizing the construction market," they should check to make sure they are still in possession of their wallets.

The Arizona State House's press release announcing the proposals grandly reports that "no current general fund money would be used for the projects." Technically, that's true. However, the difference between the government (1) collecting a tax and then cutting a check to a favored business, or (2) exempting that favored business from a portion of its tax liability, is a difference in accounting only. These programs will impose significant costs on Arizona's general fund in the form of tax revenues foregone. In many cases, the special tax benefits will go to businesses or projects that would have existed with or without the new laws, representing a true loss of otherwise-collected revenue.

The four main planks of the proposal are:

Tax breaks for manufacturers of solar energy components. Manufacturers would receive a transferable (and therefore, functionally equivalent to a refundable) credit against income tax for 10% of business investment.
Expansion of the state's existing Research & Development tax credit. The credit would go from 20% to 24% on expenses up to $2.5 million, and from 11% to 15% on expenses above $2.5 million. This increase is expected to cost the state treasury $11.2 million per year.
A special 0.75% tax on hotel rooms, restaurants and rental cars in Pima County (Tucson). This tax, subject to approval by Pima County voters, would be used to subsidize spring training facilities used by Major League Baseball teams.
Exempting certain new developments from various taxes. The exempted taxes would include sales tax for construction goods and city sales tax. Municipalities would be allowed to approve individual developments for tax exemptions on a largely discretionary basis.

This may be a particularly bad time to hand special breaks to certain businesses. Earlier this year, Arizona opted to let expire a temporary suspension of its statewide property tax. This tax will return for 2009, at a $250 million cost to Arizona taxpayers.¹ Meanwhile, Arizona's combined state and federal corporate income tax rate of 39.5% is higher than that of every OECD country in the world except Japan, whose rate is 39.56%.² Without spending cuts, tax subsidies for favored industries will increase the need for higher broad-based taxes, like the statewide property tax.

Solar Manufacturing Subsidy

This program would provide preferential tax treatment to manufacturers of solar power generation products. Individuals and corporations would be eligible for a transferable income tax credit up to 10% of a "qualified business investment" in solar manufacturing. This tax credit would not be refundable, but the right to transfer the credit to another taxpayer would make it economically equivalent to a refundable tax credit.

Under a refundable tax credit, a taxpayer whose credit exceeds his taxes due receives net cash from the state. With a transferable tax credit, such a taxpayer can't get a check back from the state, but he can sell his credit to another taxpayer with a net liability. By making this tax credit transferable instead of refundable, supporters can disingenuously claim that their plan has no direct costs to the state's general fund. But because the credit can be sold to taxpayers with net liability, it would reduce general fund receipts.

Sound tax policy means equal economic activities should be treated equally by the tax system. By providing special tax treatment for solar manufacturing, Arizona works to shift business investment from efficient opportunities to tax-favored ones. Many of the advantages cited to make Arizona well-suited for solar manufacturing-including research programs at the University of Arizona and the presence of a strong semiconductor industry-are in fact advantages for a broad range of economic activities. Instead of giving tax credits to politically connected players in a specific industry, Arizona could cut its corporate income tax and draw in more business of all kinds, as determined by the free decisions of individuals in the marketplace.

Research & Development Tax Credit

Arizona, like most states, already has a tax credit for research and development expenses. This proposal would expand the existing credit over two years, ultimately increasing it from 20% to 24% on expenses up to $2.5 million, and from 11% to 15% on expenses above $2.5 million.

The theoretical underpinning for R&D tax credits is that research activities produce positive externalities-that is, benefits that do not accrue exclusively to the researcher. R&D tax credits are supposed to compensate investors for the public benefits they create through research. Patents are intended to serve this purpose, though tax credits can fill a gap if patent protections do not sufficiently compensate innovators.

However, state R&D tax credits have almost no research-generating effect. Principally, they move research that would already happen between the states, producing a race to the bottom to see what state can provide the biggest tax incentives. Daniel J. Wilson, an economist with the Federal Reserve Bank of San Francisco, writes:

[T]he setting of R&D tax credits by states (as opposed to only the federal government) is nearly a zero-sum game. For instance, if all states were to lower their R&D user costs, e.g., by raising their tax credit rates, by the same percentage, aggregate private R&D in the nation would rise very little, if at all.³

This might mean that, even if Research & Development tax credits have no national effect, Arizona could benefit at the expense of other states by increasing its tax credit. However, to the extent that R&D credits are supporting real spillover benefits from innovation, those benefits will accrue nationally or internationally, not just in Arizona. States that choose to offer generous R&D tax credits (including Arizona) are subsidizing a public benefit that, if it exists, runs far beyond their borders.

Advocates of R&D tax credits will also point to economic benefits beyond innovation, such as the creation of new jobs. However, it is important to consider the effects on a net basis with an eye toward opportunity cost. Much of the R&D tax subsidy will go toward (1) research activities that would have happened with or without subsidy, or (2) research activities undertaken in lieu of more efficient uses of capital. These shifts into R&D do not represent economic growth, just economic change, and will consume tax benefits without accruing value to Arizona.

Finally, it is important to consider tax alternatives. Instead of further complicating its tax code with bigger credits for special activities, Arizona could best increase its competitiveness by simplifying its tax code and cutting rates on its broad-based taxes.

Special Sales Tax on Tucson Hospitality Industry for Spring Training Subsidy

This proposal would give Pima County voters the option to levy a 0.75% sales tax on hotel rooms, restaurant meals, and rental cars. Proceeds from the tax would finance upgrades to spring training facilities in the Tucson area, which are currently used by three Arizona major league teams: the Arizona Diamondbacks, Chicago White Sox (who have announced plans to move spring training facilities to Phoenix) and Colorado Rockies. The hope of the upgrades is to draw a new team or teams to train in Tucson, either from Phoenix or Florida.

High Costs and Fictional Benefits: Proponents cite economic development resulting from tourism as the primary reason for the spring training subsidy. However, researchers across the political spectrum report that sports subsidies tend to disappoint in the economic development department. Research reports published by the Brookings Institution find "that professional sports have been oversold by professional sports boosters as a catalyst for economic development"⁴ and that "the additional labor and capital income a community obtains from a sports related facility-whether a stadium, arena, or training center-generally is inadequate to justify public subsidy of that facility."⁵

Consider Tucson's last attempt to attract baseball. In 1998, Tucson Electric Park was built to the tune of $38 million. Just 10 years later, another round of public subsidies is deemed necessary to retain baseball in Tucson. Moreover, modern stadiums are double the price of those from a decade ago. If Goodyear and Glendale are any indication, we can expect a price tag between $75 and $80 million.

Who Pays? Assuming lawmakers and Pima County residents approve the proposal, a three-quarter-cent sales tax will be tacked on to purchases at hotels, restaurants, bars and rental car agencies. The rationale for placing the tax burden on these businesses is that they will benefit from additional spring training-related tourism. However, the Arizona Restaurant and Hospitality Association has already announced its opposition to the proposal.⁶

Who Benefits? If local businesses do not expect to benefit from the tax and subsidy, one should ask who will. An obvious answer is baseball team organizations which, except in the case of the Diamondbacks, lie out of state. While a subsidy benefiting the Chicago White Sox would be a generous gesture on the part of Pima County taxpayers, they should consider whether it is their most preferred use of tax dollars.

Constitutional Issues

In addition to the policy and economic problems associated with a package of handouts to favored groups, such bills may violate a number of constitutional provisions specifically designed to keep lawmakers from giving special privileges to benefit a person or class. Arizona's Constitution is strong in these protections, with three distinct provisions:

Gift Clause (Art. 9, Sec. 7), barring laws that "give or loan [the state's] credit in aid of, or make any donation or grant, by subsidy or otherwise, to any individual association or corporation . . . ." The framers of Arizona's constitution inserted this clause as a result of serious misuse of government funds in speculative railroad investments with little or no public benefit. Subsidies or other gifts benefiting private actors can violate this Clause.
Privileges or Immunities Clause (Art. 2, Sec. 13), stating that "[n]o law shall be enacted granting to any citizen, class of citizens, or corporation other than municipal, privileges or immunities which, upon the same terms, shall not equally belong to all citizens or corporations." Forcing individual and business taxpayers to subsidize the special benefits provided to other individuals and businesses could violate this Clause.
Special Laws Clause (Art. 4, Sec. 19), barring non-general laws in the area of tax assessment and collection (Subsec. 9); granting exclusive privileges or franchises to corporations, associations, or individuals (Subsec. 13); and "when a general law shall be made applicable" (Subsec. 19). Taxes levied on some but not others can violate this Clause.

These clauses have been described as intending to "limit the exercise of government power to truly public purposes and that prevent unjust enrichment of favored interests to the detriment of the taxpaying public."⁷ Arizona's Goldwater Institute has been active in challenging lobbyist-driven handouts that may violate these constitutional provisions.

Singling out hotels, restaurants, and rental cars for a punitive tax merits particular concern, not only because it inequitably shifts tax burdens to non-voting visitors. The Special Laws Clause bars the state from enacting laws not generally applicable to all within a rationally defined class. Pima County thus could not be singled out by name for the establishment of a taxing district. Instead, drafters designed a "class" of all counties with population between 500,000 and 2 million-set up to ensure that it would include Pima County and no other. A state appellate court narrowly accepted a similar "class of one" legislative design in 2002, but past cases indicate such legislation may not be entirely permissible.⁸

Such an end-run around a constitutional taxpayer protection presents serious problems. Residents of other parts of the state who visit Pima County would pay taxes to support that county, but would not have a say in how the funds are used. Excluding other counties from the legislation means baseball subsidies are supported by a funding source only authorized in one county. The Special Laws Clause is meant to "prevent the enactment of statutes bestowing special favors on preferred groups or localities."⁹ Many of the provisions in the legislative laundry list do precisely that.

Exempting certain new developments from various taxes

This proposal would allow municipalities to create special "Commercial Enhancement Zones," where developers would be exempted from certain taxes. It contains two layers of micromanagement: the state sets criteria that areas must meet if municipalities wish to designate them, and then municipalities may approve tax credits on a discretionary basis, considering such nebulous criteria as whether a development is "appropriate for the area" and will "contribute to the long-term vitality of the zone." This smacks of central planning of development, with the government using the tax code to push development toward favored locales and developers, instead of the places where it is most economically demanded. Arizona should instead push for a neutral and simple tax system that treats all economic actors alike.

Special thanks to William Luther for research assistance.

Notes

1. http://www.tucsoncitizen.com/ss/local/82727.php.

2. http://www.taxfoundation.org/news/show/22917.html.

3. "Beggar thy Neighbor? The In-State, Out-of-State, and Aggregate Effects of R&D Tax Credits," (working paper), Daniel J. Wilson, Federal Reserve Bank of San Francisco, 2005-2007. http://www.frbsf.org/publications/economics/papers/2005/wp05-08bk.pdf.

4. Robert Baade and Allen R. Sanderson, "Employment Effect of Teams and Sports Facilities," Sports, Jobs & Taxes: The Economic Impact of Sports Teams and Stadiums, Brookings Institution Press, 1997.

5. Dennis Zimmerman, "Subsidizing Stadiums: Who Benefits, Who Pays," ibid.

6. http://www.azstarnet.com/sn/fromcomments/244661.php.

7. Complaint, Turken v. Gordon, Superior Court of Arizona, Maricopa County, CV-2007-013766, at http://tinyurl.com/63c5tl.

8. See Long v. Napolitano, 203 Ariz. 247, 253-61 53 P.3d 172, 178-86 (App. 2002). See also State v. Christi, 149 Ariz. 323, 324, 718 P.2d 487, 488 (App. 1986) ("A [prohibited] local law arbitrarily singles out one locality in the jurisdiction for special treatment."); Id. ("Local or special laws are laws plainly intended to apply to an arbitrarily defined spectrum of cases."); In re Marxus B., 199 Ariz. 11, 15, 13 P.3d 290, 294 (App. 2000) ("[W]here the prospect [for a class of one becoming a class of more than one] is only theoretical, and not probable, we will find the act special or local in nature.").

9. City of Tucson v. Grezaffi, 200 Ariz. 130, 138, 23 P.3d 675, 683 (App. 2001), quoting City of Tucson v. Woods, 191 Ariz. 523, 529, 959 P.2d 394, 400 (App. 1997).

The Presidential Election Campaign Fund: A Voluntary Tax That Stirs Little Enthusiasm

Fri, 20 Jun 2008 00:00:00 EDT

Fiscal Fact No. 130

Senator Obama's abandonment of public financing for the presidential election is a first since the public funds were set up, and it refocuses attention on the concept and implementation of public financing.

Congress has been using the IRS for years to squirrel money away for presidential campaigns. The program is called the Presidential Election Campaign Fund, and little noticed by taxpayers, the Fund has been distributing millions of dollars to presidential candidates on a regular basis.

What is the Presidential Election Campaign Fund?
On the 1040 form, nestled between one's address and filing status, is a box marked "Presidential Election Campaign." A brief explanation on the 1040 directs taxpayers to check the box if they want $3 of their tax payments to go into this fund ($6 for couples). Taxpayers are assured that they are not paying extra if they check the box.

Despite this (dubious) assurance that the "contribution" costs the taxpayer nothing, only about 12 percent of taxpayers put a check in that box. Explanations for low participation boil down to four main arguments:

Taxpayers are angry about the tax code in general. Perhaps the mood of average tax filers in the middle of a 1040 is not kindly disposed to the politicians responsible for the confusing, expensive income tax code.
Taxpayers oppose public funding of political campaigns in principle. Some taxpayers may appreciate their lawmakers but still believe that politicians should fund their own careers.
Taxpayers have little or no idea what the Presidential Election Campaign Fund really is. Tax filers running across an optional, poorly explained line on their already complicated returns might skip it without a second thought.
Taxpayers disbelieve the assurance that the Presidential Election Campaign Fund will not cost them extra. Tax filers may believe that every $3 in public money has to come from somewhere.

If a 1040 filer is interested enough to learn more, a blurb in the 1040 instructions explains, "This fund helps pay for Presidential election campaigns. The fund reduces candidates' dependence on large contributions from individuals and groups and places candidates on an equal financial footing in the general election."

The Presidential Election Campaign Fund is indeed designed to level the playing field for candidates. To this end, the PECF provides candidates with public funding for their presidential primary campaigns and their general election campaigns. For primaries, the PECF works by matching individual donors' contributions dollar for dollar up to a limit. Only contributions from individuals are eligible for matching, and the limit is $250 per individual. This limit should not be confused with an individual's limit on total contributions to a candidate, which is currently set at $2,300 per election. In other words, an individual is allowed to contribute a maximum of $2,300 to a candidate's primary election fund, but only the first $250 would be matched by the PECF.

A candidate seeking his or her party's presidential nomination must also meet certain qualifications in order to receive public funds. A candidate must raise at least $5,000 in 20 different states and must agree to an overall campaign spending limit as well as various spending limits in each state. For 2008, the overall spending limit for primaries is just over $42 million.

General elections work differently. Federal funding is given in the form of direct grants rather than by matching contributions from individuals. In fact, a candidate who wishes to receive public funding for a general election campaign generally cannot accept any contributions from individuals. One exception to this rule is for contributions to a candidate's compliance fund, which is used to pay for certain legal and accounting expenses incurred to comply with Federal Election Commission regulations and relevant campaign finance legislation. Such contributions are subject to the $2,300 limit. For candidates receiving federal funds, the overall spending limit for general elections is just over $84 million. If a candidate is not federally funded, an individual's contribution to that candidate's general election fund is still subject to the regular $2,300 limit.

Taxpayer Participation
In both the primaries and general elections, the federal funds come from the tax payments of filers who voluntarily check off the box on their 1040. As noted above, the vast majority of filers do not check the box. When the PECF was first established in the 1970s, the participation rate hovered around 27 percent of filers. Since then, participation has been steadily declining.

If PECF participation is broken down by adjusted gross income (AGI) an interesting trend emerges. As AGI increases, the percentage of returns electing to contribute to the PECF increases (see Table 1). In the lowest range, taxpayers with less than $10,000 in AGI, fewer than 10 percent checked the box in 2004. In the highest income group reported by the IRS, those with an AGI of $10 million or more, 23 percent contributed. This is still not especially high, but it is curious. Why the difference?

Table 1 Federal Tax Returns Participating in the PECF Program by Adjusted Gross Income 2004
AGI Group	Returns Electing to Give at Least $3*	Total Number of Returns	Percent of Returns Electing to Contribute at Least $3
Under $10,000	2,508,016	25,476,123	9.84%
$10,000 to $20,000	2,796,991	23,169,070	12.07%
$20,000 to $30,000	2,083,853	18,025,856	11.56%
$ 30,000 to $40,000	1,589,707	13,922,755	11.42%
$ 40,000 to $50,000	1,260,157	10,599,289	11.89%
$ 50,000 to $75,000	2,328,757	18,247,472	12.76%
$ 75,000 to $100,000	1,383,957	10,009,700	13.83%
$ 100,000 to $200,000	1,702,950	9,761,383	17.45%
$ 200,000 to $500,000	436,238	2,340,905	18.64%
$ 500,000 to $1,000,000	85,294	433,315	19.68%
$1,000,000 to $1,500,000	20,591	103,939	19.81%
$1,500,000 to $2,000,000	8,908	45,095	19.75%
$2,000,000 to $5,000,000	13,037	65,500	19.90%
$5,000,000 to $10,000,000	3,448	15,832	21.78%
$10,000,000 or more	2,245	9,662	23.23%
*Joint filers can contribute up to $6 per return. Note: Tax filers with no tax liability (almost one third of all tax returns) often check the box, but that does not cause a transfer into the PEFC, so fund balances are considerably lower than these check-off data suggest. Source: IRS public use file, 2004, and Tax Foundation calculations

There are many possibilities, but two that seem likely are that people with high incomes believe politicians and elections will be more honest if the government funds elections, and lower-income people are suspicious that contrary to the assurance on the 1040, checking the box will cost them more.

In the end, it is possible that while checking the box does not increase one's taxes this year, it might increase them next year, or at least require one's neighbor to pay the extra $3 instead. For low-income filers, those for whom every dollar counts, this might seem a good reason not to check the box.

Despite the increase in participation among higher-income taxpayers, the overall participation is still rather low, averaging just over 12 percent since 2000. This is a good indication that most people either don't understand the Presidential Election Campaign Fund or understand it but do not think it is a worthy cause for their tax dollars to support.

Assessing Arizonas State Tax Policy

Mon, 09 Jun 2008 00:00:00 EDT

The State of Arizona has seen remarkable changes in its economy and demography over the past 10 years. Just from 2000 to 2007, its population increased from 5.2 million to 6.3 million. That makes it one of the fastest-growing states in the nation, continuing the trend of the 1990s when population growth was also quite rapid.

The state's economy has kept pace. Arizona's real per capita GDP averaged 2.4 percent growth from 1997 through 2006, much faster than the rest of the nation, which grew at 1.9 percent annually. This is all the more remarkable because Arizona's per capita GDP figures are skewed downward by the large fraction of new residents who are low-income immigrants.

The figures tell a powerful story: both labor and capital are flocking to Arizona. But why? True, the state's tax and regulatory policies are acceptable, but they certainly aren't stellar enough to be such a powerful magnet. New Hampshire's super-low tax levels steal economic development from its high-tax New England neighbors every day. That's not what's going on here, with the possible exception of a few California refugees who make a wrong turn on their way to Nevada.

There are myriad factors at play. One is weather. Like the rest of the South, Arizona is benefiting from people's desire to live in warmer climates. And where the desert was once daunting, technology has made it less so.

Another is the fact that along with the rest of the South and Southwest, Arizona had been below average in productivity. Areas that start off with low productivities tend to grow faster than other already high-productivity areas (Solow growth model).

Despite the fact that Arizona's economy has excelled over the past couple of decades, it has slowed recently, which is also putting a strain on state and local governments. So it is still worth looking at how the state could create a better mix of tax and spending policies.

The crucial questions when determining the optimal fiscal system in any region are: (1) identifying the public goods that government is in the best position to provide, (2) determining what principle of taxation will be underpin public policy, i.e., ability to pay, benefit principle, etc., (3) given the answers to 1 and 2, how best to administer government policies including tax laws and spending programs, and finally (4) after weighing the costs and benefits of competing policies, deciding which should be implemented.

At the state and local levels, the answers to these questions can be drastically impacted by the decisions of other governments. While some states and localities may desire high government spending and higher taxes while others prefer low spending and low taxes, taxes and spending do not operate in isolation and must take each other's policies into account. Labor and capital flow across jurisdictional boundaries (including international), each seeking to maximize its own net return. This type of fiscal competition between entities can be both beneficial and harmful for society as a whole.

Arizona: Can It Improve Its Tax System?
This paper seeks to identify how Arizona's tax and spending policies could better accommodate the fact that some economic behavior is more sensitive to taxation than others. That is, can Arizona's tax laws fit better into the flows of the market economy?

The state levies a relatively high gross receipts type of tax (Transactions Privileges Tax) of 5.6 percent on some industries plus 2.2 percent at the local level, and the tax is unfortunately levied on many business-to-business transactions. This so-called tax pyramiding can cause distortions in both production and consumption, thereby lowering living standards compared to even a revenue-neutral system that properly taxed consumption.

To the extent that a company is unable to pass its tax payments on to consumers living in other states, the taxes it pays on business inputs and the resulting tax pyramiding decrease the economic well-being of Arizona's citizens. Either their wages are reduced, or the prices of goods and services they consume are forced up, or both. Furthermore, tax pyramiding slowly but inevitably leads to a greater fraction of investment in Arizona being sector-specific, the sectors whose organization exposes it to the least tax pyramiding.

A broad tax base, properly defined, should be the goal, but when the phrase "broaden the base" is deployed to spread the tax base to business-to-business transactions, think tanks, chambers of commerce, and all experts within state government should sound an alarm.

Arizona also has a relatively high corporate tax rate, which sits at 6.968 percent. While taxing corporations in line with the benefits they receive from government services (which flow to the shareholders through higher profits) may be ideal from a given point of view, the current level of taxation may be excessive. Furthermore, the corporate income tax's role of acting as a backstop for evasion of business income earned under a personal income tax could be served with a lower corporate rate.

So what would the benefits of a lower corporate income tax for Arizona residents be? That depends on the mobility of capital and labor in the state. Capital is highly mobile across states, but as we have seen in the case of Arizona, labor is also fairly mobile. To the extent that the high corporate income tax in Arizona forces investment to flow elsewhere, it results in lower wages for Arizona workers. Therefore, lower taxes on corporate income in the state would be a way to boost wages for Arizona workers. However, if the labor is more mobile than capital, lower taxes on labor would be a more important priority for the state. Empirical evidence supports the argument that in the long run and between states, capital is more mobile than labor.

Arizona's income tax essentially uses federal taxable income as the income measure to which taxpayers apply the marginal income tax rate schedule. The tax rate schedule is slightly progressive with a top rate of 4.54 percent for 2008. The revenues collected from the state income tax are among the lowest in the nation. This is made possible by the state's moderate per capita spending and its high gross receipts tax, which brings in 27.5 percent of state and local general own-source revenue, far above the 16.6 percent national average for general sales and gross receipts taxes. This combination of taxes, including the availability of itemized deductions, which tend to benefit upper-income taxpayers most, makes Arizona's tax system one of the most regressive in the nation, although the desired level of progressivity is a question not addressed in this paper. Most public finance economists would agree that federal taxable income is far too narrow an income measure for income tax purposes. Arizona could improve its tax system by eliminating many itemized deductions and credits within its income tax and use that revenue to either lower its Transactions Privileges Tax or cut marginal income tax rates.

The economics of the statewide property tax that garnered attention earlier this spring is somewhat similar to the state's corporate income tax. Governor Napolitano cited state budgetary woes in vetoing a measure that would have eliminated the state's property tax.

Like the corporate income tax and the tax on capital gains and dividends, the state property tax is a tax on capital, but of a special kind. Its economic harm depends upon the extent to which capital in the state is fixed. If the tax only applied to existing capital, it would cause little economic damage, making the veto less problematic. However, given that the amount of capital investment in the state is far from fixed, Napolitano's veto will probably deter new investment in the state by lowering the net return to that investment.

One must keep in mind—and certainly the governor did—that the value of government services provided also affects investment. There is a tradeoff between higher taxes and lower government spending. Bemoaning the veto because investment will fall implicitly assumes that the foregone investment in Arizona is more valuable than the government spending that is funded by the continuing property tax revenue. That being said, most public finance economists argue that the property tax is a good tax for local governments, while at the state level, a better revenue source could be used.

Other Taxes
Other tax polices in Arizona could also be improved. The cigarette tax of $2.00 per pack (4th highest in the nation) is egregiously high, and it has been increased in the past few years merely to raise revenue. It is rather cowardly for politicians to impose punitive taxes on a minority of individuals for the sole purposes of raising money for some spending program that benefits all of Arizona. The Tax Foundation tends to view good public finance through the lens of the benefit principle, and this is among the grossest violations of that principle of taxation. But even under an alternative view of public finance (like ability to pay), excessive cigarette taxes are not justified.

At 19 cents per gallon, the state's gasoline tax is in the low-to-middle range of state gas taxes nationwide. Any reform of the gas tax should be in the context of transportation reform in the state, which would include the possibility of toll roads. Once again, the benefit principle is at the core of a properly administered gasoline tax. If all the revenue is being spent on popularly supported road construction and maintenance, and no overwhelming demands are being made for more roads, then the tax rate is probably at a reasonable level.

Conclusion
Arizona has seen remarkable economic and population growth over the past two decades. On top of the inevitable growth that most previously low-income states experience over time, acceptable tax rates and regulatory policies have also helped the state's economic performance. The best step that the state could take to improve its tax system is to make its sales tax look more like a proper general sales tax and less like a gross receipts tax, as well as to make its income tax look more like a good state income tax and less like the mess that is the federal tax code.

Sound Tax Policy Coming to New York (?)

Fri, 06 Jun 2008 00:00:00 EDT

Fiscal Fact No. 129

New York may be making an unconstitutional grab¹ for sales taxes from out-of-state businesses, but it appears that some positive changes to the state's property tax system may be in the offing.

In 2007, the Tax Foundation rated New York's business tax climate as the nation's third worst, with the eighth worst property tax system. New Yorkers pay 13.8 percent of personal income in state and local taxes, the third highest figure in the country. A majority of this is local taxes, of which 75 percent consists of property taxes. Property taxes have also been rising much faster than inflation, an average of 7% per year since 2001.

In this context, last year Governor Eliot Spitzer established the New York State Commission on Property Tax Relief, a bipartisan panel chaired by Nassau County Executive Thomas Suozzi (D). The panel's mandate was to propose solutions to rein in ballooning property taxes while maintaining the state's commitment to public education, which is the primary use of property tax. On Tuesday, the Commission released a set of recommendations.²

We've only preliminarily reviewed the Commission's report, but on balance it appears to contain a good set of recommendations. The proposals appear to improve an existing property tax rebate program that rewards school districts for raising taxes; provide a meaningful cap on property tax levies; and increase transparency. Additionally, the tax-limiting proposals are joined with cost-control measures, so that property tax savings can actually accrue to New Yorkers instead of being shifted to increases in other taxes. Governor David Paterson announced this week his support for the tax cap component of the proposal, and we hope to see the other components also gain momentum.

For New Yorkers who think the state's teachers' unions are contributing to the state's fiscal problems, it might be a favorable sign that the head of the largest union calls the report "anti-teacher and anti-education" and says he will lobby legislators to ignore it.³

Tuesday's report is preliminary, with a final report expected in December. Key Commission proposals include:

1. Reform New York's perverse School Tax Relief program ("STAR")

Though the media has principally focused on the proposed tax cap, we believe that property tax rebate reforms are the most important part of the commission's recommendations. The STAR program, a statewide program in New York to assist homeowners in paying school taxes, acts in practice as a matching grant for local school tax levies on property. The higher a school district sets its tax rate, the more its taxpayers get back in STAR payments, thus giving districts a good reason to set rates as high as possible. With school taxes making up 61 percent of property taxes (excluding New York City) this is a primary driver of New York's high property taxes.

How STAR works

Under the STAR program, a homeowner receives a rebate for school taxes on at least the first $30,000 of home value. The rebate is higher if the taxpayer lives in a county with high average property values or has a household income no higher than $250,000, and higher still if the taxpayer is a senior citizen (65+) with a narrowly-defined "household income" less than $70,650. The school district's tax rate is set by voters in the district, but the STAR payment comes from the state's general fund, without any cap set by the state. Unsurprisingly, this leads New York school districts to set very high tax rates, and nine of the ten U.S. counties with the highest average property tax rates are located in New York.

Property values vary widely in New York State, with New York City and its environs generally having much higher median home values than upstate New York. With a larger per capita property tax base, downstate counties tend to have lower property taxes as a percentage of home values, meaning that a $30,000 tax exemption is less valuable downstate than upstate. As such, the STAR program adjusts the exemption upward in high-value downstate counties; for Westchester County, just north of the Bronx, the 2006 Basic STAR exemption was $88,830, nearly three times the statewide standard. However, the Basic exemption is not adjusted downward in low-value counties, meaning that the STAR exemption may cover a very large percentage of median home value.

Why STAR Causes Perverse, Reverse Tax Competition:

Consider Wayne County, located directly east of Rochester, which has the highest property tax rate in the United States, averaging 2.94 percent. The owner of a median-value home in Wayne County ($99,200) receives at least 30.2 percent of his school taxes (which constitute a majority of property taxes) back in the form of a STAR rebate. If that homeowner has total household income less than $90,000, that figure rises to 48.4 percent. (Even if his household income goes as high as $250,000, he will still get a smaller bonus.) If the homeowner is over 65 with income under $70,650, he is eligible for "Enhanced STAR" and gets fully 71.6 percent of school taxes back as a rebate. And because New York uses a narrow definition of "income"—federal AGI, which is not fully inclusive of Social Security payments, further adjusted to deduct 401(k) and IRA distributions—many quite wealthy New York seniors still qualify for Enhanced STAR.

Property Tax Rates and Rebates in Ten Highest Property Tax Counties in Nation

Top U.S. Counties by Property Tax Rate	Median Home Value 2006	Average Tax Rate	Minimum Share of School Tax Rebated to Median Value Homeowner
				...With Income < $90,000
					...Senior < $70,650
Wayne County	$99,200	2.94%	30.2%	48.4%	71.6%
Niagara County	$90,700	2.91%	33.1%	52.9%	78.3%
Monroe County	$120,400	2.83%	24.9%	39.9%	59.0%
Erie County	$108,900	2.54%	27.5%	44.1%	65.2%
Fort Bend County (TX)	$161,600	2.53%	n/a	n/a	n/a
Chautauqua County	$75,300	2.52%	39.8%	63.7%	94.3%
Onondaga County	$115,900	2.50%	25.9%	41.4%	61.3%
Cayuga County	$93,200	2.42%	32.2%	51.5%	76.2%
Chemung County	$76,400	2.41%	39.3%	62.8%	92.9%
Schenectady County	$145,300	2.39%	20.6%	33.0%	48.9%

Source: U.S. Census Bureau; New York State Commission on Property Tax Relief Preliminary Report of Findings and Recommendations; New York Office of Real Property Services; Tax Foundation calculations

These rebates rise proportionally with school taxes. For every extra dollar that Wayne County assesses that "low-income" senior, he gets an additional 71.6 cents rebated to him, at the expense of taxpayers statewide. STAR places New York taxpayers in a major collective action problem: each district's voters approve a school budget which is in large part billed to taxpayers elsewhere. Indeed, in order to become net recipients of state STAR aid, school districts should raise their property tax rates as high as possible.

How to Fix STAR

The commission does not make a specific proposal on overhauling STAR, but principles it lays out include:

• Continuing to limit the STAR exemption to primary residences, but expanding it to include renters as well as owners

• Phasing out the benefit for high-income taxpayers and high-value properties

• Making benefits income-based, with a broad definition of income

• Ensuring that STAR does not fully offset any taxpayer's school tax liability or exceed a maximum limit

The purpose of local aid is to ensure that municipalities with relatively low property tax bases per capita can afford to provide essential services, including education, without taxing their populations out of their homes. STAR turns this objective on its head, by giving extra money to municipalities with larger tax bases, and by financially rewarding those school districts that raise their property taxes. Additionally, STAR is problematic because it excludes rental and non-residential property, and complicates the property tax system. As such, from our perspective, the best solution would be to replace STAR with a local aid formula entirely independent of property tax receipts.

However, even if the STAR program is maintained, it could be made significantly less harmful by implementing the commission's recommendations, if such reforms (1) reduce the number of taxpayers receiving STAR benefits, (2) reduce the magnitude of the property tax subsidy, and (3) make the tax treatment of property more neutral by including renters. STAR reform is an ideal area for bipartisan cooperation: liberals should want to fix the program because it is in many ways regressive,⁴ and conservatives should want to fix it because it encourages growth of government and wasteful spending at the local level.

2. Limit the annual rise in a municipality's total property tax levy to 4 percent or 120 percent of CPI, whichever is less

The limit would apply to all property (including non-residential), and increases below the cap in one year could be "banked" for use in later years. Additionally, voters could approve a larger increase with a 55 percent or 60 percent supermajority vote, with the required margin depending on annual changes to state aid.

For note, currently, all New York school budgets are already subject to annual voter referenda. Voters can hold down their local property taxes by rejecting school budgets and insisting on lower spending. However, even though New Yorkers report high dissatisfaction with their property tax burden, over 90% of school budgets have been approved since 1998.

The commission suggests that (1) putting the tax levy itself instead of the school budget before voters will make the tax question more transparent and voters more likely to insist on slower revenue growth, and (2) limiting referenda to years when the budget growth is particularly large will focus voters on the importance of restraining tax revenues. This is plausible, based on Massachusetts' experience with a system very similar to the one proposed in New York. Since the inception of Massachusetts' override process in 1980, only 39 percent of tax overrides have been approved.

On Thursday, Gov. David Paterson announced his support for the tax cap proposal (slightly modified to maintain the annual requirement for voter approval) and asked the legislature to implement it as soon as possible. At the Tax Foundation, we are generally lukewarm on property tax limitation measures like this one; we believe they often lead municipalities to blame the cap for slower growth of services, and therefore demand increased state aid, leading to rises in other taxes. However, this could be a favorable reform if coupled with meaningful spending control measures described below.

3. Take steps to control growth of education spending

New York primary and secondary education spending grew an average of 7.9 percent over the last six years, well above the 5.0 percent national average. Any reform that reduces property taxes but does not address the growth of spending will simply necessitate the increase of some other tax to fund education. Expense control measures are likely to be the most politically difficult part of any property tax reform plan, but they are essential to its long-term success.

Measures proposed by the commission to control expenses include (1) improving municipalities' collective bargaining positions with teachers' unions by repealing a law that grants teachers annual pay raises even if they do not approve a new contract, (2) obligating school district employees to contribute toward the cost of health insurance, (3) requiring cost-benefit analysis for new education mandates at the state level, and (4) repealing a law that requires school districts to use many contracts within each school construction project, artificially increasing construction costs.

Notes

1. See Joseph Henchman, "Amazon Files Suit Against New York Tax on Out-of-State Businesses," Tax Foundation Tax Policy Blog, May 2, 2008, http://www.taxfoundation.org/blog/show/23179.html.

2. A Preliminary Report of Findings and Recommendations to Governor David A. Paterson, available at http://www.cptr.state.ny.us/reports/CPTRPreliminaryReport_20080603.pdf.

3. Nicholas Confessore, "Panel Urges 4% Tax Cap on Property in New York," New York Times, June 3, 2008, available at http://www.nytimes.com/2008/06/03/nyregion/03taxes.html?_r=1.

4. Looking only at the set of homeowners in any one county, the system appears progressive, providing a larger percentage benefit to the owners of less valuable homes. However, several features of the program are regressive. New Yorkers who pay school taxes indirectly through rent tend to be less wealthy than homeowners, but receive no break under STAR, as renter-occupied property is excluded from the program. The program also provides the largest tax exemptions in wealthy suburban counties downstate; the amount of home value exempted from tax in tony Westchester is three times higher than in any upstate county. Finally, as the STAR program grows, the exemptions and rebates must be funded by new revenue from other taxes. Most recently, this took the form of a $1.25 jump in the highly regressive cigarette tax.