Technological Change and Tax Policy: The Future of State and Local Tax Structures
Bonnett, Thomas, Government Finance Review
As the economy shifts from goods to services and electronic commerce becomes a significant force in the economy, state and local taxing bodies are confronted with new challenges and questions.
Editor's note: The report "Is the New Global Economy Leaving State-Local Tax Structures Behind?" was prepared by the National League of Cities, the National Conference of State Legislatures, and the National Governors Association. Sections of the report and executive summary are reprinted and adapted with permission.
Prominent economic, social, demographic, and technological trends are threatening to erode the tax revenues of states and cities. The mainstays of these tax systems are the income, property, and sales taxes. Together, they generated 75.9 percent of total state and local tax revenues in FY 1994. Each is a prominent revenue source for state and local governments: the property tax generated 31.5 percent, the sales tax generated 23.8 percent, and the personal income tax generated 20.6 percent of total state-local tax revenues in FY 1994.
The most significant fiscal trend over the past 20 years has been the declining share of federal support to state and local governments, which has placed a much greater burden on current state and local taxes. Federal grants-in-aid to state and local governments averaged 21.5 percent of their total spending over the 1990-95 period. This is well below the 26.5 percent peak that occurred in 1978. Consequently, state and local governments have had to rely much more on their own tax revenue sources to generate sufficient revenue to provide services required by the public. Further, the recent trend of Congress pushing more responsibilities to state and local governments will place additional burdens on the current state-local tax structure.
If these two trends were to continue, federal grants-in-aid support to state and local governments would remain at modest levels for some time, and burdens would increase as well. That prospect increases the importance to state and local leaders of maintaining a state-local tax structure that will continue to generate adequate revenues with which to support valuable public services. The continued effectiveness of the tax structure is essential to maintain the autonomy of state and local governments. State and local leaders concerned with the independence and responsiveness of their governments should be sensitive to the stability of the state-local tax structure. The major vulnerability of the current state-local tax structure is its inability to adapt to increased mobility.
The current tax structure was built decades ago when the industrial economy produced tangible goods. The shift to the new service economy is the best-documented challenge to the current tax structure, but other social, demographic, and technological trends pose difficult challenges as well and could jeopardize the future viability of the current state-local tax structure. Each of these trends has important tax implications.
Exhibit 1 EMPLOYMENT GROWTH (in millions) 1979 1992 2005 Projected Manufacturing 21.0 18.4 17.5 Services 16.8 28.4 41.8 Source: Monthly Labor Review (November 1993), Bureau of Labor Statistics
The magnitude of the shift over the last half-century from an economy based on manufacturing goods to one dominated by knowledge-based and personal services is often not well understood, but it poses several challenges to current tax policies. In 1959, services constituted less than 40 percent of the Gross Domestic Product (GDP), while goods production constituted roughly half. In 1994, services were almost 65 percent of the GDP while goods production was approximately 37 percent. In short, there has been a dramatic shift in how the modern economy creates wealth. See Exhibit 1. State and local leaders may ask, in this context, how well the current tax system matches the modern economy. Specifically, they may ask how the current sales tax system corresponds to the fastest growing sector in the economy.
Two specific tax questions are posed: whether personal services should be included in the sales tax base and whether the property tax is biased against capital-intensive firms. There may be less rationale to limiting the sales tax to tangible goods while services - the growth sector of the economy - remain untaxed or are inconsistently taxed. Similarly, the continued reliance on the property tax as the primary source of funding for local governments may pose a heavy burden on goods-producing firms and capital-intensive industries. The effect of both policies may violate the notion of horizontal equity in taxation, impose burdens on narrow tax bases, distort private economic decision-making, and hinder economic development. The issue of reforming the tax structure to achieve tax neutrality among firms and promote economic development will merit further study.
Electronic commerce offers both boundless opportunities for, and grave threats to, the public sector. State and local governments may lag behind the private sector in implementing the latest information technologies that enable electronic funds transfer, electronic benefits transfer, electronic data interchange, digital signatures, and smart cards. An increasing number of public-sector leaders understand that those technologies hold tremendous opportunities to improve services and achieve greater efficiencies. Implementing them in the public sector is a difficult task.
Electronic commerce also poses a long-term threat to the current tax system. The threat is that consumers will increasingly use electronic media for purchasing goods and services - circumventing conventional sales taxation - and shift earned income to other jurisdictions, which would either minimize or evade conventional income taxation. Income and consumption are no longer constrained by geography.
The traditional definition of nexus for sales taxation - having a physical presence in a state - is rapidly becoming an antiquated concept as electronic commerce emerges in new markets. Unless Congress redefines nexus, electronic commerce will erode the revenue stream from state-local sales taxes. Although this potential threat is a very serious one, the recent discussions between the mail-order catalogue industry and the states present an excellent model for resolving this political conflict and a basis for measured optimism that this can be done with enlightened private sector leadership. Indeed, if the states can negotiate an agreement with the largest mail-order firms to collect sales taxes on purchases made across state boundaries, electronic vendors could be persuaded to follow this path.
From a fiscal perspective, the issue of electronic commerce concerns the legal inability of state and local governments to tax private transactions, especially relating to the consumption of goods and services. The legal issues are fraught with complexity. Many state and local officials are concerned about the potential loss of sales tax revenue. See Exhibit 2.
Many state and local officials are concerned that a growing percentage of consumers will make transactions electronically, circumventing the general sales tax - the mainstay of the state-local revenue system. Put simply, many consumers who want to update their computer operating systems next spring will have a choice between purchasing Microsoft's Windows 98 in a retail store or obtaining that software electronically. (Downloading a file is as easy as a mouse click on an icon.) The store purchase would be subject to the state sales tax. Downloading it electronically would not be taxed because the current tax rules require sellers to collect state sales tax only if they have established presence, called "nexus" within the state. See Exhibit 3. (Downloading software would not be taxed - even if the seller had an established presence in terms of property, employees and such - if the state law did not include intangible services in the sales tax base.) On the surface, this issue is strikingly similar to the current difficulty that state tax agencies have had in collecting sales tax from direct mail-order purchases. States now lose an estimated $3.5 billion to $4 billion each year from retail sales through (untaxable) mail-order businesses. Forrester Research, a research firm in Cambridge, Massachusetts, estimates electronic commerce at $36.42 billion at the end of 1997, and projects it to grow to $217.36 billion by 2000.
State and local officials are under increasing pressure to grant tax preferences that erode tax neutrality among competing firms. That economic development trend has been bolstered by advances in telecommunications and information technologies, the increased mobility of capital, the changing nature of work, and the ability of firms and individuals to locate wherever preferential tax treatment is provided.
The transformation to a new service economy should provoke thoughtful revision of the current tax system. The tax structure built in the industrial age no longer matches the modern economy, and the mismatch is growing wider. The changing nature of work from corporate downsizing, telecommuting, and public-sector innovation represent opportunities as well as challenges to the leaders of state and local governments.
As we enter the digital age, the prospect of electronic commerce may be the most visible long-term threat to the existing state-local tax structure. The advent of electronic commerce liberates consumption from geography and heightens capital mobility. The mobility of firms forces interjurisdictional tax competition. These trends make it more difficult to tax capital-intensive firms and business property fairly. The new era of deregulating the telecommunications and electric industries poses extraordinary burdens on state and local governments.
Economic, social, demographic, and technological trends threaten to imperil the future viability of the state-local tax structure. If not confronted directly by state and local leaders working closely with Congress, the viability of the state-local tax structure could be undermined, jeopardizing state autonomy and municipal independence in the future.
QUESTIONS FOR STATE AND LOCAL LEADERS
* Is the tax burden fairly shared among all taxpayers, firms, and constituencies?
* Does the tax structure encourage investment and economic development?
* Should personal services be added to the sales tax base?
* Is the property tax biased against capital-intensive, goods producing firms?
* Will corporate downsizing and telecommuting add burdens to taxing agencies?
* Will the changing nature of work affect property values?
* Will electronic commerce eviscerate sales tax revenue?
* Will the current tax structure continue to generate sufficient revenue to fund quality services?
* How should the tax structure be reformed to respond to economic, social, and technological changes?
UNDERSTANDING NEXUS FOR SALES TAXATION
Consumers who purchase goods from out-of-state mail order firms owe a use tax on taxable purchases equivalent to the sales tax they would have paid on purchases from an in-state firm. Although most states have had use taxes as long as they have had sales tax, the use tax is quite difficult to collect unless the out-of-state seller has some nexus or physical link to the state. Only if such link exists can states require collection of the tax, according to the U.S. Supreme Court opinion in the National Bellas Hess, Inc. v. Illinois Department of Revenue (1967). However, in Quill Corporation, Inc. v. North Dakota (1992), the Court ruled that the Congress could overturn the nexus provision and authorize the states to require payment.
States have been seeking relief from the nexus requirement because of 1) the effects on noncollection of state revenues and 2) adverse competitive effects on in-state retailers.
Source: Taxation of Interstate Mail Order Sales 1994 Revenue Estimates. U.S Advisory Commission on Intergovernmental Relations, May 1994, p.1.
PRINCIPLES OF A HIGH-QUALITY STATE REVENUE SYSTEM
...is composed of elements that are complementary, including the finances of both state and local governments.
...produces revenue in a reliable manner. Reliability involves stability, certainty and sufficiency.
...relies on a balanced variety of revenue sources.
...treats individuals equitably. Minimum requirements of an equitable system are that it imposes similar tax burdens on people in similar circumstances, that it minimizes regressivity, and that it minimizes taxes on low-income individuals.
...facilitates taxpayer compliance. It is easy to understand and minimizes compliance costs.
...promotes fair, efficient, and effective administration. It is as simple as possible to administer, raises revenue efficiently, is administered professionally, and is applied uniformly.
...is responsive to interstate and international economic competition.
...minimizes its involvement in spending decisions and makes any such involvement explicit.
...is accountable to taxpayers.
Source: Principles of a High-Quatity State
Revenue System, second edition, Foundation for State Legislatures and National Conference of State Legislatures, November 1992, p. 5.
FEDERAL PREEMPTION OF LOCAL TAXATION: DIRECT BROADCAST SATELLITE (DBS)
Section 601 of the Telecommunications Act of 1996 preempts the local taxation of direct-to-home satellite service. DBS is a satellite system designed with sufficient power so that inexpensive earth stations (such as receiving antennas of 18 inches in diameter) can be used for direct residential or community reception. DBS has become very popular among viewers who lack cable TV service, and as a choice for viewers instead of existing cable TV service. Note, however, that (c) of Section 601 does not "prevent taxation of a provider of direct-to-home satellite service by a State or to prevent a local taxing jurisdiction from receiving revenue derived from a tax or fee imposed or collected by a State."
Source: Bonnett, TELEWARS in the States: Telecommunications Issues in a New Era of Competition (1996), p 121.
THE CLINTON ADMINISTRATION ON STATE TAXATION
The administration also is concerned about a possible move by state and local tax authorities to target electronic commerce and Internet access. The uncertainties associated with such tax and the inconsistencies among them could stifle the development of Internet commerce.
The administration believes that the same broad principles applicable to international taxation, such as hindering the growth of electronic commerce and neutrality between conventional and electronic commerce, should be applied to electronic commerce. and states should coordinate their allocation of income derived from electronic commerce. Of course, implementation of these principles may differ at the subfederal level where indirect taxation plays a larger role.
Before any further action is taken, states and local governments should cooperate to develop a uniform, simple approach to the taxation of electronic commerce, based on existing principles of taxation where feasible.
Source: A Framework for Global Electronic Commerce, July 1, 1997.
THOMAS BONNETT is currently an independent public policy consultant and writer. He has had an extensive career in public policy. He served in the Vermont House of Representatives in the 1970s, directed New York City's Neighborhood Economic Development Division and led the Downtown Flushing Development Corporation in the 1980s, and worked for a member of Congress and the American Federation of State, County and Municipal Employees. For more information contact: National League of Cities, 1301 Pennsylvania Avenue, N.W., Washington, DC 20004-1763 (202/626-3020; Fax: 202/626-3043). Copies of the complete, 80-page book, Is the New Global Economy Leaving State-Local Tax Structures Behind? (#3701), are available for $19/each (includes shipping and handling) from the NLC Publications Center, PO Box 491, Annapolis Junction, MD 20701; 888/571-2939 or 301/725-4299; fax: 301/206-9789.…
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Publication information: Article title: Technological Change and Tax Policy: The Future of State and Local Tax Structures. Contributors: Bonnett, Thomas - Author. Magazine title: Government Finance Review. Volume: 14. Issue: 6 Publication date: December 1998. Page number: 45+. © 1999 Government Finance Officers Association. COPYRIGHT 1998 Gale Group.
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