Full Text: Addendum To Blackwell's Testimony At W&M Tax Reform Hearing.

ADDENDUM

BEFORE THE UNITED STATES HOUSE OF REPRESENTATIVES

May 1, 1996

[1] Tax reform is something America's state and local governments and tax-exempt entities can and should welcome. My service on the National Commission on Economic Growth and Tax Reform has led me to conclude that meaningful tax reform will not only serve to clarify the proper roles of the private, public and tax exempt sectors in America's economy but that an economic growth driven tax reform will significantly ease the burden of service on each of these sectors.

[2] For too long, the whole economy, including the state and local government sector, has been held back by a federal tax code that has discouraged saving and investment, retarded the growth of productivity, wages and employment, and placed more of a strain on the social safety net. State and local governments must also confront very costly problems involving compliance with and enforcement of the current tax system that results in hundreds of billions of dollars of wasted resources that could be put to better use. That is why we need tax restructuring.

[3] States and local governments are forced to deal warn a tax code that says, in effect, "Washington knows best." States that have high income taxes are considered good, progressive jurisdictions, so Washington rewards their citizens with lower federal taxes. States that raise revenues more by sales taxes, excise taxes or user fees are punished relative to states that use high income or property levies. Rather than being neutral on state fiscal policy, Washington is trying to use financial incentives to dictate the nature of state taxation. This is inconsistent with empowering state and local governments to do what they feel is best for their citizens. State and local governments should demand that the existing federal tax bias towards property and income taxes end. One alternative that has been suggested to end this federal bias is to make ALL state and local taxes -- not just property and income taxes -- deductible. However, in order to maintain the desired low year rate and high exempt amount, the cost of ending the federal bias in this deduction would have to be paid for elsewhere.

[4] What is particularly wrong about the type of taxation that Washington is compelling states to adopt is that it has a particularly adverse impact on growth. Washington is telling the states: "tax production of goods or the resources used to produce goods, rather than consumption." The federal income tax is anti- growth because it double or triple taxes income used for savings and investment, while taxing income used for consumption only once. The reason savings-deferred income taxes or sales taxes are not anti- growth is that each taxes income used for saving and investment no more heavily than income used for consumption. State and local governments should not be compelled to adopt anti-growth tax systems simply because the federal government has chosen to do so.

[5] For some time I have believed that state and local governments have been cut by the double edged sword that is taxes and taxation. Taxes choke job creation, personal income growth and free enterprise. Prof. Richard Vedder of Ohio University has recently concluded in his report prepared for the Joint Economic Committee of Congress that 1.) relatively low-tax states grew nearly one-third faster than high-tax states, 2.) Income taxes have a particularly adverse impact on income growth, 3.) Flat-rate income taxes are significantly more favorable to economic growth than progressive taxes, and 4.) Personal income in flat-rate income tax states grew about 25 percent faster than did personal income in states with a progressive rate structure.

[6] The current federal tax system makes state and local governments co-conspirators with the federal government in a system that violates the principle of horizontal equity, a principle that says that people of similar economic circumstances should pay similar taxes. Consider two otherwise identical families, both making $75,000 in income, one living in New York and the other in either Texas or Florida. The New York family probably pays $4,000 or more in state and local income taxes, while the Floridian or Texan counterpart says nothing. Because of federal tax deductibility, the New York family will probably pay close to $1,000 less in federal income taxes. This is unfair and coerces state and local governments determine their basis of taxation from federal and not state policy.

[7] This bias is not a "benefit" to taxpayers in high income tax states. The taxpayers of those states are simply being taxed more heavily than others to pay for more income transfers to, for example, the poor or students. These taxpayers are not gaining as a result of federal and state tax policies tied to high income taxes. These taxpayers are just suffering less than if there were no deduction. I would suggest that the existing federal income tax code includes an exempt amount so that the poor might get some income free of tax. If that is the case, why should America "punish" state income taxpayers who are being forced to give their money to the poor via the state income tax and transfer system for doing what the exempt amount and the existing charitable deduction on the federal level render praiseworthy. The existing tax system promotes contradictory objectives and inconsistent policies as between states and the federal government.

[8] As treasurer of state of Ohio, these facts and others compel me to support meaningful tax reform. Permit me to briefly explain why.

PROPERTY VALUES AND PROPERTY TAX RECEIPTS

[9] Contrary to the opinion of some policy makers, property values and tax receipts of local governments should remain strong under tax reform, whether or not the mortgage interest deduction is retained. If the deduction were eliminated, along with taxation of interest received by the lender, interest rates would decline to compensate. The Commission has suggested however retention of the mortgage interest deduction, provided that lenders continue to be taxed on the interest as under current law. Whichever method is chosen, economic growth due to reduced taxation of saving and investment would boost incomes and demand for housing, and would increase other types of real estate investment and the property tax base. Professor Dale Jorgenson of Harvard told the Commission that the economy would grow by an additional 9% over a decade, with an approximately 16% increase in business fixed income investment if the biases in the tax system were eliminated. Consequently, such a tax overhaul would raise state and local government income from property taxes, income taxes and sales taxes, and reduce state and local government outlays for welfare, Medicaid and unemployment compensation.

DEDUCTION OF STATE AND LOCAL TAXES

[10] Taxes are the price we pay for government services and products. It is possible that the loss of the deduction for state and local taxes would reduce citizens' desire for the goods and services provided by state and local governments by exposing their full cost, now partly concealed. In the case of consumption services received by taxpayers, this is not necessarily a bad thing. However, many of the activities of state and local governments are explicit or implicit transfer payments (welfare, education, etc.) that would be deductible if provided through private charities, or if education spending were considered "investment" in human capital. Services provided business (security, water, trash pick up, etc.) are certainly costs of doing business, and are generally of a type that would be deductible if purchased from a private vendor. These deductions could be retained in exchange for a lower exempt amount or a higher tax rate.

DEMAND FOR TAX-EXEMPT MUNICIPAL BONDS

[11] Tax restructuring will not take away any advantage enjoyed by municipal bonds, nor will it raise borrowing costs for state and local governments. Indeed, by strengthening the economy and the state and local tax base, and reducing unemployment and poverty, it will improve state and local government revenues and reduce need of welfare related outlays. In particular, tax exempt securities will not fall in price. This concern is based on a misunderstanding of the relationship between taxable and non-taxable securities and the functioning of the credit markets, and is without merit. Interest rates consist of a basic rate of return demanded by lenders, plus rate premiums reflecting differences in risk among various securities, expected inflation and taxes. Tax exempt bonds do not have the tax premium. Taxable bonds do. Under the flat tax, the tax premium in currently taxable bonds would fall to current tax exempt levels. There would be no change in the tax treatment of tax exempt bonds. Their prices and interest rates would be largely unchanged.

CHANGE IN FEDERAL DEFINITION OF TAXABLE INCOME

[12] The states that use federal definitions need to make adjustments in their taxes whenever federal taxes change. The types of tax changes the Commission contemplates would not be difficult for the states to adapt to, however. States would only have major difficulties if the federal government abandoned income taxation entirely in favor of a sales tax. Then there would be no federal definition of income for state law to refer to or data gathering to share with state income tax enforcement agencies.

[13] In conclusion, I favor an American tax system that unleashes the potential of the private rather than the public sector to confront the twenty-first century. Growth is key to the success of both the public and the private sectors in the twenty-first century. The tax code should reflect this reality.