Political Vulnerability Under the most favorable circumstances there are formidable obstacles to increasing tax rates. "Tax policy changes have a special character because rate and structural changes usually are bread-and-butter or gut issues. They involve the allocation or reallocation of money in voters' pockets. In most political situations, this sets off a panic signal in legislative halls and anxiety in politicians' hearts."167 Citizens have underscored this aversion by defeating candidates for public office who venture to say candidly that higher taxes will be needed to support expenditure programs desired by the electorate. A classic example was furnished by Governor Orville Freeman of Minnesota. According to Walter Heller, "he made a point of forthrightly telling the voters that there ain't no Santa Claus, that if they wanted the services, they would have to pay for them in higher taxes. And after the election, he woke up not Governor. "177 Recent political history is replete with such an eclipse of State political careers following tax actions. One investigator, who examined the fate of Governors attempting to succeed themselves or to run for higher office (U.S. Senator) in the 1958, 1960 and 1962 elections, concluded that "incumbency, which in virtually every other electoral office in the land, is an odds on advantage for reelection, is a liability in the office of the governor."18/ foreshortened careers of aspiring politicians who take on the task of being a State Tax Commissioner or local assessor also bespeaks the political unpopularity of taxes. The Occasionally, circumstances permit tax rate increases without threatening political careers. For example, after the Surgeon General's report linking the incidence of cancer with cigarette smoking, cigarette tax rate increases were enacted largely without fear of an accompanying adverse voter reaction. State cigarette tax rates could be, and were, catapulted to higher levels. In 1959, only two States imposed cigarette taxes of as much as 8 cents per pack. By 1967, 27 States had cigarette taxes of 8 cents or more per pack. Moreover -except for tobacco-growing North Carolina--the States (Arizona, Colorado and Oregon) that had not formerly taxed cigarettes enacted the tax, and in Oregon's case with direct approval of the voters. Ironically, the cigarette tax has one of the lowest growth potentials; an increase of 10 percent in the gross national product appears to raise cigarette tax collections only by 3 or 4 percent. Thus while higher cigarette tax collections helped States meet revenue needs, the help was short lived in most States. To cover their rising revenue requirements more adequately, States generally had to make more intensive use of other consumer-type levies. INTERSTATE COMPETITION FOR ECONOMIC GROWTH As they relate to economic development, State-local policies have taken on an activist character since World War II. While States and localities are always concerned lest their taxes drive industry "out," this defensive psychology is now supplemented with aggressive tactics designed to bring industry "in." Lively concern for economic growth is also manifested in the spreading use of industrial development bonds by localities to finance plants for lease to private industry. phasis of Business Taxation The concern for creating a favorable tax climate for industrial deelopment stands out as an important force working for reduced State and local reliance on strictly business-type levies. The contribution of business taxes to total State and local tax collections has declined slowly from 36 percent to 30 percent between 1950 and 1965.19/ The reasoning behind the mounting concern over the business tax com207 petition issue has been described as follows: This awareness of economic competitive effects has become While other State and local taxes were rising, the desire for economic growth apparently imposed an inflexible ceiling on corporate tax rates-an effective limit of 6 percent. In 1956, six States had corporate tax rates of 6 percent or more (well above the rate in most States) and did not permit Federal income tax payments as a deduction in arriving at income subject to State tax.* In the ensuing decade not one of these States increased its corporate tax rate and Mississippi's rate was cut to 3 percent. Yet, as a group, they took 39 affirmative tax increase actions: cigarettes--14 (including one new adoption); sales--8 (including two new adoptions); alcoholic beverages--8; and personal income tax--9. Although New Jersey and Minnesota recently hiked corporate taxes, the actions came at the time a new broad-based sales tax was adopted and business was relieved of part of its personal property tax burden. In their efforts to attract rather than merely hold industry, States have formulated a variety of selective strategies designed to improve their tax image while holding to a minimum the potential revenue loss from business tax reduction. The Commission identified at least five varieties of selective business tax reduction policies in its recent report on State-Local Taxation and Industrial Location: 1. Property tax exemption for new industry; 2. Locally negotiated property tax concessions; "Freeport" laws to minimize personal property tax loads; 4. Corporate income tax preferential write-off provisions; 5. Special sales tax exemptions for purchases for "new The fact that Delaware, New York and Pennsylvania do not tax tangible personal property spurred New Jersey into exempting inventories from taxation and taking over responsibility for assessing other forms of business personalty. Arizona, Connecticut, Michigan, Oregon and Wisconsin have all scaled down assessments on tangible personal property in recent years. Idaho, Maryland and Wyoming in 1967 adopted programs looking toward the eventual phase-out of the tax on inventories. Minnesota gives business the option of claiming exemption either for inventories or machinery and equipment. The difficulty of finding revenues to compensate local governments for the loss in personal property tax receipts retards similar action in other States.* Although the States make relatively less use of business taxes now than they did 15 years ago, State tax practices have been subjected to increasingly critical attention by business. It has been particularly strident with respect to State methods of exacting taxes from the firms operating across State lines. In the light of the increasingly interdependent character of the economy, questions have been raised as to whether the country should continue to tolerate independent and varied State methods of exploiting the business tax The "Willis Subcommittee" issued a four-volume report proposing legislation that initially called for a uniform national set of rules to govern State imposition of corporate income, sales and use, gross receipts, and capital stock taxes; leaving to the States only the most basic options--to tax or not--and the rate determination.21/ Industrial Development Bond Financing Local governments in about 40 States are authorized to issue bonds to finance industrial plants for lease to private enterprise. This method of attracting industry is rapidly increasing, as is the size of individual local bond issues for this purpose. It is estimated that $1.3 billion worth of industrial development bonds was issued during 1967. Much of this debt has been issued by very small communities, with individual bond flotations running as high as $20 million, $50 million, and a few over $100 million. By the end of 1967, local governments had outstanding some $2 billion of industrial development debt, mainly in the form of revenue bonds, the interest on which is exempt from Federal income taxes. In recent years, a number of abuses have been identified with industrial development bond financing, often attracting unfavorable public notice to the detriment of the public's regard for local government administration, particularly for the financial administration of the localities which participate in the practice. Some communities have used industrial development bonds to finance enterprises in excess of their employment needs, and which impose demands for public services that they cannot supply without overburdening their taxpayers and saddling themselves with excessive contingent liabilities in the form of debt service on the bonds. The practice has been subject to other abuses: financing plants for national corporations with adequate credit resources; pirating established firms by one community from another; and enabling specially incorporated areas with relatively few residents to develop tax havens at the expense of neighboring communities. Abuse of the practice for private advantage tends to 'reflect on the tax exemption of municipal securities generally and has brought forth a rising demand that Congress curb the practice by Federal legislation.2 22/ * Alaska, Massachusetts, Mississippi, North Carolina, Oregon and Wisconsin. RESTRICTED STATE AND LOCAL BORROWING AUTHORITY The stringent legal constraints placed on the power of state legislative bodies to borrow money illustrate dramatically a popular mistrust of legislative judgment. This mistrust extends to local governments and hobbles the exercise of both their taxing and borrowing powers. 23/ Broad legislative authority to borrow would enable States to participate in Federal programs, but this power is usually circumscribed severely (Table A-17). Only nine States can be said to allow their legislatures to borrow without restraint as to amount: Connecticut, Delaware, Louisiana, Maryland, Massachusetts, Minnesota, New Hampshire, Tennessee and Vermont. In the other cases, the amount the legislature may borrow is limited by the constitution, or by the requirement for electoral referendum approval or by both. Constitutional limitations on State borrowing were spawned by the financial difficulties encountered by numerous States prior to 1845, when they overextended their debt position to finance internal improvements and were subsequently forced to default. The constitutional restrictions were an effort to guard against repetition of these conditions. After 1900, however, growing pressure to construct public improvements led some State legislatures to look for ways of circumventing the constitutional borrowing restraints. This produced a trend toward use of revenue bonds, public corporations, lease-purchase agreements, and reimbursement obligations. State debt created by these devices is called nonguaranteed debt, since the States do not pledge their general funds to repay it (Table A-18). Use of nonguaranteed borrowing methods has had some important consequences. Since the State cannot pledge State credit or taxing power for bond retirement, it must pay higher interest rates. Moreover, in order to circumvent constitutional debt restrictions, States have to create special administrative organizations. In short, constitutional restrictions on general obligation borrowing can be evaded by nonguaranteed borrowing, but only at the expense of higher costs and administrative complexity. LIMITED FEDERAL ACTION TO HARMONIZE THE While the Federal, State, and local governments are free to exercise their separate taxing powers, constraints are necessarily imposed on them and especially on the Federal Government by virtue of the fact that taxes at all levels tend to converge on the same taxpayers. Currently, State and local taxes on property, income, motor fuels, and general sales taxes are deductible for Federal income tax purposes. In 1964, itemized State-local taxes amounting to $14 billion appeared on 26.5 million Federal tax returns. Deductibility of State and local taxes for Federal tax purposes involves a substantial tax reduction benefit; one that grows yearly as taxes increase and more taxpayers itemize their deductions. Assuming an average write-off of approximately 25 percent, the "cost" of itemization to the Federal Treasury in terms of individual income tax revenue foregone amounted to an estimated $3.5 billion in 1966. The deductibility of State and local taxes for Federal income tax purposes is the most significant example of intergovernmental tax comity. pose, however, is limited. It was seared into the original Federal Income Tax Act (1913) as protection against the possibility of income confiscation that might result from the uncoordinated exactions of Federal, State and local tax collectors. The deductibility provisions continue to perform this limited protective function. Persons in the highest tax bracket are able to write off their State and local tax payments against their Federal liability at 70 cents on the dollar. Because the tax reduction benefit is a function of the marginal rate, the great mass of taxpayers in the 14 to 25 percent bracket receive relatively limited benefits from deductibility.24/ Only rarely has the National Government adopted a specific tax policy designed to reduce interstate tax competition. One instance occurred after World War I when Congressional consideration of the future of the Federal estate tax chanced to coincide with the advent of interstate tax competition for wealthy residents. One or two States had just begun to advertise immunity from death taxation in national journals. At least two had amended their constitutions to guarantee freedom from inheritance taxes to those who settled within their borders. State leadership was quick to recognize that unchecked interstate tax competition practiced by a few States would quickly spread to others and destroy this tax source for all of them. Heeding the plea of State leaders, Congress agreed to substitute tax reduction and a Federal tax credit for repeal of the tax. This fixed a floor under State death taxes which effectively deterred interstate competition for wealthy residents. Each State was left free to collect death taxes not in excess of 80 percent of the Federal tax liability without adding to the net burden of its residents. Every State except Nevada imposes a tax at least equal to the maximum Federal credit. Today the credit continues to serve as a floor under State tax liability and to this extent prevents competitive tax reduction. It does not, however, prevent wide variations in State liabilities above the credit. The States feel that their share of the yield of these taxes should be increased. Some are concerned because interstate tax differentials may intrude on decisions as to where people settle and do business; they would like a higher Federal tax credit to shelter their higher tax rates against interstate competition. Tax practitioners and administrators are critical of the excessive tax complexity and interstate variety. Students of taxation lament that heterogeneity mars the death tax structure's usefulness as an instrument of public policy. With these considerations in mind, the Advisory Commission recommended that the Congress liberalize the tax credit provisions contingent on State "pickup" of the enlarged Federal tax credit and on State adoption of the estate tax concept.25/ As State and local taxes mount and their regressive character cancels out less regressive Federal tax policies, the need for a more positive form of tax integration becomes more apparent (Appendix C). The Advisory Commission's recommendations calling for both larger estate tax credits and a partial personal income tax credit are offered as building blocks for a more positive tax coordination approach to fiscal federalism. |