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“Local Income Taxes: Silly, Dumb and Harmful”

Thomson Reuters Tax & Accounting Blog David Brunori

Local income taxes: Silly, dumb and harmful. Every once in awhile an issue comes up that illustrates how good tax policy and politics diverge. One such issue is playing out in Seattle and San Francisco where city leaders are determined to adopt a local income tax. While the issue appears dead for the moment in California, San Francisco politicians want the California legislature to allow them to impose both personal and corporate income taxes. City Council members have a proposal that would allow cities to impose a tax of up to 10% of the state income tax liability.

San Francisco politicians are motivated by their desire for money; it is difficult to raise tax revenue in post Prop 13 California. Some cite rising costs for health and education. Some council members are no doubt motivated by fantasies of addressing income equality. And, according to the newspapers some political leaders are worried about the loss of federal funds due to the city's positions on immigration.

Poking an eye at President Trump seems the motivation by liberal groups in Seattle who would like a local income tax. This is somewhat odd as Washington does not tax income at the state level and citizens have rejected statewide taxes on income forever. In any event, proponents want to make Seattle "Trump Proof." I honestly do not know what that means but news reports have said proponents are concerned about the loss of federal funding because of the city's sanctuary status. A good friend in Seattle told me that he heard that proponents were really interested in making the rich pay their fair share. I have heard of two different tax proposals. First, some want a 2.5% capital gains tax on households with more than $200,000 of income. Again, this is odd since the rest of the world is reducing taxes on capital. The other idea I have heard was a flat 1% tax on all income over $200,000.

But whatever the details or their motivations, local option income taxes are poor policy choices. I say that with some weariness because I think localism is a normative good. And local political autonomy requires local fiscal autonomy. Still, local income taxes don't work, at least not well, for two reasons. First, local governments cannot effectively redistribute wealth. Local governments that try to take money from the rich and give it to the poor will inevitably end up with more of the latter and less of the former.

Second, local government taxation of business income and capital defies all common understanding of economics. It is hard enough for nations and states to tax mobile capital in a global economy. It is nearly impossible for cities to do so.

The San Francisco City Council debated this issue but it failed to pass on February 28. But, supporters vowed to continue the fight. Proponents in Seattle seem just as determined. But make no mistake: in the long run, if a city starts taxing income, wealthier citizens and businesses will migrate to the suburbs. And that cannot be a good thing.

Should groceries be exempt from sales tax? Alabama is considering joining the states that exempt food for home consumption from the sales tax. Almost all states exempt food or tax it at reduced rates. The governor has put together a study group led by the very capable Revenue Commissioner Julie Magee. The thinking traditionally is that the sales tax is regressive and exempting a necessity like food would alleviate some of the burden on the poor.

But I am not sure if exempting groceries is a good idea. First, it's an expensive way to provide relief. In Alabama, taxing groceries raises a lot of money, more than $350 million a year. The issue is complicated by the fact that the sales tax revenue in Alabama is largely dedicated to education. I am not sure having less money for education is a good outcome. Second, the exemption is not very targeted and thus probably does not reduce regressivity much. After all, rich folks buy groceries; and they buy better and more expensive groceries. And many of Alabama's poorest citizens receive supplemental nutrition assistance (formerly called food stamps). Since food purchases are already exempt from sales tax, the exemption would not provide much help to the state's poorest citizens.

Finally, the principles of sound tax policy strongly suggest that broad bases are best. Narrowing the bases inevitably puts pressure on rates (and other taxes). That alone should give political leaders pause about the exemption.

Why the Kansas pass-through law should be repealed. I, and a lot of other folks, have written about Kansas a lot over the past four years. But it is a story that will not go away. As readers know, the legislature tried to repeal the law but was thwarted by the governor's veto. Back in 2012, Kansas adopted a radical tax plan. The state exempted income from partnerships, LLCs, and sole proprietorships from income tax. The state also reduced income tax rates. Governor Brownback and his supporters believed this "experiment" would lead to significant economic growth..

The experiment did not work. The state cut taxes significantly without reducing spending and that never works. Dramatic growth did not materialize. As a result, Kansas has faced significant revenue shortfalls, which forced the enactment of higher sales and excise taxes

But the Kansas experiment should be ended because it's bad policy for two reasons. First, it overtly favors pass-through enterprises over traditional C Corporations. How would the government know that pass-through entities are "better" than C corporations? It wouldn't. You don't need to be Adam Smith to know that. Second, the Kansas tax scheme is decidedly unfair. If you are, say a doctor, in a practice operating as an LLC, you would not pay a dime of Kansas income tax. Your receptionist and nurses, however, would pay the full measure of tax. There is nothing good or just about that outcome. I am all for cutting taxes. But the Kansas pass-through experiment is not the way to do it.

Unfortunate opposition in Oklahoma. Oklahoma Governor Mary Fallin (R) has bold, innovative, and from a policy perspective, sound tax reform plans. Two of her ideas in particular are very good. She wants to broaden the sale tax bases and eliminate the corporate income tax. Unfortunately, many GOP legislatures are opposing her sales tax plan. The truth, to the extent we can talk tax policy in absolutes, is that all personal consumption should be subject to sales tax. There is no tax or economic reason to exempt some services or products while taxing others.

Broadening the base will allow for rate reductions for everyone. It will also allow for the repeal of the corporate income tax. These are ideal policy outcomes and will make Oklahoma's fiscal system and economy stronger. It is a shame not everyone can see that.

More on combined reporting. I received a lot of mail regarding my recent conversion to being a combined reporting skeptic. I want to clarify something. I admit that it is difficult to precisely measure the effects of combined reporting. My students and my research shows that combined reporting simply does not raise the revenue that proponents often think it will. But combined reporting is often enacted with rate and apportionment changes that make measurement difficult. Yet even with those complicated variables, it is pretty clear that combined reporting is no panacea. And given the negatives associated with combined reporting, it's not worth it. New Mexico, Maryland, and Alabama are considering combined reporting.

Throwback rules are dishonest. Speaking of Maryland, the state is considering a throwback rule (HB 639). Throwback rules are designed to prevent nefarious "nowhere" income. The idea is that a corporation will do business in a state where it is not subject to tax, and well, escape taxation. The fix to this problem is to pretend the sales occurred in a state that can actually tax the corporation.

Pardon my cynicism and sarcasm, but throwback rules are terrible. Apportionment formulas are supposed to determine where the economic activity occurs. Throwing the economic activity back to a state in which it did not occur is simply dishonest. If a corporation is doing business in state A, which does not or cannot tax profit from its activities, why should state B be able to tax that profit? It shouldn't.