Principles of a Good Tax System

Editor’s Note: This article by Jason Mercier outlines the principles of optimal tax policies in Washington state. It should be of interest to Californians because it offers a useful perspective on our own tax policies. Washington has succeeded in one key area, “balance and reliability,” because their three primary tax revenues, based on sales, gross business receipts (B&O tax) and property, are not likely to fluctuate much from year to year. This is in stark contrast to California, currently enjoying an alleged “surplus” thanks in large part to capital gains driven by recent IPOs. Washington also does well in “competitiveness,” being a relatively low tax state. It would be interesting to see an informed assessment of what might be an optimal tax system for California, and the principles outlined by Mercier provide a template. Any takers?

The Washington State House Finance Committee held a work session last week reviewing the state’s tax structure and how it compares nationally. I had the opportunity to present on the principles of a good tax system. I encouraged the committee to focus its tax reform efforts around the following fundamental building blocks of a good tax structure:

Simplicity  –  Current challenges:  B&O (business & occupation) tax and 1,800 taxing districts.

Accountability  –  Current challenges:  More public notice of tax bills and hearings needed and additional transparency of numerous taxing districts.

Economic Neutrality  –  Current challenges:  B&O tax, some of the highest sin taxes in the country, and predictability of tax policy.

Equity and Fairness  –  Current challenges:  Selective B&O tax relief and compounding impact of voter approved sales and property tax levies at local level on overall tax burden for low income.

Complementary  –  Current challenges:  Cost shifting of programs from state to local (unfunded mandates) and new taxing authority for local without adequate taxpayer protection (high vote threshold or voter approval).

Competitiveness  –  Based on various state ranking comparisons and net-migration of population to Washington, the state is doing well on competitiveness though our estate tax is out of the norm for states without an income tax.

Balance and Reliability  –  Realizing there is no such thing as a recession proof tax structure Washington does relatively well on balance and reliability when measuring the volatility of the sales, B&O, and property tax base.

A 2010 study by the St. Louis Federal Reserve Bank (State Tax Revenue Growth and Volatility) found that Washington’s tax structure resulted in the 4th least volatile tax revenues. The reason for this is Washington’s three major tax sources (sales, gross receipts, and property) are among the least volatile taxes. Progressive income and capital gain taxes, however, are the most volatile taxes.

According to the St. Louis Federal Reserve Bank:

“As mentioned, the retail sales and gross receipts tax is a very significant revenue source for state and local governments . . . it grows moderately relative to other tax revenues and is also reasonably stable . . .

The property tax is mainly used to finance local government. Its combination of high growth and low volatility make it a very attractive revenue source . . .

The corporate income tax is especially problematic in state budgeting because of its high volatility. Interestingly, its high volatility is not associated with a high growth rate. From a similar point of view used to analyze financial markets, this is a high-risk revenue source without compensation provided by higher expected growth . . .

As mentioned, individual income taxes also constitute a very important source of revenue for state and local governments. Their growth rate exceeds that of the retail sales and gross receipts taxes. It is also much more volatile. This volatility is undoubtedly the source of many of the current budgeting challenges faced by state and local governments.”

The relative stability of Washington’s tax structure has also been noted by Standard & Poor’s. From S&P’s July 2013 bond rating for the state:

Sales tax-based revenue structure that exhibits sensitivity to economic cycles but to a lesser degree than those of states that rely primarily on personal and corporate income taxes . . . The state’s reliance on retail sales and business and occupation (gross receipts) taxes for a combined 69% of general fund tax revenues (on a budgetary basis) typically affords more revenue stability than other states enjoy because many of them rely on personal income tax revenues.

Since you can’t tax your way out of the business cycle, for budget peace of mind when the economy recovers, states need to use a “three-legged stool” of sound budgeting:

• Meaningful spending limit to avoid overextending in the good times;
• Protected 10% reserve account (so you don’t have to resort to tax increases or deep spending cuts in the bad times); and
• Limiting base expenditures to core functions within the revenue forecast when in the good times.

So what are the benefits of a low tax burden based on sound tax principles?

• Faster economic growth
• Greater wealth creation
• End micromanagement and political favoritism
• Increased civic involvement

As previously noted, a couple of areas that need more improvement are the transparency of the state’s tax system and the B&O tax.

On tax transparency, individuals and business owners should be able to quickly and easily learn about how much officials in each taxing district add to their total tax burden. This is especially true when considering there are nearly 1,800 taxing districts in the state.

To improve tax transparency an online searchable database of all tax rates in the state should be created and modeled after the state’s searchable budget website (fiscal.wa.gov). The online tax database should be set up to allow users to find their state and local tax rates (such as property and sales taxes) by entering their zip code, street address, or by clicking on a map showing individual tax district boundaries. An online calculator should also be included to allow citizens to calculate what their potential total tax burden is and know which of their elected officials are responsible for which parts of it.

A bill was proposed in 2009 to do this but it was not adopted (SB 6105: Concerning transparency in state and local taxation). At the work session yesterday, however, Rep. Carlyle noted that improvements to the Department of Revenue’s database authorized in the current budget should allow the state to start to move in this direction.

About the Author: Jason Mercier is the Director of the Center for Government Reform at Washington Policy Center. He serves on the Executive Committee of the American Legislative Exchange Council’s Tax and Fiscal Policy Task Force and is a contributing editor of the Heartland Institute’s Budget & Tax News. Jason is also a columnist for Seattle PostGlobe.org and serves on the board of the Washington Coalition for Open Government and was an advisor to the 2002 Washington State Tax Structure Committee. He received a B.A. in Political Science from Washington State University.