Cosmetic Surgery for the Texas Margin Tax After 92 days of work in a 140-day legislative session, the Texas legislature had sent exactly one bill to Governor Rick Perry‟s desk. That‟s a surprisingly small output for the amount of effort expended. What‟s less surprising is that the single piece of legislation wasn‟t a tax bill, but that doesn‟t mean that revenue issues weren‟t on the minds of the membership. Among other revenue issues, a stormy debate rages over expanding gaming to possibly include casinos across the state. The “discussion” has sunk to the point where one lobbyist recently accused another of being a “pathological liar”—and they‟re on the same side of the issue. Also moving slowly through the legislative process is an ambitious plan to allow local governments to adopt new revenue sources, including the first-ever local option fuels tax, to fund transit and road construction, thus removing the burden of adopting new transportation taxes from state lawmakers. And then there‟s the nagging question of what on earth to do about the new business franchise tax. That latter question got an airing, ironically enough, on April 15, when the tax-writing House Ways and Means Committee heard testimony on a host of proposals for changing the tax as part of a marathon session that lasted long into the night. In total, the committee considered 22 separate franchise tax bills, along with a ream of other tax legislation. If there was a common theme, it was that the franchise tax needed to be cut. “When we started to look at the „tweaks‟ in the tax that the members wanted to make, the „tweaks‟ amounted to more than a $2 billion in cuts,” committee chairman Rene Oliveira, D-Brownsville, said with maybe a little irony in his voice. I talked to the chairman the day after the Wednesday night festivities and found him still pondering ways to chart a path through the thicket of franchise tax proposals. The committee has had more than 500 bills assigned to it this legislative session. In case you don‟t normally follow legislative activity, that‟s a mountain of work for the five months of a Texas legislative session. Not all of the legislative proposals are franchise tax bills, but Oliveira says his committee has received about 100 franchise tax bills, and virtually all of those involve letting various groups of taxpayers out from under the tax or create new deductions from the tax base. “We have the usual line up of tax bills, but what we have on top of that is unusual,” he said. “We have a brand new business tax, and some of the warts on it are starting to show. Members are feeling the pressure to do some sort of cosmetic surgery on the patient.” What that cosmetic surgery might be—for there certainly will be some done—will occupy much of the chairman‟s time in the remaining 48 days of the legislative session. For those among you who may not have followed Texas‟ experiment with its new form of business taxation, the business franchise tax—familiarly called the “margin tax” because it defines a taxable “margin” as its tax base—was enacted back in 2006. Its intent was twofold—to resolve problems with the old corporation franchise tax which was increasingly victimized by business planning strategies because of its separate entity structure and to raise money to fund school property tax cuts. Oliveira wasn‟t chairman of Ways and Means back then. He only became chairman this legislative session when the House membership chose a new speaker, Joe Straus, R-San Antonio. He also didn‟t like the margin tax when it was originally proposed. Still, he can appreciate the headaches involved in comprehensive business tax reform. “I do appreciate just how hard it was to come up with a new business tax with a broader base in Texas. You have to give a lot of credit on that score to Chairman Keffer [Jim Keffer, R-Eastland] and Representative Otto [John Otto, R-Dayton].” Keffer, the previous Ways and Means chair, and Otto were the chief architects of the grand compromise that resulted in the margin tax being enacted as the tent pole of a tax bill that allowed school property tax rates to be cut by about a third. The tax compromise that they came up with features a complex structure that gives taxpayers a choice (after a fashion) among three ways of computing their taxable margin: total revenues minus cost of goods sold, total revenue minus wages and benefits or 0.7 percent of total revenues. What remains after apportionment to Texas is multiplied by the tax rate to calculate the tax due. Most taxpayers pay at a rate of one percent but retailers and wholesalers are allowed a special 0.5 percent rate. The new law also required combined reporting of affiliated businesses for the first time. From the outset, the goal of the tax reform was to expand the number of taxpayers and boost the revenue-raising potential of the tax. There were, however, some provisions to protect the smallest businesses. Sole proprietorships were exempted, as were businesses with less than $300,000 in total revenues and those owing less than $1,000 in tax after the convoluted calculation. Even with these concessions, the tax produced howls of protest from many newly minted taxpayers—including law firms, many small service companies and others who had never paid state tax before. Thus it was that lawmakers reconsidered in 2007 and added a series of discounts for small taxpayers. Businesses with $300,000 to $900,000 in receipts qualify for a discounted margin tax with discounts ranging from 80 percent (for $300-400,000 in total revenues) down to 20 percent ($700-900,000). Taxable entities with total revenue of less than $10 million can elect to pay tax using an E- Z computation method equal to total revenue multiplied by the apportionment factor multiplied by a 0.575 percent tax rate. Those changes probably helped thousands of taxpayers, but there was still little balm to be had in Gilead—or in El Paso or Fort Worth or North Zulch for that matter. Lawmakers were dogged for months leading up to the session by criticism from groups like the National Federation of Independent Business (NFIB) that have a more expansive definition of what a small business is than the relatively micro-sized businesses helped by the exemptions and discounts in the current law. In advance of the April 15 hearing, NFIB put out a press release supporting further cuts in the tax targeted at their members and lamenting the gross unfairness of it all. “In a recent survey of its membership, 84 percent of NFIB/Texas members reported that their business tax jumped at least 100% over their old franchise tax,” the press release noted. “Over 40 percent of those same small business respondents reported business tax increases of over 500 percent. Remember, these reports are from small business owners who paid the state‟s old franchise tax.” I asked Will Newton who heads the Texas branch of NFIB what the organization‟s biggest gripe was. “One of NFIB‟s biggest arguments against this new tax structure,” he said “is that it doesn‟t take a business‟ profitability into account—a harsh consequence felt by firms losing money during a recessionary period.” He also channeled a little populist rage that‟s in the air these days: “Wall Street and big business largely endorsed this new tax, while NFIB/Texas urged caution from its inception. Small business is bearing the brunt of this tax while other sectors are unaffected or even helped by the property tax relief they experienced to offset this tax.” The complaint about the tax‟s impact on unprofitable firms is common at all business levels. That is ironic in its own way because when the tax was revised to include profits in the early 1990s, a common complaint was that businesses were now to be taxed on their legitimate earnings. In any case, the 2007 fix didn‟t quiet the critics all that much, and then things—as things seem to be doing a lot these days—got worse. Last year, the first year of the tax‟s operation, collections came in $1.8 billion short of projections. The tax produced $4.5 billion in fiscal year 2008. That was almost $2 billion more than the old tax produced in 2007, but it was almost $1.5 billion less than the $6 billion it was supposed to produce. Various explanations for the shortfall are plausible, but no one—including the state‟s chief tax collector—has yet to explain fully just what went wrong. On the face of it, this outcome made no sense. The tax is a sort of gross receipts tax with deductions, and the tax base should be huge. It wasn‟t tied solely to profits. And yet, in the retrospect, the results seem almost inevitable. It was a new tax with a new base and thousands of new taxpayers, many of whom were confused and frustrated at best. It had, in short, flaws. As Indiana University professor John Mikesell so memorably pointed out a couple of years ago: “This tax is . . . more a badly designed business profits tax, like those that emerged in the newly independent states of the former Soviet Union, than either traditional or newer gross receipts tax.” I love the former Soviet Union crack, but “poorly designed” seemed to be the most telling criticism. What to do? What to do? The answer that emerged from the Ways and Means hearing— and from elsewhere in the Capitol—seems to be: Cut taxes on small businesses some more and give the matter more serious consideration, preferably after the legislative session e nds in early June. That‟s certainly the direction Oliveira favors. “We haven‟t had a full cycle of margin tax collections yet—no audits or full implementation. We‟re dealing with data that doesn‟t tell the full story. We don‟t really know where the problems are,” he said. Of the 22 franchise tax bills discussed by the committee on April 15, 12 would increase the tax exemption for small businesses, seven proposed changes in the tax base to allow larger deductions (mainly by excluding “flow through” funds like 1099 payments from tax), two would lower the overall tax rate, and one proposed scrapping the tax altogether and returning to the previously reviled corporation franchise tax. Not one bill proposed expanding the base or raising the rate to bring in more revenue that the state will surely need to pay down the very large school property tax cuts that were the other half of the 2006 tax plan that gave birth to the margin tax. Expanding the small business exemption has several attractions. It isn‟t prohibitively expensive like some of the bills that have been put forward. It also removes a large number of taxpayers—37,000—from the tax base. It is a basic law of legislative physics that if someone isn‟t paying a tax they are less likely to complain about it. Physical law or not, the small business exemption strategy doesn‟t please all of the businesses that are currently paying the tax—especially the largest companies. One of the experts who presented testimony at the hearing was Dale Craymer of the Texas Ta xpayers and Research Association, whose membership including mostly large businesses that have traditionally paid the lion‟s share of the franchise tax. He gave the committee members a chart he devised showing the changes in franchise tax liability by size of business. He noted that 96 percent of business with total revenue less than $500,000 saw a decrease in their taxes under the tax reform, and those in the $500,000 to $1 million range saw a tax increase of seven percent. In contrast, overall businesses saw their taxes increase by an average of 46 percent from their previous liability. The hardest hit taxpayers in relative terms were those with total income of $1-10 million, whose tax liability rose more than 70 percent on average. That is, by and large, the membership of NFIB, hence the dissatisfaction. Of course, it‟s also true that that category includes a lot of businesses that are partnerships that were paying little or no tax before. Craymer also noted an important wrinkle in the data—the business categories with the largest number of goods-producing businesses like manufacturers actually saw the smallest tax increase. These businesses were, for the most part, paying a sizable tax bill before, and theyt‟re continuing to do so under the new tax. “It‟s ironic,” Craymer said, “that we are here talking about giving more tax breaks to the very taxpayers who already come out best under the tax.” He said that his group and other business groups are also dubious of simply exempting the thousands of taxpayers with total income under $1 million, effectively taking them out of the tax system. “You will get a better business tax system with more eyes watching what‟s going on here in Austin,” he said. Chairman Oliveira is sympathetic to that concern. “The bigge st problem is that proponents of this tax wanted a broad-based business tax with as many businesses as possible involved. We all agreed that part of the problem with the old tax was that not enough businesses were subject to tax. When you start to talk about carving out large numbers of new taxpayers, then we‟re really talking about going back in the old direction—fewer taxpayers and more burden on them. In the hearing last night, the groups that represent large businesses were rightly concerned that they would be left being the only ones paying the tax if we go too far in providing small business relief.” Oliveira‟s solution to the problem, which he laid out in two separate bills during the hearing, is to allow small businesses a tax cut but to sunset the reductions after two years. One of his bills is a straight $1 million exemption from tax. The other would raise the current small business discounts. Both would expire on January 1, 2012. Oliveira believes his sunset approach has a couple of advantages. First, it would give small businesses a needed boost in the current economic downturn. “I would like to see a tax cut for small businesses for now, but I don‟t think we‟re ready to make any permanent changes in the taxpayer base. I look at the temporary tax cuts I‟ve proposed as a stimulus bill for small businesses. They‟re feeling the pain of the economy right now.” He noted the recent projections from the Dallas Federal Reserve Bank that Texas might lose 300,000 jobs this year. Although it‟s late to the party, Texas is now feeling the impact of the recession, and Oliveira fears it could get worse before it gets better. “If tax breaks can save jobs, then we have to do it, even if it‟s just for a two- year period. By then, we should be in a recovery, and the stimulus may not be needed.” The other advantage of the approach is that it wouldn‟t permanently change the tax while the legislature is still largely in the dark about how it will really perform over time. He thinks that issue deserves more time and study. “I‟ve requested that the Speaker and the Lieutenant Governor to create a joint House-Senate study committee after the legislative session to see what fixes can be done and how to pay for them.” He says that up to that point, members should proceed with caution. “We have some money set aside in the budget now for tax cuts,” he said. “However, the legislative session in 2011 could be a real challenge, and we may be sorry if we cut the base down too quickly.” He said the source of his concern was both the sagging state economy, and the fact that the bill for the large property tax cuts—which weren‟t wholly financed by new taxes in 2006. We could easily be facing a $12 billion shortfall next time,” he said. At this point, House and Senate budget writers have put enough contingency funds into their proposed spending plans to cover the expected losses from tax cuts of up to $500 million. Oliveira says that his plan for a temporary $1 million exemption would cost around $85 million a year—in fact, $172.1 million for the state‟s two- year budget cycle. The question is whether that will be enough to appease other lawmakers who may want to see more relief—or permanent relief—for small taxpayers. Tax bills must originate in the House, but that doesn‟t mean the Senate isn‟t interested in the topic as well. They also agree that the cut would be a stimulus to business in tough times. “This is Texas stimulus. This is a Texas tax cut,” state Sen. Dan Patrick, R-Houston, who is sponsoring the proposed tax cut in the Senate along with 24 co-sponsors (out of 31 Senators), told reporters. Like one of Oliveira‟s bills, Patrick‟s would exempt businesses with less than $1 million a year in gross receipts. Patrick‟s bill would make the reductions permanent. Patrick, for one, would like to take matters further: “I‟d like to talk about abolishing it [the tax], but there are not the votes to do that,” he said. The one clear thing about the hearing the other night is that the long-knives are out for the margin tax at this point. The real problem is, and always has been, that too much of the property tax cuts were loaded unto the business tax. The legislature financed something like $8- 10 billion a year in property tax cuts primarily with the margin tax and a cigarette tax increase. The margin tax, as a result, was raised too high too rapidly, and even that won‟t be enough over the long haul. Mathematically, a massive edifice of property tax cuts has been erected on a very narrow and inadequate revenue base. The tax was a very large increase for most taxpayers, and for many, it was the first time they ever had to pay a state business tax at all. There were literally tens of thousands of new taxpayers that had to file for the first time in May of last year when the tax first came due, and it should come as no surprise that they didn‟t enjoy the experience. More importantly, many of the new taxpayers didn‟t own much in the way of business property so they didn‟t get an offsetting property tax cut. While they may not have gotten a franchise tax rate break, at least the large, traditional taxpayers did get some offset from reduced school taxes. Despite the less-than-torrid pace thus far, the legislature will eventually pass a fairly large body of legislation. Among those bills, it seems certain, will be a further whack at the much maligned franchise tax. I would bet that the small business exemption is put in place, and that it is made permanent. Even if Chairman Oliveira doesn‟t get his way and the reduction isn‟t temporary, I think he‟s on to a good idea with the joint legislative committee. In fact, I‟d go one better. I‟d like to see a more extensive blue-ribbon panel, much as I normally don‟t like them, to be convened. My theoretical new panel would replace the Business Tax Advisory Committee that was created by the original margin tax law and was chaired by the Comptroller of Public Accounts. That group met before the current legislative session but was hampered by a lack of data—and possibly by a lack of legislative attention. This new panel should include both lawmakers and private members. It should call witnesses, hear the complaints and, most importantly, sift through the data to get to the bottom of the margin tax‟s puzzling performance. A similar panel was created to design the margin tax originally. Maybe my idea is simply repeating history, but I think it might take such a panel to fix the tax as well. Ultimately, of course, there‟s no way to make taxpayers completely happy short of carving them out of the tax, but the state really does need to come up with a far better understanding of how the tax behaves and how it affects different businesses. Until then, lawmakers will be groping around in the dark for answers. By the same token, the legislature is in session, and the groping must go on. Ways and Means, Oliveira said, has slogged through only about 185 of the 500 bills on its plate. It‟s heard a couple of dozen of the hundred or so franchise tax bills. The show must go on. Next week‟s hearings seem likely to be just as long for the chairman. Another 50 bills are set for hearing. And it‟s important to note that the job pays only $600 a month. Think about that when you consider career options.
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