State and local business taxation: Is there a better way?

Chicago Fed Letter, Dec 2004 by Mattoon, Richard

Finally, William Sheldrake of Policy Analytics described Indiana's tax restructuring experience from 2001 and 2002. The state adopted a market value assessment property tax system in response to a State Supreme Court order in 1998. On average, this was expected to boost residential assessments by nearly 33%, representing a huge increase in residential property taxes. Changes in the property tax system provided the state with an opportunity to consider other tax reform measures. Sheldrake noted that Indiana's tax burden was lower than many midwestern states' but that the structure was relatively regressive, imposing a higher burden on lower-income groups. In addition, Indiana's statutory corporate income tax rate is relatively high for the region, and the local property tax burden is particularly difficult for manufacturing firms with high investments in plant and equipment.

A proposal to reform the state tax system was initiated by then Lt. Governor Kernan, with a goal of improving the business climate. The proposal eliminated or reduced seven major taxes, reducing state revenue in FY 2003 by slightly more than $2 billion. These cuts were designed to reduce the state reliance on the property tax. To make up for the revenue loss, two taxes were increased (the sales tax rate would rise by 1% and a graduated income tax rate was introduced) and the property tax replacement credit, was eliminated.

The second part of the proposal was designed to improve economic development and promote tax fairness. These measures eliminated the corporate gross income tax, increased the research and development credit, expanded the earned income tax credit, and increased the renter's deduction to $3,000. To pay for these measures, a business franchise tax was instituted and the rate for the corporate net income tax was raised to 8.5%.

Sheldrake noted that the business sector benefited from the repeal of the unpopular inventory tax, as well as the corporate gross income tax. In addition, the property tax burden on business assets was reduced. The major countervailing action was an increase in the corporate net income tax rate by 0.75%. For individuals, the reform reduced the impact of property tax reassessments based on market value and improved equity for low-income individuals. However, individuals faced higher sales tax rates and cigarette taxes.

Conclusion

The conference discussions suggested that state and local business taxation still lacks clear direction. Immediate revenue needs and political expediency are often primary considerations in developing tax structures. Ideally, business taxes should be restructured to more closely reflect the benefits that businesses receive from government. This could improve tax efficiency and reduce the distortions often associated with current tax structures.

1 Paul Studenski, 1940, "Toward a theory of business taxation," Journal of Political Economy, October.

2 Robert Cline, William Fox, Tom Neubig, and Andrew Phillips, 2004, "Total state and local business taxes: A 50-state study of the taxes paid by business in FY 2003," Ernst & Young, report, January.