FISCAL AFFAIRS
Is the New Global Economy Leaving State-Local Tax Structures
Behind?
Updated 15 March 1999
Tom Bonnett
National League of
Cities, National Conference of State Legislatures and National Governor's
Association
Prominent economic, social, demographic and technological trends
are threatening to erode the tax revenue of states and cities. The
mainstays of these tax systems are the income, property and sales taxes.
Together, they generated 75.9 percent of total state and local tax
revenues in fiscal 1994. Each is a prominent revenue source for state and
local governments: the property tax generated 31.5, the sales tax
generated 23.8 and the personal income tax generated 20.6 percent of total
state-local tax revenues in fiscal 1994.
The most significant fiscal trend over the past 20 years has been the
declining share of federal support to state and local governments; this
decline has placed a much greater burden on current state and local taxes.
Federal grants-in-aid to state and local governments averaged 21.5 percent
of their total spending over the 1990-95 period. This is well below the
26.5 percent peak that occurred in 1978. Consequently, state and local
governments have had to rely much more on their own tax revenue sources to
generate sufficient revenue to provide services the public requires.
Further, the recent trend of Congress pushing responsibilities to state
and local governments will place additional burdens on the current
state-local tax structure.
If these two trends were to continue, federal grants-in-aid support to
state and local governments would remain at modest levels for some time,
and burdens would increase as well. That prospect increases the importance
to state and local leaders of maintaining a state-local tax structure that
will continue to generate adequate revenues with which to support valuable
public services. The continued effectiveness of the tax structure is
essential to maintain the autonomy of state and local governments. State
and local leaders concerned with the independence and responsiveness of
their governments should be sensitive to the stability of the state-local
tax structure.
When the current state-local tax structure was constructed, most local
and regional economies were tightly bound to geography. In that era, most
people worked, shopped and lived in the same community. In these "closed"
systems, jurisdictions had a relatively easy time taxing income and
consumption to raise sufficient revenue to support public services. The
global economy today is an open system of economic production and
consumption. The major vulnerability of the current state-local tax
structure is to adapt to increased mobility.
Capital has always been mobile, but in the global economy, it can speed
from London to Hong Kong to New York in seconds. Ideas, information and
knowledge are mobile and have become important factors of production in
the new global economy. It is a cliché to talk about a shrinking world,
but transportation and telecommunications costs throughout the world have
plummeted in this century. International trade between 1990 and 1995 grew
twice as fast as the growth in world output. In 1970, about 25 percent of
the total world output was traded internationally; that figure is
projected to be 50 percent in 2000.
The mobility of the factors of production in the modern economy has
enabled global firms to comparison shop around the world for advantageous
locations for new industrial plants. Job-hungry governments have responded
by bidding for business. Two decades ago, industrial recruitment was
considered a regional competition--the sunbelt versus the rustbelt. Today,
industrial recruitment is an international competition.
The mobility of capital has enabled business to aggressively seek tax
preferences from state and local governments. The net effect has been a
reduced share of tax revenues coming from business. Each level of
government in this country collects a smaller share of its total tax
revenue from business today compared with 1946. The challenge of taxing
income and capital is a global problem and one that grows more difficult
each passing day.
The current tax structure was built decades ago when the industrial
economy produced tangible goods. The shift to the new service economy is
the best-documented challenge to the current tax structure, but other
social, demographic and technological trends pose difficult challenges as
well. The shift from a manufacturing-based economy, the changing nature of
work, the shift to electronic commerce, the mobility of firms and
interjurisdictional tax competition, the deregulation of the
telecommunications and electric industries and the aging of America are
trends that together could jeopardize the future viability of the current
state-local tax structure. Each of these trends has important tax
implications.
Economic transformation
The magnitude of the shift over the last half-century from an economy
based on manufacturing goods to one dominated by knowledge-based and
personal services is often not well understood, but it poses several
challenges to current tax policies. In 1959, services constituted less
than 40 percent of the Gross Domestic Product, while goods production
constituted roughly half. In 1994, services were almost 65 percent of the
GDP while goods production was approximately 37 percent. In short, there
has been a dramatic shift in how the modern economy creates wealth. State
and local leaders may ask, in this context, how well the current tax
system matches the modern economy. Specifically, they may ask how the
current sales tax system corresponds to the fastest growing sector in the
economy.
Two specific tax questions are posed: whether personal services should
be included in the sales tax base and whether the property tax is biased
against capital-intensive firms. There may be less rationale to limiting
the sales tax to tangible goods while services--the growth sector of the
economy--remain untaxed or are inconsistently taxed. Similarly, the
continued reliance on the property tax as the primary source of funding
for local governments may pose a heavy burden on goods-producing firms and
capital-intensive industries. The effect of both policies may violate the
notion of horizontal equity in taxation, impose burdens on narrow taxes,
distort private economic decision-making and hinder economic development.
The issue of reforming the tax structure to achieve tax neutrality among
firms and promote economic development will merit further study.
Changing Nature of Work
The increase in global competitiveness has led to major corporate
downsizing, advances in computing and telecommunications technologies have
enabled organizational restructuring such as telecommuting and
decentralizing headquarter operations, and public sector innovation
following this pattern of reengineering has fostered other changes in how
work is being organized. Each of these developments has tax implications
for state and local governments.
Electronic commerce
Electronic commerce offers both boundless opportunities for, and grave
threats to, the public sector. State and local governments may lag behind
the private sector in implementing the latest information technologies
that enable electronic funds transfer, electronic benefits transfer,
electronic data interchange, digital signatures and smart cards. An
increasing number of public sector leaders understand that those
technologies hold tremendous opportunities to improve services and to
achieve greater efficiencies. Implementing them in the public sector is a
difficult task.
Electronic commerce also poses a long-term threat to the current tax
system. The threat is that consumers will increasingly use electronic
media for purchasing goods and services--circumventing conventional sales
taxation--and shift earned income to other jurisdictions, which would
either minimize or evade conventional income taxation. Income and
consumption are no longer constrained by geography.
The traditional definition of nexus for sales taxation--having a
physical presence in a state--is rapidly becoming an antiquated concept as
electronic commerce emerges in new markets. Unless Congress redefines
nexus, electronic commerce will erode the revenue steam from state-local
sales taxes. Although this potential threat is a very serious one, the
recent discussions between the mail-order catalog industry and the states
present an excellent model for resolving this potential conflict and a
basis for measured optimism that this can be done with enlightened private
sector leadership. Indeed, if the states can negotiate an agreement with
the largest mail-order firms to collect sales taxes on purchases made
across state boundaries, electronic vendors could be persuaded to follow
this path.
Firm mobility and interjurisdictional tax competition
State and local officials are under increasing pressure to grant tax
preferences that erode tax neutrality among competing firms. That economic
development trend has been bolstered by advances in telecommunications and
information technologies, the increased mobility of capital, the changing
nature of work and the ability of firms and individuals to locate wherever
preferential tax treatment is provided.
Deregulation of the telecommunications and electric industries
Allowing competitive entry in these regulated industries will end the
practice of specialized taxation of monopoly providers. Achieving tax
equity will force state and local governments to experience substantial
tax shifting. Substantial hardship is expected for taxing jurisdictions
that rely heavily upon existing electric generating facilities to pay
local property taxes.
The Aging of America
This well-documented demographic trend may result in substantial shifts
in aggregate consumption patterns (diminishing sales tax revenues) and
create pressure for broad reforms in senior tax preferences. The growing
elderly population may diminish public sector revenues because it tends to
spend less than the average working population in general and spends more
on services, such as health care, that are not often taxed. Further,
political controversies over the vast array of senior tax preferences
become more divisive in the future.
In addition to those major threats, two immediate policy challenges to
the current state-local tax structure loom on the fiscal horizon.
Federal Tax Reform
Congressional proposals for a flat tax and a national retail sales tax
would force states to undertake major revisions of their sales and
personal income tax systems. Both would eliminate state and local
tax-exempt bonds, significantly increasing the cost of state and local
capital investment. It would be difficult to overstate the havoc caused to
the state-local tax structure if federal tax law eliminated deductions for
mortgage interest, state personal income taxes, and local property
taxes.
Federal Preemption of State or Local Taxes
Congress has been inconsistent in responding to the needs of state and
local governments. State and local leaders have lauded the Unfunded
Mandates Reform Act of 1995. The devolution of domestic programs, such as
the Temporary Assistance for Needy Families Act of 1996, has been viewed
by some as a tremendous opportunity, by others as an insurmountable
burden. In the area of federal preemption of state or local government
authority, state and local leaders are clearly displeased by the current
trend.
The Clinton administration's recommendation that Internet transactions
not be burdened by new taxes and the strong congressional interest in the
Internet Tax Freedom Act--which would preempt state and local taxation of
electronic commerce via the Internet--threaten to erode the traditional
sales tax revenue base.
Now in the seventh year of economic expansion--the national
unemployment rate is 4.3 percent, the lowest since 1973--the current
state-local tax structure is generating an adequate revenue stream to fund
essential public services. Yet the long-term threats and immediate
challenges to the existing tax structure are very serious.
The transformation to a new service economy should provoke thoughtful
revision of the current tax system. The tax structure built in the
industrial age no longer matches the modern economy, and the mismatch is
growing wider. The changing nature of work from corporate downsizing,
telecommuting, and public sector innovation represent opportunities as
well as challenges to the leaders of state and local governments.
As we enter the digital age, the prospect of electronic commerce may be
the most visible long-term threat to the existing state-local tax
structure. The advent of electronic commerce liberates consumption from
geography and heightens capital mobility. The mobility of firms forces
interjurisdictional tax competition. These trends make it more difficult
to tax capital-intensive firms and business property fairly. The new era
of deregulating the telecommunications and electric industries poses
extraordinary burdens on state and local governments.
On the horizon, the aging of America will shift relative tax burden
among age cohorts. The growing elderly population will consume less than
the working age population and spend a large share of their incomes on
services, such as health care, that are often not taxed. In addition, the
controversy of granting a full array of senior tax preferences will
escalate as the demographic shift becomes more pronounced and the
champions of generational equity gain more support among the working age
population.
Taken together, these economic, social, demographic, and technological
trends threaten to imperil the future viability of the state-local tax
structure. If not confronted directly by state and local leaders working
closely with Congress, the viability of state-local tax structure could be
undermined, jeopardizing state autonomy and municipal independence in the
future.
About the Author
Currently an independent public policy consultant and writer, Tom
Bonnett has had an extensive career in public policy, as a state
legislator, a policy analyst, and as an advisor to public officials and
nonprofit organizations. He was elected to the Vermont House of
Representatives in 1974 and reelected in 1976. In Washington, D.C.,
Bonnett worked for the American Federation of State, County and Municipal
Employees and a member of Congress. During the 1980s, he directed the
Neighborhood Economic Development Division of the New York City Planning
Department and conducted research and developed programs for the city's
homeless population at the New York City Human Resource Administration. He
also served as Executive Director of the Downtown Flushing Development
Corporation.
Bonnett worked on economic development, transportation planning,
environment and telecommunications issues for the Council of Governors'
Policy Advisors from 1992 to 1997. During this period, CGPA published
Scenarios of State Government in the Year 2010 (1993, co-authored
with Robert Olson); Strategies for Rural Competitiveness: Policy
Options for State Governments (1993); A New Vocabulary for
Governing in the 1990s: A LEXICON for Governors' Policy Advisors
(1994)--distributed by the Georgetown University Press; and
TELEWARS in the States: Telecommunications Issues in a New Era of
Competition (1996)--distributed to the academic community by the
Lawrence Erlbaum Associates, Inc.
Bonnett received a Bachelor's of Art degree from Bennington College and
received a Master's degree in Public Policy from the University of
California at Berkeley.
The book is available at NLC's
publication office (301.725.4299 or email nlcbooks@pmds.com).
© 1998, National Conference of State Legislatures
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