Back To Basics For Tax Reform In Colorado

Issue Paper #3-2000 February 28, 2000

Back To Basics For Tax Reform In Colorado

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By Barry W. Poulson Professor of Economics University of Colorado

3-2000

February 28, 2000

Back To Basics For Tax Reform In Colorado By Barry W. Poulson Professor of Economics University of Colorado

Executive Summary •

The Reagan tax revolution was designed to improve the efficiency, equity, and simplicity of the tax system. Tax reform in Colorado in 1986 paralleled these Reagan tax reforms: we lowered the marginal income tax rate, and adopted the broader federal base for the income tax. We simplified our tax system in Colorado so that taxes could be filed on a post card.

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However, tax reform introduced a flaw in the state income tax, which is the source of our current problem. The flaw was to set the flat rate on the income tax too high. The impact of the 5% flat rate has been to generate revenue growth in excess of the growth in population and inflation, the rate now permitted by the TABOR Amendment.

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Most of the surplus revenue is generated by the income tax, but only a small portion of the surplus is returned to taxpayers in the form of income tax rebates. Most of the surplus is rebated using a formula linked to the sales tax. The result is that much of the surplus is redistributed from taxpayers who paid the excess taxation to other citizens who did not pay excess taxes.

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There is a solution to this dilemma that will return our tax system to the principles of the Reagan tax revolution. We need to again reduce the marginal rate, broaden the base, and simplify our state income tax. It will probably require a cut in the income tax rate to 4 % to completely eliminate surplus revenue in the long run. HB1103, which would cut the income tax rate to 4.65%, does not go far enough because it eliminates only a small share of the total surplus revenue.

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The only other bill before the Legislature calling for broad-based tax cuts was HB 1135, which would refund surplus revenue through state sales and use tax holidays. Refunding the surplus through sales and use tax holidays involves some redistribution of income from one group of taxpayers who paid excess taxation, to another group of taxpayers who did not pay excess taxes.

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The business personal property tax is one of the most inefficient and inequitable taxes. HB 1145 would make the rebate for business personal property taxes easier to implement, and therefore would improve Colorado’s business climate.

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SB 4 would use surplus revenues to fund expenditures for education K-12. This is rather surprising in that voters chose not to use surplus revenue to fund expenditures for education K-12 just one year ago. Evidently the supporters of SB 4 do not think that voters should determine how surplus revenue is allocated, as required by the TABOR Amendment.

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Many of the other tax bills before the legislature this year call for targeted tax cuts and tax rebates. If the Legislature continues to respond to these special interests tax bills this year, as the legislature did the past year, with targeted tax cuts and tax rebates, we will end up with a tax system that is less efficient, less equitable, and more complex than if we generated no surplus revenue. The Legislature will also be open to the charge of catering to special interests and providing corporate welfare.

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Introduction It is difficult to explain the 60 odd tax bills before the Colorado Legislature this year. Every interest group in the state seems to be clamoring for tax refunds, tax cuts, or expenditures of surplus revenue to benefit their interest group. If the legislature responds to these special interests this year, as they did last year, we will end up with more loopholes and more complexity in our tax system. We seem to have forgotten the lessons learned from the tax reforms launched by the Reagan revolution, and it is time for Colorado legislators to return to these basic principles of tax reform. I will discuss first the principles that should guide tax reform in Colorado, and then some of the proposed tax bills.

I. What Are The Lessons From the Reagan Tax Revolution for Tax Reform in Colorado? The Reagan tax revolution was designed to improve the efficiency, equity, and simplicity of the tax system. This was accomplished by lowering the marginal rate and broadening the base of the income tax. This increased incentives for people to engage in productive activity and earn more income. By closing many loopholes in the income tax we simplified our tax system and reduced the incentives for tax avoidance and evasion. Tax reform in Colorado paralleled these Reagan tax reforms; we lowered the marginal income tax rate, and adopted the broader federal base for the income tax. We simplified our tax system in Colorado so that taxes could be filed on a post card. These tax reforms have played a major role in rapid economic growth over the last decade. Colorado is now ranked among the top states in attracting business and people to locate within the state. What is less well known is that tax reform a decade ago made our tax system more progressive. We adopted the more generous personal exemption and standard deductions that removed the lowest income groups from paying any income tax. The closing of loopholes and broadening of the income tax base shifted more of the tax burden to upper income groups. This is reflected in a significant shift of the tax burden from low- and middle-income groups to the top income groups over the last decade.

II. The Flaw in Our Tax System However, tax reform introduced a flaw in the income tax, which is the source of our current dilemma. The flaw was to set the flat rate on the income tax too high. At the time, we at the Independence Institute challenged the Republican leadership for raising the income tax burden. We pointed out that a revenue neutral income tax rate was about 4 1/4 %, not 5%. The 5% rate captured a significant share of the windfall created by federal tax reform, and significantly increased the income tax burden for Colorado citizens. The response from the Republican leadership was that income tax rates could be reduced in future years if this resulted in excess taxation. The impact of the 5% flat rate has been exactly as we predicted. The income tax is generating revenue growth in excess of the growth in population and inflation, the rate now permitted by the TABOR Amendment. Surplus revenues are projected at about a billion dollars a year over the next five years, or $5 billion over the period as a whole. At the same time the state will accumulate more than a billion dollars in reserves, most of which represents excess reserves above statutory requirements. What is wrong with the accumulation of surplus revenues? If the surplus revenue is simply returned to the taxpayers who paid the excess taxation, the answer is obvious. It doesn’t make sense for the state to collect excess taxes and turn around and rebate that money to taxpayers. But of course that is not what is happening to the excess tax revenues. Most of the surplus revenue is generated by the income tax, but only a small portion of the surplus is returned to taxpayers in the form of income tax rebates.

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Most of the surplus is rebated using a formula linked to the sales tax. The result is that much of the surplus is redistributed from taxpayers who paid the excess taxation to other citizens who did not pay excess taxes. Further, as a result of legislation passed last year, much of the surplus is now offset by tax rebates and tax cuts targeted to special interest groups; and, most of the 60 odd tax bills before the legislature this year will have the same effect. These loopholes are making the tax system less equitable, less efficient, and more complex.

III. Finishing the Reagan Agenda for Tax Reform in Colorado A. Cutting the State Income Tax There is a solution to this dilemma that will return our tax system to the principles of the Reagan tax revolution. We need to again reduce the marginal rate, broaden the base, and simplify our state income tax. There have been bills before the legislature calling for cuts in the income tax: HB 1021 (which was defeated) would reduce the income tax rate to 4.25%; HB1103 would cut the income tax rate to 4.65%. Of these, the bill that would best satisfy the goals for tax reform was HB 1021 cutting the income tax rate to 4.25%; HB 1103 does not go far enough in satisfying these objectives, because it eliminates only a small share of the total surplus revenue. If you look at the fiscal note attached to HB 1021 you will see that over the next two years most, but not all, of the surplus would be eliminated. After two years surplus revenue would again begin to increase with the 4.25% rate. While this was the best tax cut bill before the legislature it did not go far enough in reducing the income tax rate. It will probably require a cut in the income tax rate to 4 % to completely eliminate surplus revenue in the long run. However, by eliminating most of the surplus revenue, this bill would have obviated the need for other tax cuts and tax rebates to offset the surplus revenue. This will remove loopholes already introduced into the tax system, and create less incentive for special interest groups to lobby for additional loopholes. B. Eliminating Excess Reserves Under current tax law over the next five years the state will accumulate more than a billion dollars in reserves, most of which represent excess reserves. HB 1021 would have eliminated these excess reserves over the next two years; after two years excess reserves would then again increase with the 4.25% rate. Therefore, a reduction in the income tax rate to 4 % is required to eliminate excess reserves, as well as surplus revenue, in the long run. What is wrong with the accumulation of excess reserves? If the objective is to provide for emergency expenditures, this is already adequately provided for in our required reserve funds. Even had HB 1021 been passed, the reserves would still have increased from about $200 million to almost $300 million over the forecast period, meeting the statutory requirement that these reserves must equal 4 % of appropriations. Even with HB 1021 the emergency reserve fund would still increase from about $200 million to about $300 million to meet Constitutional requirements. These two reserve funds would equal about 7% of appropriations, which is well within the range recommended by Wall Street analysts to meet emergency expenditures. Indeed, HB 1021 would have left Colorado with reserves in the upper range compared to that in other states. If we cannot justify the accumulation of excess reserves to meet emergency expenditures is there any other justification for this excess taxation? Over the last two years a significant share of these excess reserves have been transferred out of the general fund to finance expenditures for capital construction in education, prisons, and highway construction. The total amount of this capital construction increased from about $100 million to almost $500 million. If that level of capital spending were to continue the state would exhaust all reserve funds within a few years.

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Governor Owens, recognizing that this level of spending for capital construction is not sustainable, during the past year tried to reign in some of these expenditures. Specifically, he called for cuts in some construction projects in higher education. Legislators from districts where these cuts would impact their community college or university were successful in blocking the proposed cuts. HB 1021 would have precluded the financing of capital construction from excess reserve funds. Financing would then have to come from other sources; i.e. general fund monies, or the new highway revenue bonds recently approved by voters. General fund expenditures would have to increase at something less than the statutory limit of 6% in order to free up funds for capital construction. Total appropriations, including both general fund expenditures and capital construction expenditures, would then increase at the rate required by the TABOR Amendment. C. State Sales and Use Taxes, and Tax Holidays The only other bill before the Legislature calling for broad-based tax cuts was HB 1135 which would have refunded a little more than $100 million in surplus revenue through state sales and use tax holidays. There are several reasons why this approach is inferior to income tax cuts in terms of our principles for tax reform. Most of the surplus revenue is generated by the income tax. Therefore, refunding the surplus through sales and use tax holidays involves some redistribution of income from one group of taxpayers who paid excess taxation, to another group of taxpayers who did not pay excess taxes. Some legislators defend the current rebate system in which rebates are linked to the sales tax rather than the income tax, because this reduces the federal income tax liability. The problem is that the people receiving the sales tax rebates are not the people paying excess income taxes. The magnitude of this redistribution is estimated in another Independence Institute Issue Paper #10-99, Surplus Expenditures in Colorado. The purpose of the tax reform should be to eliminate the surplus revenue, not redistribute income among taxpayers. Reducing sales and use taxes creates more incentives for consumption spending. Cutting the marginal income tax rate, on the other hand, creates incentives for productive activity that increases income, and the income tax base. Thus, the latter approach is superior on efficiency grounds. Finally, the reduction of income tax rates is a simpler approach than the cumbersome process of determining each year if a sales and use tax holiday will be implemented. On efficiency, equity, and simplicity grounds we should favor the reduction in the income tax rate to 4.25%, rather than sales and use tax holidays, or tax rebates linked to the sales tax. D. Eliminating Business Personal Property Taxation The business personal property tax is one of the most inefficient and inequitable taxes. For many small businesses this tax generates less revenue than the cost of administering the tax. We could improve our tax system by eliminating this tax altogether. Legislation passed last year offsets part of the surplus revenue with a business personal property tax rebate. While this is a second best solution it is certainly an improvement. HB 1145 would make this rebate for business personal property taxes easier to implement, and therefore should be supported.

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E. Using Surplus Revenue to Fund Expenditures for Education K-12 SB 4 would use surplus revenues to fund expenditures for education K-12. This is rather surprising in that voters chose not to use surplus revenue to fund expenditures for education K-12 just one year ago. Evidently the education interest groups and legislators supporting SB 4 do not think that voters should determine how surplus revenue is allocated, as required by the TABOR Amendment. F. Using Surplus Revenue to Fund Local Property Tax relief One of the ideas for tax reform circulating in the legislature is to use surplus state funds to provide local property tax relief. We should point out that the state already provides substantial property tax relief indirectly through state funding of education K-12. The state share has increased to about 58% of total funding for education K-12 in recent years. The state share of this education funding is even greater in school districts with lower average incomes, under the formulas used in allocating state education funds. That has decreased pressure on local school districts to raise property taxes to finance our schools. There are a number of good economic reasons why we should continue to rely primarily upon local property taxation to fund education K-12, and these reasons are explored in another Independence Issue Paper # 3-98 Solving Colorado’s Educational Finance Problem. One of the strengths of the Colorado fiscal system is that we continue to rely upon local governments rather than the state government to both finance and administer government programs. This is especially important in financing and administering our public schools. Reliance upon local property taxation to finance our schools introduces incentives to improve the schools that would not exist with state funding. Local property owners have an incentive to monitor how those property taxes are used by the local school systems, because poor schools mean lower property values. School districts that offer good quality public education are more successful in generating the property taxes required to maintain that quality. We should continue to give citizens this choice to live in schools districts where they pay higher property taxes in order to provide a better education for their children G. Targeted Tax Cuts and Tax Rebates Most of the other tax bills before the legislature this year call for targeted tax cuts and tax rebates. These bills, creating tax loopholes for special interests, should be rejected. This includes bills targeting bull semen, vending machines, etc. If the Legislature continues to respond to these special interests this year, as they did the past year, with targeted tax cuts and tax rebates, we will end up with a tax system that is less efficient, less equitable, and more complex than if we generated no surplus revenue. The Legislature will also be open to the charge of catering to special interests and providing corporate welfare through the tax system. Copyright ©2000, Independence Institute & Barry Poulson INDEPENDENCE INSTITUTE is a nonprofit, nonpartisan Colorado think tank. It is governed by a statewide board of trustees and holds a 501(c)(3) tax exemption from the IRS. Its public policy focuses on economic growth, education reform, local government effectiveness, and constitutional rights. JON CALDARA is President of the Institute. BARRY POULSON is a Professor of Economics at the University of Colorado, and Senior Fellow in Economic Policy at the Independence Institute. PERMISSION TO REPRINT this paper in whole or in part is hereby granted provided full credit is given to the Independence Institute.

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Additional Independence Institute resources on Tax Policy, and many other subjects, can be found at the Independence Institute website: http://independenceinstitute.net.

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