Every year the Council on State Taxation (COST) releases their excellent study—“Total State and Local Business Taxes” (pdf)—that quantifies business taxes by state. I have used this study on a multitude of occasions because it effectively illustrates the extent to which individual and business taxation is intertwined.
This unfortunate mixing of individual and business taxation leads to bad tax policy. For example, unless you are a business owner, most ordinary taxpayers do not realize that most businesses actually file through the individual income tax as a sole-proprietor, partnership, LLC, or S-Corporation as opposed to the traditional Corporate Income Tax which only taxes C-corporations.
The business income is not evenly distributed across the income spectrum. In a study I did for Maine, “Who Are Maine’s Rich?” (pdf) I found that:
“. . . the percentage of taxpayers that have some kind of business income soars at the income levels over $200,000—93.2 percent of taxpayer have interest income, 71 percent of taxpayers have dividend income and 63.3 percent of taxpayers have capital gains income.”
As a result, when someone says “let’s soak the rich” with higher tax rates, they are really saying “let’s soak businesses.” Higher taxes on businesses, of course, means lower economic growth since these businesses have less money to invest.
The overall results are shown Table 1 from the study below which contains some surprises. The largest tax that businesses pay, not surprisingly, are local property taxes at $242.1 billion. Naturally, businesses have to locate out of some physical location and, like households, represent much of their physical wealth.
The second highest business tax will undoubtedly come as a surprise to many—general sales taxes on business inputs at $139.8 billion. But wait, aren’t sales taxes a “consumption tax” that only impacts people? In theory, that is true but the real-world implementation of the retail sales tax is not so clean.
For example, suppose a person goes to Staples to buy a package of printer paper. Are they buying it to print a school report or the print the business tax return? Or both? There is no easy way of knowing so the sales tax that is paid increases the cost of doing business. Higher business costs mean higher prices which mean we all end up paying the sales tax on previously paid sales tax. This is formally known in economics as “sales tax pyramiding.” (pdf)
The traditional corporate income tax comes in a distant third at $53.3 billion. The taxes paid by businesses via the individual income tax are almost as large as the corporate income tax at $36.6 billion. Yet, even the individual and corporate income taxes paid combined do not equal the taxes be paid through the sales tax.
Table 5 from the study shows the amount of business taxes are paid by state, and, more importantly, the percentage take from the economy. Living in Northern New England, I get to witness how tax policy matters on a daily basis. Clearly, New Hampshire outperforms Maine and Vermont in just about every measure of economic prosperity that we have.
New Hampshire’s business taxes as a percent of Gross State Product (GSP) was 4.4 percent which is below the national average of 4.4 percent. On the other hand, Maine’s businesses taxes accounted for 6.4 percent of GSP while Vermont’s business taxes accounted for 7.4 percent of GSP. So Vermont has the 3rd highest and Maine has the 6th highest level of business taxes in the country. No wonder they have such a hard time generating economic growth.
The study concludes:
“State and local business taxes in FY 2013 continued their long recovery, despite challenges in several states. While all but 12 states have recovered to their prior peaks of tax revenue collected before the last recession, 28 states are still collecting less corporate income tax revenue than their peak year near the start of the recession. The results of this analysis for FY 2013 also point to the significance of individual income taxes on business income, which account for more tax revenue than corporate income taxes in 13 states. Despite these shifts in the composition of state and local business taxes in FY 2013, business property tax and sales tax on business inputs remain the largest components of total state and local business taxes. The continued significance of these non-income taxes is a reminder that the tax contribution of businesses encompasses far more than the corporate income taxes that are most frequently considered as part of a business’s tax contribution.”
This points to a much larger problem which is tax transparency. How are businesses supposed to properly plan when one of their most significant costs—taxes—are virtually impossible to estimate. Sure, the COST study is great in the aggregate, but not much help to the individual business owner grappling with day-to-day business issues.
To that end, business taxes must be rationalized under a completely new tax system. It just so happens that Wendy and I have designed such a tax system for New Hampshire called the Business Flat Tax. The Business Flat Tax would create the first state-level consumption tax in the country and is modeled on the national Flat Tax by Robert Hall and Alvin Rabushka of the Hoover Institution. Here is the Executive Summary:
"The holy grail of tax reform is a system that would tax all consumption in the economy a single time. Only one tax reform plan truly meets that definition and has become popularly known as “The Flat Tax.” The Flat Tax was first introduced by economists Robert Hall and Alvin Rabushka in a book by the same name published by the venerable Hoover Institution. Various attempts to enact the Flat Tax at the national level have been attempted such as the Armey-Shelby Flat Tax plan (named for Former Representative Dick Armey of Texas and Senator Shelby of Alabama and the 1996 Steve Forbes Flat Tax plan."
"Unfortunately, the broader national tax reform movement has made little progress at the state level. Most state tax reform efforts have simply involved shifting one existing tax into another existing tax with marginal changes that lack a fundamental reexamination of the overall tax structure."
"One significant exception to this was New Hampshire’s adoption of the Business Enterprise Tax (BET) in 1993. The BET was created from the ground-up with the goal of creating a true consumption tax. Thanks to the pioneering efforts of Bill Ardinger, Stan Arnold, and others, New Hampshire made a tremendous leap forward for the state tax reform movement."
"In the intervening 20 years, however, the tax reform movement in New Hampshire has remained incomplete and at times has moved backwards as both the BET and Business Profit Tax (BPT) tax rates have been increased solely as a means for higher tax revenue. Each increase in the tax rate represented a squandered opportunity to completing the path toward a true consumption tax."
"Now is the time to continue the push for tax reform as New Hampshire’s economic growth has downshifted under the weight of higher tax rates. In fact, after the 1993 tax reform the average annual growth rate was an astounding 3.8 percent, but has since fallen to an anemic rate of only 1.1 percent. This downshifting has cost New Hampshire households dearly in lost income, which is the true cost of higher taxes."
"This study will explain how folding the existing tax structure, including the BPT, BET, the now-defunct Medicaid Enhancement Tax (MET), and harmonizing the Interest and Dividends (I&D) tax rate, into a new Business Flat Tax (BFT) would make another dramatic leap in the journey for tax reform. The BFT takes its cues from the national Flat Tax plan that would tax all consumption in the New Hampshire economy a single time at the business level."
"New Hampshire is nationally lauded for its low overall tax burden. The enactment of the BFT would also propel New Hampshire’s tax structure into the same level of prominence."
The Business Flat Tax would dramatically lower marginal tax rates, lower tax compliance costs, and increase the transparency in the tax system. The tax reform plan won’t change much for New Hampshire in the COST study since it is designed to be revenue-neutral (meaning it will bring in the same amount of tax revenue as before tax reform), but for these other reasons mentioned would provide a spark to New Hampshire’s economy.
J. Scott Moody has over 18 years as a public policy economist with a specialty in tax policy and has over 180 publications. He has worked for numerous national and state-based think tanks such as Federalism In Action, Tax Foundation, Heritage Foundation, and The Maine Heritage Policy Center.