The aff exacerbates state fiscal crises

Likely Effects of Radical Tax Reform on State and Local Finance

The effects of reform plans that call for moving away from income taxation and toward consumption taxation will be felt far beyond the federal treasury. The proposals will affect state and local finance in several ways, including by making state and local income taxes more difficult to administer, by curtailing state and local revenue sources, by disrupting the tax exempt municipal bond market, and by hampering the ability of states and municipalities to export their tax burdens through federal deductibility.

A. The Effective Repeal of State and Local Income Taxes

State and local governments derive a significant portion of their tax revenues from state and local income taxes. The informational infrastructure necessary to administer such tax schemes is complex, however, so virtually all state and local income taxes "piggyback" on the federal income tax for much of the administrative mechanism needed to implement such taxes in a fair and efficient manner. 49 State and local tax authorities rely on the federal income tax infrastructure in many ways. For example, state and local tax agencies utilize federal regulations defining "taxable income and allowable deductions," receive copies of taxpayer filings prepared for federal authorities, and receive the benefits from both federal audits and from legal enforcement actions brought by federal authorities against taxpayers. 50 They also tap into the national framework of [*420] informational reporting even though they lack the legal authority to compel reporting from nonresident corporations and other entities. 51 Given the immense administrative costs of an income tax system, it seems unlikely that any individual state could retain a traditional individual or corporate income tax on its own. 52

Although all of the current reform proposals could have potentially devastating effects on state and local income taxation efforts, it should be noted that the proposals differ in the degree to which they hobble existing state and local income taxes. The Gephardt flattened tax and the USA tax would leave in place the essential national income reporting system and that alone would likely permit states to continue to administer their own income taxes. Both of these proposals, however, would cause radical changes in the definition of the tax base in a way that might not coordinate well with the public policy of individual states. The benefits of the current "piggyback" approach would be largely lost if the states chose to define the tax base in a method inconsistent with the new federal base definition and especially if the states desired to exempt from tax, or tax at a differential rate, a component of income no longer considered special under the federal scheme. In those situations, obtaining at the state level the information needed to administer the tax (especially from non-resident businesses) would be logistically (and perhaps legally) difficult.

The Hall/Rabushka-inspired plans and the National Sales or Value Added Tax, if enacted, would spell disaster for state-level income tax programs. Because federal tax changes that depart radically from the traditional model of income taxation would have no need for the types of data needed to run an income tax, one would assume the federal government will stop collecting that data and therefore the federal informational infrastructure necessary for the administration of a state income tax would be lost completely. There may be some solace for states in that both the USA tax and the [*421] various Hall/Rabushka style flat tax bills would permit states to substitute a broad-based, apportioned, state-level subtraction-method value added tax for their existing corporate income taxes and thereby piggyback on that informational infrastructure. More extreme forms of federal taxation reform, however, such as a national retail sales tax or a European-style value added tax, would likely force the states to repeal their corporate and individual income taxes as well. 53

Congress seems to be largely unconscious of the effect that wholesale federal income tax reform will have on state and local governments' ability to levy income taxes. In the Joint Committee on Taxation's study examining the impact of federal income tax reform on state and local governments, 54 there is only a brief mention of the difficulties state and local governments would have in administering income taxes in the absence of a federal income tax infrastructure. 55 In light of the seriousness of the disruption such a change would cause, the ramifications of federal tax law changes on state level tax schemes should receive much more attention.

B. Curtailing Other Revenue Raising Options

Fundamental changes at the federal level will cut off some revenue-raising options at the state and local level. The imposition of a federal sales tax or value-added tax ("VAT"), for example, in addition to depriving state and local governments of the option to tax income effectively, will precipitate other revenue-raising problems. Given state and local governments' dependence on sales tax revenues, the addition of a federal level tax on top of existing state [*422] and local taxes will create severe policy problems for state and local tax authorities. 56 Canada experienced similar problems when it adopted a VAT in 1991. 57 The issues raised by the imposition of a federal level sales tax or VAT primarily include eliminating competition and promoting coordination between the federal level tax and the state and local taxes. A big issue will be how to make the tax bases of the two systems similar enough to avoid major compliance problems.

The reality of a combined state and federal sales tax or VAT would be a very visible and very large incidence of tax on each and every transaction in goods and services. Taxpayers will be reminded of the cost of government over and over again in a much more immediate way than they are when their income taxes are automatically withheld from their paycheck every two weeks. This could have several effects on tax policy, including: (a) a "crowding out" effect in which the federal tax plus the local tax creates political pressure for reductions in state and local sales taxes; (b) political pressure from business communities (which must collect the sales and VAT taxes) for conforming the state and local sales tax base with the federal base or complete elimination of the state/local sales taxes; and (c) administrative issues with federalism overtones if states are charged with administering the federal sales tax scheme. 58

While the sales tax and VAT approaches are most worrisome, all of the reform proposals raise problems for local property taxation schemes. To the extent that base-broadening plans eliminate the home mortgage interest and property tax deductions, property values [*423] are likely to decrease (certainly in the short term). 59 Because homes are a major component of local real property tax bases, this likelihood could lead to a reduction in local property tax revenues in the absence of offsetting tax rate increases. Of course, these perturbations should only last until the next general assessment, but the resulting readjustment of the property tax rate to make the local budget balance could be politically difficult or even legally impossible, considering that some states impose legal limitations on the power of local governments to raise property tax rates. 60 To complicate matters further, this stress on the property tax regime will occur at a time when state and local tax authorities already face a troubling erosion of the property tax base through federal restrictions and preemptions. 61

In addition, the far-reaching changes in federal tax incentives could upset long-standing expectations about sales tax revenues at the state and local level. Because one goal of the wholesale shift of the federal tax system from taxation of income to taxation of consumption is to encourage savings and investment, policy makers must worry about the effect that the concomitant expected decrease in consumption would have on tax revenues. Given the key role played by sales taxes in state and local finance, a significant drop in consumption induced by federal tax law changes could reduce significantly state and local revenues from their sales taxes.

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