Hasty Tax Choices May Threaten Vermont Economy

Which way to raise $442 million in new state taxes to replace the local property tax for education? That is the question facing the Vermont legislature, and the choice it makes will have momentous consequences for Vermont's economic future.

The revised proposal approved by the House Ways and Means Committee on March 13 relies on a collection of familiar taxes, though some of them are applied in novel ways. There is a statewide property tax with different rates for residential and non-residential properties. The 5% sales tax is increased to 6%, and the 7% rooms and meals tax is increased to 9%. The gasoline tax would rise from 15 cents per gallon to 18 cents. The committee's earlier enthusiasm for a new "carbon tax", extending the sales tax to services, and taxing breakopen tickets sold in veterans' and fraternal clubs seems to have evaporated following a week of vocal opposition at public hearings.

The Committee's main invention is a new "guaranteed yield local income tax", conceived so that the proceeds from income taxes levied by voters in high income towns will have to be shared with low income towns. This novel - and undoubtedly fatally unpopular - feature was created when Deputy Attorney General William Griffin explained to the Committee that the Supreme Court's Brigham decision will not allow a town's voters to raise different amounts of education funds per child from any town tax base, whether property, income, or sales. (Gov. Dean has promised to veto any bill which includes any form of income tax increase, so the debate on this proposal may be irrelevant.)

A bipartisan group led by Rep. Ruth Dwyer (R-Thetford) is offering an alternative built upon a simple broad-based gross receipts tax in place of the present retail sales tax. This is not a familiar idea to Vermonters, but has been in use in Washington state since 1935 and more recently in West Virginia and Hawaii.

Like the property tax, the gross receipts tax, also called the business activity tax or business and occupations tax, has nothing to do with business profits. It levies a low tax rate (such as 2%) on an extremely broad base of business activity, including services. There is usually an exemption (such as $100,000) for small businesses. Receipts resulting from sales of goods and services outside of the state are also exempt, so as not to place a competitive burden on the state's producers.

The tax is simple, raises lots of money at a low rate, and spreads the tax burden over all economic activity. On the other hand, it has some disadvantages. Unlike the sales tax, it is hidden in the final price of the product. It also cascades, that is, if there are a series of transactions among businesses the tax is levied each time, so that the final price of a product may include taxes at a rate of three or more times the nominal low rate.

For instance, if a farmer sells milk to an in-state coop, he is taxed on those receipts; the coop is taxed on what the distributor pays it for its cheese; the distributor is taxed on what it gets from the retailer; and the retailer is taxed on what it gets from the customer. This cascading effect also gives a competitive advantage to large, vertically integrated companies , such as single firms that produce their own milk and manufacture, distribute, and retail dairy products.

The gross receipts tax hits hard on firms with high volume and low profit margins, such as C&S Wholesale Grocers, the state's largest private company. Creating different tax rates for different types of business, as Washington does, opens the door to political infighting among business groups seeking favorable treatment for their firms.

A similar alternative tax that attempts to deal with some of these problems is the value added tax or "single business tax" as it is called in Michigan, the only U.S. state to have one. Unlike the gross receipts tax which replaces the sales tax, the SBT replaces the corporate income tax.

It levies a low rate (like 2%) on a base consisting of a firm's adjusted gross income, plus employee compensation, plus depreciation , but minus new capital expenditures. The tax rate is then apportioned to in-state activity, typically on a formula including sales, property value, and payroll. Increasing the weighting of in-state sales in the formula favors a state's exporters, because sales made to out of state buyers are excluded from the tax base. This may, however, lead to federal court challenges from out-of-state competitors. The deduction of capital expenditures from the tax base is an obvious incentive to capital investment.

The SBT has the virtue of avoiding the cascading of the simple gross receipts tax in a chain of processing, because the tax is paid only on the value added by the firm, not the entire receipts. Like the gross receipts tax, though, it is invisible , and it is unrelated to a firm's profits. There are also significant compliance costs, incentives to cook a firm's books to reduce the tax obligation, and the temptation to charge politically-graduated rates on different types of business.

Each of these alternatives to the Ways and Means package has strengths and weaknesses. An informed debate on the state's entire tax structure, especially as it influences profit- and paycheck-creating business activity, is long overdue. The danger now is that the legislature, in a panic to appease the Equality Gods of the Supreme Court and the lawyers for the dreaded ACLU, will rush into some new $442 million taxing scheme the likely economic effects of which are very poorly understood by legislators and taxpayers alike.

March 1997