Metro Pulse/Insights/State budget showdown

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by Joe Sullivan

The state Legislature has once again snatched failure from the jaws of success in creating a new source of revenues that would start pulling Tennessee up from the bottom of the heap among the 50 states.

After appearing to be on the verge of approving a new 5 percent tax on income in excess of $100,000 for individuals and $200,000 for joint filers, the House retreated late Tuesday when nose counts showed it was one or two votes short of the 50-vote majority needed for passage. A Senate majority had been poised to pass the measure as soon as the House did so. Ironically, a year ago it was the Senate that couldn't muster a majority for a tax reform plan that included an income tax whereas the House stood ready to adopt it.

As Metro Pulse went to press on Wednesday in the midst of the most legislative turmoil in memory, it was anyone's guess what might happen next. An extension of the state's sales tax to previously untaxed services, and even a resort to spending $200 million in tobacco settlement money that had previously been dedicated to a trust fund were among the possibilities getting consideration by a House-Senate conference committee in a desperate attempt to come up with the $300 million needed to balance Gov. Don Sundquist's budget. Apparently no longer on the table, though, were either the highly regressive tax on electricity and residential fuel bills previously approved by the House or the extension of the state's business (excise) tax to partnerships and sole proprietors previously approved by the Senate.

Despite its soak-the-rich inequity, the 5 percent tax on incomes in excess of $100,000/$200,000 represented by far the most promising step toward solving the state's fiscal woes—short of the broad-based income tax that most Tennesseans still phobically oppose. The $283 million that the new tax would raise (after reducing its $457 million total take to reflect accompanying repeal of the Hall tax on dividend and interest income only) would have just about covered Sundquist's main improvement goals for the fiscal year ahead. These include: (1) finally getting TennCare on a sound financial footing, (2) making a significant start toward a five-year goal of raising higher education outlays $440 million annually per a blue ribbon commission's mandate for getting Tennessee up to snuff; and (3) pay raises for state employees who went without any in the current fiscal year.

Equally important, the new tax would have provided a highly elastic source of revenue growth in the years that follow. Revenue elasticity isn't a term with which many Tennessee taxpayers are familiar, but they should be. It measures how rapidly a given revenue source can be expected to grow in relation to overall economic growth including inflation. Income taxes are highly elastic, especially in the higher income brackets, and Tennessee's would have been all the more so because more taxpayers figure to be entering the $100,000/$200,000 bracket each year. By contrast, the sales tax on which the state remains overly dependent for more than half its total revenue is highly inelastic—and figures to become even more so in an increasingly service-oriented economy in which untaxed e-commerce is also eating away at the revenue base.

Sundquist's worthy tax reform goal has been to improve elasticity by coupling introduction of broad-based income tax with sales tax reduction. But the income tax component has run into a tidal wave of opposition based in no small part on fears that once an income tax gains a foothold its rates would inexorably go higher.

This fear is understandable among Tennesseans who've experienced nothing but tax increases over a period of many years. But this experience contrasts starkly with that of states with more elastic tax structures. Of the 41 states with a state income tax, 38 have actually reduced taxes within the past two years. As long as the economy remains robust, there is every reason to believe this trend will continue and could be extended to Tennessee if its tax structure were sufficiently elastic.

Even a highly elastic tax that only raises $300 million doesn't get us there. Such a tax would account for less than 5 percent of state revenues totaling $8.9 billion whereas sales taxes will continue to account for more than half of the total. A more nearly even mix of the two is needed.

What a new tax could do, though, is provide enough of a revenue cushion to permit further-reaching tax reform to be accomplished on a revenue neutral basis. By revenue neutral, we mean reform that doesn't raise any additional revenue but rather leaves Tennesseans collectively paying no more taxes than before.

"The ideal time to do tax reform is when you don't need additional revenue," says state Treasurer Steve Adams. Adams estimates that cutting the state sales tax in half to 3 percent coupled with a 3 percent income tax would yield "about the same amount" as the state's present tax structure. Once it's taken into account that state income taxes are deductible from federally taxable income whereas sales taxes are not, Tennesseans collectively would end up paying some $300 million less in total taxes than presently. To be sure, only those who itemize their federal income tax deductions would gain this benefit, but it's quite possible to come up with an overall structure under which a substantial majority of Tennesseans would save money. And all would benefit in the long run by eliminating the need for recurrent future tax increases.

A tax that only hits six-figure incomes for starters isn't as inequitable as it might seem because many professionals in this bracket have managed to avoid taxes that other businesses pay. Doctors, lawyers, accountants, architects and others operating as partnerships or as sole practitioners aren't subject to the 6 percent on business profits that corporations pay. (Note: professionals do pay a $200 annual licensing fee.)

It would be nice to think that these highest-income Tennesseans both recognize and are able and willing to meet the need for strengthening the state's educational system today in the name of strengthening its work force and economic growth prospects in the future. In any event, some way must be devised for them to do so.