By Greg R. Lawson

Summary

Ohio has a tax problem. The state’s tax rates have been too high for too long. Fortunately, there have been efforts to cut these rates and Governor Kasich is taking a bold step in the direction of eventually abolishing the state income tax. Unfortunately, Ohio’s tax problems do not begin and end with the state income tax.

The Buckeye state infamously boasts what has been called “the most complicated, absurd, and punitive system of municipal taxation in the nation.”[1] It is a tax system worthy of Rube Goldberg, and it begs to be changed. Recent reform efforts, however, have largely languished in the General Assembly, and much of the needed reform legislation has been significantly watered down through the give-and-take of the political process. Despite some marginal improvements, the system’s fundamental problems remain.

Failing to achieve comprehensive municipal income tax reform will miss an important opportunity to correct one of Ohio’s most burdensome and complicated issues. And that failure will continue to hamper the state’s economic prospects, especially for start-ups and entrepreneurial endeavors, the lifeblood of a vibrant economy.

The Ohio General Assembly should reform the “most complicated, absurd, and punitive” municipal income tax by making it simpler, more uniform, and more equitable for small businesses.

Policy Recommendations

Reform legislation should—at a minimum—do the following:

• Standardize reciprocal municipal income tax credits across jurisdictions for tax fairness;
   
• Allow for an eventual 20-year Net Operating Loss Carryforward to facilitate start-up business formation regardless of jurisdiction;
   
• Use a simple, “bright-line” residency test that taxes non-residents based on their primary place of employment [2]; 
   
• Set a higher threshold of $100 for filing a net pro t return (currently $10) to avoid taxpayers spending more in filing than they have in tax liability;
   
• Require a simple form for businesses to declare that they conducted no business in a specific municipality and therefore did not need to file a complete tax return for that municipality;
   
• Include a “Taxpayer Bill of Rights.”

Why Ohio’s Municipal Income Tax is the Worst in the Country

In 2010 and 2011, Ohio’s local tax burden as a percentage of personal income was the 12th highest in the nation.[3] In 2012, $4.53 billion was collected from taxpayer wallets through the municipal income tax—a figure slightly more than half of what the state of Ohio garnished from taxpayers through the state income tax that year.[4] But the extent of this onerous burden is not fully realized without appreciating the fuller context of Ohio’s local government tax system.

Local governments in Ohio raise their revenues through an unduly complicated income tax scheme that the vast majority of our sister states have long-since abandoned. In fact, only 17 states still levy any form of municipal or county income tax at all,[5] and of those, only 10 states tax both individual and business income at the municipal level.[6] By contrast, Ohio had 601 municipalities levy taxes in 2012[7]—only Pennsylvania topped that.[8]

More than just financially onerous, Ohio’s arcane system continues to violate fundamental principles of sound tax policy, namely, uniformity, simplicity, and equitable fairness. For example, the current system does not provide for uniform tax credits offered by municipalities where taxpayers reside. Although most municipalities offer credits to their residents to help offset income taxes paid to their employer’s municipality, this is not true of all jurisdictions. Instead, each municipality may decide whether and how much of a credit to offer for taxes paid in a neighboring municipality.[9] Thus, the system allows for an ad-hoc assessment of local taxes that may or may not require some workers unfortunate enough not to work where they live to pay taxes in two different municipalities and for two different amounts.

Nothing about the current system is simple or straightforward. For instance, employers and employees must file tax returns in each jurisdiction where the tax is owed, creating an administrative nightmare for businesses, like contractors, with employees working in multiple jurisdictions.[10] An electrical contractor in northeastern Ohio with only 19 employees reportedly filed an astounding 221 W-2 forms and 39 business returns, many of which resulted in less than $5 of tax liability.[11] Administrative absurdities like this can mean hundreds of hours devoted to tax compliance and thousands of dollars spent on accountants and staff dedicated to tracking tax withholdings and remittance.[12] For smaller businesses with limited accounting staff and resources, these may be significant costs that mean the difference between a “good year” and a bad one. And with similar filing requirements for individuals as well, employees must shoulder their own share of this administrative burden.

Finally, without a standardized Net Operating Loss Carryforward (NOL), Ohio’s system packs a pernicious punch on start-up businesses and fledgling ventures. As with taxpayer credits, NOLs are left to the discretion of each municipality,[13] so some start-ups are either unable to or severely limited in deducting their initial losses once they begin turning a profit. Most states, of course, do not impose municipal income taxes on their businesses, so Ohio places many would-be start-ups and potential employers at a competitive disadvantage to firms in other states. Such a disadvantage may help explain why Ohio ranks 42 out of 50 states in the University of Nebraska’s U.S. Entrepreneurship Index.[14] Start-up companies face more than enough competition and obstacles to their success as it is; they certainly do not need defunct, inequitable tax policies compounding their disadvantages and difficulties.

Proposed Reforms Represent Modest Improvement But More Needed

Although recently proposed reform efforts acknowledge some of the problems created by Ohio’s current system, and even attempt to ameliorate some of the system’s worst aspects, they still leave too many of the problems and inequities of the status quo unresolved. Shortcomings of the current reform proposal include:

• Failing to standardize credits between jurisdictions, perpetuating an uneven playing field for all taxpayers and maintaining double-taxation for some;
   
• Failing to create uniform paperwork requirements for all jurisdictions or simplify other tax forms to make it easier for start-ups and small businesses to grow;
   
• An inadequate 5-year NOL provision. Federal tax law allows for a 20-year NOL, which means that Ohio will continue to put its businesses at a competitive disadvantage as compared to other states;
   
• A slow phase-in period that does not begin until 2017 and will not be complete until 2022. Only 50 percent of the NOL may be deducted between 2017 and 2021, leaving start-up businesses that may initially not make profits at a competitive disadvantage;
   
• A proposed 20-day “casual entrant” rule that barely improves the status quo because it will still require tracking where employees spend their time to determine the appropriate tax withholdings;
   
• Failing a simple, “bright-line” residency test and instead creates a complex “test” of 11 different factors to determine whether an individual owes municipal income tax;
   
• Allowing for absurd situations in which one could owe NO state income tax, but still owe municipal income tax;
   
• Placing the burden on employees to seek refunds for taxes not owed to a municipality in situations where an employer elects to withhold taxes for all days a nonresident works in the municipality (including the first twenty days);
   
• Failing to establish reasonable filing thresholds so that taxpayers may still have to pay more to file their return than they owe in taxes;
   
• Failing to harmonize the rights of municipal income tax payers with those of state income tax payers through a uniform “Taxpayer Bill of Rights.”

Conclusion

Ohio deserves a tax structure that is straightforward, uniform, equitable, and competitive with other states. The state’s arcane municipal tax scheme violates the most basic principles of tax policy by making it confusing, complex, expensive, and burdensome for employers and employees to carry-out the most basic of civic duties: pay their taxes. Forty other states manage to fund local government without imposing municipal income taxes, putting Ohioans and their businesses at an immediate economic disadvantage. State policymakers should be looking for ways to reform the state’s entire local tax system to make Ohio more competitive and inviting to businesses, entrepreneurs, and workers. Unfortunately, recent proposals, while offering much-needed reform, barely address many of the fundamental problems with Ohio’s system. The Buckeye Institute recommends pursuing the reform measures outlined in this report to make Ohio’s tax policy simpler, fairer, and more competitive for all Ohioans.

1. Drenkard, Scott and Greg R. Lawson. “In State Tax Battle, Tar Heels Soar Above Buckeyes.” Forbes. September 23, 2013 at http://www.forbes.com/sites/realspin/2013/09/23/in-the-state-tax-battle-the-tar-heels-soar- above-the-buckeyes/ (June 3, 2014)

2. Drenkard, Scott. “Ohio’s Local Income Taxes: Complex and in Need of Reform.” Tax Foundation. May 7, 2013 at http://taxfoundation. org/article/ohios-local-income-taxes-complex-and-need-reform (October 20,2014).

3. State of Ohio Department of Taxation, “State and Local Taxation Comparison 2010-2011,” at http://www.tax.ohio.gov/Portals/0/tax_analysis/tax_data_series/state_and_local_tax_comparison/tc12/TC12CY11.pdf (June 3, 2014).

4. State of Ohio Department of Taxation, “Personal Income Tax: Tax Returns, by County, Tax Year 2012.” at http://www.tax.ohio.gov/Portals/0/tax_analysis/tax_data_series/individual_income/y3/Y3TY12.pdf (October 21, 2014).

5. Henchman, Joseph and Jason Sapia. “Local Income Taxes: City- and County-Level Income and Wage Taxes Continue to Wane.” Tax Foundation. August 31, 2011 found at http://taxfoundation.org/article/local-income-taxes-city-and-county-level-income-and-wage- taxes-continue-wane (October 20, 2014).

6. Ibid.

7. State of Ohio Department of Taxation, “Tax Rates and Amounts Collected, by Municipality, Calendar Year 2012” at http://www.tax.ohio.gov/tax_analysis/tax_data_series/individual_income/publications_tds_municipal/LG11CY12.aspx (October 21, 2014).

8. Drenkard, Scott. “Ohio’s Local Income Taxes: Complex and in Need of Reform.” Tax Foundation. May 7, 2013 at http://taxfoundation.org/ article/ohios-local-income-taxes-complex-and-need-reform (October 20,2014)

9. For examples see, Regional Income Tax Authority. “Tax Rate Tables.” 2014 at https://www.ritaohio.com/resources/tax-rates-tables/ (October 21, 2014).

10. Ashley, Andrea. “Senate Finance Committee Testimony.” June 3, 2014 at http://www.agcohio.com/hb5testimonysen nance632014. pdf (October 21, 2014).

11. Drenkard, Scott and Greg R. Lawson. “In State Tax Battle, Tar Heels Soar Above Buckeyes.” Forbes. September 23, 2013 at http://www.forbes.com/sites/realspin/2013/09/23/in-the-state-tax-battle-the-tar-heels-soar-above-the-buckeyes/ (June 3, 2014).

12. Ashley, Andrea. “Senate Finance Committee Testimony.” June 3, 2014 at http://www.agcohio.com/hb5testimonysen nance632014.pdf (October 21, 2014).

13. Ohio Rev. Code Ann. § 718.01.

14. Thompson, Eric, PhD and William Walstad, PhD. “2013 U.S. Entrepreneurship Index.” University of Nebraska- Lincoln at http://cba.unl. edu/outreach/bureau-of-business-research/research/documents/BIN_August_2014.pdf (October 21, 2014)