Budget tax plan: steps in right direction, but more cuts necessary to make Ohio competitive

Greg R. Lawson Jun 24, 2013

As the biennial budget process nears its conclusion, leaders in both the Ohio House of Representatives and Senate have put together a new tax reform package that differs from Governor Kasich’s initial proposal and differs substantially from either version the chambers separately passed. The question before the conference committee is whether these changes will move Ohio in a more competitive direction.

On the positive side of the ledger, legislative leaders and the Kasich Administration deserve a great deal of credit for continuing to recognize Ohio’s relatively high marginal personal income tax rate (PIT) as a challenge that must be overcome. To that end, the new proposal calls for a 10 percent cut to be phased in over the next three fiscal years. Over that time, Ohio taxpayers are projected to keep nearly $3.2 billion more in their pockets. In addition, small business owners operating as “pass through entities” will retain $1.7 billion in revenues in order to continue enhancing their economic competitiveness. Cumulatively, this yields over $4.8 billion in tax savings.

Although the Tax Foundation has raised questions regarding the long-term job creation aspects of the small business cut and raises questions with the new proposal, the overall thrust of lowering income taxes is significant. As Dr. Arthur Laffer and Stephen Moore show, low income tax states see population growth vs. those with higher income taxes:

For example, over the most recent 10-year period, 2001-10, the average of the nine states without income taxes— Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming—had 14% growth in population—versus 9% for all states and only 5.5% for the nine highest income tax states—Oregon, Hawaii, New Jersey, California, New York, Vermont, Maryland, Maine, and Ohio. Job growth in the nine no-income tax states was 5.5%, versus close to zero in the average state and -1.6% in the highest tax states. On balance, no-income tax states have two and one-half times the population growth of the highest income tax states, and yes, the no-income tax states even have higher tax revenue growth than the average of all states and the highest income tax states.

Furthermore, Richard Vedder makes the case that shifting from income to consumption (or sales) taxes is more conducive to economic growth:

It would appear that from the standpoint of maximizing the rate of economic growth, the optimal state and local fiscal policy would be one in which the overall tax burden is comparatively low, coupling high sales taxes with low income and property taxes.

The proposed elimination of the 12.5 percent “rollback” the state offers to local government bodies on new local levies offers an opportunity for true tax transparency. While this rollback has offered tax relief for homeowners facing new levies and now runs the risk of subjecting them to a 12.5 percent increase on most new levies that are passed, it also exposes taxpayers to the full cost of government. The state subsidy to local governments has historically made it easier than it otherwise would be for local entities to pass levies since the state was in effect subsidizing 12.5 percent of the cost. This provision may impose some measure of indirect spending discipline by submitting to the voters the actual cost of the levy. Voters may then be less likely to finance exorbitant collective bargaining packages.

The bill also implements means testing for the homestead exemption. The homestead exemption’s expansion under former Governor Strickland turned the program into an expanding black hole for state expenditures. It expanded the exemption’s initial purpose of protecting the disabled and elderly on fixed incomes into a far larger program that risked becoming unsustainable.

Accordingly, steps that are being taken to shift the tax base and encourage income growth and capital formation are decidedly positive.

But are the changes sufficient? While the 10 percent income tax cut is significant, it still leaves Ohio with a top marginal rate of 5.3 percent. This keeps Ohio’s state income tax rates (excluding Ohio’s extraordinary local income taxes) higher than three of our neighbors: Michigan, Indiana and Pennsylvania. This maintains Ohio in a position of competitive disadvantage—a position that is only exacerbated by other tax increases found in the bill.

The proposal increases the state sales tax from 5.5 percent to 5.75 percent and does so with a limited expansion of the tax base (digital downloads, magazine subscriptions, cigarillos, or small cigarettes, are added as part of “loophole” closures). Consequently, Ohio’s average sales tax rate (both state and local) will increase from the current 6.80 percent, which is already higher than nearly all of our immediate neighbor’s average: Kentucky (6 percent), Michigan (6 percent), Pennsylvania (6.34 percent) and West Virginia (6.04 percent). Once the raise is enacted, it will also eclipse Indiana, which currently has a combined rate of 7 percent. The combination of higher income and higher sales tax than our neighboring states is a bad combination.

Other revenue enhancements include a lowering of the exemption for the Commercial Activities Tax (CAT) from $1 million to $500,000, thus subjecting more high volume, small margin businesses to this tax.

The bottom line: the new tax proposal is a decidedly mixed bag. There are several very positive provisions that represent movement toward a better overall tax system in Ohio—changes that have the salutary effect of leaving more money in the pockets of Ohio’s taxpayers. But more is needed to make Ohio competitive. Without further major income tax reductions, the revenue enhancement in the proposal could subject Ohio to the worst of all worlds: relatively high income and sales tax rates.