September 16, 2014

Principles of a Privilege-Free Tax System, with Applications to the State of Nebraska

  • Jeremy Horpedahl

    Assistant Professor of Economics, University of Central Arkansas
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Nebraska is one of several states considering ways to make its tax code more efficient and fair. Every state’s code includes special privileges for politically favored industries, businesses, or groups of people, which typically require higher taxes on other economic activity.

As economist Jeremy Horpedahl demonstrates, these tax favors have real costs for working taxpayers. In a new Mercatus Center at George Mason University study, he defines government-granted tax privileges and outlines key principles for reforming sales, property, and income taxes, and economic development tax incentives.

The basic principle of a privilege-free tax system is simple: No individual or business should be treated differently from any other similarly situated individual or business. After removing privileges, policymakers should next lower tax rates across the board, in a way that applies equally to all taxpayers. 

To read the paper in its entirety, click here. See below for the author's case study on Nebraska, and for general principles all states can apply.

Case study: Nebraska

If Nebraska eliminated tax privileges and used the resulting revenue to lower tax rates, the average family in the state would save over $3,200 dollars, with no reduction in government services or spending.

  • Nebraska doled out over $2 billion in economic favors through its tax code in 2012, the latest year for which full data is available.
    • These privileges equal about ten percent of Nebraska’s total 2011 revenue, and about 29 percent of its total sales, income, and property tax collections.
  • Sales tax favors accounted for $654.8 million of this figure—equal to about 27 percent of total 2011 sales tax collections.
    • Horpedahl recommends that Nebraska begin taxing services, which should not be distinguished from physical items for economic purposes.
    • Tax exemptions on specific goods including fuel, groceries and motor vehicle trade-ins should be removed (the benefits these provide to the poor could be offset in other ways).
    • Finally, taxes on intermediate business-to-business transactions should be eliminated, because these amount to double taxation after business-to-consumer transactions are taxed.
  • Property tax favors accounted for $475.6 million.
    • These privileges take three main forms: the Homestead Exemption, Property Tax Relief Credit, and the 25% tax break for agricultural and horticultural land, which is treated differently than other business real estate.
  • Income tax favors accounted for $841.5 million.
    • Horpedahl recommends removing itemized deductions that don’t apply equally to all Nebraskans, such as the Home Mortgage Interest Deduction.
    • Expanding the state’s Earned Income Tax Credit could offset the costs of other tax reforms for low-income Nebraskans.
  • Tax credits for economic development accounted for $123.3 million.
    • These incentives are so generous that Nebraska has the lowest effective tax rate for new businesses, but only the ninth-lowest for established businesses.
    • Companies earned a total of $332 million in tax credits (not all of which have been spent yet). Together the used and unused credits equal 71 percent of the corporate taxes collected by the state since 2006.

Principles of a privilege-free tax system for all states

The author estimates that nationwide, state tax privileges cost American taxpayers $432.5 billion annually—about 40 percent of the roughly $1 trillion they spend on federal tax expenditures.

 Sales Taxes

  • Intermediate business-to-business transactions should be exempt from taxation because different industries have different production processes which require varying amounts of transactions. Levying sales taxes only on final consumer purchases avoids this problem.
  • There is generally no sound economic reason for treating services differently from goods. As the economy becomes increasingly service-based, state sales tax revenues as a percent of the economy will tend to decline, requiring higher taxes elsewhere to fund a given level of government spending.
  • Exempting basic necessities like groceries from taxation, while well-intentioned, is not an effective method for assisting those in poverty. Better options include making Earned Income Tax Credits more generous.

 Property Taxes

  • The primary form of economic privilege found in the property tax is the practice of taxing property at different rates (or assessing it differently) based on how the property is used, such as differentiating between personal, business, and agricultural properties. It is somewhat strange to single out agricultural property as being distinct from business property.
  • While a privilege-free property tax is ideal, a policy of property tax exemptions for low-income taxpayers would be preferable to current system.

Income Taxes

  • Economic privilege in the income tax code arises when individuals or corporations are able to lower their tax burden by engaging in certain activities. Even if it does have some benefits for society, the costs must also be considered.
  • One major example of privilege in federal and state income tax codes is the home mortgage interest deduction. This is the largest explicit form of tax privilege offered to individuals at the federal level, yet only about one-fifth of taxpayers take this deduction. The benefit for middle-class families (those with $30,000–$75,000 in annual income) is on average between $100 and $200. Meanwhile, about three-quarters of high-income taxpayers with more than $200,000 in annual income take the deduction, and receive almost $1,800 on average.

 Economic Development Tax Incentives

  • Tax incentives intended to spur economic development through job creation and increased economic activity are often justified by politicians on efficiency grounds. However, upon close examination, this is frequently overstated.
  • Many state governments offer businesses that agree to relocate to their state the right to pay lower tax rates, or avoid one or more taxes, typically for a limited time. Most recent research suggests that, at least on average, these tax incentives do not pay off for local and state governments.
  • Not only do bureaucrats lack the information to pick which companies will succeed, they may also lack the incentive due to the lobbying of potential beneficiaries. Thus, states may find it in their interest to avoid all such development-based tax incentives in a privilege-free state tax code.