Federal tax restructuring: experts consider impacts on states and localities.

The United States Congress is considering several proposals to restructure the federal income tax system. These initiatives consist of eliminating the income tax and replacing it with a new federal retail sales tax; a value added tax; or a flat, single-rate income tax. Congressional hearings, conferences, and economic analyses are being conducted to provide federal lawmakers with information they will need to assess the various proposals. State and local government finance officials will likewise need to analyze the key issues surrounding federal tax reform proposals, particularly those affecting their ability to finance projects, provide services, and raise revenues.

To begin developing a better understanding of the leading congressional proposals and their impacts on state and local governments, GFOA organized a panel discussion at its annual winter meeting of its standing committees, January 30-31, 1996. Speakers from Congress, Wall Street, and research/consulting groups explored some of the potential effects the tax proposals would have on state and local government finances, including how borrowing costs might be affected, what could happen to state and local revenue systems, whether states and localities would be subject to federal taxation themselves, how employee benefit plans might change, and what impact there might be on retirement savings. This article summarizes the views of the panelists: Paul Auster, majority tax counsel, House Ways and Means Committee; Steven D. Gold, senior fellow, The Urban Institute; Jane G. Gravelle, senior specialist for economic policy, Congressional Research Service; and Peter Shapiro, senior vice president, EuroBrokers.

Evaluating the Overall Benefits

Panelists generally agreed that the goals of the current tax restructuring proposals were to address broad policy objectives, such as simplifying tax preparation and administration, making the tax burden more equitable, and stimulating economic growth by increasing the incentives for taxpayers to work, save, and invest. While it was noted that each proposal supported one or more of these goals to some degree, there was great skepticism on the part of some of the speakers regarding whether many of the purported benefits of the proposals would be realized. In addition, the presenters cautioned that the potential benefits of alternative tax structures would need to be weighed against the costs. In other words, Congress would have to assess the possible impacts on specific market segments, such as state and local governments, before taking any action. In a wide-ranging discussion of economic impacts of the various plans, the topics described below were highlighted.

Distributional Effects. Nearly all of the alternative proposals result in a tax system that is considerably less progressive than the current one. Accordingly, one would expect a redistribution of the tax burden across income classes, with lower income groups paying a greater portion of the tax burden after reform than they do now. In addition, the different tax treatment afforded various types of income would raise important equity issues. Under some proposals, earned income would be subject to income taxation, but unearned income (interest on all investments) would not be taxed. Since different types of income are usually associated with younger and older populations, the tax burden would be spread differently within income groups and across generations. Distributional effects among asset classes also would arise: under most of the tax reform proposals, taxable assets would be better off and tax-exempt assets would suffer.

Simplicity. While one of the leading arguments for tax restructuring is to simplify the compliance and administrative costs of the current system, significant gains were not predicted. Most of the tax proposals would foster simpler compliance; however, the majority of individuals, who already file very simple tax returns, would not be significantly affected, and administrative simplicity would be a fairly trivial benefit compared to the potential impacts. Gold, an expert on state and local taxes, observed that a value added tax needs a lot of "enforcers," and its adoption therefore would not mean administrative burdens would be reduced.

Revenue-producing Capacity. Most panelists did not believe that the proposed alternative tax structures would be able to raise the same amount of revenue collected under the current income tax. Also mentioned was the diminished federal revenues that would be collected during times of economic growth. Under a flat tax, taxpayers would not pay proportionately higher taxes as they earned higher incomes. It has been suggested by some that federal revenues would be sufficient if a new tax structure was adopted because increased economic activity would be expected, which would generate increased revenues. Several panelists suggested, however, that the increase in revenues would not be significant enough to offset revenue losses attributed to lower tax rates.

Economic Growth. The increased rate of capital formation needed to produce economic growth may not occur. The predicted drop in overall interest rates could be insignificant and perhaps undetectable, according to some of the participants. Shapiro noted that a decline in interest rates would be driven by changes in monetary policies and federal budget-balancing efforts and not because of tax code changes. He also noted that savings rates are insensitive to changes in after-tax yields and cited a Goldman Sachs study that predicts a $30 billion increase in savings, which sounds considerable but only amounts to a 0.4 percent increase in the savings rate.

Impact on Tax-exempt Borrowing

Under most of the tax proposals, the benefits associated with tax-exempt financing would disappear. Shapiro predicted that state and local government borrowing would become much more costly, with interest rates increasing by 150 basis points. In fact, it was noted that the expectation that some kind of flat tax would be enacted caused an initial significant decrease in the spread between taxables and tax-exempts. Shapiro's assessment is considerably different from the view of proponents who claim that all interest rates will fall and that state and local government borrowing costs will decrease, but this assessment is echoed by many other market participants.

As Congress considers proposals to change the tax status of all investment income, it is important to note that a large percentage of the investors in the U.S. capital markets have no concern with tax code changes because they are tax-exempt entities themselves and are not subject to income taxation. Another interesting point that will affect the political calculus is the fact that the tax-exempt market represents only 5.5 percent of the total U.S. capital markets. Therefore, taxable investors would be expected to have a much stronger voice regarding the final direction of tax restructuring than tax-exempt investors.

Looking beyond the impacts on the tax-exempt capital markets, there are concerns for the future of the public investment in capital stock. Changing the manner in which tax-exempt bonds are treated under the tax code will have a significant impact on the types of projects state and local governments will undertake. This, in turn, could have a major impact on the economy, as public investment declines. Auster explained that Congress will hold a series of hearings to develop an understanding of these types of issues.

Two other questions tackled by the panelists were Wall Street's support for tax exemption and the likelihood that Congress would provide some other form of subsidy to states and localities if tax exemption were lost. It was suggested that Wall Street may not be an ally this time around if the financial industry stands to gain from the elimination of taxation on all investments, and it was thought by some that incentives may be necessary to stimulate state and local investments. Options include grants and interest rate subsidies.

Revenue Impacts

Tax restructuring proposals will significantly impact the nature of state and local government revenue systems and the tax policy choices available to these governments. State/local income and property taxes would not be deductible under any of the proposals. Eliminating these deductions is likely to have a significant effect on the willingness of taxpayers to pay those taxes and will make it considerably harder to raise revenues at the state and local levels in the future. Secondly, state income taxes, which currently make up one-third of state tax revenues, could be altered significantly if the federal income tax is eliminated or the tax base on which states piggyback their taxes is changed. If the federal government changes the income tax, 41 state governments, as well as some local governments, would need to conform to the federal change.

There also would be second-order effects of certain tax structure proposals. A federal sales tax would undermine state and local sales taxes by making it more difficult to increase those taxes and would reduce state and local flexibility by forcing compliance with the federal tax base. Another issue is whether state and local governments would be required to pay a federal sales tax or a federal value added tax. Currently, in Minnesota, the state agencies and local governments are required to pay the state sales tax. Thus, there already is a precedent for governmental entities paying sales taxes, although a 6 percent state sales tax is quite a different from a 21 percent federal tax rate.

State and Local Employee Benefits

Panelists agreed that employee benefits would receive less preferential treatment under all of the leading tax reform proposals, altering the incentives to offer these benefits. If, as some believe, tax benefits are the driving force behind the formation and size of health and pension plans, then the tax restructuring proposals could create a serious concern for these employee benefit systems, Gravelle warned.

Regarding pension systems, several of the proposals would afford the same tax treatment to individual savings as is provided for qualified pension plans. Thus, employer-provided pension plans would lose much of their attractiveness as an employee benefit, since employees would be able to achieve similar results through their own savings. Many of the tax proposals also would require that individual contributions to pension plans be made with after-tax dollars, and one proposal would require individuals to include employer contributions in their taxable income. Both of these initiatives also would decrease employee demand for pensions.

Another potential impact would be the elimination of the many pension qualification requirements that are imposed on retirement plans. These rules would be difficult to justify if individuals could achieve similar pension savings on their own. The complex coverage and nondiscrimination rules would no longer be defensible, and dollar limits on contributions and distributions also would be inappropriate in a system that permitted unlimited savings outside of the qualified plan context. In addition, some proposals would no longer allow employers to deduct their contributions to pensions.

Due to the combined effect of lower employee demand for pensions and lost employer incentives to provide them, overall national savings could significantly decrease. Although many employees might increase their personal savings, the overall savings of lower-paid employees are likely to dwindle, as the employer would not be contributing to them and employees would not have the personal resources to offset the loss of the employer contribution.

The advantages for health benefits are diminished under the tax proposals as well. For individuals, some of the tax alternatives would implicitly tax employer-paid health insurance as part of an individual's income, and one proposal also would tax individual health premiums. Regarding employers, most of the tax alternatives would no longer allow a deduction for employer-paid health insurance or any other fringe benefit. To ensure equity between employees of tax-exempt employers and everyone else, one of the proposals would require tax-exempt entities, including state and local governments, to pay an excise tax based on the value of health care and fringe benefits. Although there are reasons to have group health plans regardless of their tax treatment, these proposals certainly will remove incentives to begin or expand health benefits to cover more people or provide more benefits. In addition, the tax proposals do not include provisions to increase health coverage to those currently uninsured.

While it is difficult to determine the full extent to which employee benefits will be affected by any new tax structure, Congress and the administration need to be aware of the broad-based implications. The potential impact of tax proposals on employee benefits therefore will need to be explored further.

Outlook for Tax Reform

At the conclusion of the discussion, panelists were asked to predict what the federal tax system would look like in three years. Their views on the prospects for tax reform ranged from a belief that a substantial overhaul would be enacted to the opinion that no changes at all would occur. Those who were skeptical about the likelihood of dramatic changes cited citizens' inability to accept dramatic changes. Like national health care reform, substantial tax reform is attractive at first, but as the details are revealed, the support tends to whither away.

Some panelists believed a significant effort would be made to have the tax code restructured, though the success of the effort would depend primarily upon the make up of Congress and the White House after the 1996 election. Those that believed there would be only minor changes to the tax code surmised that changes would be made to dividend deductibility and capital gains reductions but that no changes would be made to the tax-exempt status of municipal bonds.

Whether or not any tax reforms are enacted, panelists agreed that municipal bonds most likely will continue to slump in comparison to U. S. Treasury securities. They attribute continued contraction to generational shifts in investment preference - baby boomers favor equities and are willing to ride out dips in equity markets. The younger investors - who did not go through the Great Depression or World War II and have only a vague memory of the bear markets of 1973 through 1975 - are not as skeptical of the markets as are their parents.

One point all speakers could agree on was the extent to which politics would influence tax restructuring. Any tax system that would emerge from Congress would most likely contain exemptions, exclusions, or other preferences. Federal lawmakers would face significant pressure to continue long-standing tax policies, such as the mortgage interest deduction and the deferred tax treatment of retirement benefits as well as the other tax code provisions discussed in this article. Even if Congress did adopt a new tax system that lacked many preferences, there was a high degree of certainty among the discussants that, over time, many preferences would reappear as Congress reacted to lobbying efforts.

RELATED ARTICLE: SOME POTENTIAL IMPACTS OF TAX RESTRUCTURING PROPOSALS

On State and Local Government Borrowing

* Elimination of tax-exempt financing

* Higher state and local government borrowing costs

* Decline in public investment

* Changes in the types of public projects undertaken

On State and Local Government Revenues

* Pressure to reduce state/local income and property taxes if they are no longer deductible

* Need to conform state/local revenue-raising policies to the federal tax alternative

* Reduction in property tax revenues if property values decline with a change in the mortgage deduction

* Imposition of new federal sales tax or value added tax on state/local governments and/or their services

On State and Local Employee Benefits

* Reduction in the attractiveness of employer-provided pensions if individual savings are afforded the same treatment as qualified pension plans

* Elimination of the deductibility and/or the tax deferral of employer/employee contributions to pension plans

* Taxation of health care premiums and other fringe benefits of employees

* Imposition of an excise tax on state and local governments based on the value of their employer-provided health care and fringe benefits

Compiled by GFOA Federal Liaison Center staff

JEANNINE C. MARKOE, a legislative analyst with GFOA's Federal Liaison Center, wrote this article with the assistance of CATHY SPAIN, director of the Federal Liaison Center.