Texas-style tax cut: a commission, with business support, was able to do what the legislature couldn't--change the tax structure in Texas.

After years of backing and filling, Texas lawmakers finally cut the state's over-extended local property tax last year. The Texas Supreme Court made them.

In a spring special session, legislators reduced the school property tax rate by a third, and made up the difference by replacing the outmoded and often-ignored state franchise tax with a broad-based business tax.

Even then, it wasn't simple. The courts and the Legislature have haggled over the Texas school finance system for years.

After watching the Legislature go through one regular 140-day session, and four special sessions that he called, and still not come up with any solution to the property tax dilemma, Republican Governor Rick Perry did something desperate. He called on John Sharp, the former Democratic state comptroller and his former friend from student days at Texas A&M University, to chair an advisory panel called the Texas Tax Reform Commission.

The reason Sharp is described as a "former friend" is that he and Perry had squared off in the 1998 race for lieutenant governor. Perry, with the enormous help of then-Governor George W. Bush's re-election coattails, was elected.

What caused Perry to turn to his Democratic rival? Partly desperation. But Perry also realized, after a chance meeting at a skeet shoot where the two re-established their friendship, that Sharp--a legislator for eight years, member of the Texas Railroad Commission for four years, and the state's tax collector for another eight years--is one of the brightest experts on both tax policy and politics in Texas. The tax problem was tied in such a convoluted knot that it required a Houdini dealmaker--whom business folks and politicians alike respected to untie it.

EQUALIZE SPENDING

For several years, Texas courts had ruled that public school per pupil spending should be equal, no matter whether the school district is rich or poor.

Most other states use a three-legged taxing system, collecting levies on property, sales and income. But Texas is one of a handful of states with no income tax. Even though one has been suggested from time to time, most officeholders would rather handle rattlesnakes than vote for an income tax.

In 1993, under an earlier order from the Texas Supreme Court to equalize per-student spending, legislators turned to a system that quickly was nicknamed "Robin Hood." That's because the state required richer districts, with greater property wealth, to share their funds with poorer districts.

Legislators also set a lid on the tax of $1.50 per $100 of taxable property. That worked for a while, but in recent years, more and more school districts reached the maximum. As they did, their abilities to spend what they felt was necessary for adequate education was hamstrung.

Richer districts, in particular, hated the system. A few school boards were shipping out millions of dollars to other school districts, while having to cut teachers and extra-curricular activities to keep spending per student equal.

Efforts to do away with Robin Hood always ran into a major problem: About nine-tenths of the public school students were in districts that received rather than sent out property tax money. If Robin Hood were to be banished, replacement money had to be found.

SHRINKING STATE SHARE

Over the years, the state's share of funding public schools had dropped from 80 percent in 1949, when a new financing system was established, to 38 percent by 2004. Clearly, school officials around the state thought the state isn't doing its share, and the Legislature and governor are to blame.

In 1997, then-Governor Bush sought to increase the state's contribution to school costs, and move away from dependence on property taxes to fund schools. But the alternative tax package passed by the Democratled House with Bush's backing was killed by the Republicans in the Senate.

Although poor districts had brought suits before that had forced the Legislature to do something, this time the rich and poor school districts banded together to sue the state. Part of the contention was that the state wasn't spending enough money to educate its children. But the more compelling and obvious argument was that Texas was, in essence, forcing a statewide property tax on local school districts. And Texas legislators and voters had passed a constitutional amendment in 1982 banning a state property tax.

The plaintiffs at the trial in the summer of 2004 argued that because more than half the school districts were at the $1.50 lid, with more joining each year, the local districts were forced to levy local property taxes, but had lost any control over the rate.

The plaintiffs were helped by Bill Ratliff, the former Republican state senator who had written the Robin Hood bill in 1993. He told the court that the bill was written under duress, and with so many districts now at the $1.50 cap, it obviously had outlived its usefulness.

In late 2004, State District Judge John Dietz ruled that school funding was inadequate and the property tax collection system unconstitutional. He gave the Legislature, which convened in regular session in January, until Oct. 1, 2005, to fix the problem.

Lieutenant Governor David Dewhurst, the presiding officer of the Senate, worked to pass a gross receipts tax that many businesses opposed. One retailer, for example, would have had to pay more than a third of its net profits in taxes. Plus, almost no businesses in Texas were allowed to even see the Dewhurst tax until it was being debated. The House killed it.

On the House side, the plan offered was a tax on businesses per employee, referred to as a "head tax." Small businesses with few employees liked it, but large employers, like retailers and airlines, didn't. It also died.

The Legislature adjourned after 140 days with no solution. A few months later, Perry turned to Sharp.

Meanwhile, the Texas Supreme Court overruled the part of Judge Dietz's ruling that said spending was inadequate, while conceding that spending needed to be raised. But the justices agreed that the collection system was indeed a state property tax, and thus unconstitutional. They gave the Legislature until June 1, 2006, to fix it.

COMMISSION GOES TO WORK

The 24-member tax commission held hearings all over the state. Sharp also worked closely with the business community to develop a new tax to replace the tattered franchise tax.

(Once, corporations paid it because it gave their executives immunity from personal liability. Partnerships escaped the tax but were subject to personal liability. A law passed later extended liability protection to partnerships. After that, large corporations like Dell converted to partnerships and quit paying the franchise tax. The result was that many companies were escaping the tax entirely.)

Originally, many commission members wanted to increase the sales tax and remove some or all exemptions. The Texas state sales tax is 6.25 cents on the dollar, and cities and metropolitan transit districts are allowed to tack on an extra two cents. The result is that the sales tax for most Texans is 8.25 percent. Sharp opposed a sales tax hike and eventually prevailed, but it wasn't easy. He credited an organized effort by the Industrial Areas Foundation, a parent group of organizations like Austin Interfaith, with helping to kill the sales tax idea. They had dozens of people at every tax commission hearing to talk about the onerousness of the sales tax on the poor.

"Some wanted just to make it a big sales tax and take out all the exemptions, including food," Sharp says. "And I knew that could never pass, because half the sales tax is paid by businesses, and they didn't want it. And consumer groups didn't want sales tax increases to pay for property tax relief, having poor folks pay for richer folks to get a tax cut. So the first thing we did was we brought in the business community, which basically as far as I could see hadn't been done. So we said that we needed them to come up with taxes."

A SOLUTION

The business tax Sharp crafted used gross revenue as a base, and then allowed businesses to deduct either the cost of goods sold, or all personnel costs, including salary and benefits, to encourage businesses not only to hire people but to give them health care. "One of the things I learned as comptroller is that you can devise a tax for big manufacturers, but it won't work for the wholesalers and retailers, and vice versa," Sharp says. "So that's where we came up with a choice, where you can pay a tax on payroll or on goods sold. You get to choose whichever is more beneficial to you, and you get to change it every year.

"By using the bifurcated rate, we were able to get a bill that the manufacturers, the wholesalers and the retailers could support. Not so much that they thought it was the best thing since sliced bread, but the alternatives had them scared to death."

The Sharp commission also proposed that wholesalers and retailers be taxed at 0.5 percent and everyone else at 1 percent, exempting small businesses with less than $300,000 in annual gross revenues. Sharp says that division is similar to the different rates used in Washington State.

One sticking point was that the proceeds of the tax shift went solely to reduce property taxes, with no new money for schools. Sharp knew that the state's school superintendents could block it. So with the help of Austin Independent School District Superintendent Pat Forgione, Sharp talked to groups of superintendents all over Texas.

"I met with maybe half of them in the state and told them I knew they weren't going to be for it because there wasn't any more money for schools," Sharp says. "And they could kill it. But I told them that there wasn't ever going to be any money for schools unless we got past this sticking point.

"The superintendents took a long-term view and agreed to say, 'Let's fix this, and let's let the process work,'" Sharp says. "And thanks mostly to Florence Shapiro [the Piano Republican chair of the Senate Education Committee], the schools eventually wound up with billions."

When the commission initially took its plan to legislators, many were skeptical. Sharp and Perry boosted the persuasion process with an almost daily string of press conferences featuring business groups endorsing the plan, including the Texas Association of Business, doctors and others. Sure enough, the plan passed the House virtually intact.

The Senate was another matter. Lieutenant Governor Dewhurst had beaten Sharp in a hard-fought race for lieutenant governor in 2002, and opposed Sharp's appointment. Dewhurst said the Sharp plan gave too much property tax relief. But several Republican senators, led by Shapiro, sweetened the pot with a few billion from the surplus for schools and helped push the bill through to an unanimous vote. The House overwhelmingly concurred with the Senate's version.

The eventual result was that the local property tax lid dropped to $1 per $100 valuation. The Legislature appropriated several billion dollars from a budget surplus to fund the tax cut in the short run. And to protect against school districts continuing to raise the property tax above that, the Legislature allowed a one-time increase of up to four cents. Anything beyond that would require a vote of the district's people. And if appraisals are raised, the tax rate has to be adjusted to keep the revenue flow the same.

The new business tax, plus a $1 increase per pack in the cigarette tax, came on Jan. 1, 2007. The business tax for 2007 will be due on March 15, 2008. And now, Texas will get a chance to see how the new tax system and approach works.

Sharp said while the commission was meeting that the business and cigarette tax weren't currently enough to cover the property tax cut, but predicted economic growth would boost what they will produce. However, budgeters and Lieutenant Governor Dewhurst and House Speaker Tom Craddick have already cautioned legislators not to spend all of a presumed budget surplus, since some of it will almost certainly be needed to help reduce the property tax.

Meanwhile, Sharp says he's been invited to visit about 30 states to discuss the new approach to taxing business.

"The business community likes it, and it raises some money," Sharp says. "We had about 90 percent of the businesses for it. You just can't be excluded from the tax base, and then say at the same time you support education. Either you do or you don't. You can't very well say you're for schools and not be willing to pay for them."

TURNING TO OLD FRIEND PAYS OFF

Republican Governor Rick Perry's selection of Democrat John Sharp to head a tax study commission was a bold move.

They'd been friends at Texas A&M University, in the same unit in the Corps of Cadets, and elected to offices: Sharp as student body president, Perry as yell leader. (Not cheer leader. Aggies yell. They don't cheer.)

After graduation, Sharp worked in Austin for five years as an examiner for the Legislative Budget Board. Perry became an Air Force pilot. In 1978, Sharp won a seat in the Texas House of Representatives. Not quite four years later, he won a special election for the Senate seat of a member who died. Perry returned from the Air Force to his family's ranch, and in 1984 was elected to a vacant House seat as a Democrat.

In 1986, Sharp was elected to the three-member Texas Railroad Commission.Three years later, Perry accepted the party-switching invitation of then-U.S. Senator Phil Gramm, a former A&M economics professor and former Democrat, and declared he was a Republican. In 1990, he narrowly upset Democratic populist Jim Hightower for Agriculture Commissioner.

Also in 1990, Sharp was elected Comptroller of Public Accounts, replacing Democrat Bob Bullock, who'd been elected lieutenant governor. Sharp and Perry were re-elected in 1994.

When Bullock said he wouldn't seek reelection in 1998, Sharp and Perry both ran for lieutenant governor, and their friendship fizzled. Perry, with Governor George W. Bush's re-election above him on the ballot, ran almost 700,000 votes behind Bush, but nonetheless beat Sharp by just under 70,000 votes--less than two percentage points.

Also in 1998, Houston multimillionaire David Dewhurst, a Republican energy tycoon spending millions of his own money, won the land commissioner job vacated by Democrat Garry Mauro, who haplessly challenged Bush. Dewhurst had considered running for lieutenant governor, but Perry backed him off.

In 2002, Sharp helped assemble the multiracial Democratic Dream Team: energy and banking multimillionaire Tony Sanchez of Laredo for governor, African-American Dallas Mayor Ron Kirk for U.S. Senate, and Sharp again for lieutenant governor. But as part of the Dream Team, Sharp got an even lower percentage of the white vote than in 1998. Dewhurst became lieutenant governor and president of the Senate.

In 2006, Sharp toyed with running against Perry for governor. But the challenge of raising millions as a non-incumbent, plus Perry's take-charge competence after Hurricanes Katrina and Rita in contrast to the ham-handed Bush administration response, squelched the idea.

So intermediaries suggested Perry draft Sharp to help solve the tax puzzle. When Perry announced the move at a press conference with Sharp by his side, it angered Dewhurst, who hadn't been consulted. But it helped solve three problems for Perry.

First, it sidelined the Democrat most likely to beat him if conditions were right.

Second, Sharp, now a tax consultant, had been a major adviser to his successor as comptroller, Republican Carole Keeton Strayhorn. The tax commission job sidelined Sharp from helping Strayhorn in her effort to unseat Perry.

And third, Sharp might actually be able to find a way out of the tax forest, and then sell it to the Legislature.

Darned if it didn't work. Sharp solved the problem, which got Perry out of a tight spot. Perry was re-elected with just 39 percent of the vote against Democrat Chris Bell and Independents Strayhorn and Kinky Friedman. Had Sharp been the Democratic nominee ... who knows?

WHAT THE TEXAS TAX PLAN DOES

* Cuts local property taxes by a third, to $1 per $100 valuation. Districts can add up to 4 cents for local programs, more if voters agree.

* Replaces Texas franchise tax. which many businesses had quit paying.

* Requires business to pay a margins tax of 1 percent, after deducting either the cost of goods purchased, or the cost of employee payroll and benefits. Retailers and wholesalers pay 0.5 percent. Sole proprietorships and general partnerships are exempt, plus companies earning less than $300.000 a year.

* Increases the tobacco tax by $1 a pack for cigarettes, to $1.41: smokeless tobacco goes from 35.2 percent to 40 percent of value.

* Taxes used-car sales at blue book value.

Dave McNeely wrote a column on Texas politics for the Austin American-Statesman for 26 years. After retiring in 2004, he continues to write a weekly column for more than two dozen newspapers, teaches at the University of Texas at Austin, and is co-writing a book on the late Lieutenant Governor Bob Bullock with former Dallas Times-Herald writer Jim Henderson. E-mail [e-mail].