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Issues in Montana tax reform.

Issues in Montana Tax Reform

Tax reform has become a perennial issue in Montana politics. Suggestions and proposals for the reform of state and local taxation are often as technically complex as they are politically divisive. Because of this, discussions among competing interests on tax needs and alternatives usually become "super-heated" in both rhetoric and emotion.

One useful method for sifting through the rhetoric is to examine how various state and local taxation measures in Montana compare with the nation as a whole, as well as with tax systems in surrounding states. It is also helpful to examine how taxes have varied over time in relation to income conditions in the state. Before making these comparisons, some criteria commonly used in evaluating alternative tax systems will be discussed.

Evaluation Criteria for State

and Local Tax Systems

Perhaps the first test that a system of taxation must meet is fiscal adequacy; that is, revenues raised through taxation should be adequate to fund the prescribed level of public services provided. Implicit in this notion of adequacy is that revenus should grow as the perceived need for additional expenditures on public programs grows. (1) In some cases, taxes and expenditure needs grow together almost automatically, as with income growth and increased demand for public services (although some adjustments in tax rates still may be required).

Another test most believe a good tax system should meet is that of economic neutrality; that is, similar businesses and economic activities should be taxed in a similar manner. This serves to minimize interference by the tax system in private economic decisions and also helps make a state's tax system more competitive with those of other state. (2)

One of the most widely accepted principles in evaluating the appropriateness of a tax system is equity. An equitable tax system is one that failry distributes the tax burdens across the population; it taxes individuals in equal circumstances equally (referred to as "horizontal equity") and taxes individuals in unlike circumstances differently (referred to as "vertical equity"). (3) The proposition that taxpayers should be taxed in relation to their ability to pay is one of the most common notions of tax fairness. Accordingly, a "progressive" tax system is one where the tax burdens of individuals progressively increase as their incomes rise. When relative tax burdens decrease as incomes rise a "regressive" tax system is in place .

Another important feature of a good tax system is accountability. A system of taxation should permit taxpayers to hold elected officials responsible for their methods of taxation; any changes in these methods should result from explicit legislative actions, rather than from complicated institutional arrangements largey hidden from the public. (4) Tax systems also should be relatively easy to administer and their effects on both taxpayers and the government should be as predictable as possible.

How a tax system is balanced in terms of state and local collections also is important. Ideally, this balance should reflect the relative needs to each level of government for the tax revenues being generated. A proper balance varies from state to state because the functional divisions between state and local government entities varies considerably among states. In general, public accountability is promoted when tax revenues spent by a statewide agency are raised by a statewide effort and revenues spent locally are raised locally. (5)

Diversity of Taxation

In the view of ACIR, a high-quality tax system also makes use of a diversity of revenue sources. By relying upon many sources of revenue, a tax system may be better able to weather unpredictable changes in the economy. Having a diversified tax system also spreads the burden of taxation andhelps keep tax rates in any particular area of taxation lower. (6) Ordinarily, states that rely heavily upon one area of taxation also impose relatively high tax rates upon it. This practice tends to distort private economic decisionmaking and can make a state's tax system uncompetitive in certain areas relative to other states. Furthermore, since no single form of taxation is ideal, spreading taxation among several sources reduces the likelihood that the faults of any one instrument of taxation will severely constrict and hamper a state's overall system of taxation. (7)

There are three major sources of state and local tax revenue -- property taxes, income taxes, and sales taxes. In the view of some, tax diversification ordinarily implies that states must rely, almost in equal amounts, upon each major source of revenue. (8)

However, some critics of strictly balanced tax systems contend such systems don't necessarily improve overall equity. For example, "adding a sales tax in a non-sales tax state may increase the regressivity of the tax system," depending upon its design. (9)

Differences in state and local circumstances also provide exceptions to this general rule. States with significant mineral resources, tourism, or other tax bases that "export" part of the region's tax burden to nonresidents can take advantage of these revenue-raising opportunities (within reason) and reduce tax burdens on residents without using strictly balanced tax systems. (10) These and other factors must be carefully weighed in considering the perceived advantages of greater tax diversification and balance.

Fiscal Capacity and Effort in Montana

How does Montana's tax system compare with other states? ACIR uses a number of methods for comparing tax systems. One of those involves notions of "tax capacity" and "tax effort." Tax capacity measures a state's potential for raising tax revenue from all available revenue sources if it takes those sources at national average rates (or rates averaged from those used by all of the states in the nation). Considered in this measure are "twenty-six widely used taxes," including property taxes, income taxes, and sales taxes as well as severance taxes and an assortment of license taxes. While neither Montana nor any other state relies upon all twenty-six taxes, the tax capacity of states measures what states could raise if they did rely upon all of these and imposed national average tax rates in doing so. (11)

Tax effort measures the extent to which a state makes use of its hypothetical tax capacity (as described above). Tax effort is calculated by "dividing a state's actual revenuess by its measured tax capacity" (both on a per capital basis). (12) The result is a ratio which indicates the overall burden on a state's tax bases, relative to the national average (which is always indicated by an index number of 100). Montana's index of tax effort for 1988 is 102 (see figure 1). Thus, the state's effort at collecting tax revenue in 1988 was slightly above the national average. This is down from 1985's tax effort (107 or 7 percent above average), but up considerably from 1983 (94 or 6 percent below the national average).

More than anything else, Montana's increasing tax effort in the 1980s is a reflection of the state economy's declining performance relative to other states, and a resulting decline in the value of the state's overall tax base (and tax capacity) relative to other states -- not a reflection of relative increases in state and local taxation in Montana. In fact, between 1983 and 1986, Montana's measured tax capacity went from about 5 percent about the national average to about 12 percent below the national average.

Sources of Taxation in Montana

How much various potential sources of tax revenue contribute to Montana's measured tax capacity and to what degree the state actually relies upon these sources for revenue is shown in figure 2. For each major category of taxation, the graph shows Montana's measured tax capacity for the tax, actual revenues generated using the tax, and the average tax capacity for the tax nationwide, all on a per capita basis.

The graph clearly indicates some of the more "salient features" of Montana's tax system. First, it shows that even though the state collects no general sales tax revenue (because it doesn't have a general sales tax), this potential source of revenue as measured by tax capacity is second only to property taxes in Montana. Second, "it shows that Montana uses the property tax at a level well above its capacity -- that is, at an effective rate well above the national average." (13) However, over 20 percent of Montana's taxable property value in 1988 was accounted for by mineral proceeds. Third, Montana's capacity for collecting personal income taxes is well below average, a clear reflection of the state's low per capita income.

Figure 3 indicates how Montana's tax collections compare with those of ten other surrounding states in the region. Using U.S. Census Bureau data, fiscal year 1988, revenues for a variety of taxes are shown on a per capita basis for each state; thus comparisons of relative tax burdens per person can be made. For

further comparison, relate per capita income estimates to relative tax burdens.

Montana's state and local tax revenues totaled $1,538 per person in 1988, ranking it seventh among the eleven states in the region (and thirty-first nationally). Montana's total revenues per person amount to 12 percent of state per capita income, ranking it fourth among the states in the region (and eleventh nationally). Per capita income in Montana is considerably below the national average and ranks ninth among the eleven states in the region. Eight of the eleven states in the region (including Montana) are below the average nationally in total revenue collections.

In the area of property taxes, per capita revenue in Montana totaled $670, third highest among the states in the region (and twelfth nationally). As a percent of per capita income, Montana's property taxes were fourth highest in the nation in 1988, trailing only Wyoming, Alaska, and Oregon. Conversely, individual income tax collections in Montana are considerably lower than average nationally ($303 per person vs. $359 nationally). The state ranks twenty-eighth nationally in income taxes per capita and twenty-fourth in income taxes as a percent of income.

Montana and Oregon are two of only five states nationally without a general sales tax (the others are New Hampshire, Delaware, and Alaska). Washington state's sales tax is the highest in the nation on a per capita basis. While it has no general sales tax revenue, Montana's selective sales tax revenue totaled $226 per person, making the state third in the region and seventeenth nationally.

Severance tax revenue on mineral production is considerably above average in Montana and two other states in the region. On a per capita basis, this revenue in Montana trails only that of Alaska ($2,044), Wyoming, ($480), and New Mexico ($194), and is only slightly greater than North Dakota's ($136).

In summary, both ACIR and Census data clearly show two areas where Montana's tax system most deviates from national averages. "By any measure, Montana relies much more heavily than most states" on property taxes and doesn't "utilize at all one of the major sources" of state and local revenue -- the general sales tax. (14) If the goal of the state were to reduce or remove these deviations, two things required would be: state adoption of a general sales tax and property tax relief.

Design of State Sales Taxes

In 1975, ACIR developed model legislation for the design of state sales taxes. In general, sales taxes should be broadly based and not exempt major categories of sales. With a relatively large sales tax base, states are better able to adopt lower nominal tax rates in collecting the desired revenue amount. A broad base also makes sales tax revenues more responsive to the general rate of economic growth and simplifies administration in collecting the tax. (15)

According to ACIR, sales tax coverage should include services as well as final goods' purchases but should avoid sales of intermediate goods and materials that become components of final goods in order to prevent double taxation. (16) Including services in the tax base increases the horizontal equity of the tax (taxing similar economic activities similarly). For example, "why should drycleaning services be exempt while retail sales of washing machines and laundry detergents are taxed?" Most states are moving toward the inclusion of services in their sales tax bases. As the national economy becomes more service-oriented, this inclusion makes the sales tax more responsive to economic growth. Inclusion of services also helps make sales taxes less regressive. (17)

Regressivity is an important issue in sales tax design. "The sales tax is generally considered a regressive tax"; that is, it tends to place a greater burden on lower-income individuals than on wealthier ones. Purchases of necessities such as food and utilities represent a larger share of available resources for low-income households than for high-income households. Hence, taxes on the sale of such necessities likewise places a greater burden on low-income households.

According to Cohen, states have three primary means for reducing the regressivity of sales taxes. The first involves adopting a progressive income tax to offset the regressive effects of a sales tax. However, this approach does have problems. For instance, there may not be a clear match between taxpayers subject to the sales tax and those subject to the income tax. Also, how one tax serves to offset another may not be readily understood by the public. Moreover, extensive adjustments in income tax rates of this type "may detract from other objectives such as economic growth." (18)

Another mechanism for providing sales tax relief is the use of the sales tax exemptions. The most common types of sales tax exemptions used by states include exemptions for purchases of food, prescription drugs, and clothing, and for payment of utility bills. However, while these exemptions serve to reduce regressivity in sales taxes, they can also significantly reduce the overall size of a sales tax base, thereby requiring a higher tax rate to achieve the same revenue objective. Of the forty-five states now using a general sales tax, twenty-seven exempt food, forty-four exempt prescription drugs, twenty-six exempt utility bills, and six exempt clothing. (19)

A third mechanism for sales tax relief is the tax credit (a credit against what otherwise must be paid in income taxes or a credit paid as a separate refund). If used in conjunction with income taxes, this credit should be payable to individuals even if they pay no income taxes (such as with extremely low-income individuals). The credit also can be fixed amount or can be phased out as income rises. (20)

The principal advantage in using a tax credit rather than tax exemptions is that tax relief can be targeted more precisely to low-income households. For a fixed amount of state revenue loss, more of it can be directed to benefit low-income households. The principal drawback of a tax credit is that it gives low-income persons sales tax relief only after they pay more for taxed consumer items -- rather than providing the more immediate tax relief achieved with exemptions. (21) Figure 4 indicates some major features of general sales taxes for states in the region. The median general sales tax among states nationally is 5 percent.

Instituting Property Tax Relief

As with sales taxes, property taxes can be quite regressive. They may "impose special hardships on homeowners" with fixed or declining incomes such as retired persons whose property wealth may be high in relation to their current incomes. States use a wide variety of measures in providing property tax relief. These include direct measures such as circuit breakers (credits or rebates for portions of property tax liabilities in excess of a certain percent of household income), homestead exemptions (exemptions for certain amounts of the assessed value or tax for certain households), property tax deferrals, and use of property classification systems in identifying some classes of property for tax relief. A variety of indirect measures also are used. (22)

Many states using homestead exemptions extend these exemptions to all homeowners, thus failing to "target property tax relief for those who need it most." A homestead exemption targeted to low-income households, such as Montana uses, alleviates this problem. However, "homestead exemptions also miss low-income renters who may be paying property taxes passed on by landlords." (23)

ACIR has long supported the use of state-financed circuit breakers. As its name implies, a circuit prevents property tax "overloads" for certain households without cutting off revenue from those able to pay. While these devices can be administratively complicated, circuit breakers better target relief to low-income households. (24)


There are many ways of judging the relative merits of alternative tax policies and alternative overall systems of state and local taxation. No system is without limitations and, at best, policymakers can only weigh the pluses and minuses of various options in attempting to devise and adopt a good overall tax system.

The political climate created by a struggling state economy both undermines and necessitates critical examination of the system of taxation. As shown in Figure 5, total personal income in Montana in inflation-adjusted dollars grew little or not at all during the early and mid-1980s. Moreover, a once-expanding population base has been declining. During this period, state tax collections on a per capita basis climbed to nearly 13 percent of state per capita income (see figure 7). Relating total state taxes to total personal income in this way is one method for gauging the overall state tax burden.

However, the state's economy has been on the mend in recent years. Total personal income in constant dollars has increased each year since 1985. While it still lags behind natinal levels, real income in Montana on a per capita basis increased by over 13 percent between 1985 and 1989. Meanwhile, per capita tax revenue in constant dollars has fallen slightly. As a result, state tax revenue per capita as a percent of per capita income has declined in recent years, falling to less than 12 percent since 1987.

If the state's economy continues to gradually improve and remain healthy, the climate for careful and prudent reevaluation of critical tax reform issues by state policy makers may improve as well.

(1) Testimony of Carol Cohen, senior analyst, U.S. Advisory Commission on Intergovernmental Relations, Washington D.C., before the Montana Tax Reform Coalitioni, Dec. 11, 1989 (transcript), p.1.

(2) ibid, p.2.

(3) ibid, p.3.

(4) ibid, pp3-4.

(5) ibid, p.5.

(6) ibid, p.4.

(7) ibid, pp.4-5.

(8) ibid, pp.5-6.

(9) ibid, p.6.

(10) ibid, p.7.

(11) ibid, p.8.

(12) ibid, p.9.

(13) ibid, p.9.

(14)ibid, pp.10-11.

(15) ibid, p.11.

(16) ibid, p.12

(17) ibid, p.12.

(18) ibid, p.13

(19) ibid, pp.13-14.

(20) ibid, p.14.

(21) ibid, p.14.

(22) ibid, p.16.

(23) ibid, p.16.

(24) ibid, p.17.
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Title Annotation:Montana Tax Reform
Publication:Montana Business Quarterly
Date:Dec 22, 1990
Previous Article:Higher education in Montana: public perceptions and preferences.
Next Article:Recession and its after-effects: the state and local outlook for 1991.

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