Taxes in Texas

The recently released recommendations of the Texas Tax Reform Commission, endorsed by Gov. Rick Perry, were met with ire and praise from politicians and pundits alike. Tax reform has been such a key priority for the legislature that Gov. Perry convened two special sessions to address the issue, both ending in gridlock.

This time around, Gov. Perry promises his tax plan to be a panacea to the woes facing taxpayers and public schools. Pushed as a political compromise that aims to satisfy everybody (businesses, taxpayers, and the courts), the latest proposal is more of a mixed bag that benefits one group at the expense of another. Sold as a tax cut, Gov. Perry’s plan is in reality a tax shift.

A Brief Background of the Politics of Taxation in Texas

In Texas, taxes hold a particularly divisive role in electoral politics. It’s impossible to understand the tax system in Texas without knowledge of its economic and constitutional constraints. Creating an equitable and pro-growth tax system is inextricably tied to the burden of financing local school districts. This is, in part, due to several constitutional provisions:

For quite some time now, local schools were financed primarily through that school district’s local property taxes. But beginning in 1989, there was a string of several court cases that ruled the pre-1989 system unconstitutional since it did not maintain an efficient system of free public schools. In other words, since the old system led to inequality between schools in low-income districts and those in wealthier districts, it was ruled unconstitutional.

In response to this ruling, starting in 1990 the Texas legislature adopted various forms of the “Robin Hood” school finance plan. Roughly stated, Robin Hood, as its name suggests, forced wealthy school districts to subsidize poorer school districts through local school property taxes. Robin Hood set a statewide maximum rate for local property taxes at $1.50 for every $100 of property value. At the time, many politicians thought that Robin Hood would end the school finance problem for good.

But they were wrong, for Robin Hood, as with many coercive government cross-subsidization schemes, had several devastating unintended consequences.

First, property taxes skyrocketed. Many school districts could increase spending without feeling the pinch, since they weren’t paying for it anyway. From 1990 to 2000, per-student spending, adjusted for inflation, increased by 20 percent. From 1997 to 2005, administrative costs grew faster than the rate of classroom spending. Operating expenses increased 57 percent, administrators increased 32 percent and central office administrators increased 35 percent. In the meanwhile, while student enrollment rose by only 13 percent. Only a very few school districts did not increase spending in excess of enrollment growth and inflation. Some school districts even used their Robin Hood spoils to finance football stadiums and JumboTrons.

As district school spending rose, school districts raised property tax rates repeatedly. By 2003, nearly 690 school districts were at or near the statutory maximum tax rate of $1.50 for every $100 of property value. By 2004, Robin Hood confiscated $1.2 billion per year from 134 school districts.

The endless round of property tax hikes had other consequences. As Harvard University researchers Caroline M. Hoxby and Ilyana Kuziemko report, Robin Hood “destroyed about $27,000 per pupil in property wealth.” Robin Hood effectively severed the link between property taxes and quality of school. People who paid exorbitant property taxes never saw that money in their districts. As a result, the value of property declined, which meant lower property tax revenues. Virginia Postrel explains, “Lowering the threshold further depresses home values. A death spiral sets in.” That’s a classic example of an anti-growth tax.

Robin Hood’s death knell may have occurred last year, when the Texas Supreme Court, in Neely vs. Orange-Cove, found that the Robin Hood system, as is currently in place, constituted a de facto statewide ad valorem tax (property tax). The court wrote:

If a cap on tax rates were to become in effect a floor as well as a ceiling, the conclusion that the Legislature had set a statewide ad valorem tax would appear to be unavoidable because the districts would then have lost all meaningful discretion in setting the tax rate.

The court then gave the legislature the deadline of June 1 to reduce property tax rates so that taxpayers wouldn’t be forced to pay the maximum rate. This is where we stand today.

The Right and Wrong Way to Reform Taxes

The skyrocketing school property taxes, coupled with the Texas Supreme Court’s ruling in Neely vs. Orange-Cove, provide a good opportunity to cut property taxes. That’s exactly what Gov. Perry’s plan does. It would reduce property taxes by $6 billion total. In 2007, it would slash rates by nearly a third, or $1.5 billion. It also eliminates the business franchise tax, which was a source of much consternation for businessmen in the state.

So far, so good. But then Gov. Perry’s tax scheme slips into dangerous territory by proposing to “pay” for the tax reductions with $4 billion in new taxes on gross receipts and cigarettes. That’s an unfortunate mistake for several reasons.

First of all, Texas is already running a $4.3 billion surplus. Overall state revenues increased by 10 percent last year. Combined state surpluses could reach $25 billion this year. The state can already afford to cut taxes without imposing new ones. After all, the budget surplus is another way of indicating that the taxes were too high in the first place.

Proponents of new taxes disingenuously argue that the surplus should be “saved” for “rainy days.” But often, these are the same people that call for increased government spending. In fact, tax relief is a more fiscally responsible way to use the surplus than new spending schemes. As the Wall Street Journal writes, “returning surpluses to taxpayers is the only way to ensure that they don’t get spent on new or expanded government programs that end up breaking the bank during the lean years. That was how many states went nearly belly-up in 2001-02.”

In reality, a property tax cut is a pro-growth strategy that may end up recouping a lot of the “lost” tax revenue. A policy that encourages more home ownership would increase the number of citizens paying taxes. Additionally, the likelihood that property values would be artificially depressed by high property tax rates drops. The result, thus, is that with rising property values, tax revenue decline may end up naturally checked if not totally mitigated.

Not only are new tax increases largely unnecessary, they can be quite harmful.

Take the cigarette tax increase, for example. A cigarette tax increase is regressive, as most cigarette smokers are low-income residents. On this matter, it’s hardly an equitable tax policy to push budget priorities onto low-income smokers for their private legal lifestyle decisions.

Additionally, high cigarette taxes face the same revenue-defeating problems that property taxes face. Cigarette taxes reduce taxable cigarette consumption; often, smokers resort to the internet or black-market to get a cheap fix. As the tax base declines, there could be a drop off in expected revenues, if not an outright loss.

A new 1 percent tax on gross receipts is also quite problematic. A tax on gross receipts is levied against all revenues, not just profits. That means that businesses running losses and businesses with very narrow profit margins would be hit the hardest. The latest numbers project that the tax liabilities of small businesses would rise by an estimated $800 million. That’s $800 million of investment the state never sees.

Finally, from the standpoint of education policy, the new tax plan hardly ameliorates the problems already afflicting local school districts. Since more of the tax burden shifts from property owners to small business owners and low-income smokers, there is more of disconnection between the parents who send their children to local schools and those who pay for it. Under the new plan, the state will pick up almost 50 percent of the education cost, compared to an estimated 36 percent today. That means more state bureaucracy, more unaccountability and higher administrative costs.

Conclusion

It is not fair to call Gov. Perry’s plan a tax cut; it is, in fact, a tax shift. To be sure, property owners are in dire need of tax relief. But that should not be a justification to raise taxes on small businesses and low-income smokers. Such measures would hamper growth.

In reality, Texas does not have a funding problem so much as it has a spending problem. Texas needs to combat out-of-control administrative overhead and increasing statewide control of local schools. But by cutting off the accountability of local schools to local parents, Gov. Perry’s plan makes the school system less responsive and more expensive.

While Gov. Perry has taken the first steps to tax relief, it is not enough. The Texas legislature must go back to the drawing board and work on an equitable and pro-growth tax relief package.