Considering Tax Expenditures in State Budget Deliberation
Posted on May 7, 2012
I am going to speak generally about three components of state public finance:
First, tax revenue; second, government expenditures; and third, the allocation of the tax burden. I will illustrate how tax expenditures, such as sales-tax exemptions and other preferential laws, affect each component of public finance.
In all of this, we must remember that budget deliberations should focus on keeping the three components of public finance in appropriate balance. For instance, expenditures should not exceed revenue, because deficit spending forces the state to borrow, which creates burdensome finance costs. On the other hand, the state should not collect more revenue than it needs to provide the appropriate level of services. Excess revenue takes resources out of the hands of the populace unnecessarily, and may lead to undesirable government expansion. Fiscal discipline keeps tax revenue and government expenditure in appropriate balance.
Finally, taxation and government expenditures generally redistribute wealth. Tax breaks for the wealthy take money from the middle and lower classes and redistribute it to the wealthy. State programs that benefit only the lower economic classes require support from the middle and upper classes. The redistributive effects of public finance determine the system’s fairness. Thus, all public finance decisions affect the state’s tax revenue, expenditures, and the allocation of the burden of taxation.
Let’s now consider each component of public finance in turn.
II. Tax Revenue
First, let’s consider tax revenue. Two important elements determine the state’s tax revenue: the tax base and the tax rate. A simple equation illustrates the computation of tax revenue.
Tax base times tax rate equals tax revenue.
I will now discuss each part of the tax revenue equation. The tax base is the source from which the state collects tax revenue.
The tax base for income tax is taxable income, the tax base for sales tax is taxable sales, and the tax base for property tax is the assessed property value.
Statutes define each of the tax bases.1 Statutes often have broad definitions of each tax base. Tax exemptions and other mechanisms erode the tax bases. For example, statutory exemptions exclude many sales from the definition of taxable sales.
Tax rates are also a product of legislation.2 Unfortunately, public-finance discussions often focus solely on tax rates. The focus should, however, include thoughtful analysis of the tax bases. Tax rates and tax bases affect the amount of tax revenue the state raises, who pays the tax, and the amount each person pays.
In fact, the tax base determines who pays a particular tax, and the tax rate determines how much they pay. General concepts apply to every type of tax, but I use state sales tax to illustrate the relationship of tax base, tax rate, and tax revenue.
A simple formula illustrates the computation of the state’s 2008 sales-tax revenue.
The state had approximately $57 billion of taxable sales taxed at 5.3%, so it raised approximately $3 billion of sales-tax revenue.3
The tax base in 2008, did not, however, include all sales. In fact, in 2008 state law exempted approximately $75 billion of sales from taxation.4
At 5.3%, those exemptions accounted for approximately $4 billion of sales-tax revenue the state did not collect.5 The $4 billion of uncollected revenue is a tax expenditure. I will say more about that shortly.
Changes in the tax base that result from the addition or repeal of exemptions can profoundly affect sales-tax revenue and the tax rate.
If the state had no sales-tax exemptions in 2008, it would have had approximately $132 billion of potential taxable sales.
The repeal of tax exemptions could significantly increase sales-tax revenue. To illustrate this point, I show the effect of complete repeal of sales-tax exemptions. Understand, however, that I do not advocate the repeal of all sales-tax exemptions. Some of them, such as certain ingredient and component parts of products manufactured for resale, are appropriate from a stateinterest standpoint and others are politically expedient. For the sake of discussion, however, I assume all the exemptions could be repealed.
The relationship of tax base, tax rate, and tax revenue is such that if the tax base gets bigger and the tax rate remains the same, tax revenue will get bigger.
Thus, if taxable sales were $132 billion, tax revenue would grow to $7 billion under the current 5.3% rate structure. Notice that the sales-tax revenue increases as the size of the tax base increases. One way to increase the tax base is to modify the definition of taxable sales by repealing sales-tax exemptions. The repeal of sales-tax exemptions could thus help eliminate the state’s budget gap.
In pursuit of a fairer tax, the state may consider broader reform that would eliminate exemptions and include more items, such as professional services, in the tax base. The result of such reform would be a broader tax base that would allow the state to reduce the sales-tax rate. Assume, for instance, that the state needed to raise $3 billion of revenue from sales tax in 2008. Assume further that the state could eliminate all of the sales-tax exemptions. With a $132 billion sales-tax base, the state could raise $3 billion of sales-tax revenue using a 2.3% sales-tax rate. This happens because a larger tax base with constant revenue needs allows the tax rate to shrink.
Another way to grow the tax base is to increase the population and business activity in the state. Exemptions that legitimately stimulate economic growth serve a valid state interest, and retaining them may help grow the tax base. We must, however, weigh the cost and benefit of each exemption to determine whether it helps increase the tax base. Undoubtedly, many sales-tax exemptions do not help increase the tax base, and we should repeal them.
III. Government Expenditures
The appropriate size of the tax base, tax rate, and tax revenue depend upon the state’s expenditures. Discussions of public finance should consider both direct and indirect government expenditures.
Direct expenditures are those expenditures for which the state writes a check or transfers funds. For example, the state writes checks or transfers funds to pay teachers, to operate courts, and to construct state buildings.
Indirect expenditures are those which provide an economic benefit to a particular person or group, even though the state does not actually write a check or transfer funds to such person or group.
A tax expenditure is an example of an indirect expenditure. A sales-tax exemption is an example of a tax expenditure. Sales-tax exemptions and tax expenditures are indirect expenditures because they provide an economic benefit to select taxpayers, even though the state does not write a check or transfer funds.
Consider why tax expenditures in general, and sales-tax exemptions in particular, are indirect expenditures. The state provides services, such as transportation infrastructure, education, police protection, and social services. Those services make sales, property ownership, and earning income possible in the state. For instance, a person could not purchase food and clothing in Kansas, if the final product or materials did not ship over Kansas roads that are protected by Kansas police. Other services, such as education and social services, continue to enhance lifestyle and provide a more competent and healthy workforce. Everyone benefits from state services and should shoulder a portion of the cost of the services.
The state determines each person’s share of the tax burden using the tax bases. Any item exempted from the broad tax base allows the beneficiary of the exemption to receive state services at a reduced cost. Exemptions are equivalent to the state providing the services at a discount, or to the state collecting the exempt amount from the beneficiaries and paying it back to them as a subsidy. Thus, the exempt amounts are economically equivalent to state direct
expenditures and subsidies, and we should treat them as such.
Tax expenditures are popular to beneficiaries because they do not appear in the state’s Budget Report as expenditures.6
Therefore, tax expenditures are comparable to off-balance-sheet financing that plagues the private sector. In short, tax expenditures allow people to secretly manipulate state finances. I therefore applaud the efforts of Secretary Wagnon and others who are making tax expenditures a part of the current budget talks, and I hope tax expenditures will become a permanent part of budget deliberations.
Considering just a few sales-tax exemptions helps clarify the need for rigorous analysis of these indirect expenditures. Income tax and property tax warrant similar scrutiny. This analysis focuses on three types of sales-tax expenditures:
First, organization-specific sales-tax expenditures; second, taxpayer-specific sales-tax expenditures; and, third, sales-tax expenditures to out-of-state beneficiaries. Consider how we might analyze each of these types of sales-tax expenditures in state budget deliberations.
A. Organization-Specific Sales-Tax Expenditures
Let’s first consider organization-specific sales-tax expenditures. The state exempts sales to several types of organizations. For example, it exempts sales of property and services to nonprofit hospitals and religious organizations. The justification for such exemptions is that those organizations provide services that the government would otherwise provide.7 Even though legitimate state interests may justify the sales-tax exemptions for such organizations, in periods of financial difficulty, tax expenditures to such organizations should be subject to the same scrutiny to which direct expenditures are subject. Two examples help illustrate this point.
Recently, the state funding for the Kansas Neurological Institute has drawn public attention. The funding for KNI is a direct expenditure. The services KNI provides are health related, just as the services provided by nonprofit hospitals are health-related. Those who are scrutinizing the direct expenditures to KNI should similarly scrutinize the indirect expenditures to nonprofit hospitals made in the form of sales-tax exemptions. Because these organizations provide similar services, we should consider cutting the expenditures to both, if we must cut expenditures to one. When considering budget cuts, it is unfair to focus solely on organizations that receive direct funding from the state.