Tax reform is, with apologies to Twitter, a trending topic this legislative season. A few governors have grabbed headlines with bold proposals like ending their state income tax. Others want to streamline their tax codes with an eye toward giving business a simpler and more predictable fiscal policy environment. Several of these reforms call for a serious discussion about “tax preferences,” which most states aren’t even equipped to have. But a few are becoming better prepared, and their efforts deserve some attention.
Tax preferences, also known as tax expenditures, are provisions in the tax code -- usually credits, waivers, exemptions, deductions or differential rates -- that benefit particular taxpayers. For example, technology companies in many states pay little or no sales tax on equipment they use to research and develop new products. Most public finance experts agree that carefully employed preferences can level the economic playing field and encourage growth in specific industries or geographic areas.
Read the April issue of Governing magazine.
But others believe tax preferences are corruption by another name. In their view, legislators use preferences mostly to trade favors with the business community. And they often do it out of sight. A recent report by the Pew Center on the States pointed out that most states don’t routinely review preferences because they’re not part of the regular appropriations process. With no one watching, it’s easy to lose track of who gets preferences and what the public gets in return.
That said, advocates and opponents both agree that many preferences don’t deliver economic benefits to taxpayers writ large, and this only sours public attitudes toward the preferences that do add value. The difficult question is what to do about it? So far states have tried two basic approaches.
One is to ask if a preference is necessary to advance the public good, and then convince state legislators to end preferences that are clearly unnecessary. The problem? Every preference, no matter how arcane or outmoded, is considered essential by those who benefit from it. Many preferences involve children, middle-class jobs in rural areas, and other groups or topics that state legislators don’t want to argue against.
A second approach is to reframe the question. Instead of asking if a preference is necessary, some states are starting to ask, “Is this preference working?” This approach calls for independent experts to supply legislators and citizens with objective evidence on what preferences accomplish and at what cost. This is the reform strategy preferred by many experts on state tax policy, including the nonpartisan Institute on Taxation and Economic Policy (ITEP).
For the past few years Washington state has tried out this approach. In 2006 the state legislature empowered the state legislative auditor to review each of the state’s roughly 500 largest tax preferences once every 10 years. Audit staff conduct the reviews as performance audits, using the best data and methods available. In each review they ask: Is this tax preference meeting its original legislative intent? Based on their findings, they recommend that the legislature continue the preference, end it or clarify that intent. A citizen advisory group -- the Citizen Commission for Performance Measurement of Tax Preferences -- sets the agenda and reviews the auditor’s findings.
The results to date suggest this approach has merit. So far the commission has reviewed 158 preferences. In 19 of those cases, audit staff concluded that the legislature should end the preference or allow it to expire. These findings are slowly but surely becoming a part of the fiscal policy discussion in Olympia.
To be clear, not everyone loves the approach, and it has its drawbacks. The commission has no way to implement its recommendations. And some wonder if it’s possible to know the legislature’s intent, especially if the preference in question was created several decades ago. The commission routinely disagrees with the audit staff’s recommendations.
But if the goal is to shed some impartial light on a rarely discussed and politically charged issue, then so far this approach is a success. According to ITEP, 15 other states have considered legislation to create something similar to the Washington model. Perhaps “sensible debate about tax preferences” will be the next trending topic.