It's been known for a long time that obsolete state tax systems are not producing the revenue states need. But what's becoming clear today is that those tax systems are not only failing to keep up with the dramatic shifts in the U.S. economy. They are a drag on economic growth.

The new economy is more than a swing from manufacturing to services. Thanks to new technology and telecommunications, products can be purchased as easily from an outlet 3,000 miles away as from one down the block. Small businesses are increasingly vital -- they now account for about a third of the value of U.S. exports. Moreover, the service economy is moving toward a further evolution: It's becoming increasingly knowledge-based. Where managerial and professional jobs accounted for roughly one-fifth of total employment in 1979, such jobs are now moving past the one-third mark.

And yet, state tax structures, developed at a time when computers -- "thinking machines" -- were the stuff of science fiction, and the American economy flourished with the automobile industry, have failed to evolve. They are "completely inefficient," says Ray Scheppach, executive director of the National Governors Association. They stifle economic vitality by creating an environment that's inhospitable to businesses.

To take one example, there is the outmoded way in which telecommunications companies are taxed. A reliable, high-quality and affordable telecommunications system is essential to the economic competitiveness of states -- to say nothing of the nation. And yet, these systems are subject to very high taxation rates in a number of states -- by a tax approach set when the industry, dominated by one telephone company, was highly regulated. The result is a damper on the telecom industry. According to a 2004 report by the Council on State Taxation, the average effective rate of state and local transaction taxes for telecommunications services is around 14 percent, compared with about 6 percent for general businesses nationwide.

That's not the only fallout from antiquated state tax systems. They are often unfair -- undertaxing one portion of the economy at the expense of others. In many states, for example, a number of services -- including things such as tattoo parlors, car washes and gardeners -- are free from any sales tax, while tangible goods -- things such as pencils, cars and garden hoes -- are subject to a higher tax rate to make up for the slack.

Over the past year, the Pew Center on the States has researched the question of how state tax systems can adjust to a new economy in which fundamental business rules have been changing. The report that follows looks not so much at the basic principles of taxation but at specific tax systems and practices that are critical to promote economic vitality.

Those tax systems are no longer a parochial matter of interest to each of the 50 states as an independent entity. That is, the battle for economic growth is not a civil war among the states anymore. It's a world war. The U.S. is already at a huge disadvantage in competing internationally based on cost. Wages in India and China, for instance, are as much as 90 percent lower than those in the U.S. The competitive strengths in the U.S. are in innovation, productivity, marketing and entrepreneurship. All of these things can be either helped or hurt by the nature of the states' tax systems -- as can the revenue base, which states need to make the investments necessary to succeed.

"States are aware that their tax structures aren't up to snuff," says Michigan Governor Jennifer Granholm. "The question for us as the state of Michigan, is, 'What is it that is going to make us competitive?' If it's not going to be price, then perhaps it's going to be quality, and that means investing in your talent. If you have class sizes of 37, then you're going to be uncompetitive."

Since 2000, virtually every state has commissioned at least one major tax reform panel to study the issue and develop proposals for modernization. Seventeen states now have in place at least an informal mechanism for continuous review of their structures. Much of this action has been propelled by fiscal shortfalls or the realization that various revenue streams are declining relative to spending pressures. In more than a handful of states, the property tax -- which has tended to rise inexorably to make up for some of these gaps -- has led to citizen rebellions. Both Florida and New Jersey, for example, have been responding to public fury about the property tax by considering major tax restructurings.

The tax questions the states will need to grapple with in coming decades are ones that lie at the heart of the new economy. How can states reshape and modify their tax systems to encourage greater interstate, federal-state and state-local cooperation -- and still retain the autonomy of each level of government? In an age of globalization, how do states compete with other countries, yet minimize tax competition among the various levels of government? How do states generate revenues from the intangible products of knowledge-based firms? How do they capture business activity within state borders when borders are increasingly irrelevant in conducting business?

There's a shortage of proven solutions for dealing with a borderless, knowledge-based economy. But some good ideas have emerged -- and are already being tested by some states -- to deal with the most basic, underlying issue: creating a tax structure that encourages economic vitality.

The material in the pages that follow has been informed not just by predictions of the world to come but by respect for the deep-seated fundamentals of a solid tax system -- one that is simple and transparent, with broad-based taxes that provide a balanced revenue stream, spread the tax burden fairly and heighten the chance of compliance.

Our research acknowledges the idea that some powerfully held beliefs about appropriate tax policy have little chance of prevailing. For example, some tax policy experts believe there should not be any corporate income taxes, because they raise a relatively small amount of money, are complex and end up being passed along to consumers anyway. Politically, however, it is unlikely that taxpayers will stand for an abolition of the corporate income tax. "Most economists come down saying corporate income taxes are really bad ideas for states," says William Fox, director of the Center for Business & Economic Research at the University of Tennessee. "But then they have to talk about the real world." Similarly, many people believe that tax incentives to corporations are a zero-sum game and potentially unproductive as an economic development tool. But incentives are not going away.

One cluster of questions addresses tactics that pertain to specifics of the new economy: the transition to services; the rapid growth of untaxed Internet sales; the need to encourage newer high-tech industries while not overburdening old-time manufacturing; an adjustment of telecommunication tax rates and complexity to a world in which telecom companies are no longer monopolies; and strategies to tax multi-state and multi-national corporations in a fair way. Those tactics have grown increasingly critical in order to preserve any kind of equity between large multi-state or multi-national firms and smaller, in-state businesses.

Four areas pertinent to vitality in the new economy are examined in the stories that follow. Fifty-state evaluations inform these articles on the transparency of tax incentives, the efficiency of tax collection, the stability of revenue streams and the tax flexibility states allow their localities -- which provide many of the key services that support the new economy.


Much of the argument over reform has tended to focus on the notion that a tax increase to any segment of the economy will drive away business, while a tax cut will do the opposite. This was the point Wisconsin state Senator Alan Lasee made during the 2006 campaign season. "High taxes," he told voters, "are driving our employees and businesses to move to other states for higher paying jobs and lower taxes."

Tax rates doubtless play some role in creating a fertile economic climate -- and if all other things were equal, businesses might choose to settle in lower-tax realms. But in the real world, all things are never equal. Some states have better-educated workforces, a better-developed network of roads or nicer public amenities. These elements, all of which require steady flows of tax revenues, are crucial to the equation.

Tolls on the Electronic Highway

There is now evidence that low tax rates by themselves are not a silver bullet. In his New Economy Index, Rob Atkinson, president of the Information Technology and Innovation Foundation, measures the progress of states in adapting to the new economy by looking at factors such as workforce creation, entrepreneurial activity and patent creation. Five of the eleven lowest-scoring states on his list are among those having the lowest tax burden: Alabama, Montana, Oklahoma, South Dakota and Wyoming. As Tom Clark, executive vice president of the Metro Denver Economic Development Corp. and the Denver Metro Chamber of Commerce, puts it, "If low tax rates were the only factor, Wyoming would be the economic epicenter of the world."

It is theoretically possible to use low tax rates to drive economic vitality. Robert G. Lynch, chair of the Department of Economics at Washington College in Maryland, points out that academic studies on tax rates "suggest that state and local tax cuts and incentives may help economic growth, provided that government services are not reduced to pay for the tax cuts."

But as Lynch makes clear, in reality, lower taxes tend to lead to service reductions, some of which inevitably fall in areas that fuel economic vitality. Bruce Johnson, a former lieutenant governor of Ohio and head of economic development for that state, notes that "ground zero for economic development is a high-value workforce." That requires a considerable investment in education as well as in quality of life to enable states to compete effectively in the worldwide market for talent. Then there are investments in R&D at a time when innovation is key to economic development and in infrastructure, including broadband access, bridges, airports and, of course, roads.


One of the tectonic shifts that marks the new economy is the long-term transition to a service economy. In 2005, service industries accounted for some 68 percent of the total U.S. gross domestic product and 79 percent of growth in the GDP. Yet, only a handful of states tax more than 80 of the 143 or so common services, according to Federation of Tax Administrators' data. "We've ignored services in the past," says Tennessee's Fox. "But with all the new forms of technology available to expand the service sector, that's no longer a reasonable idea."

A number of obstacles stand in the way. The power of interested or affected parties is high on the list. They can and do lobby their legislators effectively. Last summer, a potentially forward-looking reform in Maine failed to pass the Senate largely because a slew of services -- everything from haircuts to car towing -- would become subject to tax. "Expanding the tax base to consumer services is good tax policy," says George Washington University professor David Brunori, "but the service providers rarely see it that way."

When it comes to the taxation of professional services -- such as those provided by lawyers, accountants, financial advisers -- things get even tougher. About 20 years ago, Florida attempted a bold experiment aimed at vastly broadening its taxation of services -- to professionals and just about every service in the state's economy. When the state's newspapers and magazines realized that meant that advertising would be taxed, they mounted a full frontal assault. The state backed off, the governor suffered politically and ever since there have been very few states with the fortitude to move in the same direction at full force. Only last month, the Michigan legislature repealed a new service tax -- mostly on business-to-business transactions but also on such things as manicures and ski lift tickets -- just hours after it went into effect.

Even states that consider adding service taxes in a more marginal way have to deal with the knotty problem of taxing business inputs. The issue is sometimes called pyramiding -- at an extreme, a state could tax the services an accountant provides to a law firm, and then tax the services the law firm provides to a car manufacturer, which either builds those taxes into the price of a car or reduces its investments in the state. Most tax experts agree that that placing sales taxes on assets or services purchased by businesses is a form of double taxation and to be avoided.

States are making progress in reducing or eliminating the taxing of business inputs in an arena other than straightforward sales taxes. States that tax inventory and tangible personal property are dwindling in number. Ohio eliminated its taxation of tangible personal property, Indiana is on its way to doing so, and Michigan has enacted a 35-to-40 percent reduction in its tangible property tax.

Meanwhile, the rise of the high-tech and services-based economy has ushered in another trend: The reliance of corporations on customers who are remarkably mobile and geographically widespread. The steadily growing number of sales transactions over the Internet -- Jupiter Research Online Retail Forecasts anticipates growth of 10 to 15 percent per year over the next decade -- puts local retailers at a disadvantage. Those that sell their wares electronically often escape the sales tax. That, in turn, is contrary to the precept that taxes should be levied over as broad a base as possible so that states and localities can generate the revenue they need at the lowest possible rates.

The biggest obstacle to taxing Internet transactions has been the wide variety of sales tax structures used by the individual states (and their localities), which make it extremely difficult to coordinate a means of taxing them. The Streamlined Sales Tax Project is the clearest effort by states to deal with the complications of this world in which there are virtually no physical barriers to commerce. The ultimate goal of the project is to create an environment in which transactions conducted over the Internet could be easily taxed by states. The agreement would simplify state and local tax returns and the administration of exemptions; it would also provide for streamlined tax returns and a centralized electronic registration system for all member states. Nearly half of the states have made a commitment to either fully or partially comply with the Streamlined Sales and Use Tax Act, which requires uniformity in state and local tax-based definitions and sourcing rules for all taxable transactions.


Even as the technological complexity of the world has advanced, so too has the capacity of large companies to create business forms designed, in part, to shift tax burdens from high-tax states to low- or no-tax states. Many states allege that interstate income shifting amounts to little more than tax evasion, while corporations argue they are legally taking advantage of competing state tax systems. The state courts are divided on the issue, and the U.S. Supreme Court has yet to rule on it.

As a remedy, states have been adopting combined reporting as a more comprehensive approach to curbing artificial interstate income shifting. Combined reporting forces corporate parents and their subsidiaries to add profits together. This enables the state to tax the percentage of an out-of-state subsidiary's profits that can legitimately be attributed to the corporation's in-state operations. Many big corporations, obviously, are not advocates of combined reporting. For one thing, it closes a loophole that many enjoy. In addition, there are potentially significant compliance costs for companies required to alter their bookkeeping. Despite these drawbacks, there is no evidence that the economies of combined-reporting states have suffered compared with those without combined reporting.

The Bucks Stop Here

Among the states that don't use combined reporting is Iowa. "Our state," says Peter Fischer, professor of urban and regional planning at the University of Iowa, "loses a pretty big chunk of corporate taxes because of its unwillingness to take on combined reporting." Fischer thinks it may be that people who are simply anti-tax see it as a tax increase. Whatever the reason, it has been proposed in Iowa a number of times, but the legislature has not moved on it.

An aligned area in which states are gaining some control is in taxing a growing array of new business structures. James Edward Maule, a professor at Villanova University's School of Law, was one of the first to study the tax treatment of limited-liability companies, limited-liability partnerships and S corporations. The new entities are similar to corporations but have a more flexible ownership structure. His initial findings on the tax picture made Maule reflect that they were in a state of "chaos."

Take S corporations. The simple problem is that they pass all their profits through to shareholders and are essentially immune from corporate taxes. These profits are taxed by a state personal income tax imposed on the individual shareholders. There are now some 3.6 million S corporations in the United States. Obviously, this means that whenever a company elects to use this form, the state may lose some revenues -- and the problem is even more intense for the nine states that don't tax income.

Like S corporations, limited-liability corporations and limited-liability partnerships are also "pass-through entities" -- states generally don't impose tax at the corporate level but instead collect taxes by imposing the personal income tax (if they have one) on individual members and partners.

The chaos to which Maule refers came from states having no model for how to tax these various new business forms that aren't exactly corporations but aren't individuals, either. Without guidance, confusion reigned in the states over how to apply their tax structures to these alien new business forms. Until the states got a handle on the very concept of what these new business forms were, they couldn't properly capture taxes duly owed, if they captured any taxes at all. Fortunately, the states have gained a large measure of control in recent years. There is now a Model S Corporation Income Tax Act that provides states with a template for how to tax S corporations and is endorsed by both the American Bar Association and the Multistate Tax Commission. It gives state lawmakers and tax administrators a way to think consistently about state tax treatment of pass-through entities.

As for LLCs and LLPs, one breakthrough came when states, en masse, determined that they would no longer allow the owners of these new business forms to elect to be classified as one type of entity for federal tax purposes but another for state taxation, which might have given them more favorable treatment. A number of states also now require LLCs and LLPs to withhold taxes on the distributive state share of nonresident members' and partners' earned income. This helps ensure that the taxes properly owed to the state don't slip away as they did in the past.


Telecommunications was once an industry dominated by telephone companies that were monopolies -- and states taxed them accordingly. This was a quid pro quo for the lack of competition.

But today's industry is totally different. Not only don't telecom companies have monopolies, there is bitter competition over a business that has changed dramatically from just supplying phone lines to one that permits transfer of data through a variety of technologies -- technologies undreamt of when the codes were written. But states continue to apply the old, outdated tax regimes. Only a handful of states have undertaken telecommunications tax reform over the past decade, and in many of those states, the primary reform has been in centralizing return filing.

Detaxing Telecoms

Telecommunications companies are also hampered by major administrative burdens. Many states still require telecom companies to file more than 500 returns. This area would be another beneficiary of the streamlined sales tax movement, which requires centralized filing and payment of local taxes -- including local telecommunications taxes -- to the state governments. The agreement also contains uniform telecommunications sourcing rules and definitions. And if the states succeeded in resolving nexus questions for Internet-based sellers, the change would, for the first time, put telecommunications companies on a level playing field with Internet-based companies that sell essentially the same products and services to customers.

These taxing issues are germane not only to the economic vitality of a state but to its compact with taxpayers -- be they individuals or businesses. The way in which revenues are raised -- the fairness and transparency -- is fundamental to the trust constituents have in their government. Right now, most of the states need to modernize their tax policies to encourage growth, and to do that they need to look beyond immediate and purely political considerations. "The biggest problem we have is policy makers making decisions in a vacuum," says Utah state Senator Howard Stephenson. "Overcoming that is crucial to making good tax policy."