House of Loopholes

The more tax cuts Congress passes, the more trouble states and localities will have making ends meet.
November 2004
By Jonathan Walters  |  Senior Editor
A Senior Editor of Governing, Jonathan has been covering state and local public policy and administration for more than 30 years.

Probably the simplest way to describe the relationship of intergovernmental tax systems is to use the balloon analogy: Squeeze revenue-raising capacity at one level, and it's going to bulge out somewhere else. Absent truly drastic cuts in programs, somebody has to find the money to pick up the tab.

President George W. Bush and this Congress have proved themselves to be world-class balloon squeezers. In September, the president signed legislation to make the existing "middle-class tax cuts" permanent-- locking in place a reduced income tax rate for millions of Americans, eliminating the marriage penalty and codifying a higher per-child deduction. All this will eventually cost the U.S. Treasury an estimated $164 billion.

Meanwhile last month, members of the House and Senate were hustling to finish work on a different tax bill that only a corporate lobbyist could love. Initially intended to make a narrow fix in the revenue code to satisfy a World Trade Organization ruling, the bill instead did what many tax bills in Washington do when organized business catches wind of the chance to meddle: It became a $136 billion giveaway to oil and gas explorers, timber companies and consulting firms, among other interests.

How Congress and the president can give away so much money so guiltlessly isn't such a hard question to answer. They don't have to balance the books. Far from the front lines of actual service delivery, it's much easier to treat money as some vague abstraction. But to flip Senator Dirksen's famous adage, you chop $100 billion here and $100 billion there and pretty soon you're talking real cuts.

It is a worn-out lament that the place fiscal reality looms largest is at the state and local level. But it's true. For years, states and localities have gamely stepped into the fiscal breach--or at least tried to--in an effort to make up for the fiscal folly of their governmental partners in Washington. Lately, however, a new and more troubling trend is emerging, directly related to the balloon theory of revenue raising. Congress is beginning to insert itself more aggressively and directly into state and local fiscal policy, so that when Washington squeezes the balloon, state and local governments are less able to raise the kind of revenues they need to deal with the bulge.

The practice started several years ago with the federal ban on state and local taxation of the Internet and its sales transactions. The argument in favor of that law was simple: The Internet is a fledging form of commerce that needs nurturing. It was also wrong: Companies doing business electronically are profitable and just as capable of meeting their tax responsibilities as those doing business the traditional way.

But what was most troubling about this decision was the possibility that it would set a precedent for new federal interference in tax debates to follow. It suggested a belief among many in Congress that the federal government--while hamstringing its own ability to raise revenues--is also well within its rights to commandeer state and local tax policy.

That belief was on display most clearly this year with the introduction of a bill known officially as the "Business Activity Tax Simplification Act." That's an accurate title--if creating yet another dubious loophole can be considered simplification.

BATS (an appropriate acronym if there ever was one) carries significant bipartisan support and dozens of influential sponsors in the House. Under its provisions, states and localities would be deprived of the authority to raise billions of dollars that they're currently collecting in business franchise taxes. If it becomes law, Congress will have moved beyond denying these governments the right to new revenue--it will be preempting state and local tax codes in the collection of existing revenue.

It is hard to make much of a case that state and local tax authorities are gouging corporations under the current system. State corporate taxes have been declining for more than a decade, and now make up just 5 percent of all state revenues, according to the Federation of Tax Administrators. All the other taxes--and the individual taxpayers who must pay them--contribute the other 95 percent. At a moment of extreme fiscal distress for state and local governments almost everywhere in the country, it's hard to see what sensible public purpose this could possibly serve.

The bottom line is that states and localities now find themselves in the position of having to fight just to protect what they already have, when the conversation should really be about rationally redesigning tax policy in the face of the revolutionary changes that have converted the industrial economy of the 20th century into the service-based economy of the 21st.

More and more, Congress and the Bush administration seem to suffer from the delusion that the balloon squeeze can go on forever. Governments will just have to do more with less. And perhaps with practice, they'll find they can do even more with even less. If they perfect it, one supposes, they can do everything with nothing. Either that, or the balloon goes bang.