by Robert Kleine, Vice President and Senior Economist, and Alec Rodney, Economist
|Sixth in a series of reports on school finance reform, this report discusses how using the sales tax — the ballot proposal — to replace property tax revenues lost with P.A. 145 of 1993 will differ from using the income tax — the statutory plan — to replace those revenues.|
On March 15 the public will vote on Proposal A, determining how the state will replace the revenue from local property taxes that was cut by Public Act 145 of 1993. A “yes” vote for Proposal A means enactment of the ballot plan, and a “no” vote means enactment of the statutory plan. The plans differ in a variety of ways, but the most significant difference lies in what major source of new state revenues each plan relies on to replace the lost local property tax revenue: Whereas the ballot plan derives 55 percent of new state revenues ($1,910 million) from the sales tax, the statutory plan raises 57 percent ($1,725 million) of new state revenues from the income tax (see Exhibit 1).
In essence, the debate centers around the following question: Which is more desirable, a six‐cent sales tax or a 6 percent income tax? How individuals and households respond to this question will depend on their age, family size, and income. Collectively, voters must consider how well each of these sources will grow over time to keep up with school funding needs. Furthermore, voters must consider the degree to which each of these taxes can be passed on to nonresidents (i.e., tourists and business travelers) and the degree to which each of these taxes affects their federal tax liability.
Tax Rates Compared With Those of Other States
Michigan’s current sales tax rate, 4 percent, is one of the lowest in the country. The state’s 4.6 percent personal income tax rate is average — 31 states have income rates that are higher than Michigan’s. Exhibit 2 lists the sales and income tax rates for each state as well as the maximum sales tax rate that results when local tax rates are included.
The exhibit also shows the total tax revenue raised from the sales tax and the income tax as a percentage of state personal income. In 1991, Michigan residents spent 1.9 percent of their aggregate income on sales tax and 2.2 percent on income tax, ranking Michigan 41 for the sales tax and 28 for the income tax.
Had the proposed ballot plan been in effect in 1991, the additional revenue raised by the 2 percent sales tax would have increased the share of personal income to 2.9 percent and ranked Michigan 18th in the nation. Likewise, if the proposed statutory plan had been in effect, 3.1 percent of personal income would have been spent on income taxes, which would have ranked Michigan 9th in the nation.
Progressivity and Vertical Equity
A variety of equity questions must be considered when comparing the two taxes. The question of vertical equitycenters around how tax burdens change with household income. Many believe that tax burdens should be distributed on an ability‐to‐pay basis — those who have higher incomes should pay a larger share of their income toward taxes than those with lower incomes. A tax that meets this criterion is said to be progressive; a tax that falls most heavily on those households with the least ability‐to‐pay is said to be regressive.
Exhibit 3 shows estimated tax burdens — tax as a percentage of adjusted gross income — for various income groups for each of the taxes under current and proposed rates. The sales tax is a regressive tax: Households with incomes of less than $10,000 spend between 3.6 and 22.5 percent of their incomes on sales tax at the current four percent rate. Households with incomes of more than $40,000 spend no more than 1.5 percent of their incomes on the current sales tax. All of these percentage shares will increase 50 percent if the sales tax rate is increased to six cents.1
Because of the personal exemption, the homestead credit, and other credits, the income tax is progressive. Currently, an average household with an income of less than $10,000 pays no income tax. Because they qualify for a variety of credits, these households receive tax refunds that range from 0.5 percent to 8 percent of their income. As household income rises, the burden of the income tax increases to a high of 3.6 percent for the highest income group. Since the statutory plan includes an increase in the personal exemption from $2,100 to $3,000 per person, households with less than $10,000 income will see their tax burden decrease with the 6 percent rate. The highest income households’ tax burdens will increase 25 percent.
Exhibit 4 provides a detailed breakdown of taxable consumption as reported in Consumer Expenditures in 1992, based on the 1992 Consumer Expenditure Survey. The Exhibit 4 income ranges are larger than those in Exhibit 3, with a separate category for seniors. Exhibit 4 tax burdens are calculated only for the proposed tax increases.2 These data confirm that the sales tax is regressive and the income tax is progressive.
Another facet of vertical equity is how the proposed tax burdens fall on senior citizens, who generally have lower incomes. Most seniors will not benefit from property tax relief because their homestead credit will decrease dollar‐for‐dollar with reduced property taxes. If voters choose the ballot plan, seniors will spend a larger share of their income on the sales tax than they do now. Since seniors consume fewer taxable goods than the average household for a given income range, however, seniors’ increased tax burden will not be as large as for other age groups
If Proposal A is voted down, many seniors will be unaffected by the statutory plan’s income tax increase because much of their income is untaxed and seniors will receive larger exemptions. Income from social security (currently averaging $8,000 per year for a single retired worker and $13,600 for a retired worker and spouse), all pensions from public service, and the first $7,500 of private pensions per single ($10,000 per couple) are not subject to the Michigan income tax. In addition, the per‐person exemption for seniors will increase $900, from $3,000 to $3,900, if the income tax rate increases.
Under the statutory plan, a couple receiving private pension income and the average social security benefit will not pay any tax on their first $31,400 of household income. Unlike the increase in the sales tax, the increase in the income tax rate will not negatively affect low‐to‐middle income seniors.
Itemized Deductions, Federal Taxes, and Horizontal Equity
The ballot and statutory plans both reduce the property tax, which is fully deductible for federal tax purposes, and replace it with a variety of other taxes, some of which are not federally deductible. The increase in federal taxes due to lost deductions is $294 million under the ballot plan and $62 million under the statutory plan (see Exhibit 1). Much of this difference is due to the different treatment of state income and sales taxes under federal law.
PSC estimates that after exemptions are factored out, individuals will pay about $1.2 billion in new income taxes under the statutory plan. Since the income tax is fully deductible, individuals will pay no additional federal taxes to the extent that income tax revenue replaces property tax revenue. Under the ballot plan, individuals will pay an estimated $1.4 billion of the sales tax. Since sales taxes can not be deducted from individual federal tax returns, Michigan taxpayers will pay nearly $180 million more in federal taxes than they would if this revenue was derived from property taxes.
Because the income tax is federally deductible and the sales tax is not, horizontal equity—the principal that households from the same income group should pay the same amount of taxes — will not be the same under the ballot and statutory plans. Because the sales tax is borne equally by identical households, the ballot plan preserves horizontal equity; the statutory plan does not. Under the statutory plan, two households with identical income and family size will, on average, have the same state income tax liability and pay similar amounts of sales tax on the items they consume. However, if one household itemizes and one does not, the household that itemizes their federal taxes will pay lower taxes overall under the statutory plan because their state income tax is deductible.
Federal tax return data show that the number of households itemizing varies with income as follows: 6 percent of those with income below $20,000 itemize, 37 percent with income between $20,000 and $50,000 itemize, and 84 percent with income over $50,000 itemize.
For the most part, horizontal equity is preserved for the high‐ and low‐income ranges because most high‐income households itemize, and most low‐income household do not itemize. For the middle income range, however, a small number of households can offset as much as 28 percent of their state income taxes with federal deductions while the majority bears the full burden of the income tax.
Growth, Stability, and Exportability
While households could vote for or against Proposal A using tax equity principles alone, it also is important to consider how well each tax will raise revenue over time as school needs grow. The second and third columns of Exhibit 5 illustrate the estimated growth patterns of the increases in the sales and income taxes, respectively, if the proposed increases had been in effect for the past 20 years.
Both taxes show positive growth trends for most of the 20‐year period. The average annual compounded growth rate was 7.9 percent for the income tax and 7.1 percent for the sales tax. The income tax declined only once in 1983, while the sales tax declined twice, in 1980 and 1982. In 1992 the sales tax increase would have raised about $1.61 billion and the income tax increase would have raised about $1.57 billion.
A tax’s stability can be measured in two ways: (1) growth in total revenue over time and (2) growth in relation to personal income. The second measure of stability is important for school finance reform because, in general, education expenditures grow in relation to personal income. Consequently, the revenues that fund schools also must grow in relation to personal income.
Both the proposed sales and income taxes meet the first criterion of stability; however, only the income tax meets the second criterion as well. In terms of revenue raised per $1,000 of personal income, the income tax estimates show growth from $7.72 dollars in 1972 to $8.50 in 1992, with some years of decline in between, but a positive growth trend since 1984. The sales tax estimates show a decline from $9.14 in 1972 to $8.74 in 1992, and the trend after 1986 is downward.
The upward trend in the income tax will continue as taxable components of income, such as wage and salary earnings, continue to rise. Unless more services are included in the tax base, the sales tax revenue raised relative to personal income will continue to decline. This trend toward decline in sales tax revenue relative to incomes is due to a slowdown in consumption of taxable goods rather than simply a slowdown in consumption.
Historically, regional consumption patterns have followed national consumption patterns closely. From 1980 to 1992, the share of national consumption spent on services grew from 48 percent to 55.4 percent. This means that in Michigan, where most services are not subject to sales taxation, increased consumption of these services rather than taxable goods means a decline in sale tax revenues relative to income.
Finally, voters may want to consider the extent to which each of these taxes is exported to (i.e., paid by) nonresidents. Very few nonresidents pay Michigan income tax. The majority of nonresidents who work in Michigan pay income tax to their home states under reciprocal agreements that also allow Michigan workers to pay Michigan income tax when they work out of state. In contrast, a significant portion of the sales tax is exported to nonresidents, especially tourists and business travelers. These visitors pay sales tax on guest accommodations, car rentals, restaurant meals, gasoline, and other retail purchases. PSC estimates that anywhere from 3 to 5 percent of the sales tax burden is exported.
On March 15 Michigan voters must choose between a new school funding scheme that places more emphasis on the income tax (i.e., the statutory plan) or one that places more emphasis on the sales tax (i.e., the ballot proposal). Whereas the income tax is progressive, placing successively higher burdens on households with successively higher incomes, the sales tax has the opposite effect, placing successively higher burdens on households with the lowest incomes.
The income tax is federally deductible, and replacing property taxes with the income tax will preserve federal tax savings for Michigan residents who itemize. Since the sales tax is not deductible, Michigan residents will pay $180 million more under this plan in federal taxes due to lost property tax deductions. On average, this burden will be shared equally by households within a given income group.
With a few minor exceptions, the proposed sales and income tax increases both would have shown steady revenue growth had they been instituted in 1972, although the sales tax would have raised more revenue in each year. The income tax, however, would have grown in terms of revenue raised per $1,000 of personal income, while the sales tax would have declined. These trends will likely continue into the future unless the sales tax base is expanded to include a wider range of services.
If the issue of voting for or against Proposal A is viewed simply as a decision of whether to increase the sales tax or the income tax, considerations of fairness and long‐term stability and growth dictate a “no” vote and support of the statutory plan. The vote will not be so simple, however; each plan contains other taxes that place unequal burdens on different groups such as businesses, local school districts, and smokers.