A Tax System That Reflects the Economy

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Diego Torres Silvestre / FlickrCC

"Taxes, after all, are dues that we pay for the privileges of membership in an organized society." – Franklin D. Roosevelt

Every time I pick up the paper to read about the State legislative session, I read things like, “This is going to be a very tough session,” or, “There just isn’t enough revenue this year.”

There isn’t enough money to fix Child Protective Services. We have to cut higher education, even medical schools. K-12 funding is horrible, but we can’t do anything this year. Even funding for the Alamo is being cut.

Why is that?

A Recent History

As a result of another school finance lawsuit, the Texas Supreme Court in 2005 declared the school finance system unconstitutional, so in 2006 the State Legislature dramatically revised the tax system. The main accomplishment of the Texas Tax Reform Commission was to significantly revise the franchise tax.

Then-State Comptroller Carol Keeton Strayhorn said that this new structure would result in “the biggest bounced check in history,” and she was right. Although the new tax, which went into effect in 2008, generated around 40% more revenue than the previous formula, it underperformed its projections by more than 30%.

This quickly became an issue, because the Legislature simultaneously cut school property taxes by almost one-third, and the new formulation couldn’t make up the difference. This became the first crack in the State’s revenue foundation. More cracks would come, and new deductions and exemptions were added in each legislative session. Now, in 2017, the remnants of the franchise tax system no longer reflect the State’s economy.

Key Issues

The historic issue is that the tax structure in Texas has always relied too much on oil and gas taxes. As every oilman knows, the history of oil and gas in Texas is a boom and bust cycle. When oil prices are high, Texas is a rich state. When oil prices bottom out, Texas quickly becomes a beggar state.

The essential issue is that the current tax structure doesn’t reflect Texas’ current economy. Locally, we saw oil and natural gas production from the Eagle Ford shale hit hard by falling prices, but the larger economy didn’t even notice. The same goes for the state: Texas is no longer simply oil and agriculture. They are certainly critical components of the state economy, but in 2017, we are much more diverse.

Look at the San Antonio economy: We are energy and agriculture, but also military and tourism, biotech and health care, aerospace and cybersecurity, as well as wind and solar. On top of all that, we are a community of small businesses in every field of endeavor.

Texas needs a tax system that reflects the real economy of the state.

“All Taxes are Bad” 

When discussing the tax system, it is important to remember that “all taxes are bad.” They are bad in the sense that every tax distorts what is taxed and creates negative pressure on the business or sector being taxed. That is why businesses spend so much money on lobbyists to get their taxes lowered, exempted, or reduced through deductions.

This is also why every economic activity should be taxed. Any activity that is singled out for taxation is unfairly disadvantaged. Any sector that is singled out for exemptions is unfairly advantaged. Every sector and every business in every sector must carry its fair share of the tax burden.

What is Fair?

Senator Ted Cruz waves his arm violently as he vows to put an end to the Internal Revenue Service. Photo by Scott Ball.

Sen. Ted Cruz speaks during his campaign for President of the United States.

U.S. Sen. Ted Cruz (R-Texas) proposed an ideal solution during his presidential campaign. His proposal pertained to the federal level, but since federal taxes are unlikely to see any substantive change in the near future, we should apply Cruz’s plan to Texas’ tax system.

Cruz proposed a Value Added Tax (VAT), a sales tax that doesn’t compound. A VAT reflects the real economy of the state, because every time goods or money are exchanged, there is a tax on that exchange. It doesn’t compound, because any taxes from previous exchanges are deducted from subsequent exchanges.

Consider the following scenario: I am in line waiting to buy a stainless steel bolt. Before I can buy that bolt, someone had to pull iron ore out of the ground or from a recycling yard. That person then sells the raw iron to a manufacturer. The manufacturer pays a VAT on the sales price.

The manufacturer now takes that iron and produces a range of steel products. Some of them happen to be small blocks of stainless steel. A fabricator buys those chunks of stainless from the manufacturer. The fabricator pays a VAT on the sales price, minus the VAT paid by the manufacturer.

The fabricator produces all types and sizes of stainless steel hardware. That hardware is sold to a distributor, who pays the fabricator for the products, plus the VAT on the sales price, minus the VAT paid by the fabricator. (I’ve been in line all this time.)

My specialty store purchases stainless steel bolts from its distributor and pays wholesale for the bolts, plus the VAT on the sales price, minus the VAT paid by the distributor. When I finally buy my bolt, I pay for the bolt and its VAT, minus the VAT paid by my store. That is what non-compounding means.

All non-compounding means is that you don’t pay a tax on a tax. That used to be difficult in a paperwork world. In a computer-based world, it is quite simple.

Why is This Better?

First, it reflects the real economy of the state. Whenever money is exchanged, a tax is collected. The entire economy participates and the State has sufficient funds for essential services.

Second, it allows for a large number of very small taxes. Everyone is taxed, so no one is artificially advantaged or disadvantaged. Every transaction is taxed the same. Since every transaction is taxed, it allows the taxes to be tiny, so that they don’t distort the economy. Winners and losers aren’t selected by the tax system.

Third, it’s permanently self-adjusting. When a new industry is born, transactions occur and it pays its way. When an old industry fades, it doesn’t crash the system.

Fourth, the VAT could replace the property tax. If we wanted to grow the VAT from tiny to moderate, it could generate enough revenue to replace the property tax, which (in my mind) is the worst possible tax.

No Exemptions

Since we are talking theory here, I would not build exemptions into the tax system, because as soon as one thing is exempted, lobbyists gear up to game the system. Tax everything: food, drugs, water, electricity. No special treatment for anyone, any sector, any business.

If it is done right, everyone will howl. “The poor people will pay too much,” many will say. That is correct, but they would benefit far more from a state that could provide them with essential services. Industry leaders will advocate for their industry to be exempt, but no one should be exempt. New industries will flourish regardless, because we would find ourselves in a state with enough revenue to grow its transportation system, take care of its kids, provide a world-class education, etc.

No exemptions. No discount rates. We are all in the same boat. No luxury liners for special friends.

Why Start this Discussion?

No politician can build a platform based on new taxes, because such a position would immediately be distorted and result in a sound bite along the lines of, “He/she wants to raise your taxes.”

On many difficult issues, we the people have to start the discussion, figure out a solution, and begin to march. Once the parade forms, the politicians can jump in front.

We can’t wait for Austin to solve this problem. Austin can’t solve it. Texas can. Texans can. Let’s saddle up.

2 thoughts on “A Tax System That Reflects the Economy

  1. A state VAT, which is a tax on consumption instead of a tax on income or property, would be a political impossibility without exceptions for basic needs like food, clothes, and child care. In a state as economically segregated as Texas, it would be perceived as regressive. And without a federal VAT, wouldn’t it cause economic distortions that would hurt certain Texas businesses?

  2. The example using a bolt works for understanding How VAT would work for Goods. I’m not sure how it works for Services. Can someone explain this?

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