The most vicious fights in politics always involve not how government spends its money, but how government does or does not take money away from people. Mature people understand taxation not as a necessary evil, but as a necessary price of civic society. But whatever virtuous purposes may drive the need for taxation, those purposes do not make it immune from the rough-and-tumble political game of determining who gets what.
As the Tennessee General Assembly heads into special session to focus the full analytical might of its collective mind on matters of taxation, it is easy to look back into the 1980s and see two futures that could represent the path Tennessee might take:
Showdown at Gucci Gulch
Ronald Reagan came to power on a promise to cut tax rates, which he successfully pushed through Congress in a bill ultimately larded with tax shelter provisions setting grotesque incentives for otherwise non-economic behavior. For his second term, he offered to purge the tax system of many of the shelters and deductions (except a few prized and popular ones) in exchange for a major reduction in overall tax rates. The initiative touched off a major feeding frenzy of special interests maneuvering to keep or enhance their particular privileges, a move which was chronicled by Wall Street Journal reporters Jeffrey Birnbaum and Alan Murray in their excellent book Showdown at Gucci Gulch. Under the leadership of Reagan and two unlikely congressional paladins, House Ways and Means chairman Dan Rostenkowski and Senate Finance chairman Bob Packwood, Congress ultimately turned back most of the intense pressure from the special
interests and instead provided the promised lower rates and enhanced simplicity for a slumbering public. While neither Rostenkowski nor Packwood would leave Congress with his reputation intact, the rout of the special interests is generally considered their finest moment. The tax reform bill itself, while eroded in subsequent years, has stood the test of time better than critics expected at the time of passage.
New Florida governor Bob Martinez, elected in 1986 with a promise to reform taxes, sought to push through a broadening of the sales tax to apply the levy to services as well as goods. The move was necessary, he said, to reflect the changing economy in which commerce was increasingly driven by the sale of skills and knowledge and decreasingly by the sale of tangible goods. What Martinez didn’t realize is the first rule of political mathematics: while friends may come and go, enemies accumulate. The tax plan didn’t alter Florida’s revenue needs. It just moved around the commercial checkpoints where the state reached out to grab its revenue. It added a new class of people who were responsible for such taxeslawyers, flacks, barbers, advertising pitchmen. Martinez’ mistake may have been picking an articulate class of enemies, for they declared war on his popularity and scored a crushing victory. By 1990, Martinez had become a one-term governor. Services in Florida remain untaxed.
The story now unfolding in Tennessee is the battle between those two outcomes: whether the fight over taxation will be resolved in favor of broad fairness and general social good, or in favor of whoever has the clout to get what they want.
Faced with the opening clamor, Governor Don Sundquist has already backtracked somewhat from his original proposal, putting a revised plan on the table in a brief speech to the General Assembly Monday night that keeps the general outline of his proposal intact while softening somewhat the blow to business.
At this point, the test for Sundquist will be whether he has the toughness and the conviction to do what he clearly believes needs to be done, or whether he will merely settle for something closer on the nearer shores of the possible. Astute analysts know that character is proven in politicians when they do what they believe is right when offered the option of doing what is easy. The special session of the legislature will determine whether Sundquist’s administration will be viewed as important or not and whether the governor himself has character, or merely cunning.
Governor Don Sundquist is an unlikely reform leader. His bland style and generic policy comments got him easily labeled as more cog than big wheel. During the policy wars in Congress of the 1980s, he was mainly a Republican foot soldier and home-district advocate. But since being elected governor in 1994, he has stepped up twice with major reform initiatives on taxes and welfare that were much better than anyone had hoped.
In his first term, Sundquist redeemed a campaign pledge to limit the amount of time anyone could receive welfare benefits to 18 months. While the original proposal had the ring of welfare-bashing campaign demagogy, the actual proposal was much better. While the terminology was smarmy (filing an “individual responsibility plan”), the final proposal was a comprehensive plan in which Sundquist provided the added funding for things like childcare support and transportation assistance necessary to make a true welfare-to-work program.
Now, after an uneventful re-election campaign in which he blandly trounced John Jay Hooker’s latest solipsistic crusade, Sundquist again looked like a man who had run out of ideas. Then he stepped up with the tax package. The plan, unveiled with little foreshadowing, was tossed at the legislature’s feet during the State of the State speech and was enough of a shocker that it took a few days for the various lawmakers to get their marching orders from their various special-interest overlords.
Under Sundquist’s plan, the sales tax on groceries would be eliminated entirely at a cost to the state of about $550 million a year. This includes the cost of paying off local governments, who under the governor’s plan would also lose the power to collect local sales taxes on food. The change is estimated to save a family of four about $500 a year.
Removing the tax on food has long been a durable cause of advocates for the downtrodden, who term it the most regressive of taxes. Poor families spend a disproportionate share of their income on food, and taxes on food diminish a family’s ability to spend on that which it needs most. Few statesalmost all of them in the Southtax food sales, and fewer still try to justify it as good public policy.
One exception was Lamar Alexander, who as governor opposed an effort to phase out the tax in 1985, arguing that it was the one truly fair tax because “everybody pays something.” The legislature has backed down from that effort, and Democratic leaders have never given the notion anything but lip service since. (This perspective did not sit well with the federal government, which required states in the mid 1980s to cease collecting sales tax on food purchased with food stamps.)
Politically speaking, anyone can cut taxes. It’s only hard when one has to make the other choices that go along with cutting a tax. And it is made especially difficult when the state is already short of money. Indeed, it is unlikely that Sundquist would have stepped out on the grocery tax issue if the state were not already in a tight spot financially. Having ridden the anti-Clinton/anti-tax tide of 1994 into the governor’s office, Sundquist is ill-positioned to simply ask the legislature for more tax money, especially when it would not be clear what he wanted it for.
The long-standing curse of the Tennessee tax system, which relies so heavily on the sales tax, is that it tends to lag behind growth. In the postwar era, this has historically translated into a need for a sales tax increase every eight or nine years, with the last sales tax increase falling in 1992. This is starting to become problematical as the current rate of 6 percent (coupled with a local option of up to 2.75 percent) is against the ceiling of what can reasonably be charged as a sales tax rate.
As with most sales tax increases, the most recent one was sold on the basis of “improving education”a half-cent hike to fund the education reform program of Gov. Ned McWherter in 1992. The half-cent hike created some special problems for Sundquist. McWherter had originally made a half-hearted effort to secure passage of a comprehensive income tax. But when he found he wasn’t big enough, legislatively speaking, to get the income tax job done, he ultimately settled for much less. The half-cent sales tax increase was not adequate to fund the entire McWherter program, so McWherter said the state would phase in the education reform plan. In effect, McWherter did not have the stomach to fight on over the education program after two bitter legislative sessions that had seriously undermined his reputation as a legislative giant. Consequently, he took what he could get and declared victory.
The problem this posed for Sundquist was that it placed a prior claim on the natural growth of sales tax revenues, leaving little room for new initiatives or anything else for the rest of state government. The result has been a decade of skimpy pay raises for state workers and few major spending initiatives, despite a period of general prosperity for the state economy.
At the same time, there have been some other trends squeezing the state government. When the state allowed the creation of limited liability corporations (LLCs) earlier this decade, it provided an alternative form of business organization to incorporation. This offered businesses substantial tax avoidance benefits. LLCs have emerged as a major drain on state business tax revenues as more and more corporations have reorganized under the new statute. In addition, companies have increasingly availed themselves of loopholes that allowed them to legally shift assets from their Tennessee balance sheets to corporations chartered in Delaware, Nevada, or elsewhere, further allowing companies to avoid taxes in Tennessee.
A parallel long-term force may be the changes in the economy itself. Corporations in Tennessee currently pay franchise and excise taxes calculated as $.25 per $100 of corporate assets, and 6 percent of earnings, respectively. This system was designed about 75 years ago to capture the value of business activity in an economy shifting from agriculture to manufacturing. But as manufacturing declines, and the state’s economy becomes increasingly service-oriented, it makes less sense to tax assets, because service businesses have so few of them. Also, the future of American manufacturing is increasingly likely to shift to high-end products offering higher returns than traditional manufacturing activities. Last year, for example, General Motors worldwide posted $125 billion in manufacturing division assets and employed 594,000 workers to generate $2.5 billion in pre-tax earnings. General Electric’s manufacturing operations posted $67 billion in assets and employed nearly 300,000 workers in generating $11 billion in pre-tax earnings. By contrast, Microsoft, with just 27,000 employees and assets of about $14 billion, produced $7 billion in pre-tax earnings. So, in an economy shifting to services and higher-end manufacturing, a tax system relying on capturing the value of tangible assets appears ill-equipped to keep pace with the economic growth.
The combined effect of the LLC loophole and general economic changes has caused collections of franchise and excise taxes to dip. Sundquist projected during his speech that franchise and excise taxes faced an ongoing decline of about $100 million a yearabout 10 percent of current collectionsfor years to come.
When it came time to put together this year’s budget, the result was that Sundquist was looking at a hole of $400 million. Gaining the somnolent consent of the citizenry to an increase in taxes generally hinges on having showcase projects to justify the increase. People mind tax increases less if they think they are getting something. Taxpayers hate paying more money to get the same government they got last year. Nashville Mayor Phil Bredesen managed to retain much of his popularity through three major tax increases by pushing forward major initiatives like the arena, library, and school improvements, even though the lion’s share of those increases actually went to employee pay raises.
Sundquist, by contrast, coming off an electoral mismatch in 1998, had no mandate for showcase projects. He offered an ambitious tax package with a substantial increase in business taxes sweetened with a big cut for consumers. The original Sundquist package called for a 2.5-percent tax on payrolls and a 2.5-percent tax on earnings. The configuration would not greatly alter what current business taxpayers were paying. The new $850 million in revenue would come from taxing sole proprietorships, LLCs, and partnerships.
Economically, the proposal had several things to argue for it. Tying the taxes to payrolls would give the state’s tax base a closer connection to the growth of the state’s economy, although it would also be more susceptible than a tax on assets to an economic downturn. Making the change at a time of strong employment would similarly make it difficult for employers to immediately pass the impact of the payroll tax on to their employees. And broadening the base to capture the full array of business organizations and activities would update the tax system to reflect a changing economy. By drawing in an array of service providers, such as architects, doctors, lawyers, and accountants, the state would get revenue from business activities that stood as future growth areas.
Old friends, New Enemies
Politically, the proposal had much less going for it. Cutting out the tax on food got the obligatory backing of organized labor and the legislative black caucus. Neither group was part of Sundquist’s original victory coalition, and neither generally has the leverage to push through a big tax on business.
But Sundquist has also attracted a whole array of enemies, along with stirring up a number of the enemies he already had. Small business, big business, lawyers, doctors, other professionals, and Republicans have all come out of the woodwork to assail the tax proposal. Local government officials have complained about the impact on local governments of not being able to tax food, even though the Sundquist proposal would have replaced that revenue.
In order to wrestle with the issue, the General Assembly has put all of its other business on hold and is meeting in a special session limited only to debating matters of taxation. In his retooled proposal unveiled Monday, Sundquist abandoned the idea of taxing payrolls in favor of broadening the franchise and excise taxes and taxing employers for paying people too much (over $72,000). In order to reduce the price tag, Sundquist has also dropped the insistence that the local option tax on groceries be repealed, meaning less of the tax burden will need to be transferred from consumers to business.
But, sounding somewhat like President Clinton insisting that the one non-negotiable part of his health plan was universal coverage, Sundquist is similarly insisting that the one non-negotiable item is the repeal of the tax on groceries.
Broadening the franchise and excise taxes to sole proprietorships, partnerships, and LLCs would capture much of the additional revenue needed while falling much more gently on professionals. The tax on high salaries is intended to keep professional partnerships from disguising their profits as salaries, however. Although some loopholes will be patched, the new plan will not be as effective as the original proposal in reducing the cyclicality of the tax system as it will remain closely tied to business profitability instead of business operations.
At this point though, Sundquist has yet to get over the political hump of generating consensus that business taxes should be higherespecially for the purpose of moderating taxes falling most heavily on low-income consumers.
Legislative leaders are already looking for alternatives focused on merely filling the $400 million hole in the budget as opposed to trying to do something structural about the inadequacies of the state’s tax system. Such a fix would probably get Sundquist off the hook for the balance of his term, but then leave the next governor looking for the same kind of global solution and facing the same torrent of opposition. For their part, legislators would just like to get their phones to stop ringing.
What has been most striking about the firestorm of opposition has been the absence of any pretense of representing the broad public interest. When the executive director of the National Federation of Independent Business, the powerful small business lobby, was asked to explain why the tax shouldn’t be broadened to sole proprietorships, he said simply that most of his members were sole proprietors. Allen Ramsaur, who as an advocate for the poor during the 1980s thought the tax on groceries was an outrage, doesn’t think it’s such a bad thing now that he represents the Tennessee Bar Association.
In some regards, Sundquist’s tax proposal is a sort of Nixon-going-to-China thing: something that could only be accomplished by a Republican because only a Republican could blunt the opposition of his own party. What remains to be seen is whether Sundquist can contain the fury within his own party. The early prospects don’t look promising.
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