1. 1 Lessons from Recent State and Local Tax Reforms Presentation to Connecticut Legislative Program Review & Investigations Committee State and Local Tax Policy Forum Robert Cline, National Director, State & Local Tax Policy Economics Ernst & Young LLP, Washington, DC October 26, 2005

2. 2 Overview of CT Business Taxes Business TaxFY2004 ($mil)% of Total Property Tax $2,20436.9% Sales Tax on Business Inputs 1,52425.5% Unemployment Insurance Taxes 62110.4% Gross Receipts Taxes 4217.1% Ind. Income Tax on Business Income 3976.7% Corporate Income 3385.7% License and Other 2424.1% Excise and Selective Sales Taxes 2203.7% Total Business Taxes $5,966100.0%

3. 3 CIT: A Very Unstable Tax (US)

4. 4 Business Tax Bases

5. 5 Case Study: Ohio Tax Reform Objectives Number one objective: grow the economy by improving business tax competitiveness Reduce the tax burden on capital investments, increase taxes on consumption Impose more uniform (and stable) taxes on all industries and forms of doing business Reduce out-of-line personal income taxes (top state + local marginal rate of almost 11%) Deal with an expiring 1% temporary sales tax increase -- $1.5b problem

6. 6 Ohio Tax Reform Features Phases out corporate franchise tax (income & net worth components) -- 5 yrs. 5-yr. phase out of business tangible personal property tax (immediate elimination for new machinery & equipment purchases). Uniform 21% reduction in personal income tax rates Permanent 0.5% increase in sales tax Phases in new 0.26% CAT on sales over $1m for most businesses (excluding financial services and insurance); min. fee of $150 (sales from $150,000 to $1m); no gross receipts cap

7. 7 Commercial Activity Tax (CAT) CAT applies to both C-corps and pass-through entities Destination-based tax: exempts exports but taxes imports – no P.L. 86-272 nexus protection Excluded from base: interest and dividends Partial pyramiding relief by eliminating intercompany sales among firms in a consolidated group (elected) Addressed balance sheet impacts of changes by allowing limited carryover of unused NOLs Brightline nexus test (MTC): at least $50,000 of property or $50,000 of payroll or $500,000 of taxable receipts Solves the Cuno problem – converts tax credits to grants

8. 8 Why Did Reform Happen in Ohio? Terrible economy: loss of 200,000 manufacturing jobs Long-running public debate over tax reform & business competitiveness – “system is broken” Proactive role of the business community: lead by Ohio Business Roundtable and sharply focused on growing the economy – evaluated options for reform Leadership of Governor and legislature Need to replace temporary 1% sales tax revenue No balanced-budget constraint – $3.7b tax cut by 2010 (financed by spending constraints & econ. rebound); no tax-expenditure limits

9. 9 Tax Reform in Other States Kentucky Reforms –New law adopts a corporate AMT equal to smaller of.95 mills times gross receipts or 7.5 mills times gross profits (NJ AMA-type tax); firms pay higher of regular, AMT or min. fee ($175) –Mandatory consolidated returns; extends tax to pass-thru entities; top rate lowered to 6% (from 8.25%) Texas Proposals –Looking at alterative business tax bases: payroll, gross receipts, value added, net worth and profits –Or all of the above? Michigan Governor’s Proposal –Provide a 35% SBT tax credit for manufacturing personal property, increase profit component of the tax, go to a 100% sales factor, broaden the base and shift insur. to GRT

10. 10 Tax Reform in Other States (cont.) Pennsylvania Proposal –Lower CIT rate from 9.99 to 6.99%, accelerate phase out the capital stock and franchise, 100% sales factor –Focus on creating jobs (dynamic feedback effects) Indiana Reforms (2002) –Repealed gross income and supplemental inc. taxes; expanded ITC and R&D credits –60% reduction in school real property taxes; phase- out of inventory tax Tax studies in progress: NY, OK, Utah MD debating AMA and combined reporting

11. 11 Property Taxes Revolt on the near horizon? –Possible proposition 13 in Idaho; KS & TX court rulings; reductions debated in Iowa –Reduction in FL intangibles tax; IN 60% cut in school real prop. taxes; Ohio eliminates business tangible per. prop. tax CT Urban Rankings (MN Taxpayers Assoc.) –Homesteads: 2 nd highest (84% above ave.) –Commercial: 14 th highest (33% above ave.) –Industrial: 9 th highest (35% above ave.) State vs. local property tax relief

12. 12 Value-Added Taxes: MI’s SBT 44-yr. “experiment” with a modified VAT Pluses: –Broad-base, low-rate tax (1.9%, no increases) –Very stable, base falls 1/5 as much as profits –Uniform tax on all forms of doing business –Encourages capital investment (CAD) –No pyramiding (does not tax bus. purchases) –Indirect way to tax services –Replaced other taxes: inventory,net worth,CIT

13. 13 Value-Added Taxes: MI’s SBT (cont.) Minuses: –What is it? Consumption or business tax? –A destination-based VAT may be borne by consumers in higher prices (STN,12/25/95) –Uniform tax on all forms of doing business: heavier taxes on non-corp., low-profit, labor- intensive businesses (services & retail) –Issues related to apportionment (90% sales) and nexus (P.L. 86-272 does not apply) See: “Should States Adopt a VAT?” in Unfinished Agenda for State Tax Reform, Steve Gold, ed.,1988

14. 14 Lessons Learned There is no “best practice” tax system that CT can copy from another state, but trends are evident –Reduce taxes on mobile capital –Increase importance of consumption taxes –Reduce volatility of tax bases Reform needs to address specific CT issues Reform must look at the system of taxes –State and local taxes –Business taxes

15. 15 Lessons Learned (cont.) If economic development is a key objective, evaluate the impacts of different alternatives on CT’s competitiveness –Dynamic feedback analysis: Ohio, KY, MN, MA, PA –Focus on benefits to private sector Appreciate the difficulty in expanding sales tax bases to include services – primarily a bus. tax (See Cline et al., STN, Feb. 14, 2005) Business pays almost 50% of CT sales taxes (COST study, STN, May 9, 2005)

16. 16 Lessons Learned (cont.) Need to look more closely at economic (“final) incidence – who ultimately bears the tax burden –Who pays the corporate income tax? –Who pays the gross receipts tax? Need to recognize tax convergence –100% sales factor apportionment of CIT –GRTs vs. sales taxes –Nexus considerations: sales tax and CIT

17. 17 Where Are Business Taxes Headed? State reforms are reducing taxes on capital investment (corporate income, net worth, property, input sales taxes) making states more competitive – focus is on economic development Will Congress intervene? ITFA, BAT bill, remote sales tax collection, Cuno States should consider using stronger revenue growth as an opportunity for longer-run reform or, at least, to unwind recent anti-business tax policy decisions Business and government should work closely in developing business tax reform proposals