Tax Reform Roundtable: No. 1 Problem Is Rules Keep Changing
Who’s Who, Said What.
Participating in The Business Journal roundtable on taxes held Oct. 30 at the Holiday Inn-Boardman were Jim Rosa, principal in HBK CPAs and Consultants; state Rep. John Boccieri, D-59 Poland; John Donchess, principal at Packer Thomas; Lisa Loychik, tax principal in the Youngstown office of Cohen & Co. Inc.; Dan Wolfe, principal in Byler, Wolfe, Lutsch & Kampfer, CPAs Inc.; and Tod Porter, chairman of the economics department at Youngstown State University. Rosa and Donchess are former chairmen of the tax departments of their firms.
Dennis LaRue led the discussion, joined by Publisher Andrea Wood. Cyn Allen, registered professional reporter of Steno Scribe, recorded the discussion verbatim and LaRue edited he transcript for publication in our MidNovember edition..
The Business Journal: Before we ask the first question, a couple of observations. First, we can all agree that the primary purpose of tax collection is funding the government to provide essential services, although we can disagree as to what those services are and the degree to which government should fund them. Second, as Justice Oliver Wendell Holmes Jr. wrote, “Taxes are the price we pay for civilization,” although some might think the price paid is too high and would settle for barbarism, if not savagery, instead. To the first question:
Of the taxes small businesses pay, what percentage of their revenues goes to the federal, state and local governments? How much to each level?
Jim Rosa, principal at HBK CPAs and Consultants: That’s a pretty unfair question because taxes aren’t generally assessed based on gross revenues. They’re generally based on profits, although in Ohio, Ohio tax is on gross revenue. But if you compare taxes to what [net] income is, the rate can be as high as 50%, not counting payroll taxes, and property taxes and so forth. So if you add it all up, it probably exceeds 50% – or it could anyway. And then every industry is different. So it’s hard to assess what that percentage is, based on revenue.
John Boccieri, state representative, D-59th Ohio district: My statistics come from the Legislative Service Commission, the nonpartisan think tank for our Legislature. Legislators look through a political lens as to how we fund our government. The belief in both parties is that taxes need to be fair and they need to be clear. And where those two [goals] intersect is where the great debate begins.
The statistics show that the small businesses that are pass-through entities pay federal and individual tax rates of between 10% and 39.6%, plus self-employment taxes of 15.3%, which are calculated on the first $117,000.
“C” corporations: A small portion of businesses pay a federal corporate income tax of about 35% and [their shareholders are] then taxed again on their dividends and capital gains.
The whole notion of double taxation is of great debate in the Legislature and in Congress that we’ll hear over the next several weeks. But what I hear from small businesses, from individuals, is that they want the tax code to be fair. And they want it to be simple. We try to look at it the same way.
John Donchess, principal, Packer Thomas: To expand on what Jim [Rosa] said, which is correct. He was referring to the maximum potential rate. But it varies depending upon where you live and what business you’re in. For example, if you have a business or are an individual in Florida, it doesn’t have a state income tax, whereas Ohio does. So somebody who lives in Florida will have a lower combined rate than somebody who lives in Ohio.
Then you get into the local jurisdictions. Take Poland Township. You don’t get taxed on income where in the city of Youngstown you do. And if you live in a school district that imposes an income tax, you have a tax there. So that really adds to the complexity of what we’re dealing with, even with ordinary people
Dan Wolfe, principal, Byler, Wolfe, Lutsch & Kampfer: … In Ohio at least there are some exclusions on a pass-through [income] for a self-proprietor entity. So there is a possibility that some business income will be reduced in the state of Ohio. We do have a graduated tax, and there actually is a separate calculation on the taxable portion of that business income. But if we’re a “C” corporation, we’re paying a specific tax.
Everybody has addressed the scenario between the CAT [corporate activity tax], which is the gross revenue tax, 35% corporate tax, less the 15% at the lower levels. State and local varies, 1%, 2%, if there is anything like the income tax for school taxes.
I did a quick calculation and found [total tax rate a business might pay] could be at least 47% at some point in time. And the double taxation on dividends, which if you want to factor that in, would exceed that.
The Business Journal: Let’s pause a moment so you can explain the difference between a “C” corporation and an “S” corporation.
Wolfe, Byler, Wolfe: A “C” corporation is what most individuals see as a corporation, say General Motors. They’re an entity within themselves. Their owners receive a rate of return either when they sell their shares or on their dividends.
A subchapter “S” corporation is a tax-elective position, mostly for small corporations, where the income is reflected on the owners’ individual returns, and in most cases in proportion to their ownership. And the taxes on any profits are taxed at that individual rate.
Lisa Loychik, tax partner, Cohen & Co.: The question – [Of the taxes small business pay, what percentage of their revenues goes to the federal, state and local governments?] – was unfair because of how it was asked. You don’t base taxes on revenues but on net profit. So they can vary greatly.
Take two companies. One can have $100 million in sales and a profit – or net income – of $1 million. Somebody else can have $10 million in sales and net income of $1 million, and they’re going to pay the same rate of income tax.
And there are other taxes like payroll taxes that you can’t get around that mount up and become onerous to the employers. They have to pay them whether they’re profitable or not. So it’s hard to say.
But there’s a lot that companies can and do implement tax planning. A company that’s had a lot of tax planning done and uses a different fiscal year end, [operates under] multiple entities, and uses different accounting methods, can lower the income tax
Tod Porter, chairman, economics department at Youngstown State University: I want to distinguish between the legal incidence of the tax and economic incidence of the tax.
The key idea is that, even though the legal incidence may fall in certain places, there’s a possibility of shifting [the tax] so that the burden is placed somewhere else. Payroll taxes may be a good example because most labor economists feel that the supply of labor is relatively fixed.
With payroll taxes, you end up having the burden shifted from the employer, where they legally fall, to the employee in the form of lower wages.
Then you have this even more difficult issue of “What does the law say?” versus where does the economic burden actually end up?
The Business Journal: What are small-business owners’ primary concerns or complaints about their taxes?
Rosa, HBK: The biggest complaint is uncertainty. Because every year it seems like the rules change; the law changes. In the 40 years I’ve been in practice, there have probably been at least 40 legislative changes. And that doesn’t consider IRS regulations, IRS notices, rulings, guidance, court cases. So things change all the time.
But it’s also just [wanting] simplicity and understanding – what is my obligation? How do I consider that cost in my business planning?
At the end of 2012, we had a massive tax increase. It probably wasn’t recognized by a lot of people, but we had clients that saw their taxes go up by as much as 30% because of the way the rates changed. And so when you don’t have certainty, it’s difficult to make business decisions.
Boccieri, state representative: It’s the nature of politics, given that the business cycle runs three to five years and the terms of elective office are two or four years – six years if you’re a U.S. senator – that priorities conflict.
When you reflect on the economic outcome of what taxes mean, there is a whole host of priorities that the federal and state governments try to tackle.
For someone like me who has traveled outside the United States with the U.S. Air Force, and been to countries I never dreamed I would see, and seen people I never dreamed I would see, I can tell you some countries [levy taxes] better, and some do it more efficiently.
But when you think of the gross economic output that the United States generates, it is significant in that we have a lot of need. Since 2008 we’ve had a low-wage, low-skill recovery. Because of that, we have a depleted workforce.
Many employers I’ve visited say that we need better skilled trained workforce. Fifteen thousand manufacturing jobs are open in the Mahoning Valley right now. I was at Youngstown City Machine just a while ago, and the owner said, “I can put a person in this seat for $75,000 if they can run a high-tech lathe. We’re not getting that type of individual applying.”
One thing that separates the United States from many other industrialized countries is that we have a [large] middle class, folks who punch a time clock, buy a vehicle, buy durable goods, invest in their kids’ future. And when that middle class starts shrinking, we’re going to have a reduction in [good] economic outcomes.
Wall Street is doing very well, but the folks we see are not doing as well as they would like. That’s a big issue.
Donchess, Packer Thomas: Two other things that our clients complain about. No. 1 is the cost of compliance. The more complex it gets, the more it costs them to engage us to deal with all these things. And the second thing is the fact that we can’t always give them black-and-white answers.
The frequency of legislative changes that [Rosa] referred to makes it very difficult for taxing authorities to provide guidance, because oftentimes the legislation is very broadly based. And then the details are to be worked out, by the IRS or regulators.
When you change a law year after year, it’s virtually impossible for the IRS or any tax authority to keep up. So we’re left with a lot of uncertainty. But along with that uncertainty, our clients are looking for definitive answers, and it’s impossible for us to give that to them. We do the best we can.
But it really puts a strain [on us]. And it leads to decreasing faith in the fairness of the system.
Wolfe: … It’s difficult for a smaller business to operate in an environment that’s constantly changing, one that could have a significant impact on their business. Taxes aren’t just an aftermath, an afterthought of profitability. They’re a planned part of business development.
And if you’re a larger corporation, you have a lot of people on staff who help you balance that out.
My daughter-in-law is manager of international tax strategy for a multi-national corporation in Cleveland, and for the last two years she’s been working on trying to model changes likely to come up.[Byler Wolfe] clients cannot afford to pay us to do all of this level of modeling. In most cases it’s difficult for us to do that when dealing with a variety of clients. So a small business is behind [the 8-ball] and finds it difficult to go through that complexity on their own and understand the full impact so they can develop a strategy
Loychik, Cohen & Co.: The No. 1 complaint I get with both business and individual taxes is the complexity of compliance. And that’s not where the value is for the client.
Just one example: The changes to the Ohio income tax have been great for the small-business deduction. That’s been very good for the clients, and also the flat 3% rate or capped rate at 3% on business income.
However, I had a client who’s a resident of Florida and filed an Ohio nonresident return that was about a hundred pages long. It was probably more complicated than the California return. So the states are becoming very sophisticated.
And there are tax breaks and more tax planning you can do. However, the cost of [planning] is greater. So there’s a cost-benefit analysis there. And clients don’t understand it.
The Business Journal: Let’s talk about Ohio’s corporate activity tax. It’s been in effect more than a decade. How well has it worked? Should it be tweaked or replaced?
Rosa: That was a significant change, probably more so than any other change in the state of Ohio since maybe the lottery. And it’s really an old-fashioned tax, a gross receipts tax really.
When the CAT was initiated, you saw the personal property tax go away, the Ohio franchise tax go away, individual tax rates come down.
The statistics I saw show that it’s bringing in about the same amount of revenue as the Ohio franchise tax brought in.
Whether it’s productive, well, you have winners and losers. You always have winners and losers. So if I’m exporting outside of Ohio, I’m winning. I’m paying less tax now.[The premise] of the tax was to shift that burden outside of Ohio. So businesses [outside Ohio] that are selling in Ohio are paying more taxes to Ohio than what they were before based on how CAT was constructed. Has it been effective? I’m not really sure, John [Boccieri]. Maybe you have an opinion.
Boccieri: I do. Because I was in the Legislature when this passed, and I did not support it. One reason why is because I heard from small businesses, in particular those with large volumes of sales and low profit margins – supermarkets and auto dealers, to name two – who have been uniquely impacted by this.
It’s roughly 0.26% of gross receipts on the first million dollars received. So if you earn $150,000 to $1 million, then you pay a minimum tax of 150 bucks.
But businesses with large gross revenues and low profit margins are the ones hit the hardest. To date, Ohio is one of only five states with a statewide gross-receipts tax. More states are considering it. And as you know, shifts in the demographics of production move businesses around. But in Ohio, the CAT tax accounts for about 3.5% of revenues to the state and only 7.4% of all tax expenditures in Ohio.
So its impact in terms of [state] revenues might be small, but it has had a large impact on small businesses and how they operate.
Wolfe: The mom-and-pop businesses probably have found this to be in their favor. The mom-and-pop obviously is paying the Ohio income tax at an individual level. And it depends on the diminishing or the leaving off of the personal property tax.
Some of the higher-volume companies – I do taxes for several car dealerships – found in many cases the tax to be either a moot point or in their favor because of the high inventory valuation and the personal property tax they were paying on that. Which has gone by the wayside and been replaced by the commercial activity tax.
One car dealership in East Liverpool did a lot of out-of-state sales, so the CAT definitely benefited them.
But as was noted, there always are winners and losers. And being just a gross sales tax, there’s always the issue of somebody with low profitability [abruptly] seeing an increase in their taxes not based upon the effectiveness of their operation, but on the numbers they were reporting all along.
Loychik: I agree that some industries absolutely hate the CAT tax because it’s disproportionately affected them. However, for those outside Ohio that have benefited, for them it’s worked beautifully.
Porter, YSU: From an economist’s point of view, one of the key issues is efficiency, not wanting to bias the tax system in a way that it pits one type of business versus another.
If you want to contrast the CAT tax with a value-added tax, you’re looking at how much value does that business add during its production process, and then [the state] trying to tax that as opposed to simply taxing total revenue. We noted earlier that such a tax may put those businesses that are essentially resellers at a disadvantage. They may have high revenues, but their profits are coming from being the middlemen.
Boccieri: To add to something Dr. Porter said. He suggested that many taxes levied upon business somehow, in some way, end up on citizens and consumers in how much they pay for goods and services.
The Congressional Budget Office says that households generally bear the economic cost or burden of taxes that they pay themselves, such as individual income taxes and employees’ share of payroll taxes. In the judgment of the CBO and most economists, the employers’ share of payroll taxes is passed on to employees in the form of lower wages.
And that becomes a big deal when you shrink the buying power of consumers. They’re the engine that drives the economy of the United States. Most of our economic figures are based on consumption, and it’s only lately that the United States has seen an increase in the savings rate.
A high savings rate becomes a huge problem if folks aren’t contributing to economic growth by spending and buying. And one sector in particular that has driven the United States economy since after the Second World War is housing. And everything that goes into buying a new home – steel, wood, concrete, new drapes – if you build a third-car garage, it’s because someone’s buying another car or putting a boat in there.
But the housing sector has been upside down since the Great Recession of 2008. Only lately has it begun to get back on its feet. A big discussion in Washington is whether to keep the deduction for interest paid on mortgages. The impact of ending it would disproportionately fall on citizens who would find that they’re paying higher taxes.
The Business Journal: Since you bring up the mortgage interest deduction, this morning [Oct. 30] the National Association of Home Builders came out in opposition to what it thinks the Trump Administration is going to present as its tax reform package. Canada does not have a deduction for mortgage interest. Its rate of home ownership is about 63%. The United States rate of home ownership is about 66%. So what is the justification – to encourage home ownership? – for keeping the mortgage interest deduction?
Boccieri: No. 1: The United States economy is about three times the size of Canada’s. No. 2: The sector of the economy that has driven our recovery from every recession since the Great Depression is the housing sector. So when you add fuel to that fire, it’s going to generate a lot more economic output. One reason why we’ve had subpar, less than 3%, growth in the United States [economy] is because the housing sector hasn’t responded as robustly. It’s been harder to obtain a mortgage. And if you take away more buying power of consumers, I don’t see how that helps the economy.
Loychik: Right now interest rates are very low. If interest rates rise, and that deduction is taken away, then the impact is going to be much greater.
Rosa: That deduction is an illusion, especially under the proposals. Actually, President Trump is not talking about eliminating the mortgage interest deduction. [He’s] talking about eliminating the real estate tax deduction and all tax deductions.
But if they more than double the standard deduction – and the number of Americans that itemize today is a fairly low percentage, somewhere maybe 30% or so – that percentage would shrink. It could go down by half or more if we have a $30,000 standard deduction for married persons and $15,000 for individuals.
That’s a pretty sizable deduction. So for most Americans, that’s not going to be the driver. It’s interest rates.
I remember when I bought my first home. I had a mortgage with a double-digit interest rate. That was more difficult. And borrowing money today – that’s part of the problem – it’s so difficult. The process remains difficult. The process is just onerous.
You look at millennials today. They’re not buying homes. Well, why aren’t they buying homes? Because it’s just so difficult: the cost associated with it, the commitment to paying that mortgage every month. And the responsibilities that come with home ownership.
The Business Journal: Not to mention that many say they have a lot of student debt
Rosa: No doubt. No doubt.
Donchess: The other thing that’s happened is a change in the economic reality. When our parents were growing up, you got a job, you bought a home, and that’s where you stayed for 30, 40 years. Now we have a much more mobile society.
Buying and owning a home can be as much a burden as a benefit. Because if you’re moving every couple of years, you buy a home, and then you’ve got to worry about selling it and buying a new one.
In a lot of cases, millennials don’t want the responsibility of maintaining a home.
Jim [Rosa] is spot on when he talks about the whole idea behind the tax reform, from a policy standpoint, is that you lower the rate, you eliminate the need for deductions, and that’s fair because you don’t have winners and losers based upon whether you own a home or rent. Doubling of the standard deduction is intended to cover that.
For most Americans, it probably would. It’s the more affluent who would be affected by the loss of the home mortgage interest deduction. But that deduction is just one factor of many that go into whether you want to buy a home. You can’t compare the U.S. to Canada. You can’t really compare what happens in the U.S. to what happens in most countries, because we’re so much larger and different.
But I’m not so sure that eliminating the interest deduction would do that. There would be a transition period where things sort out. I’m not sure it would have a major impact on whether people want to buy a home because it’s only one of many factors that come into play.
Wolfe: Probably the average individual who would itemize may have $6,000 to $10,000 a year in interest just to get above even the current threshold. If we expand a married filing jointly another $12,000 in standard deduction, to exceed that, they probably at that point have to have interest deductions of $16,000.
At that point, you’re really eliminating many people who are buying homes anyway. That $16,000 would mean their mortgage payment is $2,000 a month. So at that level you get a feel for the economic scale of those individuals who would be paying that.
You could argue that if you continued that tax break, it helps only the wealthy, and not the average taxpayer.
The Business Journal: Isn’t that an example of a sacred cow, the whole idea of the mortgage tax deduction? And aren’t we going to come across a lot more sacred cows the lobbyists will defend?
Donchess: Pick your tax deduction, and it’s a sacred cow for somebody.
Loychik: There are a lot of people who are caught in the middle with the doubling of the standard deduction and the taking away of the exemptions and the way the brackets are falling. Around 110,000 to 250,000 people would actually pay more in tax if it goes through as it’s stated now. Which I’m sure has been identified and is going to be fixed.
Porter: I would agree that it creates a bias for buying versus renting that we don’t want in the tax system. And definitely many, many studies have shown that [the mortgage deduction] helps primarily upper-income individuals. So economists have never been fans of that deduction.
The Business Journal: So what is going to happen?
Rosa: It will stay. It’s a sacred cow.
Wolfe: With the expansion of the proposed standard deduction, it may stay. But it could turn out to be a moot point because many more people won’t be able to claim it anyway.
The Business Journal: Can we talk some more about the proposed tax reform? We really don’t know what the Republicans have in mind.
Rosa: We don’t.
Boccieri: And you have to look through it with a political lens. The Republicans are trying to gauge the public temperature about where and what are necessary.
The politics is we want to get something done, so let’s do something. Something’s better than nothing. With respect to what gets done is where this back-and-forth is going to happen. Those folks in elected office [ask], What is going to give us the biggest economic output? The biggest economic push if we add or take something away?
One proposal is reducing how much can be contributed tax-deferred to a 401(k) – requiring taxes be paid upfront. That’s been a discussion by the majority in Washington. And that would have a huge impact on the United States’ savings rate. So what are we incentivizing in the tax code? The deductions we allow and what we tax are going to either drive or take away from an individual’s buying power.
Rosa: From the outside looking in, John, to the political sector, it’s so frustrating. It used to be both sides of the aisle would work together, would talk. There would be an open exchange that we, as Americans, could see.
Today you get snippets. And like you say, the trial balloons are floated out. And then each party pokes each other in the eye.
No matter what, even if I agree, because you’re not in my party – that becomes the overriding issue. And we can’t work together. Why can’t we work together?
That’s so frustrating, looking in and just watching all of this. I just wish we were able to sit down at a table and do what’s best for the country. I wish we could get there.
Boccieri: Hear, hear. We cannot agree on the things we find agreeable. I’ve worked in the private sector, I’ve worked in the public sector, and I can tell you that the 24-hour news cycle has really driven a wedge into our ability to sit down and talk to each other.
You’re going to be misquoted. You’re going to be pushed into a corner in making a decision. It’s trench warfare right now in Washington.
As someone who has served in both the state Legislature and in Congress, I can tell you that Washington is one of the few places that you can propose an idea, introduce legislation, and then campaign against it. And that is a real problem.
And we have moved away from one of the foundational words that governs the United States. And that is consensus. Consensus has driven the political makeup of United States. We are finding that we can’t reach a consensus. So we need voters and citizens alike to stand up and demand that [legislators] work together.
Rosa: I attended a group in Washington, No Labels, whose objective is to remove the labels of Democrat, Republican, conservative, liberal, and try to discuss ideas. It’s a great idea. But I can’t see it getting traction in the current environment. It’s frustrating.
Porter: One other wrinkle about the whole 401(k) discussion is that it may not even be driven much by economic or policy objectives. It’s been driven by when the tax revenues are going to show up for the federal government. So you essentially have a 10-year window that they’re looking at about when is the deficit affected?
And so if Congress switches to more emphasis on Roth-type IRAs as opposed to when you’re paying your [deferred] taxes, and then pay a lower rate on that deferred income as opposed to the 401(k), what they’re doing is trying to shift some of that revenue to help them reduce the deficit in that 10-year window.
It’s not at all clear that this makes any policy sense whatsoever. It’s more of a gimmick around the constraints they’re working in politically.
Donchess: Regarding tax reform, a couple things, which follows what Lisa [Loychik] was saying. If Congress keeps the focus on helping the middle class, that will help sort a lot of these things out. I’ll give you a practical example where complexity makes absolutely no sense.
My daughter and her husband are your typical married couple. They both work, so a two-earner family, and they do reasonably well, but not great. Once they had their first child, we started looking at married filing separately versus joint returns. Because with joint rates, you go up the scale with progressive tax rates, and sometimes it’s better to file separately, even though the rates increase dramatically more. You can save on overall taxes.
Well, once they had their first child, it became even more complex because when you file separately, you can’t take certain deductions. Or certain deductions are limited: the child-care tax credit, the ability to take the credit for paying day care and child care.
My point is this. There are a lot of two-wage earner young couples raising families like that. And for that family to have to come to somebody like me so they can figure out what’s best for them makes absolutely no sense whatsoever. They’re lucky. I do it for free. I mean, others don’t have that luxury.
That is the best example I can think of for why the income tax code has to change, why it has to be made more simple.
The whole idea of lowering rates for everybody and minimizing or eliminating these special rules that apply to some and not others – not creating winners and losers – makes a ton of sense from a policy standpoint. Unfortunately, politics comes into play. But there needs to be some middle ground that can be reached to help those people. Because the wealthy people do fine.
They can afford [accountants] to lower their rates. The people with very little income are fine, because they don’t pay taxes. It’s the middle that is really struggling right now, and that’s where [reform has] to be focused, not on the wealthy. It’s those in the middle class that could be hurt by this, the people it’s supposed to help.
Wolfe: We can get into a lot of stories. I have four children, and they’re all in that same realm. But when you ask about the complexity, I mention my daughter-in-law, who has a master’s degree in taxation from the University of Denver. My son is a tax accountant for a New York Stock Exchange company based in Cleveland.
They had to come to me, because I do a lot of individual taxes. “Hey, we need help,” they said. “We’re filing separately, but we messed up.” And I had to amend their return for them.
And they work in the corporate world and partnership world. They met in the tax department of Deloitte, so they have that experience. But that’s the complexity of it. Just simple little things that happen, even somebody who you would say absolutely knows what’s going on. Unless they deal with it every day, which they don’t.
The Business Journal: So is anything going to change? Or are we just going to keep talking about what should be done?
Rosa: Over the years there has always been discussion about making the tax system simpler. And every time, every time that has been the objective. But instead it becomes more complex.
For example, there’s probably a dozen or more education-related tax incentives. That alone creates uncertainty and confusion. Should I take a credit? Should I take a deduction? What’s best for me? It’s crazy.
Loychik: I posed that question to Ron Cohen, the founder of our firm. We just celebrated 40 years. So I asked him, “How do you feel about making the tax code simpler versus fairness?”
He told me that he served 12 years on the American Institution of Certified Public Accountants’ tax executive committee, and most of their energy was spent on standardizing the rules, on how the tax code could be simplified yet be fair.
He said that after spending years on the matter, they came to a consensus to have fairness. You can’t have both. You’re going to sacrifice fairness if you simplify, because there are too many individual circumstances.
Boccieri: And that’s where the politics comes into it. What is the art of the possible in making tax laws both fair and simple? You have to find consensus, something that’s very elusive.
In terms of politics, there are so many competing interests that you have to deal with. We’re talking about generating revenue to maintain the government and have the policies that we need to move the country and the state forward.
As an example, Gov. [John] Kasich has cut the income tax for many individuals, so the hundred bucks that we’re [forgoing] at the state level has translated to nearly $300 [more] in local taxes because of the unfunded mandates continually handed down to the local government.
The tax code identifies what [our] priorities are. In politics, a budget is a statement of priorities. What are we going to prioritize in the state of Ohio?
Ohio has seven of the nation’s 100 largest metropolitan areas: Cleveland, Columbus, Cincinnati, Dayton, Akron, Toledo and Youngstown. The 16 metro areas in Ohio constitute 81% of the state’s population, 84% of the jobs in the state and 87% of the state economy.
In their analysis of the state budget document as a statement of priorities, the Brookings Institute said [and he quoted] that state policies have failed to keep pace with the changing dynamics of today’s social, environmental and economic reality. State policies set ‘rules of the development game’ too often favoring the creation of new communities over the redevelopment of older ones or subsidizing greenfield development instead of brownfield remediation.
Their analysis concludes, The result is that Ohio’s cities are weaker than they should be, and misplaced state investments fail to empower cities to leverage their assets. This disconnect impedes the development of the state at a time when Ohio most needs to realize its full potential in the global economy.
The Business Journal: School districts rely on property taxes to finance their operations. They have risen as the Ohio General Assembly has reduced state taxes. Residents are happy to pay less in state income taxes, but unhappy at the school districts seeking increases in property taxes. Is there a better or more equitable way to finance our public schools?
Rosa: This is really an interesting question. And I don’t have an answer. But again there’s the frustrating situation where three times the Ohio Supreme Court has ruled that how we fund our schools is unconstitutional. I would be in jail right now if it was me violating this, right?
I don’t understand. You’re exactly right, that the state reduction in taxes has pushed so much more obligation on the school systems, the local communities. And they have a difficult time passing local levies to fund them. This is insane. Isn’t this the most important investment we make? In our children, in their education?
The Business Journal: It’s not just the tax system that’s broken. It’s broken in terms of the education the kids are getting. Look at Youngstown City Schools versus Poland.
Loychik: Your quality of education should not depend on where you live.
The Business Journal: But that’s not the political reality.
Boccieri: So the political reality, Professor [Porter] – back me up on this – is that the socioeconomic challenges in Youngstown contrast starkly with Poland. Even though we’re spending more money per student in Youngstown than Poland, the outcomes are different, and it’s because of socioeconomic conditions even though Youngstown spends more money. So spending more money doesn’t necessarily translate into better outcomes.
Porter: First of all, the balance between state revenue versus local revenue: as you make the system rely more on local revenue, the [lack of] state funding results in greater inequality.
State revenues tend to be distributed more equally, whereas at the local level, some communities are very well off, can raise property taxes relatively easily. And then you’ve got communities that really struggle.
Some of the research I did back in the early ’90s showed an interesting shift in terms of assessed values starting to match more closely with people’s income.
For example, think about Struthers. If you go far back enough, Struthers had a really high assessed value per pupil because it had the steel plants, even though most of the residents weren’t that well off.
And then the mills closed and you had a community where it no longer had the assessed value from the industrial base. So what you see more and more is the assessed value matching the income levels within the districts.
But you have a really big variation in income levels across school districts, which are really small geographic areas. You have some districts that spend very generously per pupil and others that are really suffering. In southeastern Ohio, financing schools is a real problem.
The Business Journal: Let’s return to the question: Should we continue to fund our public schools basically on property taxes, or is there a better way?
Boccieri: It’s not all on property taxes. A good portion of it is, and it depends on, as [Porter] said, which school district you live in. If you live in a high-wealth district, you get less money from the state, so the reliance is on local property taxpayers to make up the average amount spent per student.
That average amount across the 613 school districts in Ohio is $8,000. Some districts spend more because they can afford it. Some spend less because they don’t need it. But by and large, $8,000 is what it costs to educate a student.
Taken away from this is the political reality that we have created a for-profit school system in Ohio where the highest-performing charter school has not outperformed the lowest-performing public school.
And we just crossed the Mendoza line of a billion dollars going to for-profit charter schools in the state of Ohio. [The Mendoza Line, a baseball term, is the division between acceptable mediocrity and unacceptable mediocrity.] And that is a really huge problem.
The [state Legislature’s] tax shifting has been stark. In Ohio, local taxes account for 44.4% of combined state and local taxes. That is above the U.S. average by 3%; 41.8% is the U.S. average.
And as you shift that tax burden down to lower layers of government, it hamstrings local communities from using that money for investment, to lure businesses, to offer their own tax breaks.
The Business Journal: Those seeking public office often promise to close tax loopholes. One man’s loophole is another man’s tax incentive to encourage his industry. What do you see as the most egregious loopholes? And how should they be closed or phased out?
Rosa: I hate the terminology “loophole.” Most tax incentives called a loophole are intended to be there, at least by somebody. A loophole, as I would define it, is an unintended result.
If you want an example of an unintended result – the one I can think of is carried interest, the idea that hedge fund managers can essentially pay capital gain tax rates on what’s really [their] compensation.
But again, it just depends. You’ve got [accelerated] depreciation. Well, if you’re not in a business making capital investments, you’re at a disadvantage. You can’t benefit from, say, the research credit or incentives to export.
Those provisions were put in the law with a certain intent. To call them loopholes and advertise them as somehow a black box that someone has reached in and taken something and used it inappropriately, I really wish we would lose the term and be more open about what we’re doing.
Loychik: Right. Like the depletion allowance for the oil and gas companies. So depletion is just like a giveaway, once an incentive to encourage investment deemed risky, and now oil companies are making a lot of money, and they still get the depletion allowance.
Wolfe: We talk about the home mortgage interest. You buy a second home. You still get the deduction. There was a particular reason but many of the particular reasons have been lost. You mentioned the depletion allowance; that really has lost the original intention. There is no need to continue those.
When you hear Warren Buffett say, “My tax rate is such-and-such because of capital gains,” and you say, “That’s a loophole.” Well, it is and it isn’t. Because most people’s 401(k)s are part of that capital gains that put additional investment into the community.
Many loopholes have a back-end result. We get a capital gains rate on certain domestic dividends. Corporations are paying cash. They don’t get a deduction for that. That’s double taxation.
But in a sense there is no deduction for a company paying the dividend, but as a shareholder I have to pay probably at least 15% on that. So the corporation is paying a tax on it. I’m paying a tax on it. So is it really a loophole? I don’t think you can correct what’s considered a loophole without also addressing some of the other items connected with it.
Rosa: In a lot of cases with my clients, they qualify for a benefit that had an objective, but they didn’t know it until we were filing their tax return. So it was supposed to promote a certain behavior, right?
You raise the point early on that the tax system’s primary purpose is to raise revenue to run the government, and I question that sometimes. Because I think it’s truly there in many ways to promote and affect our behavior, whether it’s business, personal or individual.
There are so many more objectives of our tax system than just raising revenue. There are social objectives. And [the tax code] is one of the levers that government has to affect our behavior.
Wolfe: The general populace, as they use the term “loopholes,” creates a very negative connotation, and people will say, “We want to close loopholes.” What about not paying taxes on the hospitalization that your company buys for you? That can be as much as $20,000 a year. Theoretically, that’s as much of a loophole as anything else on the table. But a loophole to one is a benefit to the other. It’s a difficult process and some things that have seen their day should be closed. But until we address it holistically, it’s difficult.
Porter: You just stole my thunder because I was going to talk about the nontaxation of employer-provided health insurance. In some ways, that’s one of the biggest [loopholes].
Economists talk about tax expenditures and, essentially, the money the government gave up because it’s not taxing something. And [company-paid health insurance is] certainly the biggest, and probably also politically impossible to get rid of.
But as [Wolfe] mentioned, you have a benefit that may be worth $20,000 going untaxed. Typically that benefit goes to higher-income groups. The person working at Walmart does not have employer-provided health insurance, and it really distorts our health-care system.
Some economists would argue that higher spending on health care than what we might have otherwise is negative in some ways. So yeah, that’s one of the big elephants in the room.
Donchess: We probably could all agree that once an incentive is put in the law, it’s virtually impossible to take it out. Therein lies the reason why we have been talking about simplification for decades. It doesn’t happen because, to achieve simplification, you have to remove incentives that create winners and losers. The potential losers are going to fight like cats and dogs to keep it in there. That’s what puts the brakes on a lot of the policy discussion.
The Business Journal: If taxpayers are to comply and file honest returns, they must perceive the tax system as fair. In your opinion, what are the fairest taxes, the least fair? And why?
Rosa: The fairest tax is one based on income at a graduated, progressive rate. Because every other tax is regressive. Any other tax that, regardless of your income level, is going to be regressive by its nature. The least fair? I guess you could name any of the regressive taxes.
Wolfe: I agree. Years ago when I had more energy, I taught tax at the local Kent State branches. And one of the first things I said in the initial class is, No. 1, “Don’t expect fairness in the tax law. Because tax law is predicated on ability to pay, not fairness.”
How you define “fairness” is really the question. I hear people talk about whether we should just have a flat income tax. But is that fair? If I have a family where both adults are making minimum wage, I’m going to end up paying more income tax than I do now. A flat tax may benefit those at a higher bracket more than before.
That’s equality, but isn’t necessarily fair. So I would agree. The graduated tax based on income is the fairest.
Porter: I agree with everything that has been said, but I would add that we keep talking about the federal income tax as if it was the only tax we pay. We have a progressive income tax, but we also have a somewhat regressive payroll tax system. And then we have a lot of money collected through sales taxes, which are regressive.
If you look at the U.S. tax system as a whole, it’s not at all progressive. And then you have the issue of what benefits are you providing with that money?
Much of Europe uses the VAT [value-added] tax [a national sales tax], which is somewhat regressive. But on the other hand, they’re more progressive in terms of their social safety net, and so you have more [generous health care, unemployment insurance] benefits. So you need to look at the whole system, not just an individual piece.
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