Monday, February 23, 2009

Tennessee’s Crisis Prone Tax System


By Thomas F. Dernburg

Currently, most states are suffering revenue shortages that are largely due to the recession. Tennessee is among them. But what sets Tennessee apart is that, even in good times, state and local budgets cannot be balanced without resorting to legislated tax increases and/or spending cuts.

Under normal conditions, population and productivity growth raise the state's income. To maintain current services, public spending must rise at the same rate as the rise in state income. Revenues, therefore, need to grow at that same rate.

Despite this fact that revenues rise automatically as income rises, Tennessee's tax system is such that a 1 percent increase in the state's income yields only an eight-tenth of 1 percent increase in revenue. This means that in every year, regardless of economic conditions, Tennessee governments are confronted by revenue shortages and periodic budget crises.

The Tennessee state government relies on a commodity-based sales tax for almost two-thirds of its revenue; services are not taxed. This is part of the problem because there has been a trend of a continuing shift of consumer spending away from commodity consumption into service consumption. Even in the short run, the percentage of consumer income spent on non-taxable services increases as income rises.

With the tax base dominated by sales taxes, increases in sales taxes have been the most likely candidate for raising substantial additional revenue. This has produced a vicious circle of a revenue shortfall to be followed by a sales tax increase, to be followed by another revenue shortfall a short time later, to be followed by yet another increase in the sales tax.

The sales tax was introduced in 1947 at a rate of 2 percent. It has risen to 6 percent for grocery food and to 7 percent for other commodities. Local governments add another 2.5 percent. The 8.5 percent at which food is taxed is the highest in the country. It's no wonder that citizens flock to the surrounding eight states to make large fractions of their purchases, thereby taking business away from Tennessee enterprises.

Another characteristic of the present revenue system is that it is grossly unfair. The Institute on Taxation and Economic Policy reported that Tennessee's tax system is the most regressive unfair of any state other than Florida and Washington. The 20 percent of families at the lowest income level pay roughly 11.7 percent of their income in state and local taxes. The top 1 percent pays only 3.4 percent. Poor families spend the bulk of their income on taxed food and clothing while well-to-do families spend a large fraction on untaxed services.

There have been three commissions created by the state legislature to study the tax system and propose reforms. The latest, which reported its findings in late 2004, recommended significant reductions in sales taxes with revenue losses stemming from the sales tax cuts to be offset by a graduated individual income tax. These recommendations are the same as the earlier tax study commissions. They have been ignored by the legislature, which seems to regard tax commissions as window dressing designed to side step hard decisions.

All sales taxes should be reduced with the food tax abolished entirely. A graduated individual income tax should be adopted at the same time. A graduated income tax operates through a bracket system under which poor families are exempt, with rising individual incomes causing an increase in the proportion of income taken in taxes. The tax burden on lower income families would be shifted towards higher income families, thereby addressing the fairness issue. The crisis prone characteristic of the present system would also be eliminated, because graduated income taxes generate revenue increases at a rate somewhat faster than the growth of income.

To break the vicious cycle of revenue shortfall, all sales taxes should be reduced, the food tax abolished entirely, and a graduated individual income tax system implemented in a timely fashion so as to ensure the security and equity of our state economy.
Dernburg is an emeritus professor of Economics at the American University and a former holder of the Chair of Excellence in Free Enterprise at Austin Peay State University.
Copyright (C) 2009 by the Tennessee Editorial Forum. 2/09