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ECONOMIC ANALYSIS: Evaluate today before gauging effects of tax proposal

October 29, 2007

Gov. Mitch Daniels unveiled a tax proposal Oct. 23 designed to remedy a number of widely held concerns over property taxes in the state. In a nutshell, his proposal reduces property tax collections by one-third and generates additional revenue by increasing the general sales tax 1 percentage point.

His plan offers a three-tiered property tax rate-1 percent residential, 2 percent rental and 3 percent commercial-and moves taxation (and perhaps budgetary decision making) from the township to the county level. It also shifts the burden of funding schools and child welfare from local government to the state.

Like any tax plan, this one influences behavior of both businesses and consumers. I'll be spending lots of late nights over the next few weeks trying to understand these effects. In the mean time, it is important to see where we are today.

Tax systems, including Indiana's, are regressive. That means the tax burden as a percentage of income drops as income rises. This feature is necessary since states need to balance their budgets and regressive taxes are more stable. It also helps balance out a very progressive federal tax system.

States tax four things: income, wealth, consumption and activities. But the activities tax-primarily licensing fees-is a small component of our state's budget and not part of the current proposal.

Indiana income taxes are a flat 3.4 percent of earnings. In a perfect world, income taxes would provide a nice source to offset property taxes. But the presence of three different local-option income taxes makes it difficult to adjust state income tax rates.

With income taxes in the bottom third of states nationwide, property taxes in the middle, and sales taxes in the top third, Indiana enjoys a reputation for a good tax climate.

Daniels' tax proposal has three immediate economic effects: It reduces the cost of capital for firms and individuals, increases the cost of purchasing non-food retail items, and reduces the instability in the overall tax system.

Businesses and residents will respond to these three effects by increasing capital expenditures-on businesses and residential property-and reducing consumption of taxable goods. The increase in capital expenditures is motivated both by the lower cost of capital and the reduced uncertainty about taxation. Higher sales tax rates motivate less consumption.

It's important to note, though, that sales tax increase would apply only to a small proportion of economic activity: retail goods. Services, food and most medicines are excluded. So the increase in the sales tax rate effectively is less than one-tenth of 1 percent of total collections.

It is too early to fully outline the magnitude of the Daniels proposal and its effects. Hoosiers should be asking important questions such as:

Who bears the burden and relief of the proposed tax changes? How much economic activity will shift from retail sales to other industries? And how big will the effect be on economic activity?



Hicks is director of the Bureau of Business Research at Ball State University. His column appears weekly. He can be reached at bbr@bsu.edu.
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