Indiana Considers Comprehensive Tax Reform
How have taxes evolved?
In late December, Senator Travis Holdman, the Caucus Chair and Chair of Tax and Fiscal Policy announced plans for a comprehensive review of Indiana’s state tax system. He proposes a two year or longer Blue Ribbon study that would envision an optimal tax system, without regard to the current system of state and local taxes.
The timing of this study is designed to coincide with a windfall of extra revenues that would likely occur in three years as a result of Indiana making the final pension reform payment the state undertook in 1996. This timing allows for bold and comprehensive thinking.
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At the very outset, I’ll admit I think this is a very, very good idea. For many reasons.
The major reason is that the state’s economy has been stuck in the doldrums for most of the past decade. Our GDP growth lags the nation, personal income is lower and growing more slowly than our fellow Americans and job creation has been profoundly poor for more than a decade. State and local policies contribute to these doldrums, and taxes and spending are a prime issue. It is worth reviewing the particulars of the tax system, as well as a brief review of effects of that tax system.
Indiana’s property tax system is unnecessarily complex and arcane. The sales tax base is very narrow, and eroding. The share of consumption in goods (which are taxed) has been in decline since 1945, and continue to shrink about half a percent over each biennium budget (except for a temporary COVID bump, that boosted revenues).
The state’s fastest growing sector is largely free of taxes (not for profit hospitals), and the growth in public services has not kept up with the demands of a modern economy.
Indiana’s property tax system is unnecessarily complex and arcane. Tax Increment Financing has captured almost all the net growth in property taxes (of all types) over the past decade, and we now abate or exempt the majority of new business investment.
Our state’s income tax is surprisingly complicated, far more so than federal income taxes. The corporate tax base is eroding, most likely due to distortions in the type of business formation (fewer corporations, more LLC’s). Both the Corporate and Personal Income Taxes have been subject to automatic cuts that were made with the hopes of boosting economic growth, not with an eye towards tax adequacy.
Several smaller taxes were designed badly, for political expediency rather than for the purposes of providing public services efficiently. The Casino taxes serve Indiana poorly.
These reasons alone would be sufficient to warrant such a comprehensive review. But, there are other reasons. Among them are the general lack of ‘tax literacy’ among policymakers and citizens. As I travel around the state I find legislators who don’t understand taxes, county commissioners who don’t understand their own tax structures, school boards and superintendents who don’t understand how their taxes are collected.
Most economic development officials don’t understand how the most common fiscal incentives effect their community, and most consultants don’t offer a comprehensive analysis of these issues. Taxpayers should understand a little about the taxes they pay, mostly they do not. This causes legislators to respond to the least informed citizens. And, if you don’t believe me, ask any legislator about the panicked calls they’ve had about property tax assessments this year.
Much of this is due to the unnecessary complexity of calculating and assessing taxes. No one person could possible understand it all, in all the dimensions needed to fully comprehend the scope and effect of taxes.
There’s also widespread confusion about the role taxes play in economic growth, and how spending affects public services. Hoosiers also have little understanding of how poorly we do on several key public service issues (e.g. health, crime and education). Any study of taxation needs to be combined with a discussion of public services. After all, taxes are just the price of public services.
Indiana is hardly alone in all these problems. Any thoughtful study of Indiana’s taxes will find that they compare favorably on many domains. Still, all of this suggests Indiana should take a couple years to fully consider all taxing options.
One of the first steps of understanding taxes is to understand where the state sits in the quality of public services. I addressed that issue here, just a few weeks ago. The second step is to examine broadly, how taxes have evolved in the state over the past couple decades. This can be done through a rolling list of legislative changes, but that is boring and unhelpful.
Instead, it’d be better just to examine the overall ‘effective tax rate’ for each tax. That is, how much overall tax collections have been, by the tax base (income, consumption or property).
I begin with property taxes, which were heavily modified in 2008. This modification also affected school levies, transferring 100% of operational funding to the state General Fund (minus subsequent referenda in a few locations).
What should be clear here is that the property tax reforms added significant abatement and exemption use by local governments. Today, more than one in three dollars of assessed value is either exempted from taxation, or abated by the local government. This does not include depreciation, just business and household exemptions. At the same time, the effective property tax rate is now lower than it was at the height of the pre-reform period, back in 2004-2007. The base on property taxes are the Gross Assessed Value of real and personal property in the state. Property taxes could be cut by a third if we eliminated abatements and exemptions.
Revenues to local government are increasingly reliant upon income tax collections. These local income tax collections offset some of the property tax losses experienced since the reforms. The tax base of local income taxes are personal income.
Our sales tax rate is nominally 7 percent, but only 3.1 percent of personal consumption expenditures are collected as taxes. This is due to a very narrow tax base on which sales taxes are collected. To illustrate this, in 2021, the state collected $9.072 billion in sales tax. If the state expanded the tax base to all consumption items (goods and services), annual revenues would’ve been $11.27 billion. The revenue neutral sales tax rate (with a full base) would be 3.1 cents.
Indiana has been cutting corporate taxes as well. It is worth noting that the actual payees of corporate taxes are shareholders, most of whom are retirement funds. So, a corporate tax effectively taxes savers twice for each dollar of income.
Overall, when using Gross Domestic Product as a base, Indiana’s total tax liability has declined substantially from 7.5% at the beginning of these data, to 6.8% in 2019.
Note that for direct state and local taxes, I must rely on biennial publications (from 2020 and 2021) which have yet to be published. For some state taxes only, I can use other sources, such as the National Association of State Business Officers annual report, along with data from the Bureau of Economic Analysis for the tax base data.
Taxes on individuals have mostly declined over the past 15 years, but taxes on business show very different outcomes. Overall, Indiana taxes businesses very lightly. We are far low tax for all businesses than the nation as a whole, and have cut taxes substantially in recent years.
It is worth noting that COVID saw both major shifts to consumption, and large individual and business subsidies. This will almost certainly return closer to trend, though long term changes to consumption might be effected by large shares of remote workers (less demand for transportation goods and services).
The big winner in taxes in Indiana was industrial production, whose effective tax rate plummeted from 80% of the national average down to 45.6% of the national average by 2019. Indiana’s taxes on manufacturing in particular are now at nearly the lowest in the nation.
Interestingly, these tax changes have had some effect on GDP and employment over the past 25 years. Keep in mind, that lower taxes on these industries are typically in the form of property taxes. This is a tax on capital. When you reduce the tax on something, businesses typically substitute away from other inputs, towards more of that, now lower taxed, input. So, tax cuts on capital and equipment should be anticipated to lead to increased production, along with a shift away from labor to capital. So, did that happen?
The deep cuts to industrial production accompanied larger levels of inflation adjusted GDP in Indiana, but those increases were proportionately very similar to that of the nation as a whole. So, a nearly halving of taxes on industrial production relative to the nation as a whole resulted in a roughly 1 percent higher level of GDP growth over 25 years than was experienced by the nation as a whole.
That increase in GDP is a putative benefit of the tax cut. Whether or not it is causal is another question, but even if all the relative GDP increase was due to the tax cut in Indiana, that would not meet a cost-benefit threshold, given the deep tax cuts and small GDP increase.
But, the tax cuts should also have shifted the capital to labor ratio in production. Did that happen?
Yes, it apparently did. The cumulative decline in industrial employment was far larger in Indiana than it was in the nation as a whole. While this analysis is not casual (I’ll save that for an academic paper), it is very clear that the deep cuts in taxes on industrial production in Indiana accompanied a much larger reduction in jobs, and a shift of production towards more capital intensive industries or firms.
Probably the best example of that is contained in Mughan and Propheter (2017), who estimated the effect of eliminating the tangible personal property tax on manufacturing employment in Ohio. That cut resulted in substitution of equipment for people, reducing employment in manufacturing, even as production rose.
Indiana is poised to take a couple years to fully understand the role of taxes on growth, and fully explore the individual taxes and tax system as a whole. That is much needed, and will be very revelatory. We should see lots of analysis of individual taxes and their effect on business.
I have one warning. It is certain that there’ll be a huge number of claims about the benefits of lower taxes (as well as the effects of more spending). This is a time to sort out fact from fiction, hope from experience, and claims from actual outcomes. Done well, this could provide Indiana with decades of a stronger economy. Done poorly, it will reinforce the slow growth path the state is now suffering through.
Note: This post was edited on January 12, to correct a typo.
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Professor Hicks, Thank you for providing tax analysis that is comprehensible by us non-economists. As a simple country doctor, I have a great interest in my patients and their community, as this also affects health. For decades, I have followed Dr. Ron Paul and Art Laffer, and now you. What I notice as a recurring thread in your articles is an emphasis on high levels of public spending. This causes me some concern, as I sincerely believe that our Founders sought to maximize individualism and minimize government spending. My favorite passages are in James Madison's comments on the 1792 Cod Fisheries Bill. Looked at another way, Dr. Paul was fond of saying that "we don't have a TAXING problem, we have a SPENDING problem." When it comes to medical care, I feel that the ideal situation would be the mantra: "Cash, Catastrophic insurance and Charity." The same should hold true for all of State and federal spending. Yes, certain infrastructure and public safety items are best addressed by constitutional representative entity, but as for education and medical care, government involvement is only detrimental and the increasing consolidation is leading to a globalist/collectivist tyranny. I found your analysis of tax changes and shifts in capital and labor to be extremely illuminating. Please, continue to provide insights such as that. While the flat tax is not flat and the fair tax is not fair, I keep coming back to the Laffer argument for the lowest, flattest tax on the most broad base. Once again, please do not laugh too much at these simple comments, but, as you yourself said, the goal is to increase tax literacy. Thank you for your efforts. I look forward to future essays. Simple Country Doctor, Warsaw.