How the Tax Code Interacts with
State and Local Tax Systems
President’s Advisory Panel on Federal Tax Reform
April 18, 2005
Timothy Firestine
Finance Director
Montgomery County, Maryland
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Overview
• As federal tax reform is discussed, the impact on local governments could be
dramatic.
– These measures would have a cascading effect throughout the tax system.
• Any change in the federal tax system will impact state and local tax systems, thus
the Panel needs to analyze the total impact on all taxpayers (individual and
corporate) as well as all local revenue systems.
• There is a critical need to ensure independent means for local and state
governments to obtain revenues through taxes and access to the bond market, as
direct federal and state aid is waning.
– There are nearly 10,000 different tax systems in our country and each one
would be impacted by changes in the federal tax system. Taxpayers will need
to understand how they will be affected, as well as the impact on their local
governments.
• I am not addressing specific types of reform proposals, but I would like to outline
the impact broad reform measures would have at the local level.
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Overview
• There are over 82,000 local government units.
• Local tax systems, like state tax systems, are tied to the federal system. Thus,
changes at the federal level would need to be addressed at the local level.
• The ability to implement local taxes stems from state authority. Changes to the
overall tax system could cause extensive administrative and legislative concerns
that could adversely impact local governments.
• Local governments are often dependent upon state governments to remit taxes
back to them.
– There have been many examples when the state has withheld monies owed
to local governments in order to solve their own budget problems, leaving
local governments to seek other sources of revenues or cancel projects.
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The role of local governments
and their revenue sources
• Local governments are the first line of interaction citizens have with their
government. Whether it is schools, fire and police protection, or roads,
local governments have more direct interaction with and obligations to
citizens than any other level of government. Local revenue systems are
the single most import resource for education, public safety, public
infrastructure and anti-terrorism response in the nation.
• Local governments need diversity and flexibility of revenues in order to
meet their obligations. This includes access to the tax base and also the
tax-exempt bond market.
• If local governments need to adjust their revenue sources because of
changing federal tax law, consideration must be given to the time needed
to implement new systems and rates (for instance, a voter referendum is
needed in some cases to raise taxes).
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The role of local governments
and their revenue sources
• Sources of tax revenues – local governments
•
•
•
•
•
•
Property taxes
Sales and gross receipts
Income
Corporate
License taxes
Other
72%
17%
5%
<1%
<1%
5%
• Source: State and Local Government Finances by Level of
Government and By State: 2001-2002. US Census of Bureau
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Tax Reform and Local Governments – Specific
Initiatives: Income/Sales/Property Tax
Deductibility
• Unlike other deductions in the federal income tax system, citizens have no
choice but to pay state and local income, sales, and property taxes each year.
• Why tax taxes?
– Because tax payments are not discretionary, as a matter of fairness, state and
local income, sales, and property taxes must be considered when evaluating
an individual’s ability to pay federal income taxes.
– Taking away the deduction would increase a citizen’s overall effective tax
rate.
• Deductibility of taxes preserves the ability of state and local governments to
raise revenues and to provide services, promotes equity in the federal taxing
system, discourages the migration of businesses and individuals for tax purposes,
avoids excessive cumulative federal/state/local income tax rates, and preserves
the autonomy of state and local governments.
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Tax Reform and Local Governments – Specific
Initiatives: Income/Sales/Property Tax
Deductibility
• Last year Congress implemented the ability to deduct sales tax for those
states without income tax – something that was taken away in 1986.
• Eliminating the deductions would adversely impact residents in states with
high local/state taxes.
• Revenues from property taxes - the largest source of revenues to local
governments, that are used to pay for a third of all education - would be
negatively impacted if homeowner incentives were taken away (property tax
and mortgage interest deductions).
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Tax Reform and the AMT
• Taxpayers captured under the AMT face the inability to deduct local and
state income/sales tax and property taxes, which increases their effective
tax rate and adversely impacts those citizens residing in high tax states
(e.g., CA)
• As more citizens are being affected by the AMT, many private activity
bonds, which are tax-exempt in nature, are becoming taxable. Unless this
problem is addressed, more bonds will face AMT exposure which will
curtail demand for the bonds.
– The cost to local and state governments who issue bonds the interest of
which is subject to AMT, may equate to an increase in financing costs
of 25-40 basis points over time.
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Tax Reform and Local
Governments – Macro Policies
• If serious consideration is given to a consumption tax (flat tax, national sales tax,
VAT), the federal government will need to help protect local government revenues
and autonomy that would be compromised. The Panel must include information
relative to the President’s Executive Order on Federalism in the Unfunded
Mandate Reform Act to ensure that all taxpayers fully understand the impact on
them as well as on the three levels of government. Most specifically:
– Without a federal income tax based system, the common denominator of
definitions and structure would be eliminated. This could create a variety of
problems.
– A national sales tax system would need to be set at a rate that would
incorporate state and local taxes, and address how revenues currently received
from state and local income taxes would be replaced.
– There is a great concern that under a flat or national sales tax system, all goods
and services would be taxed. Thus, items such as emergency rescue services,
and school buses would be taxed, and increase the costs for local governments
to provide services to their citizens.
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Tax Reform and Local Governments – Macro
Policies and the Tax-Exempt Bond Market
• Municipal bonds are the primary vehicle local and state governments have to
build infrastructure and provide government services used by citizens.
– Currently there are over $2 trillion worth of outstanding tax-exempt
bonds.
– Tax-exempt bonds are the primary source of revenues for capital costs for
public colleges and universities, schools, jails and prisons, and virtually
all transportation, water and wastewater facilities in the nation.
• The tax-exempt nature of the bonds makes them attractive in the marketplace
and ensures a ready demand for these instruments.
• If the federal income tax is eliminated and the exemption for municipal bonds
is withdrawn, this would in effect force state and local governments to issue
the equivalent of taxable bonds. The costs associated with this change would
be significant.
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Tax Reform and Local Governments – Macro
Policies and the Tax-Exempt Bond Market
• If all investment income becomes tax-free, demand for tax-exempt bonds will
decrease, causing an increase in debt issuance costs.
• Converting from an income-based to a consumption-based tax system would
also decrease the attractiveness of purchasing - and increase the costs of
issuing - tax-exempt bonds.
• At a time when federal aid is decreasing and bond issuance is at an all time
high in order to meet infrastructure and services needs for our citizens, the
federal government should do everything possible to make the tax-exempt
bond market efficient and avoid changes that would increase debt issuance
costs. Record tax-exempt bond issuance occurred in 2003 – $383 billion.
• Given the importance of tax-exempt bonds, simplification efforts should also
be sought to make the tax-exempt bond market work more efficiently. Some
suggestions are noted in the appendix and will also be addressed under a
separate cover.
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Wrap-up
• Tax reform measures would directly impact local governments, and
thus should not be ignored in a comprehensive review of our country’s
tax system.
• Local government obligations to their citizens will never diminish, and
as we have seen after 9/11, they have only increased. Thus, we need
the flexibility and diversity to collect revenues and access the debt
market in order to meet the needs of our citizens.
• The federal government has an important and conjoined relationship
with local governments. A complete understanding of the
interrelationships between our systems – particularly local tax systems
that are often overlooked – should be extensively studied and carefully
addressed by the Advisory Panel.
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Appendix
• Vast complications exist in the Code pertaining to tax-exempt bonds.
• These regulations cause unnecessary and costly administrative burdens to state
and local governments, and provide little benefit to the federal government.
• Specifically:
– Arbitrage Rebate Relief:
• There is no greater burden to issuers of tax-exempt debt than
complying with federal arbitrage rules.
– Smaller , less frequent issuers often do not have the staff or the
sophistication to comply with the rebate requirement
– Larger, more regular issuers of debt find themselves bearing
enormous administrative costs in complying with the rebate rules
as they apply to multiple bond issues.
– Compliance costs are too often disproportionate to the potential
arbitrage benefit involved.
– Funds that are used to pay rebates and assure compliance could
otherwise be used to reduce tax-exempt borrowing.
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Appendix
– Arbitrage Rebate Relief
• Two areas in particular require remedy
– Raising the annual debt exempted from arbitrage rebate
restrictions from $5 million to $25 million. Such a simplification
would significantly ease issuers’ cost of compliance and would
still capture 80% of market volume while eliminating 80% of the
transactions.
– Extending the spend-down exception from two years to three, as
recommended in the 2001 Joint Committee on Taxation’s
proposal
– Public Private Partnerships
• The tax code should encourage public/private partnerships to serve
the needs of communities
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Appendix
– Bank Deductibility:
• Since 1986, law permits banks to deduct 80 percent of the costs of
purchasing and carrying bonds of issuers that do not issue more
than $10 million of bonds annually. Targeted liberalization of tax
restrictions on “bank deductibility,” or bank-qualified bonds,
would ensure that small governments have access to reasonably
priced capital.
• The current $10 million exemption, set in 1986, is unrealistic in
today’s market for smaller issuers to adequately pay for needed
infrastructure. This amount should be raised to $25 million.
• There are many other simplification provisions that the panel should
review and that the tax-exempt bond community has been promoting for
years. We will be submitting these under separate cover.
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