January 2005
Volume 12 Number 1
State Tax Return
Stop The Shenanigans Or I’ll Shoot —
Tax Reform Texas Style
Kirk Lyda
Dallas
(214) 969-5013
It stands to be quite an interesting year in Texas taxation. In late November 2004
a Texas district court judge in Austin declared the Texas public school finance system
unconstitutional and enjoined the State from funding public schools, but stayed the
injunction until October 1, 2005 to give the Legislature time to attempt to fix the tax
system. See West Orange-Cove Cons. Indep. Sch. Dist. v. Neely, No. GV-100528 (Tex.
Dist. Ct. Nov. 30, 2004, pet. filed). Unless it is overturned by the Texas Supreme Court,
the ruling effectively represents a gun to the head of the Legislature to fix the Texas tax
system once and for all. The Texas courts have apparently had enough of the
shenanigans that hallmarked the attempts to reform the Texas tax system during the
last legislative session. Leaders from the legislative and executive branches are already
floating their ideas for fixing the tax system.
Background
The Texas school finance system has seen its share of litigation over the last
several decades. The West Orange case is the fifth case involving a constitutional
challenge to the system that has reached the Texas Supreme Court. See Edgewood
Indep. Sch. Dist. v. Kirby, 777 S.W.2d 391 (Tex. 1989) (known as Edgewood I);
Edgewood Indep. Sch. Dist. v. Kirby, 804 S.W.2d 491 (Tex. 1991) (Edgewood II);
Carrollton-Farmers Branch Indep. Sch. Dist. v. Edgewood Indep. Sch. Dist., 826 S.W.2d
489 (Tex. 1992) (Edgewood III); Edgewood Indep. Sch. Dist. v. Meno, 917 S.W.2d 717
(Tex. 1995) (Edgewood IV).1
At the heart of these disputes are two provisions of the Texas Constitution that, in
certain respects, are inconsistent with one another. One provision requires the
Legislature to establish and make suitable provision for the support and maintenance of
an “efficient” system of public free schools in order to the promote “[a] general diffusion
1
The Texas school finance system has been challenged in federal court as well. In Rodriguez v.
San Antonio Indep. Sch. Dist.,
411 U.S. 1 (1973), the plaintiff claimed that the system violated the equal
th
protection clause of the 14 Amendment, but the United States Supreme Court ultimately held that
“[e]ducation, of course, is not among the rights afforded explicit protection under our Federal
Constitution,” effectively shifting future litigation to the state courts.
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of knowledge,”2 while the second provision states that “[n]o State ad valorem taxes shall
be levied upon any property within this State.”3
Texas public schools are funded mostly by ad valorem taxes levied by local
school districts under comprehensive state regulation. In the past, the Texas Supreme
Court declared the public school finance system unconstitutional because, due to
varying degrees of property wealth from one district to the next, the amount of funding
varied too much from district to district,4 prompting the Legislature to enact a “county
education district” scheme in which the school districts within a county were effectively
consolidated and the tax base for the county distributed more evenly among the school
districts, all under the control of the State. The Texas Supreme Court declared that
funding system unconstitutional, not because it was inefficient or resulted in a disparate
level of funding per student, but instead, because it was in effect an invalid State
property tax.5 According to the Edgewood III Court, “[i]f the State mandates that a tax be
levied, sets the rate, and prescribes the distribution of the proceeds, the tax is a state
tax, regardless of the instrumentality which the State may choose to use.”6
The Legislature responded by enacting the “two-tiered” funding system that
generally remains in effect today. Under Tier 1, school districts receive state funds to
close the gap between the minimum tax rate and the “basic allotment” per student.
Under Tier 2, for each penny a district raises its tax rate above the minimum, the State
guarantees a certain yield per weighted student, and the tax rate for maintenance and
operations is generally capped at $1.50. Unlike the former “tiered” systems, the current
funding system contains a “Robin Hood” element under which a district with wealth per
student greater than a certain amount must transfer the excess, or the tax revenue
generated from it, so as to provide funding for school districts with less wealth. Local tax
revenue “recaptured” and redistributed by this mechanism amounted to almost $1 billion
in 2000.
The Texas Supreme Court subsequently affirmed that two-tiered funding system,
finding that it was constitutionally efficient and adequate, since the schools had enough
tax revenue to provide a “general diffusion of knowledge,” and it was not an
unconstitutional State property tax since the local school districts had some realistic
discretion in setting their tax rates (i.e., between the minimum and maximum rate,
subject to exemptions).7 The Court stressed that the system was “minimally acceptable
only when viewed through the prism of history.”8 The Court cautioned that “[i]f a cap on
tax rates were to become in effect a floor as well as a ceiling, the conclusion that the
2
See Tex. Const. art. VII, § 1.
3
Tex. Const. art. VIII, § 1-e.
4
5
6
7
8
Edgewood I; Edgewood II.
Edgewood III.
Edgewood III, 826 S.W.2d at 500 (citation and footnote omitted).
Edgewood IV.
Edgewood IV, 917 S.W.2d at 726.
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Legislature had set a statewide ad valorem tax would appear to be unavoidable
because the districts would then have lost all meaningful discretion in setting the tax
rate,”9 providing the backdrop for the current crisis. Since Edgewood IV, the level of
state funding has continued to fall, reliance on local property taxes has increased, and
approximately 39% of the school districts have reached maximum tax rates.10
West Orange Round One — We Weren’t Kidding
When We Said The Crisis Wasn’t Over
The original plaintiffs in West Orange filed suit in April 2001, alleging that the
current funding system, and specifically the $1.50 rate cap, has evolved into an
unconstitutional state ad valorem tax. Other plaintiffs intervened, claiming that the $1.50
rate cap does not provide sufficient or equitable funding to guarantee a general diffusion
of knowledge. The defendants filed a motion to dismiss, which the trial court granted.
The Court of Appeals affirmed the dismissal, and the plaintiffs sought review in the
Texas Supreme Court. The Supreme Court ruled in favor of the plaintiffs, overturning
the dismissal, and remanded the case back to the trial court, setting the stage for the
current crisis. The Supreme Court reiterated its statement in Edgewood IV that “[o]ur
judgment in this case should not be interpreted as a signal that the school finance crisis
in Texas has ended.”11
West Orange Round Two — Stop Or My Mom Will Shoot
Following a fairly lengthy trial on remand, John Dietz, a Texas district court judge
in Austin, ruled in favor of the plaintiffs. He held that the $1.50 cap on tax rates has
become both a floor and a ceiling, denying school districts meaningful discretion in
setting their tax rates, and in effect, a state ad valorem tax. Judge Dietz further held that
the current financing system is unconstitutional because the constitutional mandate of
adequacy exceeds the maximum amount of funding that is available under the State’s
current funding formulas. Judge Dietz enjoined the State from distributing any money
under the current Texas school financing system until the constitutional violations are
remedied. However, in order to give the Legislature a reasonable opportunity to cure the
constitutional deficiencies, Judge Dietz stayed the injunction until October 1, 2005.12
On December 28, 2004, the Texas Attorney General appealed the decision directly to
the Texas Supreme Court. Unless it is overturned, which seems unlikely given the
Texas Supreme Court’s previous decision in the case, Judge Dietz’s decision in West
Orange should have a significant impact on the next legislative session, which began on
January 11, 2005. During the midst of the last legislative session, and the numerous
ensuing special sessions, all of which basically amounted to nothing, Lt. Governor
David Dewhurst remarked that “[t]he last thing I want to do is find us figuratively with a
9
Edgewood IV, 917 S.W.2d at 738.
10
See West Orange-Cove Cons. Indep. Sch. Dist. v. Alanis, 107 S.W.3d 558 (Tex. 2003).
11
See West Orange, quoting Edgewood IV, 917 S.W.2d at 725.
12
See Final Judgment in West Orange-Cove Cons. Indep. Sch. Dist. v. Neely, No. GV-100528
(Tex. Dist. Ct. Nov. 30, 2004, pet. filed).
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loaded gun against our head.”13 Well, the figurative gun is now cocked and loaded. In
order to meet the mandates of the judge’s order, legislators are faced with something
they feared greatly—major tax legislation.
Legislative Proposals — Hmmm, Do You Have
Something Better Behind Curtain Number 3?
Leading Texas officials have generally expressed their own views on how the
system should be reformed, and by how much. The differences in the plans are
generally based on the level of property tax relief intended to be conferred. Republican
Governor Rick Perry has generally advocated relatively modest tax reform. The
Governor has advocated lowering local property taxes on homeowners and businesses,
and paying for it by repealing the so-called Texas franchise tax “loophole” and
extending the state lottery to include “video lottery terminals” located at horse racing
tracks. The Governor’s proposal met very stiff opposition in the Texas House last
session (it was brought to a vote and defeated unanimously by both Republicans and
Democrats).
The Texas House seems to support property tax relief in an amount similar to the
Governor’s plan. One of the more popular ideas in the House is to replace the Texas
franchise tax with a payroll tax at about a 1.5% rate. Some have suggested increasing
the sales tax rate by a modest amount. Some House members continue to consider
extending the sales tax to most services, including professional services. A similar
proposal was soundly defeated during the last legislative session.
Lieutenant Governor David Dewhurst, who heads the Texas Senate, has
generally favored greater property tax reform. The Lt. Governor has generally favored
adopting a form of broad-based value-added tax to replace the current franchise tax.
The tax base of the new tax would reportedly be a company’s net income plus
compensation costs, taxed at a rate from 1 to 3 percent.
Three general plans for reforming business taxes seemed to gain at least some
support during the last legislative session. One plan would generally have repealed the
franchise tax and replaced it with a new business tax imposed on all forms of
businesses (including corporations, LLCs, and partnerships) with three components
from which businesses could select: (i) a payroll component; (ii) a business activity
component; and (iii) a minimum alternative tax component. The payroll component
would have generally been based on the lesser of (i) a small percentage (e.g., 1.25%)
of wages paid to each employee; or (ii) $125 per employee per quarter. The business
activity component would have generally been based on business income and certain
compensation would have been included in the tax base. The minimum alternative tax
component would have generally been based on gross receipts. A second plan would
have imposed a new payroll tax, essentially calculated the same as the payroll
component described above.
13
A.J. Bauer, Dewhurst Backs Finance Special Session, The Daily Texan (Apr. 5, 2004).
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A third plan would have reformed and extended the franchise tax. The so called
“Delaware Sub” and “Geoffrey” “loopholes would have generally been closed.
Partnerships would have generally been subject to the franchise tax except for interests
owned by natural persons. An alternative minimum tax equal to 0.25% of Texas gross
revenues would have applied.
Bills that have been pre-filed in advance of the current legislative session give
some indication of what to expect. Among other things, if enacted those bills would: (i)
repeal the Texas franchise tax and replace it with a “Texas Education Business Activity
Tax” generally imposed on both entities and individuals and generally measured by
apportioned gross business receipts;14 (ii) increase the State sales tax rate by 1% to
7.25%;15 (iii) generally repeal every sales tax exemption and every franchise tax
exemption;16 (iv) increase the cigarette tax by $1 per pack;17 (v) generally extend the
Texas franchise tax to every business trust, limited liability company, or other entity that
is classified as a corporation for federal income tax purposes and that is doing business
in Texas;18 or (vi) impose a personal income tax, subject to approval by the voters.19
On January 12, 2005, Lt. Governor Dewhurst and Senator Florence Shapiro
unveiled an outline of a plan that reportedly has unanimous support in the Senate.
Although the details are rather hazy, the Senate plan would generally replace the
current local maintenance and operations tax (the tax capped at $1.50 that is the
subject of West Orange) with a $1.00 maximum state property tax. Obviously, that
would require an amendment to the Texas Constitution. The Senate plan would allow
localities to impose a 15¢ “local enrichment tax” to bolster spending at the local level.
The Senate plan would also revise the franchise tax by extending it to all business
entities except for sole proprietorships, closing current “loopholes,” and reducing the tax
rate by more than half (from 4.5% to 1.95% or lower). Other revenue would generally be
needed to fund the local property tax relief, and potential candidates include increasing
the sales tax, the motor vehicle sales tax, and tobacco and alcohol taxes, and improving
delinquent tax collections. Lt. Governor Dewhurst acknowledged that “[t]his is meant to
be a starting point,” “[o]ur feet are not in concrete.”20 Some senators have said that
while they share the Lt. Governor’s overall goals, the plan expresses “a range of ways
14
th
15
H.B. 28, 2005 Leg., 79 Reg. Sess. (Tex. 2005).
16
H.B. 118 & 119, 2005 Leg., 79 Reg. Sess. (Tex. 2005).
17
H.B. 124, 189, & 194; S.B. 97, 2005 Leg., 79 Reg. Sess. (Tex. 2005).
H.B. 28, 2005 Leg., 79 Reg. Sess. (Tex. 2005). Since the Texas Constitution prohibits a tax
on the net income of an individual without voter approval, this proposal may be unconstitutional as
applied to individuals. See Tex. Const. art. VIII, § 24(a).
th
th
th
th
18
H.B. 117, 2005 Leg., 79 Reg. Sess. (Tex. 2005). This provision may also be subject to
challenge to the extent it applies to income of an individual.
19
th
H.B. 90, 2005 Leg., 79 Reg. Sess. (Tex. 2005).
20
See Jason Embry, Lawmakers Make Education Recommendations, State Property Levy,
Revamped Franchise Tax Win Early Support, Austin American-Statesman (January 13, 2005).
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to meet those goals. Obviously I like some more than others. The devil is in the
details.”21
No Comments From The Cheap Seats, Please
Not one to watch quietly from the side lines, Texas Comptroller Strayhorn has
challenged the Governor and the Legislature to take the school finance crisis more
seriously:
The issue that will define this session is school finance. . . . I
say no matter how strong our economy is, fixing our broken
school finance system cannot be done within our existing
revenue estimate. . . . The governor needs to show the
people of Texas a real school finance reform plan that will
cut skyrocketing local property taxes, have the state pick up
more of the tab, and have equity. . . . We must drive more of
every education dollar directly into the classroom with the
teachers and the students where it belongs. . . . And we
need to say out loud: We need more money for education. . .
. Texas has just enough money to continue following Gov.
Perry in doing a poor job for our citizens. . . . It means that
we could continue to follow the governor in balancing the
budget right on the backs of our school teachers and our
most vulnerable Texans with billions and billions of dollars in
fees, charges, and out-of-pocket expenses—and avoid hard
decisions about the future. That’s the governor’s record, but
that’s not what hard-working Texans want. That’s not the
Texas way and it cannot continue. . . . There is no shortfall
when it comes to the budget. . . . There is a shortfall when it
comes to the governor’s leadership.22
Governor Perry’s Office responded that “[i]f the comptroller wants to blame the
governor for turning a $10 billion shortfall into a surplus in two short years, the governor
will be happy to share the credit with legislators and employers who are working hard to
grow our economy.”23
In short, the mix of political in-fighting, the fear of enacting what amounts to a tax
increase, and the figurative judicial gun aimed squarely at the heads of the politicians,
sets the stage for what should be a very interesting year in Texas taxation—a situation
that can only be described as tax reform Texas style. We will keep you apprised of
significant developments.■
21
Id.
22
Texas Comptroller Strayhorn News Release, Strayhorn Estimates Budget $400 Million in the
Black, Says The Shortfall Is in Governor’s Leadership (Jan. 10, 2005).
23
Office of the Governor Press Release, Statement on Comptroller’s Criticism of Spending
Decisions (Jan. 10, 2005).
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January 2005
Volume 12 Number 1
State Tax Return
This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent
developments in state and local tax. Requests for a subscription to the State Tax Return or permission
to reproduce this publication, in whole or in part, or comments and suggestions should be sent to
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Box 165017, Columbus, Ohio 43216-5017.
©Jones Day 2005. All Rights Reserved. No portion of the article may be reproduced or used without
express permission. Because of its generality, the information contained herein should not be
construed as legal advice on any specific facts and circumstances. The contents are intended for
general information purposes only.