How the Tax Code Interacts with State and Local Tax Systems

1. 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

2. 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.

3. 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 sourcesof revenues or cancel projects.

4. 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).

5. The role of local governments and their revenue sources • Sources of tax revenues – local governments • Property taxes 72% • Sales and gross receipts 17% • Income 5% • Corporate <1% • License taxes <1% • Other 5% • Source: State and Local Government Finances by Level of Government and By State: 2001-2002. US Census of Bureau

6. 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.

7. 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).

8. 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.

9. 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 buseswould be taxed, and increase the costs for local governments to provide services to their citizens.

10. 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.

11. 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.  

12. 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.

13. 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.

14. 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

15. 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.