Viable School Tax Reform

	OPINION: Viable School Tax Reform by David Hartman

Governor Rick Perry's "Texas Tax Reform Commission" headed by Chairman John Sharp has reported its findings and recommendations. Simply put, "they've done good", in that they have proposed a "reformed franchise tax" that is more broadly and equitably based, economically defensible, and appropriate for shouldering the added franchise tax burden to enable a one-third reduction in public school ad valorem taxes.

The reformed franchise tax as proposed, would replace the current corporate franchise (which levies the lesser of a 4.5 percent tax on income or a 2.5 percent tax on equity) with a 1.0 percent tax on the gross margin of all "limited liability businesses". This justification for state taxation originated with legal limited liability of corporations, which is now proposed to be joined by other types of limited liability businesses, such as limited partnerships, limited liability partnerships, professional associations, and business trusts. Exempted would be sole proprietorships; businesses with less than $300,000 total revenues (indexed for inflation) versus $150,000 at present; passive unincorporated investment entities, and not-for-profits.

The reformed franchise tax offered by the Commission proposes that business "gross margin" be the tax base. This is a new concept compared to state business tax base alternatives considered heretofore, which have included gross retail sales, value added, or net income. Gross margin as defined would be the difference of total revenue less the greater of total employment cost or cost of goods sold. This alternative has the effect of allowing service industries, whose principal expenses relate to personnel employment, to in effect substitute people for goods in determining "margin".

There are other justifiable considerations provided to avoid excessive levies where considered necessary. Retail and wholesale businesses are provided special rate of 0.5 percent tax rate on the dubious premise that their margins are too thin to bear the full tax. However, it is probably justifiable given property tax levied on Texas inventories (but in few other states) as a quid pro quo. Given that some industries, such as utilities, are so capital intensive that neither purchased goods nor personnel represent a sizable percentage of total revenues, for such entities limitation on "margin" for taxation purposes is proposed to be 70 percent.

The best measure of improvement in efficiency and equity of the reform compared to the current franchise tax is its "yield", the revenue per 1 percent anticipated. "Gaming" of the present franchise tax by corporations' use of partnerships to dodge applicability, and the narrow current definition of its tax base as only corporations, collects only $2 billion per year with a 4.5 percent income tax rate. The reformed franchise tax anticipates $6 billion from a 1 percent rate.

A yield of this level is comparable to that of a subtraction method value added tax, which is the most exacting base for comparable taxing from business to business. But the proposal is more politically realistic, in that it makes concessions to the services sector that previously has enjoyed relative freedom from state taxation, which will make the pill easier to swallow. The alternative of compensation of employees instead of cost of goods sold, and allowance of compensation up to $300,000 employee are sizable concessions to "grease the skids" to encompass truculent professions in the business tax base.

The relative decline of the Texas mining and manufacturing sectors, in parallel with that decline for the U.S. as a whole, is primarily a result of singling out manufactures for excessive and poorly designed taxation. It incorporates much the same logic as for Willie Sutton, who responded to why he robbed banks, with "that's where the money is". The reformed franchise tax would provide significant relief for this sector. Hopefully, the final version would allow energy consumption in "cost of goods sold"; netting of outbound freight from total revenues, and expensing of investment for businesses of any size. The U.S. needs to reduce the burden of taxation on manufacturing for this sector to survive, and Texas needs to reduce its tax burden to revive this sector and attract new factories.

An important reminder: tax reform that is intended to replace one third of school ad valorem taxes must include strong measures to make sure that the school districts use the increased state share of school funding to cut school ad valorem taxes by the one third as intended, instead of eating the cake on the way to the wedding.

The Texas Tax Commission and its chairman, John Sharp, should be commended for successfully bringing a fresh and viable proposal that meets both the political and financial characteristics of an optimal school finance plan. Likewise, Governor Rick Perry should be given credit for turning to the private sector for a solution, when the political initiative failed to provide a consensus plan. This proposal is as good as we are likely to get, should be acceptable to the Texas Supreme Court, and deserves a unified ratification.

Printed with permission from the Lone Star Report .

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David Hartman, a contributing editor to The Lone Star Report, was the chairman and C.E.O. of Hartland Bank, N.A., an Austin-based independent bank he formed in 1990 and sold in 1999 to Compass Bancshares. As of 1998, Hartland Bank had eight branches in Central Texas totaling $275 million in assets. It was been one of the 10 most profitable banks in its national peer group.

Hartman has long been active in Republican politics and state public service. He served on Gov. Bill Clements' Special Committee on the Organization of State Agencies as chairman of the General Government Services and Overall Structure of Government subcommittees. He was the Republican nominee for state treasurer in 1994, losing narrowly in the general election. In 1996, he served as Chairman of the Policy Group and Victory '96 Finance Chairman for the Republican Party of Texas.

Among the awards he has received are the 1995 Melvin Bradford Award as the Landrum Society's "Outstanding Conservative," and Regional Runner-Up for Inc. Magazine's 1994 "Entrepreneur of the Year."

Hartman received his bachelor of science degree from the Case Institute of Technology, where he graduated cum laude. He graduated "with distinction" with a master's degree in business administration from the Harvard Graduate School of Business.

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