[The following report was distributed to the Senate and was the basis for a resolution adopted by the UTK Faculty Senate on February 15, 1982.]
JUSTIFICATION FOR A STATE INCOME TAX
For high quality public services to be available to the citizens of Tennessee, a readjustment in the nature of public funding is essential. Federal funds are and will be diminishing, inflation has reduced the real dollar value of state revenues, and the tax burden falls disproportionately on the lower income taxpayer. In general terms, the proposed institution of a mildly graduated income tax with a reduction in sales tax will make the tax burden on Tennessee citizens more equal in distribution, will keep pace with inflation, and will make state tax revenues more responsive to growth of the state's economy.
Four general issues need to be addressed in assessing the state's tax system: the effects of inflation; responsiveness to economic growth or elasticity; the burden distribution (determined by the mix of taxes used and their characteristics); and finally the question of the appropriate amount of money which should be raised through taxes. Putting aside the issue of the "size of the pie" for a moment, the impact of inflation on the state treasury and the nature of the tax system will be examined.
Inflation
Inflation in the price of things government buys reduces the value of each public dollar. For government services to maintain existing service levels, the rate of growth in revenues must at least equal the inflation rate. Even then, service levels will decline as the population increases.
In a slightly different vein, one can also argue that state taxes should increase in real terms (adjusted for inflation) at least as rapidly as real economic growth, if state services are to keep pace with the private sector growth. In several recent years of excessive inflation and low or negative real growth, government services have actually contracted because the rate of inflation exceeded the rate of growth in taxes. In other words, dollars adjusted for inflation actually decreased.
Tax Responsiveness or Elasticity
The concept of elasticity is used by economists to describe the responsiveness of a tax or tax system to changing economic conditions. Elasticity is measured as the percentage increase in tax revenues generated by a 1 percent increase in the economy (e.g., personal income). Both the total tax system and particular taxes can be evaluated in terms of their elasticity. To maintain tax revenues roughly at comparable levels (relative to the private sector) from year to year, a tax system with an elasticity of one (1.0) would be necessary. Tennessee's current tax system has an elasticity of approximately .90, indicating that for every 1 percent increase in personal income, tax revenues increase by 0.9 percent. This amounts to a decline in public sector activity relative to the private sector activity from one year to the next. Past practice has been to restore the public sector share by periodic legislated tax increases. The difficulties of continuing this practice have become almost insurmountable because of increasing citizen tax resistance.
In summary, tax revenues must grow as rapidly as inflation if the public sector is simply to stand still. This static position, however, denotes a decline in per capita services (as population grows).
Tax Burden Distribution
In addition to elasticity, another Important characteristic of a tax system is the nature of the distribution of the burden among the taxpayers. Opinions will clearly differ on the proper distribution. in particular, should approximately the same percentage of one's income be paid in taxes, regardless of the level of income (proportional taxation)? Should taxes fall more heavily, percentagewise, on the more affluent (progressive taxation)? or should taxes fall more heavily on the less affluent (regressive taxation)? Tennessee's tax system is highly regressive because of the heavy dependence placed on sales and property taxes. Table 1 in the appendix shows the distribution of these taxes by household income class in Tennessee. The regressiveness of these taxes and their relative importance in the tax system when combined with several additional regressive taxes (selective sales and gross receipts taxes) dominates the state-local tax system.
The data in Table I indicate that the tax burdens are heaviest on the less affluent (11.2 percent of household income) and lightest on the more affluent (3.1 percent). Achieving a greater degree of proportionality (equality in burden) would be an improvement, even if the total tax revenues were not changed.
The only productive, progressive tax available to the state is a broad-based personal income tax. The addition of a mildly progressive income tax in Tennessee would not mean a progressive system, or perhaps even a proportional system, but it would become less regressive and more elastic. Thus, if one values maintaining current service levels and/or favors a more equal distribution of the tax burden, an income tax is the appropriate remedy to Tennessee's revenue dilemma. The characteristics of the tax adopted will influence both the degree of elasticity and regressivity.
Appropriate level of Aggregate Taxes
The arguments presented above about elasticity and burden distribution are essentially independent of the issue of how much money the state should raise and spend for public services. As members of the state system of higher education, we have a particular and personal interest in the size of the total Funds available for financing public services. In one sense, public service needs relate to the size of the economy and may be assessed in that respect (e.g., percentage of the state's economy) rather than in absolute terms. However, there is no consensus as to what the public share should be, so the usual practice is to compare among jurisdictions. In such comparisons, Tennessee is a low tax state.
One strategy might be to accept this low status of Tennessee taxation (and the accompanying low service levels) and just try to maintain it. A personal income tax can serve as a means to that end. To illustrate the advantage of this tax in terms of at least maintaining the status quo, an example is derived, based on the adoption of a flat-rate income tax. A flat-rate income tax with liberal personal exemptions can be assumed to have an elasticity of about 1.2. Thus, for each 1 percent increase in personal income, there will be a 1.2 percent increase in income tax revenue. Revenue increases compound over time to fairly large amounts, even with no tax rate changes or other legislated changes. Table 2 in the Appendix illustrates how revenues would increase under such a flat-rate tax. The table assumes the adoption of a 1 percent income tax in 1977 and shows the revenue growth through 1984, incorporating actual and projected rates of inflation. It should be noted that the most common flat-rate tax adopted in other states is 3 percent; thus, if Tennessee had followed this pattern in 1977, actual revenues would now be three times those shown in Table 2. The revenues and burdens generated by such a tax produce outcomes both more regressive in burden and less elastic in growth than our proposal.
Our proposal is for the state of Tennessee to adopt a personal income tax which is even more productive of revenues and graduated in its rate structure, thus providing both substantial improvement in the regressiveness of the aggregate system and a substantial increase in elasticity. An example of a tax system like this is shown in Appendix Table 3. The income tax rates are graduated (1 to 3.5 percent). This tax is considered productive enough to provide a reduction to 3 percent from 4.5 percent in the state sales tax. The benefit of this proposal is not in the immediate increase taxes, but in its growth potential.
Conclusion
In evaluating Tennessee's tax system it is also important to consider the kinds of taxes used to raise revenues. In 1979 (the most recent year for which data are available), Tennessee's state and local tax revenues came predominately from general and selective sales and gross receipts taxes (53.3 percent). This contrasts with a national average of 31.3 percent and an average of 39.4 percent for Southern Regional Education board states. The heavy dependence on sales (and property) taxes makes the Tennessee tax system highly inelastic and regressive -- in these respects, among the worst in the nation. The adoption of a moderate graduated personal income tax and a compensating reduction in the general sales tax would spread the tax burden aver a broader base, and improve the growth potential of tax revenues.
This position paper was prepared for the Legislative Committee of the UT-K Faculty Senate by Anne H. Hopkins, Ph.D., Associate Professor, Political Science UT-K
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