Ron recently shared thoughts on Ohio's tax reforms enacted in 2005 to incoming chiefs of staff of newly elected governors from various states around the US. Here are some of his thoughts in response to questions posed:
1. What problem were you trying to address with tax reform?
Motivating Factors Leading Up To Ohio's Tax Reform Initiative
* Ohio's system of taxation was a legacy system in a number of ways that continued to be weighted disproportionately on the driving sector of our state economy -- the manufacturing sectors. that was fashioned during the musrooming of the industrial revolution, when the manufacturing community was more captive and less mobile. The weight of taxation burden was substantially less on other business sectors -- typically the service sectors, and was least on the least on the production agricultural sector.
* The centerpiece of this taxation problem was the tangible personal property tax that taxes your investment in equipment, inventory and furniture and fixtures, based on its value and without regard to how your business flow was going. It was regarded as a major barrier to inducing business location and expansion. Ohio had been trying to wean itself off this tax for literally 40 years.
* Also, the state's corporate franchise tax was tough to enforce -- a problem faced by many states. This was essentially our income tax on stock companies, otherwise known as C-Corporations.
* Further, Ohio's personal income tax was problematic for several reasons. It was one of the most progressive in the nation, with a top rate of 7.5 percent on income over $200,000. Further, Ohio's income tax is levied on federal adjusted gross income, making it more that a payroll tax. It is also a business income tax on all business organizations that are not C-Corporations. In other words Ohio's income tax is levied on federal adjusted gross income, which takes into account both payroll income and intangible income from personal business activity and investments. On top of this, many of our citizens and companies also pay around a 2 percent flat income tax at this level as well.
2. What were the goals of the tax reform effort? Improve revenue growth? Enhance economic competitiveness? Improve tax fairness?
* The goal was to improve Ohio's competitiveness from a tax perspective. Ultimately as the reform package came into focus, it was an economic development initiative. Of course, not everyone buys into the view that tax policy matters for economic development. But I believe it is an important factor and there was widespread support for making tax policy changes in Ohio.
Specifically to improve our tax situation the package the stakeholders came up with was this:
1-- Repeal the tangible personal property tax levied on business inventory, equipment and furniture and fixtures, and replace it in a generally revenue neutral way with a brand new very broad tax on nearly all business activity at a rate of 26 one-hundredths of one percent.
2 -- Repeal the corporate franchise tax.
3 -- Lower all the state income tax brackets by 21 percent, with an added sweetener of expanding the exemption of low income taxpayers from paying any state income tax. This was important because it this made this much more than a business tax package.
5 -- Lock in a state sales tax rate at 5 and a half percent, that was lower than the temporary rate of six percent that was set to expire, but higher than the five percent rate that was the permanent law that was set to kick back into place.
6 -- The major inducement in the package was a substantial net tax cut of around $2 billion per year as the 5-year phasing of the package reached full strength.
3. What were the key challenges to moving the effort forward?
This was a high risk project from the outside. And, it was high risk politically. In fact, a previous attempt two years earlier to enact a similar reform package fell flat when it was proposed by the tax commissioner, though the governor's 2003 operating budget recommendation. It was essentially dead on arrival, because it did not have the critical preparations that led up the the successful initiative in 2005.
Even more controversial was proposal of a brand new tax to Ohio -- the commercial activity tax or CAT --- that was a very broad tax on nearly all business activity at a very low rate that was phased in over five years to a permanent rate of .26 percent, with the first $150k exempt and the first $1 million taxed at a flat rate of $150 million. This tax was calibrated to produce what the tangible personal tax was yielding. Since the TPP is was a local tax, the proceeds of the new CAT are placed in a separate fund that is used to replace what would have been loss of local tax revenues, based on the TPP base of each jurisdiction as it existed in 2004. Those are the highlight features. This new tax was extremely controversial with some organizations, as I indicated.
Although Ohio Manfacturer's Association and some other business and professional organizations, like the CPA, were strong proponents of the reforms, the Ohio Chamber of Commerce was a vocal opponent. This was because a number of its very large, multi-state corporate members were very opposed to this. I think they saw this a tax trend that they didn't want to see pick up popularity in other states. There is a history of states starting with a small, new tax and then increasing it over time. That happened with both of Ohio's major state tax sources -- the sales tax and the income tax.
But the package was a mixture of policy changes that both increased and decreased revenue sources, enacted new ones and repealed others. That added somewhat to the challenge of selling it. As I said, the reform package proposed to re-set the permanent sales tax rate to 5.5 percent, in effect setting up a shift from income tax reliance toward taxation of consumption. This also helped with cash flow in the first year of the new budget. This too was controversial, though it was helpful to transition from the previous non-sustainable budget construct to a new one with a better fiscal footing.
I want to emphsize the critical importance of preparation prior to 2005. There were a number of studies and stakeholder processes that led up to introduction of the reform package. The Ohio Manufacturing Association commissioned a study that helped lay the groundwork for reform. The Ohio Business Roundtable also hired Ernst and Young to lead them in a collaborative process that involved stakeholders and key leaders in developing the structure of the reform package. A substantial coalition of business organizations was enlisted in supporting the reforms.
I also want to emphasize the importance of sufficient legislative process. Here's how we did it. Placeholder tax reform legislation was introduced as HB 1 and SB 1. When the budget was introduced, the tax reform language was substituted into these top priority bills and extensive hearings were held in the Ways and Means committees of both houses. I was chairman of the Senate Ways and Means Committee at that time, and carried SB 1 as its prime sponsor. There was still a lot of work to finish the details of the package and work through the opposition and concerns with the reform package. There was a lot of support from top legislative leaders and from the administration and the supporting coalition. In addition to the major opposition from the Ohio Chamber of Commerce, there was also adamant opposition by the grocer's association and by the petroleum retail marketers. Ultimately the reforms stayed in and were enacted as part of the state's operating budget, with work continuing through the final conference committee process on the budget.
4. How did you work with the Governor? How did you work across the aisle?
* Ultimately, a critical aspect of the reform campaign was its sponsorship by Governor Bob Taft. This proposal was recommended as a centerpiece in his operating budget recommendation early in 2005.
* Lt. Governor Bruce Johnson, who was well known and respected in the legislature and in the business community, was serving as Director of the Development Department, and quarterbacked the campaign. In Ohio the Governor and Lt. Governor run in tandem on the same ticket. It was a major campaign, with a lot of opposition and pressure points. He helped bring a lot of counter-pressure that was critical to moving the initiative through to passage.
* There was also serious buy-in by legislative leaders in the Ohio House of Representatives and in the Ohio Senate.
* In 2005, all the executive posts and legislative bodies were controlled by Republicans, which also was a factor in achieving the reforms.
* But the new Democrat governor that took office in 2007 chose to embrace the continued phase in of the tax reform package. He came in with a lean budget that stayed within the confines of the restricting of revenue growth. That led to the most bipartisan budget enactment probably in Ohio's history. It passed the House and the Senate unanimously and then the conference committee report passed both sides unanimously, except for 1 no vote in the House.
The Democrat members actually probably seriously didn't like that lean budget, but they felt compelled to support their new governor.
5. What happened that you didn't expect?
The overall package was calibrated with the intent of dampening revenue growth as the net tax cut was phased in. If normal revenue growth of 5 to 6 percent was the case, the reform phasing would have dropped the actual growth to around half that, to 2.5 to 3 percent. It turned out that General Revenue Fund tax revenues were closer to flat, until FY 2009, when they dropped 12.2 percent, with the largest decline occurring in the largest tax revenue source -- the state income tax -- dropping more than 16 percent. So, as you can imagine, the lowering of the bracket rates by 4.2 percent for that year's portion of the 21 percent income tax reduction was a significant, though secondary, factor that was overwhelmed by the drop in economic activity.
Remember, Ohio's personal income tax reflects more than changes in personal income. It is highly impacted by business activity by S corporations and other business organizations that are not C Corporations. Then the projections were that the 12.2 percent lost in tax revenues from FY 2009 would be followed by another 8 percent decline last year. So the final 4.2 percent lowering of the personal income tax rate brackets was put on hold for two years, making the decline 5 percent, instead of 8 percent.