October 1 2004

They are in need of an overhaul; not a tune-up or more incremental repair, but systemic change.

(October 2004) Pennsylvania has a state and local tax system that’s evolved by slow increments since 1956, when the state added the sales tax to create a multi-source state tax system.

Over the years, there have been many proposals to modernize the tax system or its many components, using methods ranging from blue ribbon commissions of non-government volunteers to in-house government proposals. For a variety of reasons, however, the state and local tax system never has been completely overhauled.

Why change is difficult – but needed

Serious tax system restructuring takes time and effort. A new system must be equitable, efficient in application and collection, competitive in its burden, productive and reliable, understandable, and accountable to taxpayers. Despite these often-conflicting goals, developing comprehensive proposals is the easy part. Selling them to policymakers and taxpayers has been the biggest hurdle. To do little or nothing, however, will continue the slow decline of Pennsylvania’s ability to compete economically.

Historically, instead of creating a plan for change with the future in mind, Pennsylvania’s policymakers have taken the easy way out: temporary tax increases. Government raises revenues by increasing tax rates in times of need and lowers rates in times of plenty. At the state level, the personal income tax and corporation taxes are primary targets. Locally, the property tax bears the burden. Layered on top is a not-so-obvious practice of inserting exemptions for special interests and legislative priorities into the state tax code. Individually, these changes don’t always account for much, but cumulatively over time, they’ve had a real impact - eroding the tax base, thereby affecting the tax yield. At a minimum, this increases additional pressure to raise rates.

So what has changed?

Very little. Consider this statement: “The present normal tax structure of Pennsylvania dates from a period when population, income, wealth, and industries were expanding at a greater rate than the nation.”

The quote describes a basic problem with maintaining an aging tax system in a changing economy. That quotation, from a 1945 study of Pennsylvania’s tax system, could as easily have appeared in a modern analysis. The more things change, the more they stay the same!

In the 21st century, while much of the tax system still relies on the goods-based sectors of the economy, the fastest growing economic sectors are service-based. Even manufacturers are turning to servicing their products to beef up the bottom line. Within these larger trends, the constructs and business plans for many industries have been overhauled in the past few decades. The biggest trend has been the globalization of the economy, which has impacted most – if not all – businesses.

Some examples of change in other industries? Banking has grown from a multi-county local bank structure to global financial organizations. The electric utility industry has undergone deregulation and expansion across state boundaries. These trends have impacted the revenue from state and local taxes – yet the tax structure has remained largely the same.

Businesses aren’t the only taxpayers that have changed. The gap between wages and incomes of lower and higher income groups continues to widen. Policymakers have given only minimal attention to the issue by increasing the poverty exemption levels for the state personal income tax.

Underlying the economic trends are Pennsylvania’s changing demographics. The state’s population is one of the slowest growing in the nation. Within this overall static population are other disturbing trends. The number of 25-34 year-olds will be less in 2020 than it was in 1980. The percentage of retired people will increase significantly beginning in 2010. From a tax perspective, this means the taxable income base will grow slowly while non-taxable retirement income will grow rapidly. Also, the larger percentage of older people will increase the demand for services, putting more pressure on the existing tax system. Relatively fewer people will be asked to shoulder the higher burden.

Age isn’t the only demographic trend associated with taxes. The continuation of the historical movement of people from urban and rural areas to spaces in between will have a profound effect on local taxes. People who move take their tax base (income and other wealth) with them. Without commensurate replacement, the finances of those local governments left behind will suffer.

What does this all mean?

The job of government will continue to become more complicated and difficult. Pennsylvania can expect a lower rate of tax revenue growth in the future. Within the system, issues of equity and fairness will become a greater concern for people with different income levels, as well as taxpayers with similar incomes who are paying significantly different amounts of tax. An increasing divergence between economic priorities and tax system targets will add another hurdle for economic developers to overcome. Expect growing fiscal distress in declining communities.

Bottom line? Restructuring the tax system will not solve all of Pennsylvania’s problems but can play a role toward resolving many of them. Stay tuned.