We at the Tax Foundation recently released our latest edition of the State Business Tax Climate Index, and for the first time, Texas no longer ranks among the top 10 states. Indiana moved ahead of Texas thanks to concerted efforts by Govs. Mitch Daniels and Mike Pence to reduce and simplify their corporate and individual income taxes while repealing economically damaging taxes. Texas fell by standing still.
What’s holding Texas back? The answer isn’t sexy, but it affects the Texas economy more than the average citizen knows: Texas has one of the most destructive taxes on corporate and small businesses in the country. The Texas franchise tax, or margins tax, has been subject to criticism by tax experts and businesses since it took effect in 2008, and only four other states levy this type of tax.
Instead of being a tax on income, the margins tax is a tax on gross receipts, which means that businesses must pay it in good times and in bad. Its rates apply over and over throughout the production process, leading to double and triple taxation. So while the 1 percent rate of the margins tax looks paltry (retailers and wholesalers pay 0.5 percent), effective tax rates are in fact much higher because of how many times the tax is levied. All in all, the margins tax brings in an astounding 10 percent of state revenue.
For example, if you were going to make a loaf of bread under a gross receipts tax regime, the wheat would be taxed at 1 percent when it is sold from farmer to the miller, then the flour would be taxed at 1 percent when it is sold from the miller to the baker, then the bread would be taxed at 1 percent when it is sold from the baker to the distributor, and then the loaf of bread is taxed twice — once at 0.5 percent when it is sold to the distributor, then at 0.5 when the retailer sells the bread to the end consumer. Consumers, of course, bear the burden, as the pyramiding taxes are baked in to the price of the product they eventually buy.
Gross receipts taxes unfairly distort the economy because they favor industries with shorter supply lines over industries with longer, complex production. Just imagine the layers of taxes on a complex good like a computer. In some cases, gross receipts taxes even cause businesses to vertically integrate — to put the supply chain under one corporate roof — to avoid tax burdens, even if it doesn’t make any business sense to do so.
The good news is that policymakers are taking notice. Michigan got rid of its gross receipts tax in 2012, and the candidates in Virginia’s gubernatorial campaign want to repeal their state's. The Texas Tribune reported in May that 90 bills were introduced last session that sought reform of the margins tax; nine of them proposed repealing it entirely. These efforts succeeded in cutting the tax rate by 5 percent and sparing more small businesses from the harm of this cumbersome tax.
There’s much that shouldn’t change about Texas’ tax code. I’m a bit jealous of lifelong Texans; you don’t know the sinking feeling of finishing your federal income taxes just to remember that you need to pull out the state tax forms. Even Indiana, with its 3.4 percent flat income tax, can’t compete with that.
And Texas has a lot of other things going for it — large urban centers, a successful agricultural sector, favorable employment numbers and some of the largest business growth in the last decade. Gov. Rick Perry rightfully points to the tax code in part as a cause of the migration boom of businesses and individuals to the Lone Star State. But if Texas wants to continue to see the growth and prosperity that have characterized the last decade, the margins tax has got to go.
Scott Drenkard is an economist at the Tax Foundation and co-author of the 2014 State Business Tax Climate Index.