Analysis: Economy's shifts erode states' tax bases

By Nanette Byrnes

This is getting to be an annual ritual. Officials in New York, California, Florida and Washington this year have all expressed concerns about the outlook.

The problem stems partly from short-term issues, including a weak economy and woozy real estate markets, but more basic flaws explain the diminished capacity of states to raise adequate revenues, or even to forecast them accurately.

State tax codes were developed in a bricks-and-mortar era dominated by manufacturing and tangible goods, making them ill-suited to today's Web-based service economy.

Efforts to drag state tax systems into the modern age are making halting progress against a wave of anti-tax fervor and resistance from businesses.

As a result, states are less able to count on sales and corporate tax revenue, forcing them to rely on personal income taxes, a volatile revenue source.

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Consider New York's attempt to capture more of the e-commerce dollar by taxing deals from online group discount sites such as Groupon and LivingSocial.

Groupon is in the midst of a public share offering in a business that is making billions of dollars in sales. Groupon and its rivals hawk online discount coupons for goods and services ranging from meals to dental care.

Users pay no tax on these deals until the retail purchase. Few states until recently gave any clue as to how much tax they thought should come from these businesses.

On September 19, New York State's Department of Taxation and Finance issued a technical memorandum on how sales tax should be charged in the online discount coupon business.

The state split transactions into different buckets, taxing some deals at their discounted price, others at full retail.

The state's approach "almost defies logic," said Brendan Lewis, a spokesman for LivingSocial, which he said has made its views known to New York, arguing that the tax hurts shoppers and small businesses that market through the sites.

Online coupons are "an area I'm sure will get more clarity as time goes on ... probably through litigation as these things do," said Ozair Minty, senior manager in the state and local tax practice of New York accounting firm WeiserMazars.


Finding ways to tax the Web is a challenge for states with outmoded laws, said Richard Pomp, a law professor at the University of Connecticut.

The mismatch between state codes and the Web-based economy "is eviscerating the tax system in terms of its revenue potential, and as the economy shifts more toward electronic commerce, states will miss out on that growth," Pomp said.

Fifteen percent of all U.S. retailing, excluding groceries, will be done online by 2014, according to consultancy Forrester Research. That will amount to $259 billion in sales.

States will lose at least $10 billion this year in uncollected online sales tax revenues, estimated University of Tennessee researchers.

No company dominates the online market like <AMZN.O>, and states want to collect more sales tax from the online retailer. Since June, Tennessee, California and South Carolina have cut deals with the company which assure it will begin collecting sales tax on purchases made by state residents within the next few years.

A key impediment for the states is a 1992 U.S. Supreme Court decision that prevents a state from collecting sales tax from vendors that lack a physical presence in the state. National legislation to help states overcome this barrier is circulating in the Senate and the House of Representatives.

From a sales tax perspective, "what is the difference between buying a book online and buying a digital book?" asked Joe Huddleston, executive director of the Multistate Tax Commission, a Washington-based agency that in part works to preserve state taxing authority. "There shouldn't be any difference, but for many states there is."


One simple step that more states should take no matter what, said Connecticut's Pomp, would be to change sales taxes to apply to all personal property and services, not just tangible personal property.

Only seven of the 50 states tax a significant number of services, costing them billions of dollars in lost revenue every year, a 2008 Federation of Tax Administrators report found.

Michigan tried to extend its sales tax to services, but the law was repealed in 2007 before it went into effect after businesses complained it was arbitrary. Golf green fees carried no tax, but ski lift tickets did, for example.

While state sales tax codes are widely outmoded, state corporate income taxes have declined.

By 2009, they had fallen to $40 billion across the country, compared to personal income tax receipts of $246 billion, according to a study by the Pew Center on the States and The Nelson A. Rockefeller Institute of Government.

This follows a similar pattern on the federal level. Experts have said both trends reflect corporations' success at lobbying legislators for special tax treatment.

With sales and corporate taxes in eclipse, states are increasingly dependent on the personal income tax. Notoriously volatile, these streams of tax revenue ebb and flow with the economy and the stock market.

Between October 2009 and June 2011, personal income taxes ranged from a quarterly drop of 28 percent to a jump of more than 15 percent, the Rockefeller Institute reported last month. That makes forecasting budgets tougher and tougher.


This volatility is on display in Greenwich, Connecticut, a wealthy hub of hedge fund and private equity activity.

In 2007, Greenwich residents, less than 2 percent of the state's population, paid more than 14 percent of all state individual income tax revenues, state figures show.

But in 2009, town tax collections fell to $613 million from $759 million two years before.

"Connecticut's budget surpluses or deficits have almost entirely been linked to Wall Street," said Fergus Cullen, executive director or the Yankee Institute for Public Policy, a free market think tank based in Hartford.

State tax codes may be difficult to repair as long as the economy is struggling, said Annette Nellen, a business professor at San Jose State University who follows California's tax woes.

"In tough economic times, you usually don't get great tax policy," she warned. "It's more like desperation."

(Reporting by Nanette Byrnes in Chapel Hill, North Carolina)