What is Going On with State Taxes?

Tax Day is here again.

With the recent federal income tax changes, things have probably been a bit confusing this year. We will leave discussions about your withholdings to your tax accountant, but we can try to help you understand what has been going on with state taxes in Utah.

Surplus or Not?

It may be quite confusing to hear in the media that Utah has an over $1 billion surplus, but at the same time seems to have all sorts of budgetary issues. A gas tax that doesn’t fully pay for roads, higher education being funded almost completely out of the education fund that was meant for K-12 education, and a diminishing sales tax base as the economy becomes more service based.

And then every year, it seems that a bunch of other fees and taxes, including property taxes, continue to go up.

So what’s really going on?

How Utah Funds Government

As is expected with public policy, the answers are nuanced and often misunderstood without context—which means it’s very difficult to talk about in 30-second sound bites.

The first thing to understand is how Utah’s governments are funded. This is where the three-legged stool analogy comes into play. The three legs are property tax, sales tax, and income tax.

The idea is that when there is a proper balance between these three taxes, the system can work properly. Property taxes provide stability, sales taxes are responsive to the ups and downs of the economy, and the income tax is thought to be a “fair” way for people to contribute to the system based on their ability to pay.

Whether or not you (or we) disagree with this premise is a topic of conversation for another time. With regards to the discussion in this article, we’ll start from here.

Where is the Imbalance?

Based on the three-legged stool concept, Utah’s tax structure is out of balance. The first issue, is that Utah collects too much money via the income tax. The second issue is that Utah’s sales tax revenue is not increasing at nearly the same rate as property and income taxes.

Natural questions to ask in response to this are, 1) Is this an actual problem? and 2) Why is this a problem?

In response to the first question, a government that is able to keep taxes relatively low, not engage in rapid increases of taxes, and therefore prioritize the economy over its own needs, is one that has a structurally balanced tax system that can predict with general accuracy what its revenues will be over time.

The second question has many answers and many proposed solutions.

The Income Tax

Utah’s income tax is currently generating a lot of revenue, because the economy is continues to do well. Additionally, federal income tax restructuring did result in a windfall for Utah’s income tax. Legislators have sought to mitigate this by lowering the overall rate from 5% to 4.95% and by partially restoring the effects of a child tax deduction that had been eliminated by reform.

Those changes have not fully balanced state income tax revenues back to their pre-reform trajectories, and disagreement remains on how to fix it.

The question becomes whether or not larger families should be paying a normal share of income taxes since those children most likely attend public K-12 schools that depend upon the income tax. Based upon the answer to this question, one of two policy options would be pursued: decrease the overall income tax rate for everyone or completely restore the effects of the old child tax deductions.

There is a third option, which is to change nothing, and instead use the excess funds to further increase funding to K-12 education (not a good idea). You can read more about Libertas’ position on how we use income taxes to fund education here.

There are further problems with how Utah uses income taxes that will be discussed later.

The Sales Tax

Utah’s sales tax revenue is currently not growing nearly as fast as other tax streams (if you are wondering why tax revenues are growing generally, simply look to population increases and inflation). The reason: moving from a goods based economy to a services based economy.

It is important to note that a lot of work has already been done to mitigate these perceived problems with the sales tax. Online sales of goods are now taxed and market facilitators (think eBay) are also now taxed. This provided hundreds of millions of new sales tax dollars to the state of Utah. One could argue that the effects of these recent changes will not be fully known for a couple more years.

As for taxing services in addition to tangible goods, you’ve probably heard a lot about that in the news in recent months. This will not be an easy issue to tackle and Utah needs to think seriously about the implications of such a change. Two items that will be vital to consider are that business to business transactions should not be taxed and that tiny side-businesses operated by Utahns should also be exempt (think the part-time piano teacher or the teenager mowing lawns in the summer).

Utah can forego the sales tax revenue from those two sources for a few reasons. First, taxing online sales is relatively lucrative for the state and, along with taxing market facilitators, will continue to bring in a significant amount of revenue. But even more importantly, the real reason Utah has a problem with sales taxes has nothing to do with sales tax. It has everything to do with transportation and the gas tax.

The Real Problem: Gas Tax and Transportation

What many Utahns don’t realize is that over half a billion dollars is earmarked from the general fund (sales taxes) every year for transportation. That is more money than the proposed sales tax reform is supposed to generate.

Gas taxes used to be more than enough to pay for transportation infrastructure, but growth, mass transit, fuel efficiency, and alternative energies have flipped the equation.

It is inevitable that the gas tax must be replaced with a different kind of user fee for transportation. What this is remains to be seen (but to the Legislature’s credit, they have been investigating the issue). Whatever form this funding mechanism takes, it needs to happen soon; simply ratcheting up the gas tax won’t solve the underlying issue.

In terms of long-term growth and what our transportation infrastructure will look like, autonomous vehicles raise serious questions about how Utah should plan for the future. By the time Utah doubles its population in 2060, will the concept of a parking lot and transit be radically different? Will vehicle ownership in population centers plummet? These questions have significant implications for infrastructure investment—and the taxes used to fund them.

The Cascading Effect of Transportation

Now it starts to become apparent where the holes in Utah’s budgets are. Over half a billion dollars is being siphoned from the general fund (sales taxes) to transportation, and then around $800 million is siphoned from the education fund (income taxes) to pay for higher education.

The end result is an unhealthy dependence on income tax revenue. Overall income tax revenues rise and fall with the economy, and are therefore a poor way to solely plan a state budget in the long-term. It is also abundantly clear that low income tax rates are tied to a business friendly climate and that states whose income tax rates are low have thriving economies.

When the sales tax and income tax is cannibalized by other budget areas, it leads to local governments (including local school districts) feeling the strain. This is when you start seeing proposals to raise property taxes and other “fees.” Transportation has become such a problem for some communities in Utah that “transportation fees” are being added onto your utility bill. This is obviously poor budgeting, but it all leads back to structural imbalances in the state tax structure.

What Needs to Be Done?

Conversations about modernizing the sales tax base can be productive if lawmakers keep in mind the important principle of avoiding the taxation of business inputs. Consequently, Utah must avoid taxing business to business transactions at all costs.

In the long run, Utah will get a bigger bang for its sales tax buck if lawmakers begin to seriously consider replacing the gas tax and begin planning for a much different transportation infrastructure in the future.

Then Utah would be in a position to keep taxes low, fund higher education mostly out of the general fund (sales taxes), and lower income tax rates while providing sufficient funding for K-12 education. That three-legged stool would be become balanced again.