Texas famously does not have an income tax, but it does have a tax on businesses’ gross receipts — not profits, but cash flow. This is the “franchise tax.” The tale of how that came to be might be filed under: How to take a race-baiting class-warfare lawsuit and turn it into a pretty good tax cut that basically everybody hates. Texas politics gets a little weird sometimes. (Warning: Wonkiness Ahead.)
Back in the dark ages of 1984, the Mexican American Legal Defense and Education Fund (MALDEF) filed a lawsuit against the state of Texas on behalf of the Edgewood Independent School District of San Antonio, alleging that Texas’s system of public-school finance, which relied almost exclusively on local property taxes, was unconstitutional. Because some districts are property-rich and some are property-poor, the same tax rate produced wildly different revenues from community to community. MALDEF argued that, under the state constitution, funding public schools was a state responsibility, not a mainly local one. The Texas Supreme Court, in a unanimous ruling, upheld MALDEF’s complaint, and there followed a decades-long saga that found the Lone Star State trying to construct a new system of school financing that would pass constitutional muster, and failing twice before it settled on a plan.
The new funding plan, adopted in 1993, had two salient features: a hard cap of $1.50 in school taxes per $100 in property value to fund “maintenance and operations” — your basic day-to-day school stuff, not including bond issues for capital improvements — and a condition that any revenues in excess of a statewide per-student ceiling be “recaptured” by the state and transferred from wealthier school districts to poorer ones. The latter feature gave the program its nickname, the “Robin Hood system.” Wealthy school districts were given a choice: They could either have their “excess” funds expropriated by the state and redistributed, or else enter into an agreement with a poorer cousin and transfer the money themselves.
But Texas’s constitution is a complicated document. In addition to prohibiting a state income tax, it also prohibits a statewide property tax. Pretty soon, practically every district in the state had run up against that $1.50 per $100 cap in order to meet statewide educational mandates, meaning that the state in effect had a uniform rate of property taxation to support schools. Another plaintiff argued that this, was equivalent to an unconstitutional statewide property tax, and the Supreme Court agreed in a 2005 ruling.
That left the Texas legislature with a three-pronged problem: First, it had to give local school districts enough discretion that the state would no longer have what amounted to a statewide property tax for schools. Second, it had to make sure that school districts were still able to raise sufficient revenues to get the job done. Third, it wanted to do both of those things without opening the door to endless, uncontrolled property-tax increases.
In 2006 the Texas legislature enacted a new plan to try to get all of that done. But Texas does things a little differently: Rather than raise the property-tax cap, the legislature cut it by a third, from $1.50 per $100 to $1.00 per $100, but allowed local school districts to raise taxes beyond that cap — on the condition that voters approved the tax hike in a referendum. Voters are not much inclined to do that, and the legislature didn’t want public-school revenues cut by a third overnight, so it rejiggered its statewide business tax, changing the formula for calculating tax liabilities and applying it to more kinds of businesses, i.e. broadening the tax base. The idea was that the new revenues generated by the revised franchise tax would offset the one-third reduction in the property-tax ceiling.
Under the original model, the franchise tax only applied to “standard corporations,” usually bigger businesses, and not to limited-liability companies and the like. And it only applied to “retained earnings” — i.e., to profit. The new franchise tax applies to all businesses except sole proprietorships and family partnerships, and it doesn’t just tax profits: It taxes cash flow. Businesses are allowed to exclude one of three expenses: payroll, the cost of goods, or certain contract costs. The thinking behind that is that some businesses (especially services) are labor-intensive, while others (like retailers) spend a lot of money on products for resale. So a hotel could exclude all of its labor costs from the calculation, while a grocery store could exclude the cost of wholesale groceries bought for resale. The contracts exclusion was added later when the legislature figured out that some businesses, such as trucking brokerages, pay a ton of money out in costs that are not quite goods and not quite labor, and were being unfairly penalized. Recognizing that retailers often work on slender margins, the legislature decided to tax them at 0.5 percent, and everybody else at 1 percent.
This change had several important effects. The first was that lots of businesses had to start paying the franchise tax for the first time, or saw their tax liability go up. The second was that lots of businesses saw their property taxes cut. Depending on what kind of business you were running, this might come out to a net tax increase or a net tax cut. Talmadge Heflin, who was the Texas legislature’s budgetary boss (chairman of the house appropriations committee) before joining the Texas Public Policy Foundation, explains that the plan was supposed to be revenue neutral. In fact, the revised franchise tax didn’t produce as much new revenue as expected, making the change a net tax cut for the state as a whole.
The more observant reader will notice an important point here: In addition to broadening the base of the franchise tax, the legislature shifted the tax burden from capital-intensive businesses to service businesses. Under the old franchise tax, businesses that built factories and expanded their plants got hit by both the franchise tax and the property tax. Under the new version, they saw their property taxes cut by a third, which in most cases more than offset the revised franchise tax. A high-end law firm or insurance agency, on the other hand, might have been raking in millions of dollars a year but paying no property taxes at all on its rented office space. (Not directly, anyway: Their landlords were certain to have been passing on as much of their property taxes as the market would bear.) The new version brought them onto the tax rolls.
Lowering the tax on capital-intensive businesses is a good way to attract capital-intensive businesses to your state. The franchise-tax reform played into Texas’s economic strength: People tend to think of Texas as having an oil-and-gas economy, but, as Ed Glaeser pointed out in a 2008 article, Texas has lots of manufacturing and light industry, too. “Both greater Houston and Manhattan have about 2 million employees,” Mr. Glaeser wrote in City Journal. “In Manhattan, almost 600,000 work in the idea-intensive sectors of finance, insurance, and professional services; only 2 percent are in manufacturing, and fewer than that in construction. Finance increasingly drives New York City’s economy as a whole. By contrast, Houston is a manufacturing powerhouse that makes machinery, food products, and electronics, with a retail sector twice the size of Manhattan’s and lots of middle-class jobs.” Note that 2008 publication date: There’s more than one reason that Texas weathered the credit crunch better than lots of other states.
Of course, not everybody is happy about the franchise-tax reform, especially the people who now have to pay the tax when they didn’t have to pay it before. And nobody likes the fact that businesses have to pay even if they’re losing money. But they have to pay property taxes when they’re losing money, too.
Mr. Heflin has an idea for further reforming Texas’s taxes: Get rid of both the property tax and the franchise tax by raising the sales-tax rate a bit and applying it to everything except food and medical expenses. While the state would still collect certain fees and, more significant, taxes associated with the energy industry, that would leave most Texans with just one state tax to keep up with. The money out of pocket would be the same, but compliance would be simpler. And being a state with no income tax and no property tax would give Texas some real bragging rights — a nontrivial consideration, to say the least.
— Kevin D. Williamson is a deputy managing editor of National Review.