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Should Texans Be Taxed at the 'Margin'?

Gov. Rick Perry’s proposal to reform the state’s main business tax throws light on a problem most Texans likely didn’t know they had. A tax that hinders economic growth without raising the revenue its backers confidently predicted. Wouldn’t most of us call that a problem?  

Consider the so-called margin tax, enacted in 2006 to help alleviate the pain of high local property tax rates brought about by court orders to equalize funding of public schools. Lawmakers had good intentions—the legendary paving material used on the road to hell. They decided to wring more money out of business through overhaul of the franchise tax.

It hasn’t worked out—as you might expect of a complex levy that treats businesses differently in ways widely deemed unfair. To start with, wholesalers and retailers qualify for a lower tax rate—0.5 percent—than the 1 percent rate levied on everyone else, including  partnerships, LLCs, joint ventures, and incorporated political committees.  

How does the thing work—or, more to the point, not work?

Under legislative surgery, the old corporate income tax, known as the franchise tax, turned into a levy on business “margin,” defined as—take your pick—total revenue minus cost of goods sold, total revenue minus compensation, or total revenue times 70 percent. You do get a discount: as much as 80 percent “if Total Revenue is greater than $300,000 and less than $400,000,” all the way down to 20 percent “if Total Revenue is greater than or equal to $700,000 and less than $900,000.”

A lot of entities that had previously gone untaxed—partnerships, unprofitable businesses, and small businesses—fell into the snare. That was when exclusions and exemptions started to multiply. Small business, unsurprisingly aghast at the notion of another burden on profits, procured a temporary exemption for entities with revenues of less than $1 million a year. (Perry would make the exemption permanent.)

Other brush fires quickly sprang up, and still flicker. What was the meaning of “cost of goods sold”?  Texas and the IRS differ widely as to the definition. Thousands of state businesses, eligible or not, are suspected by the comptroller’s office of deciding for themselves what to claim. The Tax Foundation points to discrepancies between the margin tax law’s treatment of essentially similar businesses: some getting the higher rate, some the lower.

The National Federation of Independent Business says the margin tax is “crippling the small and mid-sized businesses without bringing in” as much revenue as originally predicted. Complicated bits of tax legislation do tend to have this depressing effect, as the IRS code, opaque in many respects even to tax experts, demonstrates over and over.

The only thing better than reforming the margin tax, as many see it, would be running the whole thing through the shredder. Texas’ enviable prosperity is built on, among other foundations, that of a rational tax system that encourages investment and work: no income tax, plus relatively low taxes overall. We need to act fast in any case before we lose our reputation for prudence. Nevada, starved for cash, is considering, we hear, a “Texas-style” margin tax. How would you like those odds at the craps table?