Politically Thinking: State's tax system due for revisions

Vermont’s tax system will be a major agenda item in this fall’s campaign and in next year’s legislative session. A blue-ribbon commission on the state’s tax structure will report to the governor and the Legislature early in 2011. The commissioners — Kathy Hoyt, Bill Sayre and Bill Schubart — all have long experience with tax and economic policy from both business and government perspectives.

Vermont’s tax system needs substantial reform. The commission’s report could begin a serious re-examination of how the state raises the revenues to support its operations. The principal state taxes — on sales and income — are based on the economy of the 20th century, not the 21st. The design of these taxes does not reflect an economy in which capital is increasingly financial, intellectual, or human, rather than fixed plant and equipment, in which that capital is mobile all over the nation and the world, and in which purchases can just as easily be made online from distant vendors as from local merchants.

A blue-ribbon commission on California’s tax system made its report last year. While California’s public finances are in much worse shape than Vermont’s, much of the California commission’s analysis is applicable to Vermont. The problems the California commission identified with that state’s tax system are also concerns in Vermont.

The Vermont tax system is volatile. One percent of the state’s income taxpayers provide 25 percent of the dollars raised by that tax, making the income tax very sensitive to business cycle changes that disproportionately affect high-income individuals. The sales tax has a high rate with a narrow base, and does not cover a large part of the state’s economic activity. Vermont’s relatively high sales and income tax rates may make the state uncompetitive in a world in which individuals and assets are increasingly mobile.

A solution to these problems that the blue-ribbon commission should carefully consider would be a substantial reduction in Vermont’s income and sales tax rates, coupled with a significant broadening of the base of both of those taxes. Lower tax rates would make Vermont more competitive, while broadening the tax base would make the tax system more equitable and less subject to short-term fluctuations in revenue.

How might such a system be designed? The Vermont income tax now includes five brackets, ranging from 3.5 to 9.4 percent. A revised income tax could start with a substantial personal allowance of $20,000 for each adult and $10,000 for each dependent child. Income above these amounts would be taxed at just two rates, say 4 percent up to $100,000 and 6 percent on higher amounts.

The only deductions allowed would be for mortgage interest on a primary residence, charitable contributions, and property taxes. All income would be taxed at the same rates, whether it comes from wages and salaries, business income, capital gains, or other sources.

Broadening the base of the sales tax could be accompanied by a reduction in the rate from the current 6 percent to 3 percent. Two principal areas would be encompassed by a broader sales tax. The first is services, particularly those purchased by businesses, such as accounting, architectural, computing, consulting, legal, and tax services. The second is online purchases from out-of-state vendors.

A lower sales tax would help brick-and-mortar Vermont businesses compete with online merchants. It would also help businesses in the Connecticut River valley facing competition from tax-free New Hampshire. If the rooms and meals tax — now 9 percent — were replaced by the lower general sales tax rate, Vermont’s tourist industry would also see major benefits.

Eric L. Davis is professor emeritus of political science at Middlebury College.

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