The business margins tax has come under increasing attack as being bad for business. One of its leading critics is Senator Dan Patrick, who e-mailed me a detailed critique of the business tax, which I have posted below, and responded to as well. My credentials as an economist are a bit suspect, but I did find this analysis online by the Federal Reserve Bank of Dallas. I am going to excerpt selections from the article below. Southwest Economy Issue 2, March/April 2008 Federal Reserve Bank of Dallas Will New Business Tax Dull Texas’ Competitive Edge? By Jason L. Saving In today’s global economy, high corporate tax rates are more harmful than ever because it has become easier for mobile productive resources to cross borders in search of more favorable business climates. Nations seem quite aware of this. The European Union’s corporate tax rates have fallen by a third over the past decade, with five member states making cuts in 2006 alone. Asian nations, too, have responded to global competition by reducing the tax bite on business. In fact, all members of the Organization for Economic Cooperation and Development impose lower corporate tax rates than they did in the mid-1980s. It’s in this context—though not for this reason—that Texas recently revamped the franchise tax, its main vehicle of corporate taxation. This year, the state implemented a version that’s expected to raise more than twice the revenue of the old tax, changing both the number of businesses subject to taxation and the distribution of the burden across sectors. The new way of taxing businesses raises an important issue: Will it erode the Texas economy’s highly competitive business climate? * * * * Revenue from the franchise tax hasn’t kept up with an expanding Texas economy. Between 1997 and 2006, for example, nominal franchise-tax receipts grew at an annual rate of 4.2 percent, versus 6.6 percent for the overall state economy. Moreover, the franchise tax had the lowest growth rate of Texas’ major taxes in the decade, partly because productive resources shifted toward sectors and legal forms that bear a relatively small share of the franchise-tax burden. * * * * Economic theory suggests the tax code should treat similar businesses the same. When this doesn’t occur, resources flow disproportionately to favored businesses and sectors, and overall economic activity falls below what it would have been in the absence of distortions. One aspect of the franchise tax that produces unequal treatment is the legal status of businesses. For a variety of reasons, the franchise tax has never applied to sole proprietorships, which are generally small and comprise about three-quarters of Texas businesses.[1] The franchise tax also exempts partnerships and other noncorporate entities that share many of the economic characteristics of corporations. These exemptions provide an incentive for businesses to operate as sole proprietorships or partnerships to escape franchise taxes—a spur that’s particularly strong in states like Texas that don’t levy personal income taxes. Another feature of the franchise tax is the so-called Delaware sub loophole. By becoming a subsidiary of an out-of-state holding company and funneling income to it, Texas firms can legally avoid most franchise-tax liability. Delaware has been a common choice as a headquarters state due to its favorable corporate tax laws. Former Texas Comptroller Carol Keeton Strayhorn once assessed the loophole’s cost to the state treasury at about $300 million a year. In addition, the franchise tax doesn’t reflect the modern Texas economy. The tax’s wealth-based nature imposes a relatively high burden on capital-intensive industries like manufacturing and mining but a relatively low burden on labor-intensive industries, such as construction and services. Perhaps a justification could be made for this tax scheme in the early 20th century, when manufacturing and oil and gas constituted a substantial portion of Texas’ economy. But in 2007, service-sector businesses made up two-thirds of the state economy, creating a situation in which similarly sized businesses had very different tax liabilities, depending on what they produced and how they produced it. Texas GDP by Sector 1st Qtr 2007 Mining 12% Construction 6% Manufacturing 15% Trade 10% Finance, insurance, real estate 16% Other services 25% Utility, transportation, information 10% Do franchise taxes fall disproportionately on certain sectors of the Texas economy? The data say yes. Mining faces the highest franchise tax burden at $2,083 per employee, followed by utilities, transportation and information at $1,073 and manufacturing at $574. Construction, trade and “other services” (including professional and business services) pay between $97 and $308 per employee. * * * * The margin tax has several implications for the state economy. First, it slightly raises Texas businesses’ aggregate tax burden. Second, it to some degree reduces distortions across sectors, encouraging a more efficient—and productive—allocation of resources within Texas. Finally, it moves the tax structure toward treating similar businesses the same, which should also foster a better use of resources. What does this mean for Texas’ business environment? To answer this question, it’s helpful to recall perceptions under the old franchise tax. Texas had the nation’s sixth-best business climate and eighth-lowest overall tax burden, according to the nonpartisan Tax Foundation. placed the state’s business climate second behind Virginia’s, and the Fraser Institute ranked it eighth. While any single study can be disputed, it’s hard to challenge the general finding that the Texas business climate has been widely regarded as above average. And this business climate has helped Texas compete globally. Recent Southwest Economy articles have documented how Texas is increasingly open to the global economy and how its growth rate has exceeded the nation’s. Both measures are consistent with a favorable business climate. Today’s globalizing, technology-rich economy allows factors of production to move faster and farther in seeking places where they can be used most effectively. In this environment, it makes sense that states like Texas with relatively favorable business climates would see their economies—and populations—grow faster than in the U.S. overall. Because the margin tax will raise more money than the previous franchise tax, it’s tempting to conclude it will harm the state’s business climate. But the new tax also treats sectors and businesses somewhat more equally than the old franchise tax did, producing a more efficient allocation of resources. The higher revenue and greater efficiencies will offset themselves to some degree, mitigating the negative impact of a higher franchise tax burden on the overall business climate. Other tax changes made concurrently with the new margin tax—notably, a reduction in property tax burdens borne by both businesses and individuals—further mitigate the adverse impact and could arguably leave Texas with a slightly more favorable business climate than it had under the previous franchise tax. Such an outcome isn’t a certainty, of course, and vigilance will be needed if Texas is to retain its reputation as an attractive place for business.