Texas Awaits Ruling on Franchise Tax’s Fate

By: - October 18, 2012 12:00 am

Any day now, the Texas Supreme Court could rule that the state’s major business tax is unconstitutional. If it does, Texas lawmakers will have a major new budget problem to solve, while many Texans will not be shedding any tears.

In 2006, the legislature modified the franchise tax that businesses pay, as part of a tax swap that also reduced property taxes and raised cigarette taxes. The moves came in response to a state Supreme Court ruling that found the school funding scheme in Texas to be unconstitutional.

Under the old franchise tax, what businesses paid was primarily based on their profits. Under the new franchise tax, which has become known as the margin tax or margins tax, the starting point is companies’ total revenue, though various deductions cut into that base. The concept was to cover more businesses, raise more money and make the tax system better aligned with the modern economy by, for example, taxing more heavily companies that provide services.

Critics on the left, the right and in between have several objections to the tax. Advocates for public services note that it hasn’t come close to providing the revenue the state expected. It’s averaged about $4.5 billion a year, instead of the $6 billion that was promised. That shortfall helped contribute to Texas facing its most serious budget problems in modern history in 2011.

Business groups complain that the tax affects more small businesses than the old franchise tax and costs firms money even when they don’t turn a profit. They argue that the tax’s various deductions and definitions make it costly and confusing to calculate what is owed.

“What Texas is doing is setting the example of what not to do in state tax policy,” says Will Newton, the executive director of Texas’ chapter of the National Federation of Independent Business. “What we have is the most complicated, convoluted system of taxation ever devised by state government.”

And some businesses object that the various deductions and the tax’s two rates — half a percent for retailers and wholesalers and 1 percent for others companies, such as manufacturers — make some companies winners and others losers. It’s that final complaint that prompted the Nestle company to challenge the tax’s constitutionality.

Nestle’s particular objection is that it pays the 1 percent rate, even though it only sells its goods in Texas, while manufacturing them elsewhere. But, because the Texas Constitution declares that “taxation shall be equal and uniform,” that objection gets at a bigger constitutional principle. “There is no question that there are disparities in the tax,” says Dale Craymer, president of the Texas Taxpayers and Research Association. “The question is just whether those disparities rise to a level of being unconstitutional.”

When the legislature wrote the law creating the tax back in 2006, it did something unusual. Expecting that there would be legal objections and not wanting doubts to linger, it allowed challenges to go directly to the Texas Supreme Court and required the court to decide in 120 days. Nestle’s current challenge was filed in late June (an earlier one was thrown out on a technicality), requiring a ruling soon if the court abides by the schedule the legislature mandates.

The most dramatic outcome would be for the court to throw the tax out and require refunds dating back to its start. Peter Nolan, a lawyer who represents Nestle, argues that even if court rules the tax unconstitutional, it’s more likely to only do so prospectively, by setting a future end date for the tax. “There’s no financial disaster,” Nolan says. “There’s no economic cliff.”

Even without such a ruling, many lawmakers want to change the tax. They are expected to debate the tax next year, even if the court upholds it.

Still, Craymer argues, turning that talk into action is politically difficult. While the state’s budget situation has improved substantially since 2011, it will be hard-pressed to find money for a deep tax cut. That means any changes that reduce the burden on some taxpayers would have to raise it on others, likely spurring a backlash from those who would pay more.

What would change the political dynamics, Craymer says, is if the court forces the legislature’s hand—in the Nestle case, another challenge to the tax or in a new school finance ruling. “Restructuring the franchise tax,” he says, “is going to take some kind of outside catalyst.”

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Josh Goodman

Josh Goodman helps lead research on fiscal management and place-based economic development programs as part of Pew’s state fiscal health project. Goodman has served as a primary author for Pew studies that examine how states should evaluate tax incentives and maintain budget discipline when implementing those incentives.