The Tax Man. Yeah, the Tax Man.

Should $4 billion appear too small, be thankful John Sharp doesn’t take it all.

May 2006By Comments

GIVE RICK PERRY SOME CREDIT. After two regular sessions and three special sessions of nothing but futility and failure on school finance and with the state facing a June 1 deadline to rectify a school-funding method that the Texas Supreme Court has ruled unconstitutional, he finally figured out the solution: If you have to raise taxes, ask a Democrat.

That Democrat, of course, was John Sharp, his onetime Aggie buddy and, more recently, a bitter political opponent of both his and Lieutenant Governor David Dewhurst’s. The story of how Sharp and Perry encountered each other at a skeet range east of Austin in July 2005 has been widely told around the Capitol. Once it was clear that neither was going to open fire on the other, they patched up their friendship, and Perry subsequently appointed Sharp, who served as state comptroller between 1991 and 1999 and knows the tax structure inside and out, to head his Texas Tax Reform Commission. Sharp’s charge was to develop a plan to reduce school property taxes by finding other sources of revenue. That mission accomplished, he now finds himself in the strange position of lobbying to save the career of the man who ruined his.

Make no mistake: The special session that began April 17 is the last train for the GOP leadership and legislative majority to board if they want to prove themselves capable of governing the state. If the session fails and if the unthinkable comes to pass—a shutdown of the public schools come June 1—all hell will break loose. You would think that responsible politicians would never let the situation come to this.

I interviewed Sharp at an Austin restaurant a few days before the start of the special session, in between two briefings at the Capitol. He was in great spirits, clearly pleased not just that he’s back in the game but that his proposed solution to the problem—a reformed business tax—had survived its incubation period without major opposition. “[Bob] Bullock used to say, ‘If a tax bill lives for forty-eight hours, it’s going to pass.’ We’re well past that deadline, and this bill is getting stronger,” Sharp told me, citing the oft-brilliant, oft-manic former Democratic comptroller and lieutenant governor who, seven years after his death, still remains a point of reference in many a political discussion. I said that I had noticed Sharp make several references to Bullock during the unveiling of the tax bill the previous week. “Oh, I talk to Bullock every day,” Sharp said. I don’t think he was kidding.

Sharp is the unluckiest politician in recent Texas history, one who had the misfortune to be the last viable Democrat just as George W. Bush was at the height of his popularity in the state, a public servant of great competence and intelligence at the exact moment when those qualities ceased to matter if you had a D after your name. He might have beaten Perry anyway in the 1998 lieutenant governor’s race had he not made the decision to take an effective anti-Perry ad off TV in favor of a positive spot about himself. Four years later, he lost to Dewhurst in a race he expected to win with the help of conservative Democratic votes—only by that time, most conservative Democrats had become Republicans.

The stimulus for Perry’s turning to Sharp was the Supreme Court’s ruling last fall that the state’s reliance on property taxes to fund education had increased to the point that it amounted to a statewide property tax, which is prohibited by the state constitution. So many school districts are taxing at or near the maximum allowable rate of $1.50 per $100 of property value that they have little room to raise taxes to meet local needs. Hence the need for new revenue to “buy down” the property tax rate and provide room for districts to raise money locally. Sharp’s piece of the puzzle is to revise the state’s loophole-ridden business franchise tax to raise more revenue without being a burden on the economy.

The art of taxation has been described as the art of plucking the most feathers from the fattest goose in a manner that produces the least hissing. Business plays the role of the goose. The logic for taxing business is that it gets legal protection from the state in the form of limited liability and thus has an obligation to help support state government and also that it benefits from state-run public schools and universities, which educate and train its future employees. The modern Texas economy is built around professional-services firms, which have avoided paying the franchise tax by arranging themselves as partnerhips— as have some of the state’s biggest companies. As far back as 1997, when Governor Bush pressed for property tax cuts funded by a reformed business tax, it was clear that the franchise tax had lost much of its usefulness. But no progress had been made until Perry and Sharp got together.

The problem, Sharp explained to me, has always been “how to make it work for H-E-B and Dow”—that is, how to write a tax bill that is fair for businesses like H-E-B, a retailer with a thin profit margin, and Dow Chemical, a manufacturer with a higher profit margin. Recent efforts to reform the business tax focused on a payroll tax, which had the backing of Speaker Tom Craddick. But a payroll tax murders labor-intensive businesses like insurance companies, and especially retailers like H-E-B. It was Christmas for capital-intensive manufacturers like Dow, which need only a small number of employees. Sharp’s solution was twofold. First, he imposed a gross-receipts tax with two different rates: half a percent for retailers and wholesalers, one percent for everybody else. Then he allowed companies to deduct—dealer’s choice—either their labor costs or their cost of goods sold. H-E-B would choose cost of goods sold. So would Dow. But insurance companies and airlines, which sell services, not goods, would choose to deduct payroll. Dow will pay a lot of tax, but because of the value of its industrial plant, it will enjoy the biggest benefits from property tax cuts.

But there was still one more problem, and that was how to bring the service sector of the economy under the bill. This was achieved by closing the loopholes that let certain kinds of business organizations escape paying the franchise tax. Lawyers, public spirited as ever, complained that if the Legislature made partnerships subject to a gross-receipts tax with deductions, they were effectively imposing a personal income tax—a no-no both politically and constitutionally. “How can it be an income tax,” Sharp said to me, “if you have to pay when you don’t make a profit?” This part of the bill is the one that doctrinaire Republicans are the most likely to oppose, since partnerships are new taxpayers and the taxes are (oh, no!) new taxes. Furthermore, the majority of professionals are presumed to be Republicans.

The Sharp plan represents the best chance Texas has ever had for tax reform. The old system, with its high property taxes, created a disincentive for companies to move their headquarters to Texas or expand their operations here. The new system creates an incentive to move or expand, not only by lowering property taxes but also by repealing a law that allowed the state to tax out-of-state shipments under certain circumstances, much to the displeasure of Dell and other megashippers.

Still, its eventual passage is by no means certain. The most outspoken conservative Republicans oppose any kind of tax increase, including one on cigarettes (another part of Sharp’s package). Take House member Debbie Riddle, of Tomball, who is still remembered for a comment she made three years ago: “Where did this idea come from that everybody deserves free education . . .? It comes from Moscow, from Russia. It came straight out of the pit of hell.” After receiving the details of the Sharp plan, Riddle released a statement that called for a 30 percent school property tax cut and added, “I will not support the implementation of new taxes. For the current biennium, the state’s budget is more than $130 billion. A 30 percent reduction in property taxes will cost the state approximately $5 billion. By my math, that leaves plenty of places in the budget that can be cut to make up the difference.”

Other conservatives support dipping into the state treasury to fund a portion of the tax cuts, spending money that is accumulating for the next biennium. Sharp has proposed spending $1 billion from this so-called surplus to ensure that the property tax reductions exceed the amount of new taxes, which means his plan cannot accurately be called a tax increase. Other conservatives want to fund the entire tax cut from the surplus. This would avoid a tax increase this session but create a $4 billion to $5 billion hole for next session because the property tax reduction must be ongoing or else the school finance system will be challenged in court again. Some conservatives will argue for filling that hole, as Riddle did, by reducing spending rather than raising taxes. Others may support an increase in the sales tax rather than a new business tax.

The peril for Perry and other Republicans who are on the ballot this fall is that there are enough hard-line conservatives in the House and the Senate to prevent passage of Sharp’s plan—which is to say, Perry’s plan—without Democratic votes. In a bipartisan political environment like the one Texas enjoyed in the  Bush years, it would have been easy for the governor and legislative leaders to get Democratic support. But Perry and Craddick have operated with such complete disdain for the Democrats that the trust and good faith necessary for dealmaking doesn’t exist. If that weren’t reason enough to be concerned, Perry and Dewhurst and Craddick have never been able to get along. The time has come for them to put aside their differences, not just to keep the public schools open but to protect their own considerable ambitions.

The last train is about to leave. All aboard.

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