David Norris still remembers staring in disbelief at the 2008 tax bill for his conference-and-event-center company. In 2007 he’d paid the State of Texas $157. A year later, the number had soared to a staggering $21,000. That increase wasn’t the result of an uptick in revenue. It was a consequence of the state’s new business tax, which had just taken effect.
For Norris, the impact was serious. Over the course of its eighteen years in existence, Norris Conference Centers had grown to three locations, in Houston, Austin, and San Antonio, and the tax hit just as the company was expanding into Fort Worth and planning a second Houston location. The last thing he needed was a new drain on his cash flow. Norris quickly came to the conclusion that the law was one of the worst he’d seen in 25 years of doing business in Texas, and he’s been calling for its repeal ever since. “They created this completely unfair tax,” he says. “It came out of nowhere.”
Norris’s opinion is shared by many business owners, tax experts, and lawmakers. In a state that views all taxes with disdain, few levies have drawn more scorn than the Texas business tax. People like Norris complain that the tax is too complicated to calculate and that it punishes businesses that are losing money. Tax experts say it impedes economic growth. And many lawmakers criticize it for generating less revenue than it was supposed to. “This failed miserably,” declared Senator Royce West, a Democrat from Dallas, during a Senate Finance Committee meeting in early March.
In fact, the tax is the target of more than two dozen bills in the current legislative session, which call for revising it or eliminating it altogether. Americans for Prosperity, the free-market advocacy group backed by the Koch brothers, has launched a grassroots campaign for its repeal, and business groups such as the National Federation of Independent Businesses (NFIB) are clamoring for its demise. Even lawmakers who voted to adopt it, such as Senator Jane Nelson, a Republican from Flower Mound, now say that they regret their support. “There has been some buyer’s remorse associated with the tax,” says Dale Craymer, the president of the Texas Taxpayers and Research Association.
In 2006, when the tax was created, politicians were feeling tremendous pressure from their constituents to reduce the tax burden on property owners, who had been unhappy with rapidly rising rates. At the same time, the governor and the Legislature needed to comply with the Texas Supreme Court’s recent order to make state funding for wealthy and poor school districts equitable. Because property taxes are the primary funding source for schools, reducing them was only going to make that problem worse.
To deal with these conflicting demands, Governor Rick Perry appointed a special commission, led by former comptroller John Sharp, to come up with alternative methods of raising revenue. The commission quickly zeroed in on the state’s tax on business, known as the franchise tax. The tax was riddled with loopholes and didn’t apply to many of the service-oriented businesses and partnerships that play a larger role in the Texas economy than they once did. “The old franchise tax had basically become a voluntary tax,” says Karey Barton, a staffer on the commission who is now an associate deputy comptroller.
Legislators had considered a host of options: a payroll tax, a head tax on employees, a gross receipts tax. All were rejected. Instead, the commission settled on a tax that gave businesses a choice of which expenses to deduct. The flexibility of the deductions was supposed to make it business-friendly. “On paper, as it was designed, it was very appealing,” Craymer says. The law drew mostly Republican support and passed in the third special session, which Perry had called to address the school funding issue.
But there were early signs of trouble. The margins tax, as it has come to be known, was adopted in part to offset the loss of nearly $8 billion in annual revenue in that year’s tax-cut package, which included those promised reductions in the property tax. Sharp’s successor as comptroller, Carole Keeton Strayhorn, warned that it would not generate the $6 billion that had been projected, creating a structural deficit.
And the flexibility that was supposed to make the tax attractive actually made it more complicated. Under the state’s old franchise tax, businesses basically calculated their payments by adding up their profits and the compensation paid to officers and directors, multiplied that amount by the percentage of their sales that took place in Texas, and applied a 4.5 percent tax rate to that number. Under the margins tax, by contrast, businesses start with their total revenue, then have the option of subtracting one of four figures: $1 million; 30 percent of their total revenue; the total cost of employee compensation; or the cost of goods sold, which includes expenses such as raw materials. They then multiply that by the percentage of their sales that take place in Texas and pay 1 percent of that number as tax. Unless they’re a retailer or wholesaler, in which case the rate is only 0.5 percent.
Offering so many options has had an unexpected downside, as companies have essentially been forced to calculate the tax using each of the four methods to determine which is cheapest. “Under the old tax, businesses could pay someone a few hundred bucks to do their taxes,” says Will Newton, the executive director of the Texas chapter of the NFIB. “Now it costs several thousand dollars to hire a CPA.”
But that’s not the worst part, according to Norris. As shocked as he was by his 2008 tax bill, he was even more dismayed by what happened over the next two years. His company was expanding when the recession hit and credit dried up. “Both of those years we lost substantial amounts of money,” he says. “And both of those years we had to write $55,000 checks to the State of Texas. Even the IRS doesn’t do that to us.” That’s because rather than taxing a company’s profitability, the margins tax is pegged to how much a company brings in before expenses, so money-losing companies must still pay up. That makes a bad year even worse.
And no matter how businesses calculate it, the tax hits some harder than others. A manufacturing company, for example, may have significant raw material costs or a large employee base that enables it to reduce its tax bill. By contrast, Norris Conference Centers has about $10 million in annual sales, but the nature of the business—hosting meetings and events such as weddings—means it’s likely to have far less “costs of goods sold” than most manufacturers and a smaller workforce relative to its revenue. As a result, the company has a higher tax bill than many other businesses of the same size. “I don’t mind paying my share of taxes, but I’m paying two or three times my share,” Norris says.
Perhaps the biggest disappointment, though, is that the margins tax, as Strayhorn and others warned, has never brought in as much money as it was supposed to. In 2013, for instance, it brought in about $4.8 billion—considerably less than the projected $6 billion. That sort of shortfall contributed to budget problems in 2009 and 2011, in part because Perry insisted on no new sources of tax revenue.
As if all of this weren’t enough, the margins tax encourages businesses to act against the interests of consumers through something called tax pyramiding. Take the hand tools industry, for example. A straight retail tax, such as a sales tax, is levied only on the final transaction—when you buy a hammer at the hardware store. But a margins tax applies levies at every step of the way—to the steel mill, the toolmaker, the distributor, and the retailer—in addition to the sales tax paid by the consumer.
Generally, we want businesses to specialize and trade with one another, which creates more jobs and broadens the state’s economic base. The margins tax, by contrast, encourages businesses to control all phases of the production process, so there are fewer transactions along the way that can be taxed. The result is the sort of concentration of production in fewer hands that discourages new players from entering the field. So far, the oil boom has masked some of these consequences. “The ‘Texas miracle’ has been in spite of the margin tax, not because of the margin tax,” says Scott Drenkard, an economist with the Tax Foundation, an independent tax policy research group in Washington, D.C., and the author of a report, “The Texas Margin Tax: A Failed Experiment.”
Now, just as in 2006, lawmakers are talking tax reform. As this magazine went to press, the Senate had approved a measure that would cut state taxes by $4.6 billion over the next two years, and the NFIB was calling for a 25 percent reduction in the margins tax each year, which would eliminate the tax in four years. “You can’t just take billions of dollars off the table, but the state can slowly wean itself from this revenue stream,” Newton says. But getting rid of the margins tax would leave us in the same position we were in a decade ago, when too few entities were paying any sort of business tax at all. If nothing replaced the margins tax, a mere 55,000 businesses out of 1 million operating in the state would pay taxes.
And no one seems sure how to replace the money that would be lost. Currently the state is flush with oil and gas revenue, but those numbers will likely drop off now that oil is selling for about half of what it did a year ago. Drenkard proposes getting rid of any sort of business tax and making the state’s sales tax more productive by expanding it to include items that are not currently taxed, such as food, dry cleaning, and magazine subscriptions. But many would object, because sales taxes disproportionately affect the poor, consuming a higher percentage of their income.
For the moment, the Lege would rather cut the business tax than expand the sales tax. Senate budget writers in mid-March passed a relief package out of committee that would reduce business tax bills by 15 percent, raise the small-business exemption from $1 million in annual sales to $4 million, and simplify the calculation for some companies. Those changes will help Norris and other midsize businesses, but they aren’t the sweeping reform the NFIB and other groups had hoped for. While there was some support for a simple tax on profits, similar to a corporate—gasp!—income tax, the conversation is now focused on phasing out the tax over time and not replacing it with anything. That’s likely to feed more disagreement among small and large businesses and leave future legislatures scrambling to find additional tax revenue. And while it would certainly be simpler than what we have now, it may not be fairer. Many voters—and even many business owners—believe that companies should pay their share to keep the state running.