TCCRI submitted the following written testimony to the Senate Finance Committee in advance of the committee’s March 30, 2016 hearing on the Texas Franchise Tax. The testimony argues that:
Eliminating the franchise tax would make Texas one of only four states without a corporate income tax or gross receipts-style business tax, which would be a boon for investment, job creation, and economic growth. Legislators have already set Texas on a path toward elimination of the franchise tax and they should stay the course.
Since the current iteration of the Texas franchise tax was first collected in 2008 (and even before it was enacted), the tax has been controversial and a source of much criticism. Many of these criticisms stem from the fact that the franchise tax is a form of (gross) margins taxation, which is generally acknowledged to be an inefficient form of taxation with high compliance costs for businesses that are subjected to it. Indeed, in their 2015 publication “The Texas Margin Tax: A Failed Experiment,” The Tax Foundation noted that:
- The Texas Margin Tax is routinely the subject of scrutiny from tax scholars because of its complexity and unfairness.
- The Margin Tax creates tax pyramiding, the process of taxes stacking on top of other taxes as a product moves through the production chain.
- The Margin Tax has attracted many lawsuits because of its structure. Of the three most notable challenges, one was decided in favor of the taxpayers, another in favor of the state, and one is still ongoing.
Indeed, if the decision of the 3rd Court of Appeals in the pending franchise tax lawsuit is upheld by the Texas Supreme Court, revenue collections from the franchise tax will decline by approximately $1.5 billion per year. At issue in this case is how the “cost of goods sold” (COGS) deduction should be applied to movie theaters. This is the most vivid illustration of the perverse nature of the tax. In order to avoid the tax being declared an unconstitutional income tax, the legislature created a complex “cost of goods sold” (COGS) deduction from a taxable entity’s gross revenue. The precise definition and application of the COGS deduction has been the central issue in numerous lawsuits, while multiple bills addressing and redefining the deduction have been filed in each legislative session since the tax was created.
The Tax Foundation further emphasizes the complexity of the COGS issue, noting that “Texas permits numerous items as “cost of goods sold” that differ from federal tax rules, many of which were directly added when the legislation was enacted … tens of thousands of taxpayers have taken “cost of goods sold” deductions they were not eligible for, under state law.”
Understanding these issues and the negative impact that the franchise tax is having on the state’s business climate, the Texas legislature has already set itself on the path toward elimination of the franchise tax. In the 2015 legislative session, House Bill 32 reduced the rates of the tax by one-quarter, increased the annual maximum revenue threshold for filing an “EZ” franchise tax return from $10 million to $20 million, and lowered the EZ filing rate by 42 percent. HB 32 also directed the Comptroller of Public Accounts to study the future fiscal and economic effects of repealing the franchise tax. Per the Legislative Budget Board (LBB), the cuts to the franchise tax enacted in HB 32 amount to a $2.6 billion tax reduction over the course of the current (2016-17) biennium.
Phasing out the franchise tax is an approach that the legislature must continue to pursue. Beyond the basic economic deficiencies of margins taxation, the franchise tax has failed on two other fronts: it has failed to help keep down property taxes, and it has failed to keep the state out of court. It was only five years from the implementation of the franchise tax to the current school finance lawsuit that is currently before the Supreme Court of Texas.
Although the franchise tax is the state’s primary business tax, it generated only 4.3 percent of all state revenues in FY2015. Incrementally reducing or slowing the growth of state outlays by one or two percent for each of the next two or three biennia could see the tax phased out five or six years from now.