State taxation has become increasingly harsh. Developments beyond the reach of governors and legislators have made the ideal of progressive taxation more elusive.
Theodore Roosevelt argued a century ago — amplifying the views of Andrew Carnegie and Adam Smith -that taxation should fall most heavily on those who can best bear it: “I believe in a graduated income tax on big fortunes, and … a graduated inheritance tax on big fortunes.”
Within a decade, he won the debate. A constitutional amendment, passed unanimously in the Senate, authorized the in-come tax. Congress enacted the estate tax at the behest of Southern and Western lawmakers, anxious that the cost of preparedness for overseas war not be borne by farmers, tradesmen and workers.
These progressive federal taxes have given a rare break to Americans of mod-est means. Almost every other tax takes proportionately more from the poor and middle class. Through tariffs on imports, excise taxes on liquor, fishing poles and crankcase fluid, sucker taxes on cigarettes and lucky numbers, bridge tolls, auto tag fees, sales taxes and FICA, most taxes are regressive, falling most heavily on those with stagnant incomes.
State governments especially rely on regressive taxes and fees. The mandate that a state’s budget be balanced every year means that states must rely on safely recurring sources like sales tax and bridge tolls, since income taxes are cyclical, and estate tax revenue spasmodic.
Delaware has historically been able to extract revenue less regressively than most states. Yet, its modestly progressive tax structure will be difficult, although not impossible, to preserve, due to changes in federal law, mobility of capital and the creativity of other states.
Three factors have helped Delaware taxpayers pay less tax than their neighbors.
The first factor was oval-shaped. Through the first half of the 20th century, the Three Cousins — Pierre, Alfred and Coleman du Pont — personally financed many of Delaware’s schools, high-ways and other public institutions with their share of gunpowder profits derived worldwide.
A generation later, a corporate income tax was instituted, with the acquiescence of the state’s chemical industry. Schools and highways were financed from Lucite, Lycra and Tyvek. Meanwhile, the ability to deduct state taxes against high federal rates permitted state personal income tax brackets unimaginable today — topping at 14 percent in the 1960s, 18 to 19 per-cent in the 1970s. Second, much of Delaware’s other revenue came from elsewhere. The business world incorporates here, bringing many ancillary benefits. Credit card holders make monthly payments to Delaware banks. The state was a decade ahead of the field in legalizing one-armed games of chance. Half of all inheritance tax revenue came from out-of-state beneficiaries.
Third, Russ Peterson established the Cabinet form of government, but Pete du Pont showed how to make it work. His most important legacy was financial discipline, backed with structure and attitude, which enabled Delaware to ascend from the nation’s worst credit risk in 1977 to one of the best, and stay at that level even during turbulent times. Thrifty with its spending, creative in collecting money, the state managed never to adopt a sales tax.
That legerdemain is more difficult now. The geysers of revenue that emerged after 1980 — gambling, bank franchise tax and unclaimed property — have reached or passed their peak, while traditional in-come tax sources had to be changed.
The state’s revenue needs, however, have not peaked. “Cutting government revenue” means either cutting programs or deficit spending. The facile claim that “the state has a spending problem” doesn’t explain which programs are to be ended, what erosion in social services is desirable, or which schools should lose their librarians.
Rather, the state will have to be more resourceful than ever — and its residents braced to pay more — if the state is to maintain its top-line revenue. The recently-discovered revenue streams are not annuities. Unclaimed property comes to Delaware due to a 6-3 Supreme Court decision. Because the 1993 case applied federal common law rather than a constitutional principle, it could be reversed at any time by Congress, where Delaware is outnumbered. The bank franchise tax rests on a compact industry that could operate with equal efficiency elsewhere. State lottery proceeds shrank as Pennsylvania and Maryland tiptoed into the casino business. Corporate franchise tax revenue appears safe for now, but in an era where aimless “disruption” is considered a virtue, complacency is not recommended.
Taxes are not intended to be fun. But, they can be reasonably fair and not cause harmful side-effects as they raise the revenue needed for the common mission of an organized society. Here are some suggestions for the state’s policy-makers, and those who wish to influence them.
Personal Income Tax
Delaware’s personal income tax tops out at 6.6 percent on taxable incomes of $60,000, with liberal income-splitting rules. Pennsylvania, whose constitution mandates a flat rate, taxes all income at 3.07 percent, with no deductions. Maryland’s brackets reach 4.75 percent at $3,000, then 5.75 percent for a couple with taxable income of $300,000. New Jersey’s rates reach 6.37 percent at $75,000 and 8.97 percent at $500,000. The double-figure rates of an earlier generation are impractical. State taxes were once deductible against federal rates that could reach 70 percent, and people needed to live near their work. Both factors have changed irrevocably. Having a flat tax for taxable income above $60,000 creates perceptions. Legislators may have to decide whether the perception of those making $65,000 or of those making $650,000 is more important. The state should not adopt abrupt or gimmicky responses to the new federal tax law, a monstrosity that gives bar napkins everywhere a bad name. Rather, the state should take the long view, in the expectation that this law will have a short life and be shredded within four years. If it’s not, there will be more serious problems, like benzene in the Brandywine and oceanfront views in Georgetown. If the new law’s unusual features cause a windfall, the state should guard against the two likely impulses: to spend the extra money immediately, or use the short-term bonanza as an excuse for permanent tax cuts. Both choices were made in the last 20 years, each looking poor in hindsight.
Corporate Income Tax
To address a major revenue crunch as its population and needs boomed, Delaware adopted a corporate income tax in 1958, based on the portion of a corporation’s overall payroll, property and sales that are located here. In 2016, the formula was changed to one where the tax is based solely on sales within the state. The change reduced the tax of major employers but was no giveaway. The traditional formula, in universal use 60 years ago, has been abandoned by every other Eastern state. Corporate income tax will remain important, but it can drop by as much as 50 percent during recessions.
Gross Receipts Tax
A low, broadly-based tax on businesses, gross receipts tax receipts climb with inflation, resist recessions and provide stability. It raises 6 per-cent of state revenue — more during economic doldrums. That sounds smaller than it really is. Gross receipts tax raises more than corporate income tax, cigarette tax and liquor tax, combined. It exceeds all personal income tax raised from Kent County.
The tax is stable and low (0.72% for retailers, 0.384% for service providers, 0.18% for manufacturers). That’s one penny on a $3 bottle of milk. (Compare that to 18 cents of sales tax in neighboring states.) The tax is easy to administer. The return is filed on the proverbial post card. It exempts businesses grossing less than $1.2 million per year ($15 mil-lion for manufacturers).
The tax has been imposed on retailers since 1871, and was three times higher in 1925 than now. In the 1975 revenue crisis, leading to a February walkout by teachers over an undelivered pay raise, the General Assembly adopted a reform long proposed by Rep. Jim McGinnis, to expand the gross receipts tax to include services, as well as goods. The revised tax stabilized the state’s finances, and McGinnis was handily elected lieutenant governor a year later.
Should a tax be imposed on a business, whether or not it makes a profit? Motorists pay bridge tolls even if they’re broke. Families pay income tax whether they have increased their net worth or slid deeper into debt.
As Bill Remington wrote here in 2004, after 25 years as an advisor to nine Secretaries of Finance of both parties, the last 10 as Director of Revenue:
“A fair tax should be proportionate to the taxpayer’s ability to pay. To be considered fair, a tax should be proportion-ate to benefits received from the taxing government. Neither criterion is easily applied. Though it is often argued that the gross receipts tax fails the first criterion, it is not clear this is true. The ability of a business to pay any expense is in fact roughly proportionate to its sales, since the existence of receipts from sales is the basic source of the ability to pay expenses. The fact that those making business decisions have made decisions or presented them in such a way that certain taxes are compared with profits determined after other costs (including executive compensation and depreciation) are taken into account is an artifact of presentation, not necessarily of the ability to pay.
“Second, though it may be difficult to determine the value of the benefits a business, including a business running a net current loss, receives from public services (like the education of its workforce and their children, police protection of the place of employment and of employees), it is clear the value is not zero. Once it is established the value is not zero, it seems like proportionality to gross income is not a terrible measure, if the measure is in any case inevitably arbitrary.”1
Is the gross receipts tax ultimately passed on to the consumer? No evidence suggests so. Interstate retailers price their goods regionally, across state lines. Local merchants charge what the market will bear, and don’t reduce price just be-cause a cost has dropped. Do you know any lawyers who reduced their fees, or merchants who cut the cost of toothpaste, when the General Assembly lowered the gross receipts tax from 2005 to 2009?
Pension Exclusion
Tax exemptions should have sound policy basis. Those with identical income should be taxed similarly, unless there are compelling reasons to do otherwise. Delaware’s exemption of the first $12,500 of pension income has no basis in public policy except inertia. The population eligible for this exclusion — anyone over 60, even if not retired — is growing, needlessly shorting the income tax and shifting the cost of government to younger tax-payers. Property Tax
Delaware property taxes rank fifth lowest in the nation, slotted between Louisiana and South Carolina. If rates were doubled, Delaware would be at the national midpoint, and still well below Pennsylvania and New Jersey.
Of equal importance, reassessment is overdue. Delaware property taxes are based on appraisals that are, depending on the county, 32 to 44 years old. No property tax boost would be accepted based on these rickety valuations. Reassessment would cause some homeowners’ taxes to rise, and an equal number to decline, but overall must be revenue-neu-tral.2 Most importantly, it would realign tax liability with the real world.
Not to reassess shifts the tax burden from Seaford to Bethany, from Dunlin-den Acres to Middletown — in effect, causing an annual transfer of wealth in the other direction. “Property tax is a form of wealth tax,” observed Bill Chandler in an interview while still Chancellor. “Property taxes are based on a value that is a measure of wealth, an ability to pay. But by assessing a property today ac-cording to a value as if it had been built in 1974, you are grossly understating that wealth. This creates an inequality in tax payments that is difficult to reconcile in any notion of fairness.” 3
Every state and county legislator knows reassessment is overdue, and have been told as much by task forces that have recommended it. As Ed Ratledge of University of Delaware noted in these pages six years ago, reassessment could permit many functions now left to school districts to be addressed on a coherent state-wide basis.4
Realty Transfer Tax
Last summer’s increase from 3 to 4 percent was a bludgeon, but the real impact of the tax is not in Brookside or Rodney Village. Flippers, investors and vacation home buyers are the real tar-get. The sale of a $2-million strip shopping center will now yield $80,000 — in a transaction where the seller is likely avoiding income tax entirely by a tax-deferred exchange, a stratagem that can be employed endlessly until the seller dies, the basis is stepped up, and no gain is ever recognized.
Washingtonians brag that they avoid the real estate transfer tax by titling their Rehoboth cottages in LLC’s, which they sell in transactions that don’t require recording. Actually, that loophole was closed in 1986, and our smug Bay Bridge visitors might soon encounter audits. Sales Tax
The Land of Tax-Free Shopping seems to have less allure than just 10 years ago. Over a dozen vacant storefronts greeted my semiannual visit to the Concord Mall last summer and anchor tenant Sears was as desolate as Connie Mack Stadium on a chilly September night.
Since suggestions of a state tax were whispered in the 1970s, small retailers, big business and labor have united in opposition. But if fewer people drive to Delaware to save the 6 percent, because Internet retailers provide free delivery and skip the sales tax, how important is the absence of a sales tax?
Patience is in order. Long-discussed federal legislation, or cases percolating through federal courts, might lead to a requirement that large Internet retailers collect sales tax, whether or not they have bodies and bricks in the vendee’s state. Such a change would restore the advantage of in-person shopping in Delaware, once again rendering verboten any discussion of a Delaware sales tax.
Medicaid
There is no less edifying sight than the scurrying of middle-aged children to contort their aging parents’ affairs so that the children can inherit property while the state pays for their long-term custodial care.
Delaware regulations actually restrict the Division of Social Services from recovering the Medicaid costs it has expended for long-term care to two sources: a patient’s probate estate and real estate. This requires the state to pay nursing home costs for solvent seniors who have created trusts to exploit this loophole.
Many other states have addressed this problem by including trusts, life estates and similar vehicles within Medicaid recovery. Delaware must confront whether this growing subsidy to the non-indigent should remain a priority.
Estate Tax
Like most states, Delaware was robbed of its estate tax by an ill-considered provision in the 2001 tax act. Included among its upper-income sugar plums was a time bomb for states: it changed the state death tax credit into a deduction, immolating 75 years of sensible policy designed to prevent state-shopping. The state death tax credit painlessly shifted estate tax revenue, assessed by the federal government, to state governments, without costing their residents a dime. For most states, it was the only progressive element in their tax laws.
Elimination of the credit launched a race to the bottom. States eliminated their death taxes, since they were no longer painless, being only deductions, not dollar-for-dollar credits. Delaware did so, but in 2009, during the Great Recession, reinstated the tax.
Did this increase out-migration that hurt the state? There’s no data, although there has been vigorous argument by anecdote. Since Willis Carrier developed air conditioning in 1902, retirees have moved to Florida, where the constitution prohibits a state income tax and the ballparks host spring training.
Because estate tax revenue is spasmodic in a small state, it was almost in-evitable that the tax would be again re-pealed, as happened last summer, as part of the bargaining for an increase in the franchise tax.
If in the 2021 tax bill, the Federal government revives the state death tax credit, Delaware should change how it treats the estate tax revenue. Just as a well-advised heir treats an inheritance as a legacy to be preserved, and not spent within 12 months, the state should con-sider devoting all estate tax receipts to an endowment fund for projects that require a massive one-time investment. Important initiatives could be considered, not swiftly dismissed because “the money’s not there.” Such a proposal was introduced 50 years ago by GOP Reps. Laird Stabler Jr. and George Hering.
Divestiture Fund
There’s precedent to hold tax receipts in an endowment fund. When DuPont had to divest its General Motors stock in 1961-63, Delaware received $29 million, manna that would never recur, which the General Assembly placed into a special fund to be used only for major capital expenses.
In the 1970’s, though, it was regularly tapped by legislatures under control of both parties as a last-minute patch for the operating budget, and finally emptied by 1976. After 40 years of incorporating sound fiscal management into its culture, the state should have learned bet-ter. It should again undertake such a fund, fund it with non-recurring tax revenue, maintain it with discipline and use it prudently.
Three-Fifths Rule
After a decade of successive financial calamities, the General Assembly adopted a constitutional amendment, proposed in 1978 by Gov. du Pont, a Republican, and Lt. Gov. McGinnis, a Democrat, to require a three-fifths majority in both legislative chambers to adopt or increase a tax.
Although Republican Senators Dan Weiss and Andy Knox saw practical problems with the proposal, designed to make tax increases more difficult and prevent what du Pont described as “midnight raids,” the amendment rolled with scant opposition, part of the modernization of the State’s financial practices, gaining hearty acceptance from a public weary of whip-lash from hastily-conceived tax legislation, and generally chary of taxes in the Proposition 13 era.
The ensuing professionalization of state revenue management, the establishment of the Delaware Economic and Finance Advisory Council and the rainy day fund, regularized procedures for the Joint Finance Committee, and the collegial, result-oriented process known as the Delaware Way, proved enormously successful, yielding consistent AAA bond ratings for over a generation.
Yet, the three-fifths rule does not prevent last-minute legislation. It simply adds new tools to the combatants in June negotiations. Too much legislation is still made on June 30, often after last call. The principal effect of the three-fifths rule is to tilt the field in favor of the defense. Fiscal shortfalls can be used as hostage for issues unrelated to budget or finance.
Potential mischief arises in ways that didn’t exist in a prior, less polarized era. In the 1970s, last-minute negotiations could be oafish — expansion of the Delaware Supreme Court to five members was delayed by four years because of a legislator’s pique over a failed bill to benefit asphalt contractors — but not ideological. The parties overlapped then. When the three-fifths rule was adopted, most of the state Senate’s liberals were Republicans.
In 2017, though, the arguments no longer center on paving contractors. In effect, last spring’s discussion in the legislature had sounds of, “You want a tax increase? Then we want something back on environmental regulation, labor law or social legislation.”
The three-fifths rule, if misused in the contention of an ideology-polarized era, could lead to late-night damage not envisioned by its original proponents.
NOTES
1. William M. Remington, Delaware’s Tax System in a Digital Age, DELAWARE LAWYER, vol. 22, no. 3, p. 19.
2. State law permits property tax revenue to increase by 15 percent in the first year after reassessment, to cover the cost, but must return to its prior level thereafter. 9 Del. C. § 8002.
3. Reid Champagne, A Mess to Reassess, DELAWARE TODAY, August 2008.
4. Edward C. Ratledge, Delaware’s Revenue Portfolio, DELAWARE LAWYER, vol. 30, no. 2, p. 12.