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Michigan Supplemental Report

Tax Environment

Michigan has been one of a handful of states to really reform its tax system in the last decade. A major change in the state-local tax system occurred in 1994, when the state steered itself away from an extreme dependence on property taxes and developed a much more classic “three-legged” tax stool through the abolishment of local school-operating property taxes for home owners and an increase in sales taxes that citizens approved through Proposal A. This resulted in a fairly even distribution of property, income and sales taxes. At the same time, the state took on a much greater responsibility for funding K-12 education. Prior to this tax shift, Michigan had one of the lowest percentages of state financing of K-12 education.

Another aspect of the 1994 ballot proposal was a per parcel cap on annual increases in taxable value, limited to the Consumer Price Index or 5 percent, whichever was less. It also stipulated that any future increases of the property tax for school operating expenses would require a three-quarters vote of the legislature. (There had been limits on property tax increases in Michigan since the Headlee Amendment to the Michigan Constitution passed in 1978. This states that unit wide property taxes, adjusted for new construction, cannot increase faster than the rate of inflation without a taxpayer vote.”)

Another unusual feature to Michigan’s tax system is its single business tax, which replaced eight other taxes back in the 1970s. This is a modified value-added tax, which is unusual in the U.S. In census figures, it’s recorded as a corporate income tax, which makes it appear as if Michigan collects a higher percentage of business taxes than all but four other states. This is misleading since other states collect taxes from business in a variety of ways and the net affect is often hidden. Although “transparency” is hailed as a virtue by academics, the fact that Michigan’s business taxes are simple and visible has been a public relations problem for the state. The Single Business Tax is now being phased out

Recent Tax Developments

• Michigan was one of seven states that approved tax amnesty programs in FY2002. About $30 million was collected.

• The tax rate on cigarettes and other tobacco products was increased to $1.25 per pack from 75-cents a pack as of August 1, 2002.

• In summer, 2002, Michigan’s legislature voted to delay the next scheduled 0.1 percent drop in the state’s single business tax, saving the state $80 million in the current fiscal year. At the same time, it voted the tax out of existence as of 2010. (The single business tax had been scheduled for total phase-out by 2021.)

Budget Information

According to figures from the Senate Fiscal Agency, tax cuts plus the weakening economy resulted in FY2002 revenues that were $1.35 billion less than what actually came in during FY1999. FY2003 showed a little revenue growth, largely thanks to an increase in the cigarette tax, but while general fund appropriations were $9.2 billion, ongoing general fund revenues were only $8.5 billion in the current fiscal year, which ends September 30, 2003. To support spending in excess of revenues, Michigan used up its rainy day fund over a three-year period, leaving a zero balance for FY2004.

In addition to its rainy day fund, the state has used many other one-time revenue sources. A $1 billion surplus in the school aid fund will be gone by the end of the current fiscal year. A $200 million general fund surplus was used as well as $260 million in tobacco settlement revenues and $100 million from the employment security fund, according to the Citizens Research Council.

While the FY2003 budget was balanced, albeit with one-time resources when it began on October 1, it quickly fell out of balance — by about $500 million. To help solve its budget problems, the state entered into an early retirement program for 8,000 employees (out of 60,000 total) during the current fiscal year. Budgeters confront a $1.6 billion gap between proposed spending and available revenues for next year. New Governor Jennifer Granholm’s proposed budget for FY2004 was based on January 2003 revenue estimates and closed that gap largely through spending cuts, as well as some proposed closings of tax “loopholes”. But a consensus revenue estimate in May once again lowered general fund revenue expectations for FY2004 — this time by $32.9 million drop from the January estimate.

The School aid fund is also in for lean times. In the current fiscal year, school revenues were increased by about $500 million through an accounting change — a shift in the due date of the tax that the state levies on property. This revenue will not be available in FY2004. In addition, the new consensus estimate that was issued in May, 2003 revealed that the state expected $91.9 million less to come into the school aid fund in the current fiscal year than what was expected in January. Gov. Granholm has proposed that a reserve fund for revenue sharing be used to patch that hole. But more problems are likely next year. The FY2004 school-fund estimate was reduced by $105.7 million.

Pressures on the spending side have compounded revenue weakness. For example, in FY2003, health costs for employees are up 15 to 20 percent; also, many state employees are on a defined benefit retirement plan and the pension contribution rate of the employer recently went from 16.5 percent to 19.5 percent of salary.

Adequacy

Michigan’s tax system is in transition, with several key taxes facing elimination and no decisions made yet as to how that revenue is going to be replaced.

Back in 1998, the legislature decided on a 23 year phase out of the state’s unusual single business tax, so that the 2.3 percent tax that was in place at the time would drop a tenth of a percentage point a year until it was gone by 2021. At the same time, a tenth of a percentage point cut in the income tax was put in place for five years. The impact of this rate drop has been compounded by the weakness in the economy during the last several years, though since the state has a flat income tax rate, the economic downturn has not had as profound an impact on revenues as in states with graduated rates. In addition, in recent years, the state has repealed its inheritance tax and its intangibles tax.

At the time they passed the cut to the business tax, legislators stipulated that the single business tax cuts would not take place if the state’s rainy day fund dropped below $250 million — a situation encountered in FY2003. The legislature allowed this freeze of the tax rate to take place, but unable to give a tax cut in that year, voted to abolish the single business tax entirely by 2010.

Another factor facing Michigan’s revenue future is its generosity to senior citizens. The state does not tax social security income or any public pension income and a good deal of private pension, as well as IRA income, is shielded as well. In fact, Michigan’s preferential income tax treatment for seniors is among the most generous in the nation, according to “Demographic Change And Fiscal Stress on Michigan” by Paul L. Menchik, a professor in the Department of Economics at University of Michigan. These policies are bound to have an increasing impact on the state’s revenue picture due to the aging of the population. Menchik points out in his report that the Census Bureau shows the proportion of people over age 65 as rising from 12.37 percent to 18.07 percent of the state population between 2000 and 2025.

Fairness

A major fairness issue involves the state’s unusual single business tax, which was designed as a broad-based tax to be paid by all businesses, but has been modified extensively over the last 25 years, with exemptions multiplying. “We’ve chipped away so that it’s a shell of what the original idea was. The business community has done a very good job of lobbying to increase exemptions and exclusions so that half the businesses in the state don’t even file a return,” says Gary Olson, director of the Senate Fiscal Agency.

The Michigan Economic Growth Authority also has had a great deal of discretion to reduce the tax burden of specific businesses through tax breaks for new investment.

There is a fairly marked difference in the percentage of income paid by the lowest income residents and the highest income residents. Looking at state and local taxes, the top 1 percent of the population pays 6.7% of its income in taxes, while the lowest 20% pays 13.3% of its income. In Who Pays? A Distributional Analysis of the Tax Systems in all 50 States, the flat income tax rate and the “comparatively high cigarette tax” are listed as regressive factors, while the indexing of personal exemptions and the state’s property tax circuit breakers are considered progressive. http://www.itepnet.org/whopays.htm.

While the highest proportion of revenue comes from the sales tax, which is generally considered a more regressive tax, this is mitigated by the fact that food purchased for home consumption and prescription drugs are exempt.

On the other hand, the fact that a number of exemptions have slipped into the sales tax code brings up other questions of inequity. Legislative staffers say that the sales tax has been “nickled and dimed” over the years. Exempt items include most items sold through vending machines; meals served by employers to their employees and qualified trucks and trailers purchased by interstate motor carriers. For a full list see the Executive Budget Tax Expenditure Appendix, FY2004 at http://www.michigan.gov/treasury/1,1607,7-121-1750 — 2122 — ,00.html. In addition, the state taxes relatively few services. A 1996 report by the Federation of Tax Administrators shows the state with only 29 services taxed out of a possible total of 164 and a 2002 addendum to the report notes that there have no major tax changes in Michigan in this area since then. http://www.taxadmin.org/fta/pub/services/services.html

Management

In its organizational structure, Michigan also is unusual. The Bureau of Revenue falls under an appointed Treasurer with a wide range of responsibilities and a staff that’s larger than the other Midwest states put together. The only two other states with a similar structure are Virginia and New Jersey, according to former Treasurer Douglas Roberts.

The Bureau of Revenue was reorganized in 2000 through a business process reengineering project. It has a good reputation both within and outside the state, particularly for its collection efforts. The property tax assessment system also is considered to work well.

The state has made a number of improvements in processing of tax returns. According to former Treasurer Douglas Roberts the time for this task has been cut from a month to seven days for electronic returns. Technology is very good. About 60 percent of income tax returns are processed electronically. According to an audit report from the Department of Revenue in North Carolina, Michigan has been particularly good at marketing electronic options to taxpayers through public information campaigns and guarantees that refunds will be processed in a shorter period of time. The Computerized Refund Information System (CRIS) provides information on the status of taxpayer refunds.

The state has generally good information about its revenue systems, including a thorough tax expenditure report, which details the cost of exemptions and credits. It also has the capacity to analyze the impact of tax changes on different income groups, according to the Corporation for Enterprise Development. Several years ago it contracted for a customer service benchmarking study. Through a balanced score card measurement approach, the Department of Treasury has been developing ways to track its own progress toward its internal goals. The website is complete, informative and well organized.

Local Issues

In the last year, there’s been much talk about the need for reform among city and county officials who are unhappy about the funding of local government in Michigan. The problem: cuts in state funds combined with caps on property tax, and a legislative prohibition against enacting new local taxes without legislative permission, have left many local communities struggling with their finances. Although Michigan cities may use a local income tax, there are no local option sales taxes and they are prohibited from utilizing other taxes — entertainment or hotel taxes, for instance — that are available to local governments elsewhere. The Michigan Supreme Court has also narrowed the definition of “fees” that can be levied without voter approval.

One significant problem, according to Michael Brady, director of state and federal affairs for the Michigan Municipal League, is that legislative language attached to Proposal A in 1994 changed the way the Headlee Amendment was interpreted. Before that, this 1978 amendment forced the millage rate to roll down when revenue growth exceeded inflation. But it also allowed local governments to roll the millage rate up when revenue growth was less than inflation. Following Proposal A, this practice was prohibited and local governments could no longer adjust themselves upward. Observers note that steep increases in health insurance costs and a Michigan requirement that binding arbitration be used for public safety employees has put a lot of spending pressure on local officials that find their revenue sources capped. Cuts in revenue sharing have exacerbated the problem.

The passage of Proposal A helped to alleviate substantial inequities in school funding. Prior to this property tax reform amendment, per student funding in full K-12 districts ranged from $3300 to $11,000. The highest districts now are still way above the lowest ones, but there is now a guaranteed base of $6700 per student, according to Doug Drake, associate director at the State Policy Center at Wayne State University.

Noteworthy Programs

• Michigan’s FarStar Field Audit Research Selection Tracking and Reporting system has received two national awards — one from the National Governor’s Association and one from NASCIO. Michigan officials say this system substantially improves the efficiency of its audit staff, and the audit selection process, by putting all information in a single place. The system enables the state’s 200 field auditors to access information quickly and with better service to taxpayers. According to an article in Governing (October, 2001), the software, utilizing four years of tax information stored in a data warehouse, was able to review nearly 260,000 taxpayer accounts, compared with 3800 files a year that were analyzed prior to its use.

• Voluntary Disclosure. If a company is concerned that it owes back taxes and voluntarily presents its books to auditors, the Bureau of Revenue will only track back what’s owed for four years. One of the benefits for the state is that once a company comes in for the review, it becomes a much better taxpayer in the future. Through this program, $126 million in prior taxes has been collected and the state estimates that it has increased future collections by $44 million.

• Customer Service initiatives. In recent years, Michigan has made a number of efforts to improve customer service. For example: Tax preparation videos in libraries and legislative offices provide guidance to citizens; training is provided to volunteers who want to help the elderly or low-income citizens with their state tax returns, and there’s an automated Tele-Help system, which provides recordings about various tax topics. The state has a Problem Resolution Office. When citizens call with tax problems or questions, all tax information relating to that person can be accessed with their social security number and an effort is made to deal with the issue in one call. According to former Treasurer Douglas Roberts, very careful records are kept on the nature of the problems coming in, as well as the solutions offered. In addition, a Tax Practitioner Hotline provides service to tax professionals.

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