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Pennsylvania Supplemental Report

Tax Environment

There is a good deal of discomfort with Pennsylvania’s tax system. In a poll conducted at the end of last summer by Issues PA, an education project of the Pennsylvania Economy League, 72 percent of respondents said they thought the tax system needed a major overhaul.

If there is one focal point for Pennsylvanian’s unhappiness it is the property tax that is levied on the local level. For thirty years, reforming the tax — and relieving Pennsylvanians of their property tax burden — has been debated in the legislature. Property tax reform came closest to fruition after a 1988 special session, in which the legislature passed a plan to shift funding for schools from the property tax to the state income tax. But a referendum the following year failed by a 3 to 1 margin.

Pennsylvania is an aging state. It has the second largest number of senior citizens in the country, after Florida. (The tax system is also geared to the senior citizen — retirement income isn’t taxed; the lottery money is all spent on senior citizen programs and property tax and rent rebates are offered for low-income seniors.)

Recent Tax Developments

• The legislature temporarily reduced the pace by which the capital stock and franchise tax was to be phased out. The schedule now calls for a lowering of the rate by one quarter mil for tax years 2002 and 2003. For 2004, the reduction will go up to the originally scheduled 1 mil a year until the phase out is complete in 2010.

• The $20.7 billion FY2003 budget, which was signed into law June 29, included a tripling of the cigarette tax to $1 a pack. This tax hike went into effect July 15 2002.

• A September 10 report by the House Select Committee on Public Education Funding recommended that property taxes be cut in half for Pennsylvania citizens and that the state add $1.5 billion more to its annual education funding. This would create a 50-50 split in education funding for the state and its local governments. Currently local governments pay about 65%.

• At the legislature’s request, then Governor Mark Schweiker called a special session in September 2002 to discuss property tax reform. But the special session ended three months later without concrete action.

Budget Information

A weakening of revenues in the FY2002 budget left the state facing a $1.2 billion year-end deficit. Part of this was covered by a $750 million withdrawal from the state’s rainy day fund. About $310 million in state spending for environmental, health care and education programs was frozen between September 2001 and January 2002.

The FY2003 state budget was balanced with about $1 to $1.5 billion in one-time revenues, and projections midway through the year still showed it coming in about $433 million short of balance.

Prior to the November election, the FY2004 budget gap was projected at between $700 million and $1.8 billion. Another issue facing the state after the election was the desire of Governor Ed Rendell to devote $1.5 billion of state money to help drive down school property taxes.

In March 2003, the legislature passed a budget with sizeable spending cuts in human services and public transportation, as well as other programs. After the U.S. Congress allotted $20 billion for cash-strapped states in May, it was announced that $897 million in additional federal dollars — half of which was designated for Medicaid — would be coming to Pennsylvania, easing the state’s budget strain. Gov. Rendell suggested that some of the new money should be used to restore funding that was cut this past winter, but that the “windfall” should be regarded as one-time money that does not remove the need for his proposed tax changes.

Adequacy

The State of Pennsylvania has a balanced tax structure with a fairly high percentage of combined state and local revenues raised at the local level, where the property tax, while unfair and disliked, has provided some stability. The income tax is flat with a low rate, and the state is equally dependent on the sales tax. While tax receipts have suffered in the economic downturn, the impact has not been as profound as in neighboring states like New York or Ohio, where the declines in a graduated income tax were far more severe.

As in many other states, Pennsylvania’s leaders took advantage of the economic boom of the 1990s and cut taxes. The corporate net income tax rate was dropped from a very high 12.25 percent to 9.99 percent, which is one of the highest in the country. The base also has been narrowing. The Capital Stock and Franchise Tax, which was 12 mils in 1995, is being phased out and is currently down to 7.24 mils. Pennsylvania’s leadership did slow the pace of the phase out in the last year.

For the FY2003 budget, Pennsylvania decoupled from the federal government, so that it would not lose additional revenue due to changes enacted in the federal corporate income tax depreciation schedule.

In addition to adequacy of revenues, revenue mixture is a concern. New Governor Ed Rendell is eager to shift the responsibility for school funding away from local property taxes and has been pushing an increase in the income tax rate, the legalization of slot machines at horse racetracks, some new fees and specialized taxes (like an increase in the tax on beer), and the closing of corporate loopholes.

Fairness

In terms of tax equity, the major blemish on Pennsylvania’s tax system is its local property tax, which is frequently lambasted by citizens for being regressive, confusing and unfair. Unlike most other states, Pennsylvania has traditionally taken a hands-off approach to property tax administration. With decisions in the hands of local governments, counties have sometimes gone for decades without reappraising property. The situation has improved somewhat in recent years, but not across the board. Infrequent reappraisal means that two homeowners in similar houses may be paying property tax bills at opposite ends of the spectrum. Without reappraisals that pick up increases in property values, the yield from property tax stagnates and the rates climb ever more ferociously, making property tax particularly onerous for individuals whose houses are appraised at close to market value (for example, those who have just purchased.)

Pennsylvania has a uniformity clause that states “all taxes shall be uniform upon the same class of subjects.” This does not apply to the administration of taxes and so it has not protected taxpayers from the property tax problems mentioned above, except during a legal appeal.

In terms of tax credits and exemptions, the uniformity clause has helped minimize the use of tax credits and insured that credits are not written solely for specific businesses. It also has kept business property tax rates on a par with property taxes for individuals. On the other hand, the uniformity clause is also behind the state’s choice of a flat income tax, which tends to be more regressive. Pennsylvania’s leaders have made an effort to decrease the burden on lower income people by creating, by constitutional amendment, an exemption for low-income individuals. (A family of four with an income below $30,000 would not pay any tax, for example.) Otherwise, there are relatively few exemptions or deductions allowed in the state’s broad income tax. The one major exception in this broad tax base is that neither Social Security income nor pensions are taxed — one of many examples of preferential treatment given to older Pennsylvanians.

There also are property tax rebates for senior citizens, widows, widowers and permanently disabled persons with incomes less than $15,000. These are based on a sliding income scale and are also available to renters.

In terms of the sales tax, the major exemptions of food, clothing, household products and pharmaceuticals narrow the sales tax base, though they also make it less regressive. Other special interest exemptions have been creeping into the tax code every year, however, and there are many services that are untaxed, including computer services, professional services, business services and many personal services. http://www.taxadmin.org/fta/pub/services/services.html

Management

Pennsylvania has been working at making the administrative side of filing taxes easier for businesses by moving toward a one-stop shopping approach (though the legislature has not yet consolidated reporting requirements for different kinds of taxes). There has also been a concerted effort by the Department of Revenue to communicate with its various communities. As new systems and programs are added, there’s an effort to do presentations to the affected community and listen to their input.

The state does decently on tax analysis. It has a tax expenditure report, which is part of the budget document (available on the web). It also has some capacity to analyze the impact of tax changes on different income groups, according to the State Asset Development Report Card from the Corporation for Enterprise Development . http://sadrc.cfed.org/states/pa.php

In 1995, when former Governor Ridge began his first term, technology in the Department of Revenue was lacking. There were 200 personal computers for a department of 2300. Today, there are 2000 computers and the department has moved from a paper process to an electronic workflow process. Paper is now largely imaged with the data subsequently handled through computers. About 1.5 million tax returns -around one third of the total — are filed electronically through the Federal/State Electronic Filing Program. (The majority of the state’s 2.5 million homeowner rebates are handled electronically as well). Only about 3 percent of businesses file taxes electronically, but the majority of money received by the state is filed electronically.

Taxpayers who have corporate income tax appeals, sales and use tax appeals and personal income tax appeals pending can access the status of actions on the appeals by email.

One challenge faced by the department is the high percentage of employees facing retirement. Many staffers joined the Department of Revenue around 1971 when the income tax and lottery were both started. One way the state has been dealing with these projected retirements is through a massive training program.

The appeals process in the state could use improvement. There is no independent tax court and several different levels of administrative appeals before taxpayers have recourse to the courts. Critics contend that the process of pursuing an appeal is expensive and cumbersome, without early opportunities for negotiation. Another issue that nettles taxpayers is that different corporate taxes require separate appeals, often with subtly different rules. Departmental officials also worry that the lack of a “qualified court that deals in tax matters” limits the quality of decisions. This means that ambiguous issues tend to stay unresolved unless they’re changed legislatively.

Pennsylvania is one of the few states that take almost no administrative role in property tax management. (There is a State Tax Equalization Board that gathers information on the relationship between assessed and market value that is utilized in property tax appeals. www.steb.state.pa.us)

The state’s backseat role stems from a clear historical tradition of strong local control. But it results in a system that is often unfair and inefficient in terms of management. One particularly startling aspect of this tradition is that each unit of local government elects its own tax collector, whereas in many other states tax collection is a county function. This means that within Pennsylvania there are some 3100 separate tax collection efforts. Without much oversight this is also an area that is vulnerable to scandal.

Local Issues

In general, the state’s share of total state and local revenues is significantly below average and the state has traditionally allowed its local governments a good deal of freedom to raise their own revenues as well as the responsibility to fund their own services. This puts heavy weight on the state’s property tax system, which is one of the key funding sources for local education, as well as an important source of revenue for boroughs, townships, cities and counties.

While strong local control and responsibility have many positive aspects, there are also negatives.

The many relatively independent cities, towns, boroughs, townships, municipal authoritities, and counties within the borders of Pennsylvania complicate the issue. There are more than 2630 units of local government and over 2000 municipal authorities. (The authorities, similar to special districts, cannot raise taxes, but can impose fees.)

Everyone lives in a borough, township, town or city, and each of these is located in a county. Each of these governmental units has a certain millage limit in terms of what it can collect from local property taxes. Pennsylvania is one of the few states that allow municipalities and school districts to use earned income and wage taxes, usually to a maximum of 1 percent (usually 1/2 percent each), but higher under special circumstances. Special taxes, above the general limits, are allowed, though often voter approval is required — for street lighting, for instance, or fire service or libraries.

The biggest pull on property taxes comes from Pennsylvania’s 501 school districts, which overlap other units of local government. In the end, about 70 percent of the property taxes collected in the state go to schools. It is the school portion of the property tax, which is, in effect, unlimited. This has been steadily heading upward as the state has tended to place caps on its own contributions, but hasn’t curtailed its mandates.

There actually is a limit to school district real estate taxes in state law, but personnel costs are not covered by the limit, which effectively removes it. School districts also have the option to trade off a portion of their real estate taxes for a higher income tax, but they have been extremely reluctant to do this because it means that any future attempt to raise real estate taxes would be subject to a referendum. Schools also can make use of an occupation tax, in which there is a millage rate applied to an assessment that is levied based on a person’s occupation. (A sanitation worker is assessed at a certain level; a doctor or lawyer at a higher level. You are assessed the same amount for a specific profession whether or not you make $500 practicing two hours a month or have a salary in excess of $1 million).

When schools are largely funded at the local level, one of the effects is often a major disparity in funding from one school district to the next. While there are state add-ons for high poverty areas, a study called the Funding Gap, from the Education Trust, showed Pennsylvania to have the fourth largest gap of U.S. states between per student funding in poor and wealthy school districts. In contrast to many other states, Pennsylvania’s courts have stayed away from this issue, saying it is a legislative not a judicial matter.

Gov. Ed Rendell supports a shift in funding for schools from local to state taxes. He has said that he would like to decrease school property taxes by increasing state funding for public schools by $1.5 billion, with about $500 million of this money coming from legalizing slot machines at racetracks.

Noteworthy Programs

• A major training drive. Using a training firm in Florida, the state launched a massive customer service training initiative. This touched 2200 of 2300 employees, with 100 percent of managers receiving “Managing Extraordinary Service training.” More than 40 percent of employees were also trained in Leadership for Results.

• A Taxpayer Service and Information Center was set up in 1997 — a one stop shop for taxpayers. The system can track the individual who was talked to and how long they’ve been on line. Citizens seem very happy with this service, say department officials. Emails receive a response within 48 hours. A big problem prior to the set up of the one service center was that there were a lot of calls abandoned because of the long time they had to wait on hold. The 1997 phone system setup is now being upgraded.

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