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South Carolina Supplemental Report

Tax Environment

The state’s tax system has been the focus of many different study groups and commissions over the years — some driven by personal or political agendas. Just in the last decade, there was an ad hoc committee on tax structure in 1994, a property tax accountability reform group in 1995, a tax reform task force in 1999, and a local government funding steering committee in 2000.

Two tax study committees were in operation in Fiscal Year 2003. One was commissioned by the Speaker of the House for the House of Representatives — The House Ad Hoc Committee on Taxation. In addition, a joint committee on taxation was re-established last year. This was a re-creation of an entity that was in operation about ten years ago. (The Chairman of Senate Finance appointed three members; the Chair of House Ways and Means appointed another three and the Governor appointed three.)

While many of the recommendations of old committees still sit on shelves, there are several important changes that have resulted. One significant example is the decision of the state to take over funding of school property taxes assessed on the first $100,000 of a home’s value. (To some observers, this was an ill thought out move, based on sticker shock in three counties that had recently undergone reassessments after long periods without. These counties, in which the major cities of Columbia, Greenville and Charleston are located, were very vocal about their displeasure with high property taxes, whereas a survey of the population as a whole at the time did not reveal much displeasure with property taxes.)

South Carolina is a relatively poor state that is still heavily rural. Eighty percent of income tax filers have incomes of $25,000 or less.

Recent Tax Developments

• A new lottery was put in place in 2001, based on a constitutional change approved by voters in November 2000. Revenue was expected to be about $150 million to $200 million a year.

• As of 2001, the assessment rate on cars is dropping over a period of six years from 10.5 percent to 6 percent. On average, this means that an effective tax rate of about 2.9% will drop to about 1.6%.

• Starting in January, 2003 cars must have a temporary registration as soon as they’re purchased. Previously, South Carolinians used to be able to wait 30 days before registering a car. Given the high property tax on vehicles, this resulted in a lot of gaming of the system and a lot of unregistered vehicles.

• In FY2002, a temporary reduction of 1 percent of the sales tax on groceries expired, sending that tax from 4 percent back to 5 percent. The plan was to keep the tax at the 5 percent level through FY2003 and then begin reducing it again by 1 percent a year until it disappears entirely.

• An effort to raise South Carolina’s fourth-from-the-lowest in the country cigarette tax during the 2002 session failed. But the successful effort to table the proposal in the House won by only a small margin, leading to conjecture that a cigarette tax increase may be a possibility in the future. The state’s 7-cents a pack tax was set in 1972.

• The ruling of a chief administrative law judge last spring, relating to a 1989 decision to tax the pensions of state retirees, could cost South Carolina as much as $300 million, and considerably more if a similar lawsuit involving federal retirees is successful. The ruling was not final, however, since several legal questions were still to be resolved.

• At the end of July 2002, a House legislative panel began its work in re-examining South Carolina’s tax system. This was expected to result in a report and proposed legislation in 2003.

• South Carolina had its third August sales tax holiday in 2002. Each one has saved citizens or cost the state about $3 million.

• In a tax amnesty that ran between October 15 and December 2, 2002, the Revenue Department collected more than $60 million, significantly more than it had projected.

Budget Information

The state took in less money in FY2002 than in the previous year — the first time in nearly 50 years that this has happened. This decline in actual revenues of 3.2 percent was primarily due to huge capital losses that could be charged against personal income taxes. Collections from wage earners rose by 1 percent, but collections from quarterly and year-end payers fell 15 percent. Corporate income collections also dropped 33 percent, reflecting weak earnings and accounting adjustments.

In Fall 2002, roughly after the first quarter of the FY2003 fiscal year, forecasters cut their estimate for FY2003 by $331 million or 6.2 percent. After the election, incumbent Governor Jim Hodges, who lost to new Gov. Mark Sanford, called a special budget session to deal with the revenue shortfall. He proposed to protect public school education, higher education and health care and cut other agencies 6.5 percent. Instead, legislators cut agencies 4.5 percent across the board. Observers toted up a total of $942 million in temporary and permanent spending cuts that had been made over the prior 18 months. No money was provided for cost of living increases for employees nor was there a pool of money provided for merit-pay increases.

Forecasters met again in February 2003 and cut the estimate for FY2003 by another $137.2 million and reduced the forecast for FY2004 by the same amount. This means the forecasted revenues for FY2004 are the same as those actually collected three years before — a 6 percent contraction in real revenues, if inflation is taken into account.

In June 2003, the General Assembly adopted a budget for FY2004 that did not include new Governor Mark Sanford’s plan to hike cigarette taxes and reduce income taxes. The FY2004 budget was described in newspapers as “the tightest budget in modern history” with substantial cuts in education funding. In early June it appeared as if the state’s per student funding would be $1777 in FY2004 compared with $2002 in FY2001.

A related issue that may be a major factor in future budgets is a court case scheduled to be heard in late July which challenges the way South Carolina funds schools. Thirty-six school districts have been suing the state, contending that the current funding system is inequitable.

Despite the economic shocks of the last several years, the state has been able to maintain its AAA credit rating.

Adequacy

South Carolina has a very balanced tax system, especially when state and local taxes are looked at together. This blend of wealth, income and consumption taxes gives the state a nice mixture of stable taxes and those that are more responsive to changes in the economy. This provides South Carolina with the same benefits of a diversified investment portfolio that balances high-yield instruments with safer ones. In terms of tax burden, the state is right in the middle in the percentage of income taxed and on the lower end in terms of taxes per capita.

But observers worry that, as in many states, its tax policies have not adapted to a changing economy.

One of the major problems in terms of adequacy (and fairness) is that over the years, more and more holes have been poked in South Carolina’s taxes, through an increasing number of exemptions.

In addition, during the robust economic times of the mid to late 1990s, the legislature cut about $1.2 billion in ongoing taxes without engaging in a parallel effort to cut services. In September 2001, for instance, the Associated Press reported that due to tax law changes the state had collected $714 million less in income and sales taxes, while spending $468 million more on property tax relief for businesses, homes and cars. Even in FY2001, a significant amount of one-time revenues were used to mask the effect of those tax changes.

In fact, the last major general tax increase was in 1984 with the education improvement act — an additional 1 cent on sales that is earmarked for innovations and teachers salaries. Since then, the following actions have been taken that reduce the tax load. Governor Campbell in 1987 indexed the tax brackets to half of inflation. Before that, there was bracket creep as a result of not indexing the brackets. The corporate income tax was reduced over 3 years from 6 to 5 percent. Then, in 1995, the state agreed to cover the school operating taxes assessed on the first $100,000 in value of a home.

Meanwhile, on the spending side, Medicaid costs are increasing. And while prison costs have stabilized, that line had been heading upwards due to truth in sentencing legislation. The population of the state is aging and that also creates more spending pressures.

Fairness

Thanks to the indexing of its tax brackets, South Carolina’s basic tax structure is close to proportional in terms of the way the tax burden is distributed between wealthier and poorer individuals.

The Institute on Taxation & Economic Policy does point out some regressive features, however: The sales tax applies to food and there is capital gains exclusion in the income tax.

Another aspect of the system that contributes to more regressive taxation is that rental property taxes, on which there are no tax breaks, are high relative to homes. Also, there is a personal property tax on cars. The elderly and homeowners receive preferential treatment on their taxes, regardless of their income. (In 1999, the homestead exemption for people over 65 was raised from $20,000 to $50,000.)

The sales tax has been laden with exemptions — on the sale of newspapers, or any equipment purchased by newspaper publishers, books used for study, religious publications, certain items sold to diabetics (though normally taxed to anyone else), electricity for residential use, wrapping paper, twine, paper bags and containers, toll charges for long distance telephones, vacation time sharing plans, fuel sold for farm equipment. The list goes on.

A presentation given last spring by the former revenue director illustrates some of the problems in trying to draw the line of what is taxed and what isn’t. In that case, she was talking about the state’s August 2002 sales tax holiday in which a bride’s gown was exempt from taxes during the holiday but a groom’s rented tuxedo wasn’t. A backpack was exempt if it was to be used for books, but not for hiking. Computers and peripherals were exempt but computer parts were not.

The sales tax on a number of luxury items has been capped — another regressive feature. For example, the sales tax on cars is capped at $300 — so the buyer of a second hand $6,000 vehicle will pay the same in tax as the owner of a new Jaguar. There is also a sales tax cap on planes and boats.

There are a number of equity issues created by the significant use of tax incentives in South Carolina. For businesses that don’t get credits — those that have been in the state a while and aren’t expanding or creating new jobs, property taxes can be quite high. For example, South Carolina has a classified property tax system, which means that different classes of property are taxed differently. (Farms or owner-occupied residences are assessed at 4 percent, but rental apartments and commercial properties are assessed at 6 percent and industrial property is assessed at 10.5 percent.) A new or expanding manufacturer can negotiate with a county council to substitute a fee-in-lieu payment for their property tax bill. And this fee may be frozen for as much as 30 years. Meanwhile, an existing manufacturer is stuck with a property tax bill that’s as much as 30 percent higher.

Management

South Carolina’s Department of Revenue has had an excellent reputation due to its quality management initiatives, good training programs, relatively strong technology and willingness to innovate. However, severe staff cutbacks in the last year have impeded the department’s ability to do its job. An August 19, 2002 article in State Tax Notes showed South Carolina to be the state that had made the most dramatic cutbacks over the past two years — with a budget cut of 24.5 percent. This not only necessitated sizeable personnel cutbacks but the closing of several district offices.

Despite the budget cuts, there are a number of areas in which South Carolina stands out.

The Department of Revenue is extremely customer oriented, putting a good deal of effort over recent years to making the system as understandable and straightforward as possible. The 2002 accountability report has a full list of the activities that the Department has engaged in to reach its various “customer” groups — for example, its problem resolution office, automated tax help line, taxpayer advocate, workshops and speakers bureau. Each year, a customer satisfaction survey is conducted and the results have generally shown satisfaction increasing.

In terms of technology, South Carolina has an integrated tax system and does well, relative to other states, in its use of electronic filing and payment options. About 60 percent of its funds are now electronically transmitted. (A credit card payment option was introduced in January, 2001). According to its own accountability report, it leads the nation in terms of the percentage of individual income tax returns that are electronically filed — 57 percent in tax year 2001. (According to its figures, the other top five states that year were: Alabama: 50 percent; Iowa: 47 percent; Montana: 46 percent; and Georgia: 41 percent.)

Business taxes have been slower to move to an electronic platform. And the state has not yet moved aggressively to develop the sophisticated data-mining capabilities seen in such states as Iowa, Texas or Virginia. The state’s former revenue director described South Carolina’s abilities to store and analyze data, which are still dependent on a 1986-era non relational database, as bearing greater similarity to a “mini storage shed” rather than a data warehouse.

As a state, South Carolina has a tradition of attempting to measure what it does. Agencies are required to prepare accountability reports, which provide a good many statistics to help analyze their work in the previous year. The Department of Revenue’s accountability report for 2002 is available at http://www.scstatehouse.net/reports/aar2002/aar2002.htm

Although the state prepares a tax expenditure report, it is not available on the web. South Carolina also lacks the capacity to measure the effect of tax changes on different segments of its population, according to the State Assets Development Report Card, which is put out by the Corporation for Enterprise Development. http://sadrc.cfed.org/states/sc.php

With so many budget cuts suffered over the last two years, the Department of Revenue has made a concerted effort to communicate to legislators that spending on revenue activities has an immediate return in terms of higher revenues. According to statistics in its 2002 accountability report, every dollar spent in 2002 provided an $18.16 return. In fact, the legislature did provide some extra audit and compliance positions following its 24 percent total cut to the department. In general, enforcement activities have taken a larger percent of the total department budget since FY1999 and this trend appears to be continuing. The department also became somewhat more aggressive in the direction of its compliance activities in the Hodges administration. Previously, the Taxpayers Rights Act, which prohibits grading an auditor on how much money he collects, had led the department to focus on closing audit cases and processing more audits without regard to amounts involved. More recently, the department acknowledged that it is okay to look at the dollar figures involved without evaluating the auditor based on that factor.

In terms of property tax administration, there were significant improvements made in the 1990s. Before that, there was no mandated reassessment cycle and some counties went for years without being reassessed. This is what caused much of the sticker shock in large cities and high growth counties in the early 1990s that led to the state’s homestead exemption. A 5 year assessment cycle was put in for locally assessed properties and the state oversees the assessment process, making sure that sales and market ratios are within certain limits. The state also does a good deal of training in this area, assesses all the industrial and utility property itself, and is responsible for reporting.

The current five-year assessment cycle may still be longer than is optimal, particularly since counties are allowed to delay the process another year if they want. This is often a temptation in an election year, particularly since South Carolina has elected assessors.

There also has been a growing sense in South Carolina that the state could improve its revenue estimation.

Local Issues

A major change in state/local funding occurred in 1994, when the state stepped in to fund the property taxes due for schools based on the first $100,000 of home value. As soon as the state shouldered this responsibility, counties began to increase property tax rates, which encouraged the legislature to impose millage caps in 1995. In 1999, the state changed the way it provides this replacement funding, basing it on a per capita amount to each school district to replace those local school property tax dollars, with the districts making up any shortfall. This has been a burden on school districts when combined with reductions in state aid per pupil.

Although the disparity in per-student funding between high and low poverty districts has narrowed a good deal, according to a study by the Education Trust, the adequacy and equity of school funding is still a major issue. A court case on this topic is scheduled to be heard in late July in Clarendon County.

A study group on the funding of local government came up with 28 recommendations for change several years ago, but most are still sitting on the shelf. That study did have a few results, however, with more revenue diversity provided to cities and counties through the local option sales tax. In addition, the legislature has backed off from unfunded mandates on counties and cities.

Schools do not have a diversified revenue stream and are therefore very vulnerable to any adverse revenue actions taken by the state.

One issue with tax incentives in South Carolina is that many of them are given at the county level in the form of fee-in-lieu payments that substitute a lower fixed annual payment in place of the property tax for years into the future. “The problem is that we’ve put a lot of those decisions at the county level. They don’t’ really have the expertise and it puts them in competition with each other,” says Holley Ulbrich, economist and fellow at the Strom Thurmond Institute at Clemson University. This also means that counties may remove sizeable hunks of the tax base which is shared by schools, but the school districts have little say in the matter.

(Fee in lieu agreements are business tax incentives. The agreement is negotiated between a new or expanding business and a county council. Instead of being assessed at 10.5 percent, they’re asked to make a payment equivalent to a 4 percent or 6 percent assessment rate and that amount may be frozen for as much as 30 years.)

Noteworthy Programs

• Computer forums or “resource rings.” The state has formed discussion communities on its local area network. These cover sales and use taxes, individual income taxes, corporate income taxes, property taxes, and miscellaneous taxes. They are each headed by experts, have representatives from each division of the department and its nine taxpayer service centers, and employees who need or want to learn more about these individual areas are encouraged to participate. This helps staffers share information about taxes and get questions answered by experts. If they can’t answer a question, it is forwarded to the policy section of the Office of General Counsel for an official policy interpretation. These computer forums have helped make sure that issues are interpreted consistently by the different operating divisions and offices of the Department of Revenue. An important lessons learned in their first year of operation was that just having a computer forum doesn’t get you very far unless the process has active management involvement.

• The South Carolina Business One Stop Program is being started to make sure that taxpayers who register to do business in South Carolina do not have to have multiple contacts with different agencies, but can register once on a website maintained by the Department of Revenue and the Employment Securities Commission. That information is then transmitted to other agencies that might need it.

• Statewide debt collection. Based on the idea that agencies and local governments should not function as stovepipes, the Department of Revenue has taken on the task of collecting debts owed to the state’s 80 agencies, 46 counties, 230 municipalities, 80 school districts, 80 higher education institutions as well as public service districts and county hospitals. (Participation is optional).

The tool used by the department is the refund offset, which was authorized by the Setoff Debt Collection Act back in the late 1990s. Other governmental entities or agencies give the Department of Revenue an electronic list of their debtors, and DOR matches that against the refunds it’s sending out. If someone owes money to another governmental unit, their refund is fair game. Meanwhile, the Department of Revenue takes $25 off the top as its fee. A total of $58.6 million was collected from the setoff in 2002 — the fourth year of the program. Note: There has been some criticism of this process by people who question whether due process is followed when refunds are offset. The Department of Revenue has made notice requirements consistent and more easily understood to address this criticism.

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