Fiscal Impact of TPT Contracting Simplification: Less Revenue for State and Most Municipalities
March 14, 2013One of the priorities for Governor Jan Brewer is simplifying Arizona’s complex transaction privilege tax system, including as it pertains to contracting, as most states tax contractors at the point of purchase. Because Arizona is a growth state, many communities heavily rely on revenue from contractors to pay for growth and general administrative expenses and prioritized capital projects.
Tax simplification is an important step to make the state eligible for added internet revenues. If Congress enacts enabling legislation the state will be expected to make uniform its tax base. It’s also expected that the state will need to ease the administrative burden, so that on line retailers remit taxes to the Department of Revenue, and assist with tax calculation software if local tax rates differ between jurisdictions.
Policy Analysis
March14, 2013
Fiscal Impact of TPT Contracting Simplification: Less Revenue for State and Most Municipalities
Dave Wells, Ph.D.
Research Director, Grand Canyon Institute
One of the priorities for Governor Jan Brewer is simplifying Arizona’s complex transaction privilege tax system, including as it pertains to contracting, as most states tax contractors at the point of purchase. Because Arizona is a growth state, many communities heavily rely on revenue from contractors to pay for growth and general administrative expenses and prioritized capital projects.
Tax simplification is an important step to make the state eligible for added internet revenues. If Congress enacts enabling legislation the state will be expected to make uniform its tax base. It’s also expected that the state will need to ease the administrative burden, so that on line retailers remit taxes to the Department of Revenue, and assist with tax calculation software if local tax rates differ between jurisdictions.
Another reason for simplifying tax collection relates to reducing business costs, so businesses, especially small businesses, use fewer resources to be in compliance. Changes like making the tax base uniform go a long-way here.
As with any statutory change, especially in tight fiscal times, an additional concern is whether a change reduces revenue, is revenue neutral or enhances revenue. In addition, as construction has historically been a large share of the Arizona economy, changes to that component will have distributional effects.
One of the key shortcomings with the current contracting transaction privilege tax system is noncompliance with contractors, meaning that they fail to pay the full amount due, currently assessed based on 65 percent of the contract. Finance divisions at the local level are not directly part of the inspection process, and it’s normally too costly to do extensive audits, so at least for large projects they look for general compliance based on an estimated value. The Arizona Department of Revenue for program cities and towns is even farther divorced from the local construction projects. Thus, the system as designed requires occasional audits to monitor compliance, and is fairly inefficient relative to potential revenue, though historically a reasonably lucrative source of tax revenue for the state and municipalities due to the size of the construction sector in the Arizona economy.
The Arizona Department of Revenue estimates noncompliance at 31 percent. Using a similar methodology, the Grand Canyon Institute arrives at 28 percent. The difference between the two lies with areas of noncompliance that are difficult to quantify.
The Transaction Privilege Tax Simplification Taskforce used a 41 percent materials cost assumption. Again, the Grand Canyon Institute finds that to be a highly credible number, but based on the Economic Census arrived at 39 percent for our estimate.
Collectively, the Grand Canyon Institute estimates that changing to a point of sale for construction materials will reduce state sales tax revenue by $85 million. However, due to higher shared revenues, cities and counties would receive $40 million more. But receipts to the General Fund will decline by $125 million. However, though cities receive $15 million of the $40 million, their locally generated revenues are projected to decline by $25 million, leaving cities also with less revenue. Furthermore, point of sale for contracting materials, GCI expects to be fairly concentrated in larger cities. Consequently, declines in revenues would be proportionately larger in most cities and towns with the exception of the state’s three largest cities: Phoenix, Tucson and Mesa. However, due to large areas of unincorporated areas near Tucson, Tucson may also see a net loss in revenue. GCI does want to caution that the estimated distribution among cities is speculative, as opposed to the much stronger data sources used elsewhere in the report.
Given that the Joint Legislative Budget Committee projects the General Fund remaining stagnant at $9 billion through fiscal year 2016, and that state spending has fallen in real terms precipitously since 2007, there are serious questions whether the state can afford this kind of lost revenue, especially as one considers the possibility of another economic slowdown before the end of the decade. This change to construction sales tax is not a change that improves economic growth, as there’s no indication despite its complexity and inefficiencies that the current system has inhibited construction growth in the state.
The Good: Efficient Taxes, Steps to Unifying the Tax Base
Louisiana, Colorado, Alabama and Arizona stand out from the rest of the country in local reporting requirements in addition to state reporting requirements. One goal of tax simplification is to reduce these reporting requirements, which can benefit businesses both inside and outside the state.
As noted in the TPT Simplification Task Force Final Report, the contracting tax is both complex and practically complex to enforce, requiring substantial audits far more than other areas of the TPT system.
Current Environment: Impact Fees and Construction Sales Tax
Impact fees are an ideal means of paying for growth, as construction is assessed to pay for costs associated with it. Two years ago SB1525 was passed by the legislature to provide uniformity with respect to the definition of impact fees. That change in definition roughly reduced most municipalities’ impact fees by about 17 percent. This resulted from a requirement to remove categories, such as general administrative, from impact fees. SB1525 also restricts service areas to prevent communities from expending monies on areas unrelated to growth such as Art Centers.
Municipalities are now in the process of doing complex engineering analyses to determine exact amounts for impact fees. They will no longer be able to try and use comparables from other communities (e.g., if community X paid $10 million for firehouse, so will community Y), as has sometimes been the case, and must instead rely on licensed professionals. By August 1, 2014 new fees need to be in place that will restrict many of the costs of development formerly covered by impact fees. A developer-majority committee oversees this at the municipal level. Under SB1525, impact fees can cover expanded library space, but not the books to fill the library. They can include parks, but if the parks include substantial added amenities beyond open space, impact fees may not cover them. The net effect is likely to result in a further reduction of impact fees at least in some communities.
Regardless of one’s view on SB1525, its fiscal impact has been to curb revenue sources for cities that have already had to deal with the fiscal challenges from the economic slowdown since 2008. In addition, some growth communities such as Surprise and Queen Creek charge higher TPT rates on prime contracting than general retail. Communities engage in such policies since growth is such a key part of their local economies. SB1525 also curtails this practice.
SB1525 also requires communities like these that had higher construction sales taxes than on retail to rebate that portion against impact fees. For instance, in Surprise the regular retail rate is 2.2 percent, but the prime contacting rate is 3.7 percent, then 1.5 percent is deemed discriminatory, and SB1525 requires that those proceeds be rebated against impact fees. The net effect is that these communities will be coming up with lower impact fees as a consequence.
Right now cities are bound to include those rebates in their calculations of new impact fees, and they are on a very tight timetable to do so and complete it and have it in place by August 1, 2014. Consequently, it’s critical If the legislature changes construction sales tax for localities to point of sale that they also immediately address this issue for localities, so that cities currently charging a discriminatory prime contracting rate aren’t forced to include revenues they no longer will be receiving as a rebate on impact fees, which the current language of HB2657 does not address.
Generally, impact fees pay for the immediate cost of development, and municipalities tend to use construction sales tax to pay for broader, more general capital projects or general operating expenses. These issues are enhanced since the passage of SB1525. Impact fees can’t be used to cover general administration. Likewise, a new park in one neighborhood may create pressures to upgrade existing parks. Or growth may require added lanes to a road, but impact fees may cover only part of that expense. As construction has been a huge part of Arizona’s economy historically, many communities rely a great deal on construction sales tax, especially during stronger economic times.
Changes to formulas under SB1525 may limit the ability of growth communities to meet all the costs tied to growth.
Compliance with the Current Contracting Tax System
Every five years, the Census Bureau conducts an economic census that becomes the basis of estimating GDP. The last one with available data is from 2007. The Census only covers businesses with employees, so to the Census, the Grand Canyon Institute also includes the Non-Employee businesses statistics from the Census Bureau.
In doing so, the Grand Canyon Institute followed a similar methodology to the Arizona Department of Revenue. Arizona Department of Revenue numbers are used to determine the tax base for contracting/construction and this is divided by the construction portion of the economy as determined by the census.
Table 1 Tax Base from Contracting Calendar Year 2007
Source: Arizona Department of Revenue Annual Reports 2007, 2008.
Table 1 illustrates how the contracting base was calculated based on Arizona Department of Revenue tax data.
Table 2 illustrates how the Construction economic base for contracting was determined from Census data, and the tax base was divided by the census economic base to determine compliance.
There are a number of areas expressed in the TPT Simplification Taskforce Report related to businesses applying the contracting tax (65 percent of the retail tax) to items that do not qualify or misuse of tax exemption certificates at the retail level. Neither is quantified. The Grand Canyon Institute chose to add into the economic base the additional non-construction business activity done by construction firms as noted in the Census to try and capture these broader elements of noncompliance. The Arizona Department of Revenue’s higher rate of noncompliance is likely due to estimating these impacts as larger. The Grand Canyon Institute uses 72 percent compliance in its estimates (see Table 2).
Table 2 Economic Census Contracting and Estimated Compliance
Source: Economic Census 2007, NonEmployer Survey 2007, Arizona Department of Revenue Annual Reports 2007, 2008.
Note that a 1999 Study by Arthur Andersen done for the state found a significantly lower compliance rate, 58 percent. The Grand Canyon Institute was not able to review that study, but the Census reports that after the 1997 economic census the methodology of construction was changed to improve estimates. Hence, the GCI doubts that is a reliable estimate.
That same study came up with a 41 percent material cost, which the Transaction Privilege Tax Simplification Taskforce used in their report. A fiscal analysis completed for similar legislation in 2006 by Jack Corey used a 37 percent material cost assumption, the same figure as had been used in 1999 by the Arizona Department of Revenue.
The Grand Canyon Institute used data from the Economic Census and finds support for 37 percent as a material cost assumption. Table 3 provides the Grand Canyon Institute calculation. The economic census at the state level combines fuel costs with material. In determining the actual cost of materials, GCI deducted the cost of gasoline and diesel fuels used in construction as they are not part of the TPT and multiplied the material costs subject to TPT (95.7 percent of the total) to the original material share to arrive at our estimate.
Based on calculations for the United States and Arizona, GCI estimates that 39 is closer to the actual share for material costs subject to TPT and use tax, and thinks 41 percent is likely too high, meaning estimates using 41 percent will overstate revenue projections from a construction material-sourced tax.
Table 3 Material Costs in Contracting
Source: Economic Census 2007
State Tax Change: $125 million less to General Fund, $40 million more to Municipalities
Next the prior estimates are applied to estimate revenue from material sourcing. However, material sourcing may come from out of state or in state. Based on the 2010 Washington State compliance study and tax information available at their Department’s web site by industry code, GCI arrives at additional findings. No other data source appears available to estimate construction use taxes or compliance.
- Retail-based sales taxes have 99 percent compliance
- 97 percent of materials for construction were sourced from in state firms
- 3 percent of materials for construction came from out of state
- Use tax compliance for out of state sales was 87 percent for construction, better than the 77 percent compliance overall for businesses and the use tax in Washington state. For Arizona, GCI assumes 85 percent compliance, if the tax is assessed at point of sale, as at the time Washington state was assessing the tax on contractors selling it to the final consumer.
Arizona’s TPT system is rather complicated and includes a nonshared and distributional component. The change to a material sourced tax increases the distributional base to 40 percent (2 percent of the 5 percent tax) from 20 percent, and reduces the nonshared portion that goes to the General Fund exclusively. The distributional portion goes 25 percent to cities, 40.51 percent to counties and 34.49 percent to the state General Fund.
Rather than being revenue neutral, as suggested by Scenario #1 of the TPT Simplification Taskforce, collectively, GCI estimates the change will reduce revenues from contracting by $85 million. In addition, the GCI estimates the loss of revenues to the General Fund would equal $125 million instead of $60 million under Scenario #1. GCI sees cities gaining $15 million and counties gaining $25 million.
A quick way to evaluate the revenue effect is to compare compliance times the taxable portion. Since the TPT Simplification Task Force used 69 percent compliance and 41 percent for materials, they come up with a revenue neutral figure as 0.69 times 0.65 (the contracting rate) is approximately equal to 1 times 0.41 (they assumed 100 percent compliance with the point of sales tax and also use tax). The Grand Canyon Institute estimates higher current compliance and lower materials, resulting in the revenue shortfall. The Grand Canyon Institute also believes it uses more realistic compliance numbers by breaking point of sales into in state and out of state sales with different compliance rates for each.
Table 4 Contracting as 65% of Contract v. Materials Sourced
Based on Financial data from Arizona and Washington State Dept. of Revenue
State and Local Speculative Analysis of Cities: Less Revenue for Most
The Arizona League of Cities of Towns circulated calculations of the construction sales tax by municipality. To that we’ve shown each city’s current share of construction sales tax revenues.
The first chart, Table 5, illustrates the current situation for FY2012 and includes both the local contracting TPT as well as the city’s share of SSR (State Shared Revenue) from contracting. These represent total current revenues from construction, though in Table 6 and Table 8 GCI makes adjustments for $13 million in construction sales taxes that SB1525 requires be rebated against impact fees from those communities that charge a higher rate on construction than retail..
Table 5 City and Town Current State and Local Contracting TPT Revenues FY2012
Table 6 shows the impact across all municipalities of a change to a material-sourced tax system and illustrates the net revenue change to cities and towns.Source: Arizona League of Cities and Towns and author’s calculations
Table 6 Aggregate Impact on Cities and Towns of Material-Source Tax
$168 million is the current local tax revenue generated by local construction taxes. $24 million represents the current state shared revenue cities and town receive based on construction alone. A change to a retail material sourced tax, the Grand Canyon Institute estimates based on using actual city ax rates will generate $142 million. Plus, the higher portion of state shared revenue bring is $15 million more. However, $157 million in new revenue falls short of the $168 million currently received, so cities and towns lose $11 million or 5.5 percent of total construction revenues with a change to a material-sourced tax. This comparison is the best one to use when comparing the overall policy change to how city and town revenues had been structured.
SB1525, however, disallows added revenue to municipalities if they charge a higher construction tax rate than retail. SB1525 required that the amount be rebated against impact fees. Thus, under this law which just went into effect on January 1, 2012, municipalities which charged a discriminatory rate on contracting have to rebate that amount against impact fees, so the added tax rate no longer produces added revenues. Using that as a base, reduces current construction revenues by $13 million (see Table 8 for the particular municipalities impacted) and leads to a small $3 million or 1.5 percent gain collectively for cities and towns.
Tables 7 and 8 are more speculative (they are located at the end of the text). All estimates to this point in the analysis have been firmly grounded in a well-developed methodology. Unfortunately, there’s no publicly available data on the location of construction material suppliers. Large commercial builders don’t’ source from Home Depot or your local hardware store. However, we can use general principles of economics to speculate how material sourced taxing might be distributed. Generally, material suppliers would be expected to locate in regional centers with larger populations, as opposed to on the periphery where growth may be occurring, though there may be some suppliers in those areas. Hence, GCI expects there would be disproportionate supplier locations in Phoenix, Mesa and Tucson, and to a lesser degree small cities that are regional centers, Prescott and Flagstaff.
Based on economic theory, Table 7 illustrates a speculative distribution of material sourced-taxes, presuming a disproportionate distribution near population centers and key regional hubs. In fiscal year 2012, using the base amounts from Table 6, Table 7 shows their projected distribution among cities and towns. The distribution is significantly skewed toward larger municipalities, such that net gains are focused primarily on two of the three largest cities, Phoenix and Mesa, especially Phoenix.
Tucson is an unusual case. In the Phoenix-area, you can list a number of cities that border any given city. In Pima County only four other communities are incorporated besides Tucson, and, only one of which, South Tucson, actually borders Tucson. So Tucson is for the most part surrounded by unincorporated areas, and 36 percent of Pima County’s population lives in unincorporated areas, most of it adjacent to Tucson. Consequently, and based on conversations with Tucson officials, the Grand Canyon Institute speculates the impact to be lessened by these factors. The city estimates their net loss at $7 million, which may be more accurate than the $1 million loss speculated by GCI.
In Table 7, Total TPT Contracting Revenues and Current SSR (contracting) refer to revenues cities are receiving now as also expressed in Table 5 and Table 6. The Increased SSR represents the distribution of the $15 million in additional state shared revenue that comes due to the rise in the distributional share of the tax under a materials sourced tax as also noted in those tables.
The remaining columns are speculative. The first is the hypothesized share of construction materials sales occurring at the locality. It’s weighted in a manner that emphasizes relative population as well in some cases if a city is a regional center—which was applied to Flagstaff and Prescott. For the general weights, GCI presumes a city with four times the population of another will have twice the per capita construction materials, and a city with nine times the population of another will have three times the per capita construction materials.
GCI’s analysis makes use of the local tax rates applied to contracting and retail in determining the expected revenue to be generated.
SB1525 disallows added revenue from discriminatory construction tax rates, which a number of communities have. However, to get a better picture of how cities are being squeezed financially, those mandatory rebates are not included in Table 7. Keep in mind that reduced impact fee revenue are not included in Table 7. Table 7 effectively is using a pre-SB1525 base.
Table 8 identifies the lost revenue due to the required rebate against impact fees in SB1525 and illustrates the impact of point of sale taxes on municipalities. For those municipalities that charge a higher tax on construction contracts than retail, the degree to which it is higher will be required to be rebated against impact fees, so there will be no added revenue. Table 8 uses SB1525 as a partial base. It illustrates net changes in revenue due to mandatory rebates of construction taxes against impact fee for some communities post-SB1525, but it does not include reduced impact fees overall due to the more stringent criteria for calculating impact fees. Table 8 shows that SB1525 has reduced revenues significantly in those communities that had higher construction tax rates than for retail, a.k.a. discriminatory construction tax rates. These communities alone have lost $13 million in construction tax revenue that is required to be rebated against impact fees. When that adjustment is added, the net effect is that changing to material-based sourcing leads to a modest $3 million gain. This gain is entirely the result of the greater state-shared revenue, as the locally generated sales taxes from construction are $12 million short. This is summarized in Table 6.
However, as with Table 7, Table 8 shows that most communities do not see revenue gains, but experience losses. Phoenix and Mesa have significant gains, but almost all of the rest of the state falls short.
Conclusion
Collecting taxes at point of sale is both simpler and provides far greater compliance than the current contracting-based assessments. Unfortunately, tax simplification as designed for contracting comes at a significant cost. State base revenues decline by $85 million (plus a decline in Prop. 301 monies) with the state General Fund taking an even larger hit at $125 million. In addition, though cities would gain $15 million in state share, locally generated tax is projected to decline by $12 million, meaning cities come out ahead by $3 million, but GCI speculates that this will be concentrated in large areas like Phoenix, and the vast majority of cities and towns will suffer losses.
These losses are compounded if one considers how SB1525 has already reduced local finances. If one uses a pre-SB1525 world as the base, then municipalities end up $11 million short. That adjusts the requirement that discriminatory construction tax rates can no longer be used to enhance municipal revenue, but does not adjust for lower impact fees overall as a consequence of SB1525, so this understates revenue losses. As noted earlier, almost every municipality in Arizona suffers lost revenue, especially those that had higher construction tax rates relative to retail. The only ones that show gains are Phoenix and Mesa.
Fiscal issues are particularly striking in light of JLBC forecasts that the current $9 general fund is projected to only increase through FY2016 by $100 million, due to added business tax deductions coming on line in the next few years. A change to a materials-sourced tax would wipe out even that small nominal increase. At a 2.5 percent annual inflation, the General Fund needs to grow $235 million annually, so Arizona is falling short, which is particularly disconcerting should there be another economic slowdown before the decade ends.
As a report issued last month by Grand Canyon fellow Tom Rex noted, the state’s past tax policies have reduced the General Fund by $3.1 billion without having a significant impact on economic growth. From a fiscal standpoint, as it relates to contracting, this tax change will not bring added growth, and while the simplification and greater compliance it offers are strengths, the price tag of $125 million to the General Fund, which in stronger economic times would be double that, raise serious concerns regarding whether Arizona can afford it. Likewise, the structural changes to the local-based construction revenues would significantly shift recipients so that most localities end up net losers.
Fortunately, contracting reform does not appear to be a requirement to meet the internet sales requirements for Congressional legislation, so it need not be an obstacle to other parts of sales tax simplification, such as uniform tax bases at the local level.
Table 7 Speculative Distribution of Construction Materials Tax
Dave Wells holds a doctorate in Political Economy and Public Policy and is the Research Director for the Grand Canyon Institute.
Reach the author at DWells@azgci.org or contact the Grand Canyon Institute at (602) 595-1025
The Grand Canyon Institute, a 501(c)3 nonprofit organization, is a centrist think-thank led by a bipartisan group of former state lawmakers, economists, community leaders, and academicians. The Grand Canyon Institute serves as an independent voice reflecting a pragmatic approach to addressing economic, fiscal, budgetary and taxation issues confronting Arizona.
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