A Tax Reform Test in Maine

Maine is about to answer the question of whether a state can overhaul its income and sales tax structure to better withstand the ups and downs of the economy.

Voters will be asked in Tuesday’s (June 8) primary election to give their consent to a law approved last year by the Democrat-led Legislature and Democratic Governor John Baldacci that would create a single, lower income tax rate for most Mainers. The measure also would expand the 5 percent sales tax base to include previously exempt services and goods such as movies, dry cleaning, jewelry repair and limousine rentals.

“If this succeeds, then I do think it presents an interesting new model for how to structure a state tax system,” says economist Richard Woodbury, a former Maine legislator who recently analyzed the ballot measure for the Federal Reserve Bank of Boston.

Maine’s vote highlights a discussion taking place in many state capitals. The sharp decline in tax revenues during the past two years has drawn attention to the volatility of state tax structures. The long-term solution, many state officials say, is moving toward a stable, diverse revenue system that reflects the changes in a state’s economic base over time. Baldacci calls it “a tax structure for the 21 ^st century.”

Most states are putting off the difficult decisions about restructuring their tax systems, instead responding to the urgency of the financial crisis by raising taxes, cutting spending or both. Oregon and Rhode Island are two exceptions. In Oregon, voters in January approved reordering the state’s income tax structure to include a new, higher tax bracket on the wealthy and a higher tax rate on corporations. In Rhode Island on Friday (June 4), the General Assembly approved a broad restructuring of the state income tax system, trimming the top tax rate from 9.9 percent to 5.99 percent.

An uneven tax system

For decades, Maine has struggled with a high top income tax rate, narrow sales tax base and steep property taxes but lacked the political momentum to change its tax system. Lawmakers finally broke the logjam when they voted to broaden the sales tax base so they could lower income tax rates in a way that nearly every Mainer would wind up paying less in taxes. It is the biggest change in the state’s tax structure since the Legislature approved a state income tax 41 years ago.

Maine’s plan would be even more extensive than Oregon’s. Maine currently has four income tax brackets, with a top rate of 8.5 percent that even applies to average taxpayers making $20,150 per year. Under the new law, Maine would create a single, 6.5 percent tax on everyone except residents earning over $250,000 per year, who would pay 6.85 percent. The current tax deductions and exemptions would be replaced by a household credit, which would be partially refundable at lower income levels and phased out at higher income levels. State revenue officials say 95 percent of Mainers would pay lower income taxes.

To make up the $90 million per year lost in the income tax cut, the Legislature and Baldacci want to expand the state sales tax to include more than 100 entertainment, rental, transportation and repair services — many of which are targeted at out-of-staters. The state’s meals and lodging tax would rise from 7 percent to 8.5 percent. Maine, which taxes few services compared to other states, would join states that have moved in recent years to expand their tax base to include more services despite opposition from the businesses affected.

Tuesday’s ballot language is confusing, which may help explain why about 20 percent of Maine voters are undecided, according to one poll of 600 residents. A “no” vote supports the tax changes while a “yes” vote opposes it by favoring repealing the law. Turnout will be heavier than usual for a June primary because seven Republicans and four Democrats will be competing for their parties’ nominations for governor.

Reflecting the partisan split on the issue, the four Democrats support the tax overhaul while six of the seven Republicans oppose it. The one Republican who backs reform, state Senator Peter Mills, was the only GOP lawmaker to vote in favor of the legislation, although he hardly mentions it in his campaign.

GOP leaders, through an organization called Still Fed Up With Taxes , contend that the additional sales taxes and higher meals and lodging taxes would unduly hurt 300,000 elderly and low income residents. Republican State Senator David Trahan, a leader of the effort to repeal the tax law, acknowledges that they will be eligible for a $50 sales tax credit “but will have to file an income tax return to get it. The state is betting many won’t bother.” He cites $5.7 million per year in revenue that state officials are building into the budget because of people who do not file for the credit.

Trahan also says the sales tax expansion would stifle tourism by shifting Maine’s tax burden onto out-of-state residents. “We’re a tourist-based economy,” says Trahan, who says he will sponsor his own tax-cut legislation if voters reject the ballot measure Tuesday. “Most of the taxes in this law nail the tourist. I can’t think of a worse time to be doing that.”

Opponents are stressing how the dozens of new sales taxes would add up. In one commercial , an announcer tells the story of “Your Wedding Day: Complete with New Maine Taxes” about fictional couple Dennis and Michelle who now will be socked with a tax on jewelry repair, hired bands and DJs, limousine and tuxedo rentals, lodging for their relatives from out of state and meals and liquor at the reception. The bride cries throughout the ad.

Supporters of the law, who formed a group called No Higher Taxes for Maine , say the reforms would help stabilize tax revenues to allow the state to cope with budget shortfalls better than it has the past two years. As House Majority Leader John Piotti puts it, “We can’t continue to have a system where in good years fully 40 percent of our sales tax revenue comes from the sales of just two items — new cars and building supplies — which tank in a recession.”

Shifting tax burdens

Contrary to opponents’ claims, backers say elderly, low- and middle-income Mainers will see their tax burden drop by over 18 percent, according to an analysis by the state revenue department. Revenue officials concluded if the law were to go into effect January 1 as planned, the average Maine family would pay less in income taxes, more in sales taxes but still come out ahead with $77 in savings.

Tourists still would come to Maine, reform proponents say, because neighboring Vermont and New Hampshire have higher tax rates for eating in restaurants and staying in hotels. (New Hampshire does not have sales tax, which tax reform opponents say would encourage Mainers to cross the state line to save money on services.)

Baldacci and other reform supporters are portraying a vote for repealing the new law as a vote for a tax increase. In one commercial , a woman is shown “walking” a lobster on a leash in a park. “Come here, Precious,” the woman says. An announcer concludes, “Mainers know a bad idea when they see one, like … a plan to raise income taxes in a bad economy.”

“If the new law is repealed, the highest income tax rate in Maine will increase by 30 percent,” Baldacci said Saturday (May 29) in his weekly radio address . “To me, that’s unacceptable. The law will help working families, the elderly and businesses. It will make our tax code more stable. And it will help our economy grow.”

Although the Maine Chamber of Commerce defends the tax overhaul, business leaders are split depending on how they would be affected. The Maine restaurant and lodging industry, for example, is fighting the tax change. In an editorial called “Maine Miracle,” The Wall Street Journal endorsed the tax reform effort. “This is a big income tax cut,” the editorial said. “No state has improved its economic attractiveness more than Maine.”

The Tax Foundation, a nonpartisan tax education group based in Washington, historically has singled out Maine for its uneven tax system. The organization says there is a lot to like about the new law that other states may want to duplicate. Rhode Island is one state watching; Democratic Senate leaders there have proposed simplifying income tax rates.

“When you look at these tax reform efforts and a state’s ability to get something passed, there’s a bias towards the status quo, an inertia not to change anything,” says Kail Padgitt, an economist at the foundation. “If Maine can maintain this, it’s a good sign people understand the role of tax policy.”