For the past few months, Massachusetts has been embroiled in a battle over a proposed state sales tax on software services.  In a never-ending search for more revenues, the new tax was included in by Governor Deval Patrick in his January 2013 budget proposal.  The terms of the tax as passed in July were expected to raise about $160 million per year, with a goal of helping to plug a funding shortfall in the transportation budget. 

Software is a big business in Massachusetts, and the negative reactions were both immediate and strong.  In recent days, both the MA House and Senate have voted to repeal the tax.  Patrick has signaled he no longer supports the tax either, and is expected to sign the repeal into law. 

A lesson one could take from this incident is that democracy works, particularly when legislators pass an unpopular tax with little coordination with the affected parties.  This take on the situation is correct, of course.  But it is also incomplete.  In principle, broadening your sales tax base, including the taxation of both goods and services, is a fine idea.  In fact, the more services one can include, the more possible it will be for a state to actually lower its present sales tax rate -- thereby reducing the tax-related distortions to economic activity.  Reducing tax exemptions, such as on internet sales, is another part of this strategy.  The present system, where most people pay no taxes on internet purchases, unfairly disadvantages brick-and-mortar businesses in state, though the latter both hire local people and pay local taxes. 

Plow the field of tax breaks first

There are a number of other takeaways from the software tax debacle that are important. 

First, make sure you know what you are doing.  Otherwise, the legislative language casts a broad net that enmeshes many unintended parties.  Even providers who ultimately determine they need not pay the tax (or need pay only very little) often incur high tracking and administrative costs in order to reach that conclusion.

Second, a new type of tax is always more palatable (and less distortionary) if it is deployed with as low a rate as possible, and across many sectors at once.  Tagging only software services with the full 6.25% MA sales tax rate was probably not a very good strategy -- particularly given how many small firms were affected, and the possibility of consumers bypassing the tax by buying from other states.

The most important lesson from Patrick's latest attempt to implement new taxes is that he can find valuable lesson ideas in the Massachusetts Tax Expenditure Budget.  Consider it the "Cliff Notes" of increasing revenues.  Yet, unlike new taxes, which can disproportionately harm one or two sectors, the removal of existing tax subsidies can often make the marketplace more fair.  As noted below, tax breaks for energy are common, and removing these has the additional benefit of more effectively aligning the state's environmental and fiscal policies.

As Governor Patrick is looking hard for ways to make up the $161 million in tax revenue the software service tax repeal will remove from state coffers, here are some ideas:

Filling Revenue Shortfalls in Massachusetts, by the Numbers1

What Deval Patrick is trying to get back:  lost revenues from killing the software services tax

$161 million - Expected revenue from poorly-structured software services tax

Narrowing tax expenditures offers a cleaner way to right the state's fiscal ship

$26,600 million - Total FY2013 tax expenditures quantified for Massachusetts.  Not all of them warrant removal, but there are lots to choose from that do.

Filling the void: ending tax breaks for energy consumption.  Utilities already have a number of programs to ensure the poor have access to basic energy services.  There is no need to subsidize all consumers; consuming energy should be subject to the same sales tax as any other good.  Current incentives reduce the incentive for consumers to invest in more efficient energy appliances and demand reduction.

$585 million - Value of tax exemptions in FY2013 for Massachusetts consumers using fuel oil, natural gas, propane, steam, and electricity.2

$46 - Annual per capita savings by making electricity, even from polluting sources, free from taxation.

$59 million - tax exemption for fuel used in operating aircraft and railroads.3

Filling the void:  treating film like a normal industry.  Yeah, it's cool to see Boston landscapes in movies.  But not nearly as cool as being able to fix our roads and bridges, and support our public schools with state grants.

4 - Number of separate tax breaks Massachusetts has for the film industry.4

$82.6 million - FY 2013 revenue loss from the largest of the film industry tax subsidies, the corporate tax credit for payroll and non-wage production (item 2.614).  These tax credits are freely transferable, great for out-of-state firms that otherwise have no MA tax on which to use the tax credit.

$0.97 million - Average savings per film company using the film industry tax break above.

Filling the void:  broader-based taxation of internet services.  A software services tax unfairly punished one sector, but a tax on our consumption of internet services would be easy to implement and place the sector on more equal footing with other goods and services consumed in the state.  More detail on exactly what federal law requires (and why) would be needed in order to remove this tax subsidy item.

$147 million - FY 2013 revenue loss from tax exemption granted for internet access and related services (e.g., web hosting).  The State notes that this subsidy is provided so the state is "in conformity with federal law."  Lifeline access for the poor does not seem a driver:  telephone services are similarly exempt, but only up $30/month.  At the very least, a similar approach could be used for internet services.

  • 1Tax expenditure data for FY2013 can be accessed in this table:
  • 2Estimated FY2013 revenues losses were $306.4m for electricity consumers, $84.2m for heating fuel, $180.2m for piped and bottled gas, and $14.4m for steam.
  • 3The state justifies this exemption as an effort to further interstate commerce, and out of concern that state-taxation of transport fuels would violate the commerce clause in the U.S. Constitution. Many states provide these exemptions, though often just for trips going outside of the state. Moreover, because it is a common issue across states, a multi-state solution to have equal taxation of transport fuels that cross state lines would solve any commerce clause concerns while also providing more appropriate environmental signals.  A system to equitably remit tax proceeds back to the individual states would help them meet their fiscal needs as well.
  • 4Item 1.611: film payroll and production tax credit (personal income tax); item 2.614: film payroll and non-wage production tax credit (corporate income tax); item 3.004: tax exemption for sales to motion picture production companies; and item 3.421: sales tax exemption for film purchases for commercial exhibition.
Natural gas fracking well in Louisiana

A number of recent articles on subsidies going wrong provide a useful set of examples on how and how not to structure these programs.  Examples include Evergreen Solar, GM and Chrysler, tax credits for film production, and Goldman Sachs. 

1)  What happens with hopes or hype crash with market reality?  Massachusetts firm Evergreen Solar announced that it was shutting down its in-state production facility due to high costs.  The firm received approximately $58 million in state incentives only a couple of years ago. 

I like this company, and take no pleasure in its struggles.  (I own a small number of shares, so its low stock price is not a point of glee either).  But there are some useful lessons for the subsidy grantees.  First, if subsidies are for job creation, there needs to be a formal contract demonstrating what will be provided and when.  Since state governments love these things, they ought to pool together to generate a standard agreement for this type of arrangement, and work with performance bonding companies so that states get compensated if the terms aren't met even if the firm is bought out or goes bankrupt.  Massachusetts did have some guarantees, which is better than many states.  But all should do better.

Second, state programs may seem big in the State House, but are piddly in terms of broader investments by national governments and private capital providers.  These programs can't overcome big forces in the economy -- whether it is missing infrastructure to connect power generation to the grid, or the Chinese government surreptisiously subsidizing the very energy technologies you are trying to anchor in your state (as they do for solar and a variety of other energy technologies as well).  Dreams are nice.  Really understanding why a particular industry hasn't succeeded in the past in your state, region, or country is much better before you plunk taxpayer cash on the table.

2)  Knowing when to hold them or when to fold them isn't something governments have normally been good at.  Here are examples of the government's sale of GM stock in the restructured firm's recent IPO and a second sale of Chrysler's finance arm.  The Congressional oversight panel argued that the sales left a great deal of money on the table.  In the Chrysler example, the asset was resold within only 7 months for 30 percent more, a loss to taxpayers of about $1.5 billion. With GM, the IPO price was less than the government's break-even on the loans, locking in a loss on the investment.

To me, the question about break-even seems irrelevant for a number of reasons.  The feds main interest in these subsidies has been to boost the general economy, not to meet certain targets for return on a specific investment.  Furthermore, if we entered into a double-dip recession, perhaps the prices received would look good right now, rather than bad:  nobody knows the future.  But there are challenges to governments being smart on the exit strategies from these deals that stem from less expertise and from political pressures from interested parties.  These are hard to overcome.

The flip side to undershooting break-even is that given the timing and amounts of capital poured into the firms, a reasonable return -- even under government management -- should be well above break even.  It would be quite interesting to compare the fed's deal terms and realized returns with those of other distressed situation lenders (Warren Buffett to Goldman Sachs, for example).  Buffett wanted a huge risk premium on his money.  Maybe the government doesn't need one quite so large given its other goals.  But it ought to do better than break even for sure; and its returns should be presented not only in gross numbers, but in comparison to what happened to private capital during that same period.

3)  Subsidy arbitrage, and subsidy power rules

This one is simple.  If government subsidies create disparities in the pricing of risk or capital in the marketplace and the government program, many parties will try to exploit that differential for their own gain.  The bigger the gap, the bigger the arbitrage opportunity, and the longer the line will be to get in.  Because subsidy policy arises from a complex set of political drivers, it is not surprising that powerful, well-connected groups are the ones best able to exploit these subsidy opportunities.  Indeed, these are the groups that so often actually create the subsidies from wholecloth, a process that I refer to as policy-enhanced investing.  The government may try to direct how those subsidies are distributed within eligible recipients, but generally it is a losing game.  The subsidies will flow to the powerful.

Two examples:

-Massachusetts, again -- though this time with subsidies to film production.  My own views on the efficicacy of a bunch of states and provinces bidding against each other to provide the largest subsidies for film production are fairly negative.  This example illustrates one reason why.  As noted in a Boston Herald report, one quarter of the tax credits the state provided went to out-of-state actors earning $1 million or more.  Total claims for tax credits in 2009 were $82.4 million, a hefty chunk of change for a small state.  Distasteful perhaps.  But it shouldn't really be a surprise given that these actors are also the more powerful players in the film's value chain.

-Goldman Sachs.  The bailouts gave them access to cheap money.  They are smart, and figure out ways to exploit this access for the benefits of themselves and their clients -- such as kicking in a bunch of money to Facebook.  Good for the country?  Likely not.  Facebook would find investors regardless.  No regular person would care if Facebook's IPO price increased 4x rather than 5x due to the absence of cheap money from Treasury.  Goldman employees would remain better paid than a teacher or public health worker.  But it is a logical outcome of the way this process was structured, and likely but one of a long list of similar examples. 

Deal structure matters quite a bit in the subsidy area, but is too often glossed over.  Tying payments to outcomes rather than investments; forcing potential recipients to bid against each other for the minimum subsidy required to achieve that outcome; and establishing clawback provisions guaranteed by third parties if private entities take the subsidies but don't live up to their side of the bargain would all be good starting points.



Natural gas fracking well in Louisiana

I wanted to call attention to an important study released last month by the Manomet Center for Conservation Sciences, prepared for the Massachusetts Department of Energy Resources.  Authored by a study team led by my former colleague Tom Walker, the analysis delves in to the many complicated elements of the biomass fuel chain.  They nicely highlight competing demands for woody biomass on state land, helping to bring a level of sophistication in thinking about biomass power that Tim Searchinger and others brought to the liquid biofuels market a couple of years back. 

In both sectors, it all comes back to land, so a high degree of overlap should not come as a surprise.  Bringing policy (state and otherwise) along to reflect this more complex view of energy solutions may be challenging, but it is high time to begin the process. The approach seems to mark a step forward for how biomass energy is viewed in the state, something I've been critical of in the past.

The report also contains some very good information on subsidies to biomass energy in general, including those on offer through state and regional carbon reduction plans.  Just as federal policies sometimes introduce higher subsidies to a new favored use (e.g., cellulosic production) to outbid federal subsidies already in place (corn ethanol and corn production in general), the table below illustrates how this lunacy could be replicated at the state or regional level. 

Both liquid biofuels and biomass power are subsidized, yet are likely to compete for the same feedstocks. The Manomet study indicates that will take a good $40/ green ton to pull biomass from power markets into liquid biofuels.  Some of this may come from technical improvements.  Most would likely need to come from higher subsidies to cellulosic plants so they can outbid the subsidized biomass electricity producers.