United States: Stop the Shenanigans or I’ll Shoot — Tax Reform Texas Style

It stands to be quite an interesting year in Texas taxation. In late November 2004 a Texas district court judge in Austin declared the Texas public school finance system unconstitutional and enjoined the State from funding public schools, but stayed the injunction until October 1, 2005 to give the Legislature time to attempt to fix the tax system. See West Orange-Cove Cons. Indep. Sch. Dist. v. Neely, No. GV-100528 (Tex. Dist. Ct. Nov. 30, 2004, pet. filed). Unless it is overturned by the Texas Supreme Court, the ruling effectively represents a gun to the head of the Legislature to fix the Texas tax system once and for all. The Texas courts have apparently had enough of the shenanigans that hallmarked the attempts to reform the Texas tax system during the last legislative session. Leaders from the legislative and executive branches are already floating their ideas for fixing the tax system.

The Texas school finance system has seen its share of litigation over the last several decades. The West Orange case is the fifth case involving a constitutional challenge to the system that has reached the Texas Supreme Court. See Edgewood Indep. Sch. Dist. v. Kirby, 777 S.W.2d 391 (Tex. 1989) (known as Edgewood I); Edgewood Indep. Sch. Dist. v. Kirby, 804 S.W.2d 491 (Tex. 1991) (Edgewood II); Carrollton-Farmers Branch Indep. Sch. Dist. v. Edgewood Indep. Sch. Dist., 826 S.W.2d 489 (Tex. 1992) (Edgewood III); Edgewood Indep. Sch. Dist. v. Meno, 917 S.W.2d 717 (Tex. 1995) (Edgewood IV).¹

At the heart of these disputes are two provisions of the Texas Constitution that, in certain respects, are inconsistent with one another. One provision requires the Legislature to establish and make suitable provision for the support and maintenance of an "efficient" system of public free schools in order to the promote "[a] general diffusion of knowledge,"² while the second provision states that "[n]o State ad valorem taxes shall be levied upon any property within this State."³

Texas public schools are funded mostly by ad valorem taxes levied by local school districts under comprehensive state regulation. In the past, the Texas Supreme Court declared the public school finance system unconstitutional because, due to varying degrees of property wealth from one district to the next, the amount of funding varied too much from district to district,⁴ prompting the Legislature to enact a "county education district" scheme in which the school districts within a county were effectively consolidated and the tax base for the county distributed more evenly among the school districts, all under the control of the State. The Texas Supreme Court declared that funding system unconstitutional, not because it was inefficient or resulted in a disparate level of funding per student, but instead, because it was in effect an invalid State property tax.⁵ According to the Edgewood III Court, "[i]f the State mandates that a tax be levied, sets the rate, and prescribes the distribution of the proceeds, the tax is a state tax, regardless of the instrumentality which the State may choose to use."⁶

The Legislature responded by enacting the "two-tiered" funding system that generally remains in effect today. Under Tier 1, school districts receive state funds to close the gap between the minimum tax rate and the "basic allotment" per student. Under Tier 2, for each penny a district raises its tax rate above the minimum, the State guarantees a certain yield per weighted student, and the tax rate for maintenance and operations is generally capped at $1.50. Unlike the former "tiered" systems, the current funding system contains a "Robin Hood" element under which a district with wealth per student greater than a certain amount must transfer the excess, or the tax revenue generated from it, so as to provide funding for school districts with less wealth. Local tax revenue "recaptured" and redistributed by this mechanism amounted to almost $1 billion in 2000.

The Texas Supreme Court subsequently affirmed that two-tiered funding system, finding that it was constitutionally efficient and adequate, since the schools had enough tax revenue to provide a "general diffusion of knowledge," and it was not an unconstitutional State property tax since the local school districts had some realistic discretion in setting their tax rates (i.e., between the minimum and maximum rate, subject to exemptions).⁷ The Court stressed that the system was "minimally acceptable only when viewed through the prism of history."⁸ The Court cautioned that "[i]f a cap on tax rates were to become in effect a floor as well as a ceiling, the conclusion that the Legislature had set a statewide ad valorem tax would appear to be unavoidable because the districts would then have lost all meaningful discretion in setting the tax rate,"⁹ providing the backdrop for the current crisis. Since Edgewood IV, the level of state funding has continued to fall, reliance on local property taxes has increased, and approximately 39% of the school districts have reached maximum tax rates.¹⁰

The original plaintiffs in West Orange filed suit in April 2001, alleging that the current funding system, and specifically the $1.50 rate cap, has evolved into an unconstitutional state ad valorem tax. Other plaintiffs intervened, claiming that the $1.50 rate cap does not provide sufficient or equitable funding to guarantee a general diffusion of knowledge. The defendants filed a motion to dismiss, which the trial court granted. The Court of Appeals affirmed the dismissal, and the plaintiffs sought review in the Texas Supreme Court. The Supreme Court ruled in favor of the plaintiffs, overturning the dismissal, and remanded the case back to the trial court, setting the stage for the current crisis. The Supreme Court reiterated its statement in Edgewood IV that "[o]ur judgment in this case should not be interpreted as a signal that the school finance crisis in Texas has ended."¹¹

Following a fairly lengthy trial on remand, John Dietz, a Texas district court judge in Austin, ruled in favor of the plaintiffs. He held that the $1.50 cap on tax rates has become both a floor and a ceiling, denying school districts meaningful discretion in setting their tax rates, and in effect, a state ad valorem tax. Judge Dietz further held that the current financing system is unconstitutional because the constitutional mandate of adequacy exceeds the maximum amount of funding that is available under the State’s current funding formulas. Judge Dietz enjoined the State from distributing any money under the current Texas school financing system until the constitutional violations are remedied. However, in order to give the Legislature a reasonable opportunity to cure the constitutional deficiencies, Judge Dietz stayed the injunction until October 1, 2005.¹² On December 28, 2004, the Texas Attorney General appealed the decision directly to the Texas Supreme Court. Unless it is overturned, which seems unlikely given the Texas Supreme Court’s previous decision in the case, Judge Dietz’s decision in West Orange should have a significant impact on the next legislative session, which began on January 11, 2005. During the midst of the last legislative session, and the numerous ensuing special sessions, all of which basically amounted to nothing, Lt. Governor David Dewhurst remarked that "[t]he last thing I want to do is find us figuratively with a loaded gun against our head."¹³ Well, the figurative gun is now cocked and loaded. In order to meet the mandates of the judge’s order, legislators are faced with something they feared greatly—major tax legislation.

Leading Texas officials have generally expressed their own views on how the system should be reformed, and by how much. The differences in the plans are generally based on the level of property tax relief intended to be conferred. Republican Governor Rick Perry has generally advocated relatively modest tax reform. The Governor has advocated lowering local property taxes on homeowners and businesses, and paying for it by repealing the so-called Texas franchise tax "loophole" and extending the state lottery to include "video lottery terminals" located at horse racing tracks. The Governor’s proposal met very stiff opposition in the Texas House last session (it was brought to a vote and defeated unanimously by both Republicans and Democrats).

The Texas House seems to support property tax relief in an amount similar to the Governor’s plan. One of the more popular ideas in the House is to replace the Texas franchise tax with a payroll tax at about a 1.5% rate. Some have suggested increasing the sales tax rate by a modest amount. Some House members continue to consider extending the sales tax to most services, including professional services. A similar proposal was soundly defeated during the last legislative session.

Lieutenant Governor David Dewhurst, who heads the Texas Senate, has generally favored greater property tax reform. The Lt. Governor has generally favored adopting a form of broadbased value-added tax to replace the current franchise tax. The tax base of the new tax would reportedly be a company’s net income plus compensation costs, taxed at a rate from 1 to 3 percent.

Three general plans for reforming business taxes seemed to gain at least some support during the last legislative session. One plan would generally have repealed the franchise tax and replaced it with a new business tax imposed on all forms of businesses (including corporations, LLCs, and partnerships) with three components from which businesses could select: (i) a payroll component; (ii) a business activity component; and (iii) a minimum alternative tax component. The payroll component would have generally been based on the lesser of (i) a small percentage (e.g., 1.25%) of wages paid to each employee; or (ii) $125 per employee per quarter. The business activity component would have generally been based on business income and certain compensation would have been included in the tax base. The minimum alternative tax component would have generally been based on gross receipts. A second plan would have imposed a new payroll tax, essentially calculated the same as the payroll component described above.

A third plan would have reformed and extended the franchise tax. The so called "Delaware Sub" and "Geoffrey" "loopholes would have generally been closed. Partnerships would have generally been subject to the franchise tax except for interests owned by natural persons. An alternative minimum tax equal to 0.25% of Texas gross revenues would have applied.

Bills that have been pre-filed in advance of the current legislative session give some indication of what to expect. Among other things, if enacted those bills would: (i) repeal the Texas franchise tax and replace it with a "Texas Education Business Activity Tax" generally imposed on both entities and individuals and generally measured by apportioned gross business receipts;¹⁴ (ii) increase the State sales tax rate by 1% to 7.25%;¹⁵ (iii) generally repeal every sales tax exemption and every franchise tax exemption;¹⁶ (iv) increase the cigarette tax by $1 per pack;¹⁷ (v) generally extend the Texas franchise tax to every business trust, limited liability company, or other entity that is classified as a corporation for federal income tax purposes and that is doing business in Texas;¹⁸ or (vi) impose a personal income tax, subject to approval by the voters.¹⁹

On January 12, 2005, Lt. Governor Dewhurst and Senator Florence Shapiro unveiled an outline of a plan that reportedly has unanimous support in the Senate. Although the details are rather hazy, the Senate plan would generally replace the current local maintenance and operations tax (the tax capped at $1.50 that is the subject of West Orange) with a $1.00 maximum state property tax. Obviously, that would require an amendment to the Texas Constitution. The Senate plan would allow localities to impose a 15¢ "local enrichment tax" to bolster spending at the local level. The Senate plan would also revise the franchise tax by extending it to all business entities except for sole proprietorships, closing current "loopholes," and reducing the tax rate by more than half (from 4.5% to 1.95% or lower). Other revenue would generally be needed to fund the local property tax relief, and potential candidates include increasing the sales tax, the motor vehicle sales tax, and tobacco and alcohol taxes, and improving delinquent tax collections. Lt. Governor Dewhurst acknowledged that "[t]his is meant to be a starting point," "[o]ur feet are not in concrete."²⁰ Some senators have said that while they share the Lt. Governor’s overall goals, the plan expresses "a range of ways to meet those goals. Obviously I like some more than others. The devil is in the details."²¹

Not one to watch quietly from the side lines, Texas Comptroller Strayhorn has challenged the Governor and the Legislature to take the school finance crisis more seriously:

Governor Perry’s Office responded that "[i]f the comptroller wants to blame the governor for turning a $10 billion shortfall into a surplus in two short years, the governor will be happy to share the credit with legislators and employers who are working hard to grow our economy."²³ In short, the mix of political in-fighting, the fear of enacting what amounts to a tax increase, and the figurative judicial gun aimed squarely at the heads of the politicians, sets the stage for what should be a very interesting year in Texas taxation—a situation that can only be described as tax reform Texas style. We will keep you apprised of significant developments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.