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The Tax System of the United States

Introduction

Taxation ranks as one of the main sources of funding, which governments require for expenditure and investment needs. It acts as an antidote to aid dependency in many economies, in addition to enabling countries to attain sustainable economic growth. Subsequently, it is imperative for governments to design and implement effective tax systems. A country’s tax system determines international and domestic investment decisions. One of the issues that investors take into account while evaluating a country’s tax system includes the degree of fairness and transparency. Enhancing a country’s resource mobilization is not only dependent on raising revenue, but also the effectiveness of the implemented tax system. The system should enhance good governance, promote inclusiveness, and take into account the society’s views on wealth and income inequalities (Tax Foundation 2014).

Furthermore, the tax system should promote social justice. A report by the Tax Foundation (2013) shows that taxation “is integral to strengthening the effective functioning of the state and to the social contract between governments and citizens” (par. 3). The United States has a unique tax system, which is established at both state and federal levels. The state and federal taxes are different and each state has the responsibility of implementing its own tax system. Subsequently, the federal government cannot interfere with any of the state’s tax systems. This study compares and contrasts the tax systems adopted by the states of Texas and California. Thus, it provides the reader with sufficient information that can assist him or her in setting a business in either of the two states.

Analysis

Taxes are an important component of California’s local and state fiscal system. During its 2003/2004 fiscal year, California spent $260 billion to pay for different services utilized by residents and businesses.

Personal income tax

Personal Income Tax (PIT) constitutes one of the main sources of California’s tax revenue. The tax was established in 1935. The tax has been imposed on both California residents and non-residents. However, PIT on “California residents is only charged on income derived from within the state” (Tax Foundation, 2014, par.14). The PTI is also levied on businesses such as partnerships, trusts, estates, and sole proprietorships. According to Tax foundation (2014), California invokes “personal income tax on all personal sources of income such as capital gains, salaries, wages, business-related income, and dividends unless it is excluded” (par. 4). California’s PIT is more volatile as compared to the state personal income. The difference emanates from the view that the tax system is applicable to capital gains. The graph below illustrates the volatility of the PIT as compared to the citizens’ personal income over the past two decades.

Personal income tax
Source: (Legislative Analyst Office 2013).

California has formulated five main tax-filing statuses to cater to different categories of citizens. Tax foundation (2014) notes that these statuses include “the married filing a joint tax return, surviving spouse, single status, and the married filing a separate tax return; there are six main tax brackets to cater for the different filing statuses” (par. 6). The income tax rate ranges from 1% to 12.3% depending on the taxpayers’ income. Tax Foundation (2014) posits that the “California’s PIT can be defined as progressive, which means that citizens are subject to higher taxes as their income increases” (par. 7).

Unlike California, Texas does not charge personal income tax. However, the state has imposed a franchise tax on business entities. California’s tax burden is relatively high, when compared to Texas as illustrated below.

Personal income tax
Source: (Legislative Analyst Office 2012).

In 2009, the local and state tax burden in California averaged $ 11.30 for every $100 of the individual personal income, which is relatively high as compared to the US national average.

Sales and use tax

The sales and use tax [SUT] is classified as the 2nd largest source of tax revenue in California. The SUT is comprised of two main components, which include the use and the sales tax. Both California and Texas have integrated the SUT in their tax system. Sales Tax Institute (2014) notes, “the sales tax was designed in 1933 and is levied on all retailers dealing with tangible personal property” (par. 5). The use tax was designed in 193, and it is levied on all consumers of products purchased from other US states, but intended for consumption in the respective states – California and Texas. Some of the goods, which are subject to the SUT, include household furnishings, motor vehicles, appliances, and clothing (Sales Tax Institute 2014).

The two states have diverse rates of SUT; however, the SUT rate is relatively high in California as compared to Texas. On January 1, 2013, California announced its intention to increase the base SUT by a margin of 0.25% (Sales Tax Institute, 2014). Subsequently, the SUT will increase from 7.25% to 7.5%. On the other hand, Texas levies an SUT of 6.25%. Counties, cities, and other transit authorities may include an additional 2% to the SUT. There are a number of exemptions to the SUT on several items such as manufacturing, electricity, and gas production equipment, and machinery sold to other businesses. The chart below shows a comparison between the SUT in California and Texas from 2011 to 2013. From the chart, it is evident that the SUT in California has undergone a significant increase over the past three years compared to that of Texas (Sales Tax Institute 2014).

2013 2012 2011
California 7.50% 7.25% 8.25%
Texas 6.25% 6.25% 6.25%
Sales and use tax
Source: (Tax Foundation 2012).

Corporation tax

Both Texas and California have imposed a comprehensive corporate tax. California is ranked amongst the 45 states that have imposed a broad-based tax on the profits earned by organizations. It is considered as the 3rd largest source of California’s General Fund revenue. The corporation tax is comprised of three main types of individual taxes, which include “corporate income tax, franchise tax, and bank tax” (Tax Foundation, 2012, par. 5). All businesses operating in California and Texas are subject to franchise tax for their operation in the states.

Texas undertook a number of reductions on the franchise tax rate. For example, businesses that produce their annual report on or after 1 January 2014, and before 1 January 2015 are subject to a franchise tax rate of 0.975% on their taxable profit margin. Texas franchise tax is very complex. Subsequently, its computation requires a range of information similar to that used in the calculation of income tax (Tax Foundation 2014).

Unlike Texas, California’s tax system is less complex. The tax is decided by considering the corporation’s income for its preceding financial year. The franchise tax “is applicable to businesses whose total annual revenue is more than $1,030,000” (Tax Foundation, 2012, par. 8). Retail and wholesale businesses operating in Texas are required to pay 0.5% of their total annual revenue as franchise revenue. However, “businesses that do not have taxable income are required to pay an annual minimum franchise tax of $800 by the California state government, while foreign corporations doing business in California are subject to a franchise tax of 8.84%, which is commonly referred to as ‘privilege tax’” (Tax Foundation, 2012, par. 6). This rate is considered to e relatively high.

Organizations that do not have substantial business activities in California are charged corporate income tax. On the other hand, “banks and other financial institutions operating in California are required to pay bank tax” (Tax Foundation, 2014, par. 9). Despite the three main tax categorizations, corporation franchise tax forms one of the main sources of revenue for California State. The franchise tax in California is commonly referred to as the ‘margin tax’. Corporation tax in California has undergone a significant growth over the past few years as compared with Texas. The growth has emanated from the profit growth of businesses operating in the state.

Property tax

Both Texas and California have implemented property tax as one of their main sources of revenue. Texas has instituted an ad valorem tax, which is charged on property owned by individuals and businesses such as corporations and proprietorships. The tax is applicable to property irrespective of whether it is under domestic or foreign ownership. The tax is imposed based on the Uniform Standards of Professional Appraisals Practices [USPAP] and the Property Tax Code. The rates vary from one region to another, and taxes are based on the value of the property (Bexar County Appraisal District 2014). California’s property tax is more complex and ambiguous to the public. The tax is levied on different types of properties such as “commercial offices, owner-occupied homes, and investments” (Tax Foundation, 2012, par. 7). These properties are subject to a tax base of 1%.

Insurance tax

According to the US Tax Foundation (2012), health maintenance and insurance institutions in Texas are required to pay a predetermined insurance tax. The tax is based on the insurance policies issued to the residents. In Texas, the tax charged ranges between 1.35% and 1.75%. However, a higher tax is levied on insurance companies, which deal with life, health, and accident coverage. Similarly, California has integrated comprehensive insurance tax revenue. The tax is applicable on all insurance policies except with regard to the motor and real estate sectors.

Other taxes paid

Both Texas and California have implemented other taxes, which do not fall under the above tax categories. Some of these taxes are explained herein.

Unemployment insurance tax

Texas and California state governments have also implemented the unemployment insurance tax. In Texas, this tax is levied on employees’ taxable wages of up to $9,000. Moreover, new employers are required to pay the industry average or 2.7% as tax. The unemployment insurance tax in California is relatively low as compared to that of Texas. The employers are required to “pay UI tax on annual taxable wages of up to $7,000” (Tax Foundation, 2013, par. 11). The amount of tax varies depending on the benefits provided by the employer.

Estate tax

This form of tax is only applicable in California. According to Tax Foundation (2013), “the tax was implemented in 1982 and it is charged on individual property holdings upon their death” (par. 8). However, the estate tax does not impose a significant tax burden on California’s taxpayers as the federal law provides an opportunity for taxpayers to file for a tax credit, which is applicable on the estate tax. Subsequently, estate tax does not contribute much to California’s tax revenue.

Generation-skipping Transfer Tax

This form of tax is only applicable in California. Tax Foundation (2013) notes that the “amount of GST tax charged is equivalent to what is allowed by the US federal government as the appropriate tax credit” (par. 6). The tax is similar to estate tax, in that it is charged on the total value of property interest, which is transferred to individuals.

Motor-vehicle levies

Both California and Texas have implemented motor vehicle levies as a source of revenue. The two states charge tax on all vehicles purchased by their residents either from within or without the respective state. The levies form a significant proportion of states’ special and transportation fund. The two states have categorized the motor vehicle levies into three main groups, which include:

  • Truck weight fees; charged on commercial vehicles using the states’ roads based on the gross weight.
  • Vehicle license fees; charged annually on vehicles registered in the two states.
  • Fuel taxes; charged on every gallon of fuel sold.

Tobacco-related tax

This tax is charged on the cigarettes sold in the state. Subsequently, cigarette consumers are charged a higher retail price for consuming tobacco products. California was motivated to institute the tobacco tax due to health concerns and the need to raise sufficient taxes to meet the state’s budget needs. In Texas, tobacco products attract a levy known as special sales tax.

Alcoholic beverages taxes

California charges a “levy on alcoholic beverages, which is based on per-gallon basis” (Tax Foundation, 2014, par. 7). This tax is in addition to the federal tax on alcoholic products. Additionally, all retail establishments “dealing with liquor are charged an annual license fee” (Tax Foundation, 2014, par. 11).

Impact of an entity conducting business in a multistate environment

The above analysis shows that both Texas and California have different tax systems. Subsequently, there is a high probability that firms operating in the two states experience challenges filing their tax returns. A multistate enterprise operating in California and Texas would experience challenges due to the complexity of the respective states tax systems. Subsequently, such businesses would be required to evaluate the tax environment continuously in order to understand the tax changes. Considering this aspect will improve the effectiveness with which they file their tax returns.

The two states have unique tax systems. California’s tax system is more progressive while that of Texas is more regressive. The analysis shows that California implements progressive tax change as compared to Texas. Subsequently, it would be burdensome to operate a business in California. This assertion holds because their businesses will be subject to high tax burden. On the other hand, Texas is characterized as a low-tax state. According to the Tax Foundation (2014), Texas local and state tax burden is ranked amongst the lowest in the US. The business environment is more appealing as compared to that of California. The attractiveness of Texas as compared to California is further enhanced by the view that businesses are not subjected to state income tax. Texas also boasts relatively inexpensive labor costs (Tax Foundation 2014).

The complexity of the tax system in California has made most businesses consider relocating their operations to other states that are more business friendly. Subsequently, businesses operating in California are likely to experience poor financial performance emanating from the state’s tax system. For example, in 2013, California’s governor announced his intention to increase taxes in an effort to close the $16 billion budget deficit. This move is an indicator that businesses operating in the state should prepare for tough times ahead.

Conclusion

Taxation constitutes one of the most important sources of revenue for most governments. Its significance arises from the view that it strengthens the effectiveness with which governments provide different services to their citizens. However, it is imperative for governments to design effective tax systems. The tax system design influences the attractiveness of an economy to local and foreign investors. Every state in the US has the responsibility of designing and implementing its own tax system. From the above analysis, one can assert that the Texas tax system is relatively fair as compared to that of California. However, the Texas tax system is more regressive as compared to that of California, which is progressive. Subsequently, doing business in California is more challenging as compared to operating in Texas. The diversity in the states’ tax system poses a major challenge to businesses operating in the two states due to their respective complexities. In a bid to attract investors, it is imperative for California to consider adjusting its tax system in order to attract investors.

Reference List

Bexar County Appraisal District: Welcome to Bexar County appraisal district. (2014). Web.

Legislative Analyst Office: California facts. (2013). Web.

Legislative Analyst Office: Understanding California’s property taxes. (2012). Web.

Sales Tax Institute: States sales tax rates. (2014). Web.

Tax Foundation: California. (2014). Web.

Tax Foundation: State and local sales tax rates, 2011-2013. (2013). Web.

Tax Foundation: Texas’ state and local tax burden, 1977-2010. (2012). Web.