State and Local Taxes

October 27, 2003

SUMMARY:  Virginia has a number of inefficient taxes that may have a number of harmful, though unintended, consequences. Among these are the estate tax, the car tax, and the BPOL tax. Of the proposals to increase taxes, the best is applying the sales tax to all internet purchases by Virginia residents.

The world of taxes is a strange place where lots of things that seem like they should be true aren't, especially when they are applied to the state and local levels.

One of the things not usually appreciated is that a progressive tax rate—whereby a higher rate is applied to increasing levels of income—causes huge revenue swings. When the economy turns down, more people drop to income levels where the rate is less, so you raise proportionately less tax revenue than the decline. On the other hand, when the economy grows, more people are bumped into higher brackets, and you raise proportionately more revenue than the overall amount of growth. This is especially true when, as in the federal tax system, the top tier of taxpayers pay most of the tax. At the national level, the top 10% of the taxpayers pay almost 65% of the total tax. Given a government's propensity to spend all its revenue, even in good times, that means that in bad times the cutbacks must be even more painful.

The tax-raisers among us fail to appreciate that raising taxes isn't the solution to raise revenue. Virginia's huge revenue growth in the 1990s was the result of a very healthy economy in which higher incomes, increased personal spending, and great corporate performance resulted in higher tax bills without rate increases.

Raising tax rates or imposing new taxes often has the perverse effect of lowering revenues, especially at the state and local levels. Businesses and individuals can relocate to places where taxes are less or don't exist. Wealthy individuals can pay lawyers and accountants to take advantage of the tax laws to minimize their taxes, and the higher the tax rates, the more incentive they have to do so.

The Death Tax on Estates

This is a prime example of a tax that can be avoided. Virginia is in the minority of states that impose a tax on estates. The Washington Post has recently reported that Virginia is, for a number of reasons, one of the most desirable states in which to retire, but, by retaining the death tax, Virginia encourages wealthy retirees to find another state in which to enjoy their retirement. Wealthy retirees are desirable residents of the Commonwealth because they use few state and local services, but pay lots of income, sales, and real estate taxes.

The estate tax has an equally pernicious effect on small businesses and family farms. When a small business owner dies, the children may have to liquidate the business to pay the death tax. As a result, all the founder's efforts to pass the fruits of a lifetime of labor on to his or her children will be for naught. And the disruptive effects may impact employee jobs and wages.

It's also worth noting that the death tax doesn't raise much revenue - about $133 million a year out of a total state revenue of $10.6 billion.

The estate tax should be repealed.

The Car Tax

The remainder of the car tax still in effect is almost at the stage of being a nuisance tax, where the $25 cost of the decal for the windshield is a large percentage of the total tax paid - and in the case of older cars, more than the tax itself.

The car tax phase-out will continue when Virginia's growth rate exceeds 5%. We may see that point arrive sooner rather than later.

Corporate Tax

Of course, corporations don't really pay this tax, they just pass it on to the consumers (via price increases), workers (via lower wages or fewer jobs) or shareholders (via lower dividends or reduced share value. Studies have shown that corporations are reluctant to locate to high tax states, or are willing to relocate out of them. There are five states with no corporate income tax (NV, SD, TX, WA, WY) and eight more with lower rates than Virginia's.

Ultimately Virginia should do away with the corporate tax. Under static analysis, that's a revenue loser. But if the growth from more businesses coming to Virginia is factored in - not to mention existing businesses paying workers more or hiring more workers - it will certainly result in increases in sales and income tax revenue, offsetting some or all of what is lost.

BPOL - Business, Professional, Occupational, and License Tax

BPOL taxes businesses on the total amount of revenue they take in - even if they have to spend most or all of it on actually operating the business, and even if the business is losing money. The BPOL tax alone can turn a small profit into a loss - and hurt further investment in building and growing a small business. It's particularly onerous for a startup business, not only because that business will likely not turn a profit for some time, but also because of the paperwork involved.

BPOL is inherently unfair to low-margin businesses such as grocery stores, gas stations, and fast food restaurants. Because they need high revenues to earn small profits, this tax is going to be much harder on them than on high margin businesses where most of the revenue is profit.

This is a tax that should be eliminated ASAP.

Internet Taxes

Federal law prohibits states and localities from imposing taxes on internet service providers the way these jurisdictions do on local, long-distance, and cell phone providers. That's a good thing. The amount of tax in a phone bill is outrageous, and Fairfax County residents will soon be noticing the new $3.00 monthly tax on each cell phone. Internet access shouldn't become a cash cow for the state and localities in the same way.

On the other hand, it makes sense to allow Virginia to collect sales tax on sales to Virginia residents made on the internet. In fact, internet sellers with a physical presence in Virginia must collect sales tax now. Companies have argued that with the different local sales tax rates, this is too burdensome, but in the age of sophisticated computers, this is no longer a valid argument. The lack of sales tax collection now benefits companies like Amazon (no physical presence) against Barnes and Noble (stores are a physical presence). It also benefits small internet sellers with one office in another state. There's no economic justification for this advantage; the days of testing the practicality of commerce on the internet are well behind us.

Income Taxes

Some have argued that the top rate of 5.75% is imposed at too low an income level, making the income tax less of a graduated tax than is desirable. While that is certainly true, raising the income thresholds for the lower rates would result in a tax cut; what these critics would like to do is to substantially raise the rates for the middle and upper income taxpayers, resulting in a large tax and revenue increase. In addition to that being a growth-inhibiting measure, that also makes overall tax revenues far more volatile, as described above.

Some have proposed removing the income tax exemptions for those age 62 and over. This exemption came about as the result of a lawsuit on unequal treatment of retirement income by the Commonwealth. It would be extremely interesting to see a breakdown of taxpayers over 62 by income. It's possible that a good tradeoff would be the elimination of this deduction in exchange for lower rates overall, but it should not be taken away from those over 62 without some means of compensation.

It should be mentioned that Virginia's state income tax is easy to calculate and can be filed on-line at the Department of Taxation's web site. DTA should be commended for this initiative. Anyone doing their own taxes should try on-line filing!


The Commonwealth of Virginia restricts the ability of its counties to impose taxes. Counties can't tax unless the state says they can. Independent cities, such as Alexandria, don't fall under these restrictions; they can and do levy taxes on such things as cigarettes, meals, and lodging with permission.

Equalization is the idea that both cities and counties should have the same taxing powers. In reality, almost all supporters of equalization want counties to be given these powers, not have them taken away from cities.

Equalization is very appealing to Northern Virginians whose experience has been that when they send tax dollars to Richmond, they only get pennies back. The problem with equalization is that taxes influence consumer behavior, and especially so when consumers can drive a few miles to shop for a better tax rate. For example, it's been clear that residents of other states come to Virginia to buy their cigarettes. When they do, they also buy milk, bread, beer, diapers, and other items, boosting the local economy. When a local jurisdiction adjusts its tax rates, it may have a much greater impact on commerce than the one item being taxed would suggest.

The best solution would be to impose a state-wide tax and send 100% of it back to the county or city in which it was collected. A second best solution would be to allow localities to levy or increase these taxes if the legislature fails, for five consecutive years, to pass a state-wide tax in that area when it is supported (co-patroned) by 33% of the legislators.


Some have proposed that sales tax be collected on services. That would mean that you would pay sales tax when you see your doctor, dentist, lawyer, barber, or auto mechanic. Collection of a tax on services is harmful to the economy and very onerous to the consumer as well as the provider. For example, how do you tax healthcare services where the provider bills one number, the health insurance company allows a lesser amount, and the consumer pays a deductible. Which amount gets taxed? And given that we all spend a lot on services these days, this would work out to being a hefty tax increase!


User fees may be a useful source of revenue, but they are one with a decidedly limited impact. Governments provide services and facilities for the very reason that they are uneconomical for the private sector to provide since users would not pay their proportionate share of the total cost. And where government competes with the private sector (for example, golf courses and trash removal), government must price competitively, often without the private sector efficiencies. The net result is that while user fees can sometimes increase fairness and revenue, they aren't going to solve any but the smallest of revenue problems.

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