Does South Dakota offer road map for tax trade-off?

Nebraska does not tax purchases by churches or health care facilities, though Gov. Dave Heineman has proposed eliminating their exemptions.

LINCOLN — Scott VanderWal makes a good living running cattle and tilling the fertile soil near Volga, S.D.

Yet, unlike his farming brethren in Nebraska, he has never paid a dime of income tax to the state. That's because South Dakota is one of nine states that don't levy an income tax.

There is a trade-off: VanderWal had to pay state sales taxes on a $250,000 combine he bought four years ago. He also pays sales taxes when he buys groceries, hires an accountant, gets the carburetor cleaned on his car or gets his hair cut.

All those sales are tax exempt in Nebraska.

“We're used to it,” said the 49-year-old farmer. “You just figure (sales taxes) into your budget for the year.”

Paying sales taxes, he said, just seems fair: You pay only when you have the money to purchase something. And because groceries are taxed, everyone pays a little.

In the tax debate, Nebraskans may want to look at what happens in South Dakota.

Gov. Dave Heineman has proposed a dramatic shift in taxes in the Cornhusker State so that its tax system will look more like those in South Dakota, Texas, Florida and other states that don't have an income tax.

His initial proposal — at least the more “bold and courageous” of two he plans to introduce — would shift $2.4billion from income taxes now paid by individuals and corporations to sales taxes that farmers, businesses and consumers do not currently pay.

Current Nebraska sales tax exemptions would go away on machinery, seeds, fertilizer and energy used by farmers; equipment, energy and component parts used by businesses; and hospital beds and prescription drug bills paid by sick people. Even dorm room bills sent to parents of students would be taxed.

While it's pretty easy to see how oil-rich states such as Texas and Alaska, or tourism meccas like Florida and Nevada, can forgo a state income tax, it gets more complicated when it comes to South Dakota, a rural state with more cows than people.

So how do they do it?

While South Dakota does see extra government revenue from casinos and tourism, the simple answer is that it gets by with fewer government services and thus has lower taxes.

South Dakota also taxes many more transactions — such as lawyer bills and snow removal — and makes schools and churches pay sales taxes on construction materials and a 2 percent “contractor fee” on all construction projects. Nebraska does not tax purchases by churches or health care facilities, though Heineman has proposed eliminating their exemptions.

So, should Nebraska adopt a sales-tax based system to raise money for its state universities, roads and social services?

That question is more difficult to answer.

David Owen, who heads the South Dakota Chamber of Commerce and Industry, said there is “an ocean of trade-offs” in every tax system.

South Dakotans love not having to pay state income taxes, Owen said, and it's an attractive incentive when businesses look to locate in the state. But there are downsides.

Owen said there are worries in his state that new construction is deterred when businesses have to pay an extra 2 percent for a state contractor fee, on top of the sales taxes owed on equipment purchased by a manufacturer.

“In an ideal world, we wouldn't” tax manufacturing equipment, Owen said. “We may be the only one.”

Nebraska currently doesn't tax manufacturing equipment, though this exemption is another one targeted for removal under Heineman's more ambitious tax plan.

VanderWal, the farmer, said his local church wasn't too happy when it had to pay the contractor fee on the construction of an addition recently. South Dakota churches get a property tax exemption, as they do in Nebraska, but they don't enjoy the sales tax breaks that religious entities here get.

Owen, the state chamber official, said South Dakota's broad sales tax is less subject to the “social engineering” and winners and losers of a system like Nebraska's, which has a long list of sales tax exemptions. Businesses come to the Nebraska Legislature every year asking for a new exemption, a parade that's avoided in South Dakota.

When it comes to business and population growth, South Dakota has outpaced Nebraska in recent years — one of the arguments Heineman makes in touting a shift from income to sales taxes.

During the decade that ended in 2010, South Dakota had the highest population growth, 7.9 percent, of any of 12 Midwestern states. Nebraska's growth was lower: 6.7 percent.

David Drozd of the Center for Public Affairs Research at the University of Nebraska at Omaha said favorable tax policy probably played a role in that higher growth. Each of the nine states that do not levy an income tax either led the region in population growth or grew faster than the national average, he said.

South Dakota also beat Nebraska, from 2001 to 2011, in the rate of job growth, adding 7.3 percent more jobs over that decade compared with 3percent growth in Nebraska, said Eric Thompson of the University of Nebraska-Lincoln Bureau of Business Research.

But Thompson — who has urged Nebraska to expand its sales tax base to include groceries and health care services — said the higher job-growth rate in South Dakota is probably due more to its overall lower taxes.

“A big part of it is that they just have a smaller government that does less,” he said.

Figures compiled by the Kaiser Family Foundation, using state budget data, show that in 2010, South Dakota spent $4,692 per capita in state spending — 13th-lowest among all states. That compared with $5,260 per capita in Nebraska, which ranked 21st.

By having a broader sales tax base — by taxing more services and purchases — South Dakota also gets by with a lower sales tax rate, 4 cents. That compares with a state rate in Nebraska of 5.5 cents.

Lower taxes, and the lack of an income tax, are two of the reasons cited by Yankton businessman Gary Blom for running his 40-state trucking company out of his home state.

Twenty years ago, Blom moved from Michigan back to South Dakota. Family and the laid-back lifestyle were big reasons, but it also helps that he and his company pay no state income taxes.

“Overall, we're a much cheaper state to live in,” he said. “Yet, we don't have business beating down their doors to come here.”

Big corporations, Blom said, just don't like being “out in the middle of nowhere,” regardless of the tax advantages.

Whether eliminating income taxes will spur job growth is a big debate in Nebraska.

Heineman and supporters of his plans say it will, insisting that companies are more concerned with paying income taxes than sales taxes. The University of Connecticut's Richard Pomp, a national authority on state taxes who spoke in Lincoln last week, said there's no proof that eliminating income taxes will create jobs.

VanderWal, president of the South Dakota Farm Bureau, said that although he likes his state's tax system, he was alarmed to hear that Heineman's plan included expanding taxes onto “inputs” utilized by farmers, such as seed, farm chemicals and energy used to power irrigation systems.

Taxing farm equipment is one thing, he said, but taxing the inputs used to produce a crop represents “double taxation,” because sales taxes will be paid again when that crop is turned into a product and sold.

“It's a huge tax shift,” VanderWal said of Nebraska's proposal. “You're going to eliminate an income tax that everyone pays and start taxing ag inputs, which is paid by a relatively small number of people.”

Farm profits have been high in recent years, Heineman pointed out last week. Rural bankers aren't loaning money, he said, because farmers have so much cash on hand. His point: They can afford it.

But VanderWal, like representatives of Nebraska farm groups, warns that the good times could turn to bad pretty quickly in what is a very cyclical business.

Another native South Dakotan, State Sen. Jeremy Nordquist of Omaha, said he's not convinced that his home state's tax plan is preferable.

Nordquist said a tax system based mostly on sales taxes — about 74 percent of South Dakota's revenue comes from sales taxes and the contractor fee — is less predictable than a more balanced system like Nebraska's, which relies largely on sales and income taxes. In the current budget year, about 39 percent of Nebraska's gross tax receipts have come from sales taxes.

Nordquist said the result for South Dakota is that it can't make the long-term investments in higher education that Nebraska can.

Low- and middle-income families would lose, he said, because they don't pay a lot of state income taxes. They also would lose a current income tax credit for child care in exchange for new tax bills for hospital stays, prescription drugs and college dorm rooms for their children.

He has labeled Heineman's plan “dead on arrival.”

“There's going to be a tremendous amount of opposition to it,” Nordquist said. “This is a dramatically different direction.”

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Summaries of tax reform plans proposed by Gov. Dave Heineman

The plan the governor has termed “bold and courageous” would:

» Eliminate the state's personal income tax and corporate income tax — taxes that now generate about $2.4 billion a year, or about 53 percent of the state's annual tax revenue.

» Eliminate income taxes now levied on military pensions, Social Security checks and pensions of all kinds.

» Rescind nearly 30 sales tax exemptions, worth an estimated $2.4 billion, to replace the loss of income taxes. (The plan would not cut overall tax revenue; rather, it would shift the load onto sales taxes.)

» Retain sales tax exemptions on items such as food, newspapers, state lottery tickets, school lunches and nonprofit health clinics.

» Require sales taxes to be paid on farm machinery, seed, chemicals and energy purchased by farmers; equipment, energy and component parts bought by businesses and industries; and hospital beds, dorm rooms and prescription drugs paid for by individuals and families.

The less-ambitious plan would:

» Eliminate the $262 million a year in corporate income taxes paid by some companies and family farm corporations.

» Exempt the first $12,000 of retirement income for a married couple ($6,000 for individuals).

» Replace those taxes by rescinding about $395 million worth of sales tax exemptions.

» Eliminate businesses' sales tax exemptions on containers and molds and dies, and energy bills; farmers would lose exemptions on seed, agriculture chemicals and energy; hospitals would lose exemptions on medical equipment purchases.

» Retain several of the exemptions that would go away in the more ambitious tax reform plan, such as breaks on purchases of agriculture and manufacturing equipment, one provided for ingredients and component parts used in manufacturing, and college dorm and hospital rooms.

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