Part II of TCCRI's recently published State Budget & Taxation Task Force Report discussed the flaws of the state’s franchise tax and the need to repeal it. What follows is an excerpt from the Report on that topic.
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The tax base for the franchise tax, referred to as a business’s margin, equals the business’s total annual revenue minus its choice of a deduction. When calculating its margin, a business can generally choose to deduct one of the following from total revenue: 30 percent of total revenue; cost of goods sold; cost of compensation; or $1 million. Once the business’s margin is known, the franchise tax liability is calculated by multiplying it by the applicable tax rate. Currently, the franchise tax rate is 0.375 percent for retailers and wholesalers, and 0.75 percent for other businesses.
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Since the current iteration of the Texas franchise tax was first collected in 2008 (and even before it was enacted), the tax has been controversial and a source of much criticism. Many of these criticisms stem from the fact that the franchise tax is a form of (gross) margins taxation, which is generally acknowledged to be an inefficient form of taxation with high compliance costs for businesses that are subjected to it.[i] Rather than being based on the income or profit of a business, the franchise tax is based on the gross receipts of a business. According to a June 2022 Tax Foundation report, Texas is one of only seven states to levy a gross receipts tax, although several others permit local gross receipts taxes.[ii] Since 2017, several states have beaten back attempts to impose a gross receipts tax by highlighting the flaws of such a tax.[iii]
Understanding these issues and the negative impact that the franchise tax is having on the state’s business climate,[iv] the Texas legislature has already set itself on the path toward elimination of the franchise tax. In the 2015 legislative session, House Bill 32 reduced the rates of the tax by one-quarter, increased the annual maximum revenue threshold for filing an “EZ” franchise tax return from $10 million to $20 million, and lowered the EZ filing tax rate by 42 percent. House Bill 32 (84R, 2015) also directed the Comptroller of Public Accounts to study the future fiscal and economic effects of repealing the franchise tax. Per the Legislative Budget Board (LBB), the cuts to the franchise tax enacted in HB 32 amounted to a $2.6 billion tax reduction over the course of the 2016-17 biennium alone. The Comptroller’s 2024-25 Biennial Revenue Estimate, released in January 2023, projected that the tax would raise $11.83 billion throughout the 2022-23 biennium, with $3.55 billion going to the Property Tax Relief Fund and the remaining $8.28 billion going to general revenue.[v] For the 2024025 biennium, those numbers are expected to increase to $3.78 billion and $8.83 billion, respectively.[vi]
During the 86th Session, Senate Bill 66 (Nelson | companion bill House Bill 2759; Murphy) would have phased out the franchise tax gradually in the following manner: if a BRE for a given biennium shows general revenue-related funds available for certification by the Comptroller that are more than five percent greater than the same figure for the preceding biennium, half of the excess funds would be used to lower franchise tax rates. The process would be repeated each subsequent biennium. Over time, this mechanism would result in an elimination of the franchise tax.
The 85th Session also offered some interesting paths to eliminating the franchise tax. House Bill 28 would have accomplished a phaseout of the franchise tax by first identifying the lesser of $3.5 billion or the ending balance of general revenue-related funds available for certification for the preceding biennium. Franchise tax rates would then be set to generate franchise tax savings equal to this amount. The process would be repeated each biennium. When the franchise tax so adjusted would be less than 15 percent of the franchise tax rate effective on September 1, 2017, the franchise tax would be eliminated entirely. Additionally, HB 388 (85R; Rep. Murphy) would have phased out the franchise tax on a definite date. It would have phased out the franchise tax by reducing it incrementally each year for four years, then keeping the tax rate constant for one more year before eliminating the tax entirely.
House Bill 3000 (87R; Cason) would have repealed the franchise tax and, for the 2022-23 biennium only, would have tapped the ESF to replace the forgone franchise tax revenue. Even more aggressively, House Bill 3404 (87R; Guillen) would have eliminated the franchise tax on January 1, 2022, with no provision for the forgone revenue…
Although the foregoing bills were not enacted into law, the Legislature should continue to pursue the idea behind them. Given the state’s strong financial position, outright repeal of the franchise tax is possible and should be pursued. If immediate repeal is not feasible, then a phase out of the tax should be considered.
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Policy Recommendation: Eliminate the Franchise Tax Through a Phaseout
Like all forms of margin-based taxation (where tax liability is based on the top-line revenue of a business, rather than some calculation of net income) the Texas franchise tax has serious flaws. The tax is complex, with businesses having a multitude of ways to calculate their liability, unclear rules pertaining to what can be excluded from “total revenue” in adjusting their gross revenue, as well as what items can be included in the deductions for either “cost of goods sold” or “compensation.” Margins taxation is also especially punitive for businesses that have narrow margins and can create situations in which businesses owe tax to the state despite having recorded a loss.
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Eliminating the franchise tax – which… accounted for only 3.1 percent of all state revenue and 7.3 percent of all state tax revenue in FY 2022- would make Texas one of only three states without a corporate income tax or gross receipts-style business tax,[vii] which would be a boon for investment, job creation, and economic growth. The Legislature should continue its phaseout of the franchise tax. To avoid a situation in which repeal of the tax exacerbates an unanticipated shortfall in state revenue, the Legislature could eliminate the franchise tax over time by using as a template legislation from the 85th or 86th legislative sessions that was discussed above, such as SB 66 (86R; Nelson). Using such bills as a model would ensure that the phaseout of the franchise tax goes smoothly.
You can read this entire section and the rest of the report here.
Notably, two excellent bills relating to the franchise tax have been filed thus far in the 88th Legislative Session; each of House Bill 1226 (Metcalf) and House Bill 391 (Goldman) would repeal the franchise tax beginning in 2024.
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[i] Ben Wilterdink, “Margin Tax is the Epitome of Bad Tax Policy,” American Legislative Exchange Council (July 9, 2014), https://alec.org/article/margin-tax-epitome-bad-tax-policy/. [ii] Janelle Fritts, “Does Your State Have a Gross Receipts Tax?” Tax Foundation (June 7, 2022), https://taxfoundation.org/state-gross-receipts-taxes-2022/. [iii] Garrett Watson, “Resisting the Allure of Gross Receipts Taxes: An Assessment of Their Costs and Consequences,” Tax Foundation (February 6, 2019), https://taxfoundation.org/gross-receipts-tax/#_ftnref75. [iv] Scott Drenkard, “The Texas Margin Tax: A Failed Experiment,” Tax Foundation (2015). [v] Comptroller, 2024-25 Biennial Revenue Estimate (January 2023). [vi] Id. [vii] Janelle Cammenga, “State Corporate Income Tax Rates and Brackets for 2019”, Tax Foundation (February 27, 2019), https://taxfoundation.org/state-corporate-rates-brackets-2019/.