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The Potential Pitfalls of the Margin Tax: What You Should Know

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In 2006, faced with the possibility of having to shut down public schools because of falling property tax revenues, Texas legislators enacted big changes to finance education, including a new 1 percent margin tax added to the long-standing Texas franchise tax levied on businesses. The intention was to generate an additional $3 billion in revenues each year.

Texas’s margin tax went into full effect in 2008, and it has been extremely unpopular in a state generally known for business-friendly tax policies. But the Lone Star State is not the only one levying such a tax: Ohio, Delaware, and Washington have their own versions.

Here’s what you need to know about the margin tax and why many experts are concerned that it could damage the economy.

How It Works

Also referred to as a modified gross receipts tax, this type of taxation requires Texas businesses to pay a straight 1 percent tax (0.5 percent for retailers and wholesalers) on total revenues rather than net profits. Under this system, a business could show a net loss for the year but still owe a large tax bill to the state based on total revenues.

Texas specifically levies margin taxes on businesses with revenues of $1 million or more. The taxable margin is calculated by subtracting the least of either the production cost of goods sold (excluding services), the cost of compensation, or 70 percent of the business’s total revenue as a tax base.

Volatile Tax Base

Volatility is one of the reasons economists are leery of the margin tax. Unlike property and sales taxes, which tend to remain stable from year to year, a tax on businesses’ total revenues can change dramatically every year, making it difficult for legislators to plan annual budgets for core state services and responsibilities. The margin tax in Texas, in fact, has failed to meet its revenue projections every year since it was instituted, according to the Tax Foundation.

Tax Pyramiding

An additional concern about this type of taxation structure is that it can result in tax pyramiding, a phenomenon wherein consumer goods become more expensive because a tax is paid at every level of production. A complex product that involves several buyers before reaching the consumer, such as a good made of multiple components supplied by different businesses, is taxed at each step. For the businesses involved to make a profit, each one needs to increase its prices, resulting in a much higher cost to the end consumer.

Effect on Business Models

Ultimately, the biggest concern about the margin tax is that it can penalize legitimate business models. A business that runs on a slim profit margin will have a more difficult time paying its tax bill, for instance, than a similar business that operates with a larger profit margin. This allows for a tax model to dictate what makes a successful business model, when most would agree that business owners should have more leeway in determining their best practices.

The Bottom Line

Middle-class consumers might think esoteric discussions of business tax policies have nothing to do with them, but with said policies come volatile tax bases, potentially higher prices for goods, and the potential for more business closings. As such, they should be on everyone’s radar.

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Emily Guy Birken is a former educator and respected personal finance writer. She is the author of the best-seller The Five Years Before You Retire, and the forth-coming book Choose Your Retirement. Her work has appeared on Huffington Post, Yahoo Finance, Business Insider, MSN Money, and Kiplinger's, and Birken has been a guest on Wisconsin Public Radio as well as several podcasts, including Stacking Benjamins and The Doughroller.Birken's background in education allows her to make complex financial topics relatable and easily understood by the layperson. Her mix of no-nonsense advice, humor, and research into the latest studies on finance and behavior make her work a go-to resource for anyone hoping to get a better handle on money matter.