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Friday, March 31, 2017

School Funding: The Threat of Higher Taxes

On Monday, at 10AM at the Wyoming Oil And Gas Conservation Commission on 2211 King Boulevard in Casper, the Select Committee on School Finance Recalibration will hold its first meeting. This is one of the most important committees that our legislature has appointed in many years. Its purpose is, plainly, to come up with as much new revenue as they can to avoid reductions in K-12 education spending. 

This is no small task. Back in November the Joint Education Committee accepted a report suggesting that the state's budget deficit would reach $900 million in fiscal year 2022. The legislative leadership has never refuted this number, but I have...
I believe it is an exaggeration of our state's current macroeconomic trend. My forecast stands: we are about to enter a new state of macroeconomic stability at a lower long-term level of activity than we have seen in the past 15 years. Barring any permanent changes to government spending, I maintain that we will see a stabilization of the budget deficit in the $700-$750 million bracket from 2020 and on. 

The problem is that this new School Finance Re-Taxation committee is, in all likelihood, going to come up with a variety of ways to impose new taxes on us. If they do, my macroeconomic forecast will immediately change for the worse. 

The forecast that suggests a stabilized budget deficit is based on the following, so called stylized facts about the Wyoming economy:

1. Jobs lost in the minerals sector are, for the most part, gone and will not come back. There are several reasons for this:
a) There is a long-term trend of declining coal demand domestically, with coal being replaced primarily with natural gas for electricity production. Since 90 percent of coal production in the United States is used for energy production, the long-term, relative decline in coal demand is a trend to be reckoned with.
b) Exports of U.S. coal is actually declining. One reason for this is the notorious inability of the European economy to get back on its feet again, as well as the macroeconomic problems in China. On top of this, Germany, a major coal consuming country, has made the economically self-destructive decision to replace coal with wind mills. (Imagine what that country is going to look like in 2030 when their ban on internal combustion engines goes into effect and everyone has to drive electric cars...)
c) In 2016, U.S. total energy consumption seems to have stalled about 3-4 percent below where it topped out during the last business-cycle growth period. This suggests that even if we continue to see reasonable GDP growth rates nationally, we will not see a surge in coal demand for the purposes of energy production. Recent actions by the Trump administration to deregulate the coal industry will save the jobs we have in the coal industry, and they will definitely contribute to the stabilization of coal production in Wyoming. However, there will be no increase as a result of the deregulation. The overall economic trends do not favor such an increase.

2. The non-minerals industry will stabilize, but will not grow. For the better part of the past year, the non-minerals industry has been losing jobs faster than the minerals industry. This will continue for a few more months, but during the second half of 2017, if not before, we will see a stabilization of non-minerals jobs (just like employment in the minerals industry will stabilize).

3. Government will not change its overall payroll costs. In other words,one of the main drivers of government spending will remain intact. Furthermore, there will probably be no structural reform to government spending programs before 2020 (I do hope I am wrong on this one!) which keeps both the state and local governments going at current cost levels.

4. The legislative efforts to raise taxes fail.

Under these four stylized facts (a fancy economics term for assumptions that are based on a series of observations of economic facts, then organized by general theoretical and empirical relevance), it is safe to predict that the state's budget deficit will stabilize at about $700-750 million per year in 2020, and not increase beyond that. However, it is unlikely that this status quo will actually materialize over the next 4-5 years. I am especially worried about point 4 above.

During the legislative session we heard the occasional proposal that the budget deficit be closed by equal measures of spending cuts and tax increases. If we use this as the reference point for what the School Funding Re-Taxation committee will be discussing, and if we assume that they still believe in a deficit of $900 million by 2022, then this committee will probably suggest tax increases in the vicinity of $450 million.

How would they go about increasing taxes by that much? The first thought that comes to mind is to reinstate the income tax. A $450-million collection through an income tax requires far more than a simple three-percent tax on personal income, which arithmetically and statically would be the rate needed. Two factors negatively affect collection: about 28 percent of all potential income-tax payers work for government, meaning their income-tax increase affects the burden on private-sector employed taxpayers; and secondly, a significant number of high-earning residents will leave Wyoming. 

It is not out of the realm that, with these variables in mind, an income tax to raise $450 million in new revenue would have to land at four percent. This money would come out of the pockets of everyone of us, including the average non-minerals, private-sector employee who makes $36,000 per year. To him or her, a four-percent income tax represents a loss of $1,440 per year. 

The negative effects on the Wyoming economy from a tax of this size are going to be significant. An estimate using a standard Keynesian consumption multiplier suggests job losses in the 7,000-10,000 bracket. In other words: we could lose as many as ten thousand taxpayers as a result of the income tax, not counting those who leave the state to avoid the tax.

An income tax is still unlikely, but looking at the alternatives, I suggest you all nevertheless get prepared for a proposal for an income tax. To collect $450 million through other taxes, the legislature would have to:
  • Increase its revenue from property taxes by 41 percent; since the "reaction time" - price elasticity for you econo-nerds out there - to a property-tax increase is relatively slow, you could take last year's property-tax payments, up them by 41 percent and ask yourself how easily you could cope with that bill; or
  • Raise sales taxes so that revenue increases by 50 percent; or
  • Mix the two.
Revenue from sales taxes is comparatively sensitive to price elasticity reactions. It is easier for people to change their consumption habits in response to increases in sales and excise taxes, than to change their residence in response to an increase in property taxes. Therefore, if the School Funding Re-Taxation committee wants to secure as much new revenue as possible over the short term, they will probably go for property-tax increases. 

Long term, though, the property tax increase is about as bad an idea as an income tax. It depresses real estate prices, ultimately pulling down property taxes; it grabs money out of people's monthly budgets, forcing them to cut back first on discretionary spending, then on regular spending; and, not to forget, an increase in property taxes directly affects people's ability to take out a second mortgage and buy durable products like cars and appliances. 

The quantitative effects of an increase in property taxes are smaller over the short term than for an income tax - a rough multiplier estimate would place job losses in the 3-4,000 range. However, as the property-tax increase gradually works its way through the economy, depressing property values and forcing cuts in durables spending, the effects could very well exceed those from the income tax. 

For every dynamic estimate of a tax increase, it is always important to remember that the state loses tax revenue by other means than the tax they increased. An income tax depresses revenue from sales and excise taxes; a sales-tax increase holds back property taxes as people's budgets tighten and they hold off on buying a property, or go for cheaper ones; a property-tax increase has both short and long term effects on sales-tax revenue. 

To sum up: any attempt at closing even half of the budget deficit predicted by the Joint Education Committee and others in the legislature, would result in a further decline in private-sector economic activity in Wyoming. A loss of 10,000 jobs over a period of 18-24 months would ratchet down overall economic activity in our state by at least as much as we have seen in the past year, but stretch out the pain over two years. This is a dangerous scenario: perhaps the worst that can happen to an economy is that it slowly but relentlessly declines over a protracted period of time. Short, but big shocks tend to have much less negative effects over time than a slowly progressing economic crisis. The protracted scenario destroys entrepreneurship and confidence in the private sector and thereby erodes the very foundation upon which long-term economic stability, prosperity and economic freedom are built. 

It is no exaggeration to say that our state's economic future depends on what the School Funding committee will propose in its final report. Let us hope they get this right from day one and stay away from any proposal that raises or introduces new taxes.

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