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Thursday, May 18, 2017

The Timing of Tax and Spending Reform

During my testimony to the Joint Revenue Committee in Saratoga last week, a question came up about the restructuring of our state's tax base. Chairman Peterson and Co-Chairman Madden are both of the opinion that it is not good for our state to rely so heavily on the minerals industry, and that it would be wise to restructure the tax base. Co-Chairman Madden had asked a representative from the Legislative Service Office to make a presentation about the Wyoming state tax base, a presentation that informatively compared our state to several others.

I agree with Chairman Peterson and Co-Chairman Madden on this matter. By relying heavily on the minerals industry, we are not only asking a small part of our businesses to pull an overly heavy load on behalf of the state government, but we also expose ourselves heavily to industry-specific changes both in the business cycle and in long-term trends within that industry. However, there are some risks associated with a restructuring of our tax system, risks that I believe the Joint Revenue Committee, as well as other legislators, need to take into account. 

The good news about tax-base reforms is that there are plenty of examples of such reforms from around the world. The bad news is that most of them have failed to accomplish what they set out to get done. The reason for this is not that the reform idea has been bad, but that the reforms have been executed either at the wrong point in time, or with the wrong policy goal in mind. 

The last point is the most important one here. A reform to the tax base of a country, a state or a province is often guided by the policy goal of "revenue neutrality". This means, simply, that the tax base should deliver the same amount of tax revenue after the reform as it did before. This goal is sometimes spoken of as "no new deficits" from the reform. 

Regardless of whether the goal of revenue neutrality is accomplished statically - over one year - or dynamically with growth effects taken into account, the one point where these reforms fail is that they do not adjust for growth in government spending. If government spending grows at X percent, and the new tax base is supposed to keep up with it, then the underlying economic activity that pays the "new" tax base must grow at least on par with X percent - or else the new tax base will open up a deficit. 

If the tax-base reform stimulates economic growth, it is easier - though not necessarily a given - that the new tax base will keep up with government spending. However, if there is a deficit in the budget at the time of the tax reform, the policy goal of revenue neutrality significantly raises the risk that the tax reform leaves the budget with an even greater deficit. The reason, again, is that such reforms usually do not account for the growth in government spending; with a deficit, the new tax base actually has to lead to a faster growth in tax revenue than in spending in order to eliminate the deficit.

To avoid these problems, and still get a tax-base reform done, I have a suggestion:

1. Break the long-term trajectory of growing spending by means of an agency-wide efficiency overhaul of the state government. This is not a long-term solution to our problem of structural over-spending, but it is an important "game changer". It introduces a new way of thinking in government and, more importantly, it can shave off enough government outlays to buy us much-needed time to initiate reforms as per point 2 below. However, the efficiency overhaul would have to be all-inclusive; no state agency, no program would be exempt. That does not mean all agencies would make the same amount of cuts - some might even be operating at a high level of efficiency today - but it would mean that the new fiscal regime, so to speak, would go into effect on short notice. 

2. Start reforms that will permanently and structurally reduce government spending by a substantial amount. A good example is comprehensive school-choice reform, which over time could cut state spending by hundreds of millions of dollars if done right. Another example is to repatriate Medicaid (eliminate federal funds) and open it up to free-market solutions, both on the insurance side and on the provider side. 

3. Once we have gotten the ball rolling no item 2, and therefore have a reasonable idea what the state's expenditures will be in the foreseeable future, it is time to reform the state's tax base. By this point in time, we can most likely combine a shift away from heavy dependency on the minerals industry with a moderate, initial reduction in the overall tax burden on our state's economy. If done right, though, the tax-base reform would make it easy for the legislature to reduce taxes as the efficiency overhaul and, especially, structural spending reforms permanently reduce government spending. 

In other words, with this order of reforms, the legislature could create a tax-base reform that has an "easy button" for tax cuts but is biased against higher taxes. 

To illustrate the points I have made above, I put together three panels with some simple numbers. I have added them as a simple illustration of this three-step reform sequence.

The first panel assumes that the government budget is in balance. The tax base consists of raw materials (R) where annual economic activity is worth $1,000 per year, and of consumption (C) which is also worth $1,000 per year. Government spending is divided between education (E) and health care (H) with total spending of $100 on education (GE) and $100 on health care (GH). 

All these variables, R, C, GH and GE, grow at five percent per year. The tax rates imposed on R and C are, respectively, 15 and 5 percent. Over a period of five years, the government's budget stays balanced, as illustrated by the base scenario. A tax reform to even out the tax burden between R and C makes no difference to the government's bottom line, as shown in the lower, tax-base shift part of this panel:


PANEL 1: BUDGET IN BALANCE
Base scenario
1901 1902 1903 1904 1905
R 1000 TR  1,000.00  1,050.00  1,102.50  1,157.63  1,215.51
C 1000 TC  1,000.00  1,050.00  1,102.50  1,157.63  1,215.51
E 100 GE  100.00  105.00  110.25  115.76  121.55
H 100 GH  100.00  105.00  110.25  115.76  121.55
dR 5.0% 5.0% 5.0% 5.0%
dC 5.0% 5.0% 5.0% 5.0%
dE 5.0% 5.0% 5.0% 5.0%
dH 5.0% 5.0% 5.0% 5.0%
tR 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%
tC 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
1901 1902 1903 1904 1905
T  200.00  210.00  220.50  231.53  243.10
G  200.00  210.00  220.50  231.53  243.10
D  -    -    -    -    -  
Tax base shift
1901 1902 1903 1904 1905
R 1000 TR  1,000.00  1,050.00  1,102.50  1,157.63  1,215.51
C 1000 TC  1,000.00  1,050.00  1,102.50  1,157.63  1,215.51
E 100 GE  100.00  105.00  110.25  115.76  121.55
H 100 GH  100.00  105.00  110.25  115.76  121.55
dR 5.0% 5.0% 5.0% 5.0%
dC 5.0% 5.0% 5.0% 5.0%
dE 5.0% 5.0% 5.0% 5.0%
dH 5.0% 5.0% 5.0% 5.0%
tR 15.0% 15.0% 15.0% 10.0% 10.0% 10.0%
tC 5.0% 5.0% 5.0% 10.0% 10.0% 10.0%
1901 1902 1903 1904 1905
T  200.00  210.00  220.50  231.53  243.10
G  200.00  210.00  220.50  231.53  243.10
D  -    -    -    -    -  


In Panel 2 we change the growth rate of the two economic activities that constitute the tax base. The growth in R slows down first, followed by a reduction in the growth rate of C. We now get a deficit in the base scenario, but as the tax-base shift scenario shows, the deficit does not go away with the tax reform. The reason is, as illustrated above in Panel 1, that the tax-base reform is designed to be revenue neutral:


PANEL 2: SLOW GROWTH
Base scenario
1901 1902 1903 1904 1905
R 1000 TR  1,000.00  1,025.00  1,035.25  1,045.60  1,056.06
C 1000 TC  1,000.00  1,050.00  1,102.50  1,130.06  1,158.31
E 100 GE  100.00  105.00  110.25  115.76  121.55
H 100 GH  100.00  105.00  110.25  115.76  121.55
dR 2.5% 1.0% 1.0% 1.0%
dC 5.0% 5.0% 2.5% 2.5%
dE 5.0% 5.0% 5.0% 5.0%
dH 5.0% 5.0% 5.0% 5.0%
tR 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%
tC 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
1901 1902 1903 1904 1905
0.14 T  200.00  206.25  210.41  213.34  216.32
0.06 G  200.00  210.00  220.50  231.53  243.10
D  -   -3.75 -10.09 -18.18 -26.78
Tax base shift
1901 1902 1903 1904 1905
R 1000 TR  1,000.00  1,025.00  1,035.25  1,045.60  1,056.06
C 1000 TC  1,000.00  1,050.00  1,102.50  1,130.06  1,158.31
E 100 GE  100.00  105.00  110.25  115.76  121.55
H 100 GH  100.00  105.00  110.25  115.76  121.55
dR 2.5% 1.0% 1.0% 1.0%
dC 5.0% 5.0% 2.5% 2.5%
dE 5.0% 5.0% 5.0% 5.0%
dH 5.0% 5.0% 5.0% 5.0%
tR 15.0% 15.0% 15.0% 10.0% 10.0% 10.0%
tC 5.0% 5.0% 5.0% 10.0% 10.0% 10.0%
1901 1902 1903 1904 1905
0.14 T  200.00  206.25  213.78  217.57  221.44
0.06 G  200.00  210.00  220.50  231.53  243.10
D  -   -3.75 -6.72 -13.96 -21.66


Let us keep the same tax reform, and with it the goal of revenue neutrality, but let us now add a restriction on the spending side: no government program can grow faster than the growth rate of the tax base. The difference in Panel 3 is that while R and C slow down as before, we now reduce the growth in GE and GH and thereby balance the budget while at the same time allowing for the tax-base reform to go into effect:


PANEL 3: SPENDING ADJUSTMENT
Base scenario
1901 1902 1903 1904 1905
R 1000 TR  1,000.00  1,025.00  1,035.25  1,045.60  1,056.06
C 1000 TC  1,000.00  1,050.00  1,102.50  1,130.06  1,158.31
E 100 GE  100.00  105.00  110.25  115.76  121.55
H 100 GH  100.00  105.00  110.25  115.76  121.55
dR 2.5% 1.0% 1.0% 1.0%
dC 5.0% 5.0% 2.5% 2.5%
dE 5.0% 5.0% 5.0% 5.0%
dH 5.0% 5.0% 5.0% 5.0%
tR 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%
tC 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
1901 1902 1903 1904 1905
0.14 T  200.00  206.25  210.41  213.34  216.32
0.06 G  200.00  210.00  220.50  231.53  243.10
D  -   -3.75 -10.09 -18.18 -26.78
Tax base shift
1901 1902 1903 1904 1905
R 1000 TR  1,000.00  1,025.00  1,035.25  1,045.60  1,056.06
C 1000 TC  1,000.00  1,050.00  1,102.50  1,130.06  1,158.31
E 100 GE  100.00  103.13  106.89  108.78  110.72
H 100 GH  100.00  103.13  106.89  108.78  110.72
dR 2.5% 1.0% 1.0% 1.0%
dC 5.0% 5.0% 2.5% 2.5%
dE 3.1% 3.6% 1.8% 1.8%
dH 3.1% 3.6% 1.8% 1.8%
tR 15.0% 15.0% 15.0% 10.0% 10.0% 10.0%
tC 5.0% 5.0% 5.0% 10.0% 10.0% 10.0%
1901 1902 1903 1904 1905
0.14 T  200.00  206.25  213.78  217.57  221.44
0.06 G  200.00  206.25  213.78  217.57  221.44
D  -    -    -    -    -  


We could change these scenarios quite a bit by, for example, introducing a growth-stimulating component to the tax reform. We could also assume that we implement structural spending reforms that stop spending from growing altogether, and perhaps even decline. 

In addition to getting the sequencing right, this simple example illustrates why it is important to have a long-term outlook on major reforms to state government finances. The effects of what our legislature does in the next two years will be felt for decades to come. Essentially, we only get one chance to fix our state's economy, so we better make damn sure (pardon my Swedish) that we get it right from day one.

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