Thursday, June 15, 2017

Lessons from the Kansas Tax Cuts

Updated with a more detailed account for state spending.
Since 2011, I have been suggesting that Wyoming is not the low-tax, small government state its unwarranted reputation suggests. Since about that same year, I have been criticizing the Tax Foundation for its clumsy ranking of Wyoming as having the best tax climate in the country. One of my arguments has been to point to our state's poor economic growth record and ask where the benefits are, if it so happened to be that we were indeed a low-tax state.

Truth is, we are not a low-tax state.
The average non-minerals private sector employee - who is also the average employee in the state - is scraping by on $37,000 per year. He, or she, is not helped by the absence of an income tax, when sales, gasoline, property and other taxes decimate their paychecks.

Soon, their employers may have to surrender a Gross Receipts Tax to government, on top of everything else. 

Wyoming is in dire need of tax reform. At its meeting this spring in Saratoga, the Joint Revenue Committee discussed this at length, for which they deserve recognition. They continued the discussion at their meeting this past Monday in Riverton, for which they also deserve recognition. 

What they do not deserve recognition for is the reason why they want to reform the tax system. Their goal is to maximize revenue collection and thereby protect our state's government sector against any more than the lenient reductions in spending it has been forced to execute thus far. 

The real reason why we need a tax reform is, of course, not to increase revenue for government. The real reason is to align government with the ability of the private sector to pay for it. The goal with a Wyoming tax reform must be the exact opposite of what our elected representatives strive for. Where they want increased revenue, a real reform must reduce the tax burden on Wyoming families and businesses. 

The problem is that we cannot execute substantial tax cuts unless we first implement major reductions in spending, and that is an uphill battle for us taxpayers. Legislative resistance to spending cuts is formidable. 

We need spending cuts to lead the way for two reasons: 

  • We already have a projected budget deficit that dips deep into the hundreds of millions of dollars, and since we cannot bond or monetize sustained deficits, we have to strive for balance; and
  • Proponents of tax cuts that are not preceded by spending cuts point to the Laffer curve as the savior of deficit-ridden governments, but in reality the Laffer curve does not work at the state level. 

Assuming that the first point is self explanatory, we move on to the second point. To illustrate what is wrong with the Laffer curve at the state level - as opposed to the national level - let us take a look at the recent, failed attempt at cutting taxes in Kansas. They failed not because they relied on the Laffer curve, but the debate around their tax cuts provides a good context for our discussion.

At the center of the story of the Kansas tax cuts, we find the Tax Foundation, a think tank in Washington, DC the foremost publication of which is an annual report on the ranking of states based on their business tax climate. 

Back in 2012, when Kansas Governor Brownback was in full swing working with the state's legislature on major tax cuts, the Tax Foundation offered its unwavering support:
Good tax reform means broadening the tax base while lowering the rate, as that removes distortions that harm economic growth. It sounds like Brownback’s plan moves in this direction. The difficulty will be in convincing the recipients of those various special deductions to trade losing them for lower rates. On business tax climate, Kansas is currently middle of the pack, so Brownback’s instincts and approach in his proposal are correct.
Here, the Tax Foundation declares what kind of tax reform they would have wanted to see in Kansas: a neutrality-based shift in taxation. More on the exact meaning of this type of reform in a moment; for now, let us note that the neutrality term is very important. A neutrality-based tax reform is to be distinguished from a growth-based tax reform. The difference is illustrated well in the debate over the Kansas tax reform: in 2013 the legislature in Topeka concentrated their reform on growth generation, which took it away from the neutrality-based reform that the Tax Foundation wanted. 

The growth profile was exhibited in a concentration on cutting tax rates; the Tax Foundation, on their end, wanted a broadening of the tax base. The Foundation's executive director, Joe Henchman, and economist Liz Malm argued that the Kansas legislature should stay the course and combine lower tax rates with a broader base. 

In theory, the Tax Foundation had a clear-cut argument. A combination of lower tax rates and neutrality in taxation generates more GDP growth, while a broadening of the tax base - meaning taxes are paid at more points in the economy - preserves tax revenue and, later on, helps collect more revenue. 

That, again, is the theory. In practice, it is difficult to get a reform to work this way at the national level (although President Reagan showed it could work and President Bush Jr. convincingly demonstrated that this theory works) but it is practically impossible to make it happen at the state level.

At the heart of the problem, and rarely discussed, is the concept of neutrality. It has two meanings, the first of which is that government should not tax different economic activities differently. Government should not give tax preference to private consumption over savings; if one is taxed more leniently than the other, people will make their spending and savings decisions based in part on the difference in tax rates. 

Likewise, taxation neutrality requires government to impose the same tax rate on income from investments as on income from work. 

The theory behind this neutrality argument is sound, but its practice in tax reform has consequences that one would hope conservatives would be more concerned about. In order to generate growth, this tax reform must neutralize taxation at lower rates than were in place before the reform. This is not a problem per se, but since practically every tax system in the world has different tax rates in place for different economic activities - and relieves some activities of taxation altogether - the pursuit of neutrality in taxation necessitates an increase in taxation on activities that initially were not taxed. 

It is here that the problems begin for the Tax Foundation and its reform ideas. The second meaning of tax neutrality is, namely, to protect government spending against drastic reductions in revenue. A reform is neutral with regard to government spending if it produces at least as much revenue after the reform than before the reform. This adds a second purpose to the broadening of the tax base that we just discussed: the first purpose is to neutralize taxation of different economic activities; the second is to neutralize tax revenue for government. 

The first neutrality purpose raises taxes on economic activities that were taxed leniently, or not at all, prior to the reform; the second neutrality purpose mandates that those tax increases in combination be substantial enough to protect government revenue and thereby avoid painful spending reductions.

In part, revenue neutrality is achieved through increased economic growth and thereby an expansion of economic activity across the new, broader tax base. The problem is that the pursuit of revenue neutrality actually conflicts with the pursuit of new economic growth. If growth is going to replace any part of existing tax revenue, then by logical necessity the tax reform must initially lead to a drop in revenue. That drop in revenue, in turn, opens up a window for growth that tax reformists such as the Tax Foundation rely on to preserve revenue.

This is what we know as a traditional Laffer curve. 

While there is nothing wrong with the theory behind Laffer's invention, and while it proved successful in helping the Bush Jr. administration drastically reduce the budget deficit, there is one caveat in the curve that is often neglected in tax-reform debates. It takes time, often significant time, before the Laffer effect on tax revenue kicks in. If a government does not reduce its spending while the Laffer curve goes to work, the point where revenue neutrality is achieved will be pushed further into the future. 

However, even if there is a reduction or a freeze in government spending, so as to allow the budget to "wait for" the Laffer effect, there will still be a budget deficit for a period of time. Government must fund this deficit, either through the issuance of bonds on the open market for government debt, or by simply trading IOUs for newly printed money. 

In a words, deficit monetization. 

Theoretically, state governments could do the former, but in practice they are precluded from funding deficits. Like most states, Kansas lawmakers are constitutionally mandated to balance the budget, and the absence of a monetary printing press in Topeka makes it impossible for the state government to fund its deficits other than under totally exceptional circumstances. Kansas cannot run deficits, and therefore the state's lawmakers cannot use the Laffer curve and the Tax Foundation's reform ideas to cut taxes. 

Fortunately, the Kansas legislature did not follow the recommendation from the Tax Foundation. Their focus on reduced tax rates created a reform that was more growth oriented than revenue oriented. Consequently, their reform did not deliver revenue as intended, and the state ended up with a budget deficit. The deficit, in turn, was a function of the delay in growth generated by the lower taxes. 

Critics of the Kansas reform have picked up on the deficit part. With thinly veiled gloat between the lines, in the past week or so media has been broadcasting that Republicans in Kansas have surrendered to the deficit and abandoned the tax cuts they passed five years ago. The Chicago Tribune, for example
Republicans in Kansas broke ranks with the state's conservative governor Wednesday night, voting to raise rates and put an end to a series of tax cuts. The GOP revolt is a defeat for Gov. Sam Brownback, who overhauled the state's tax system beginning in 2012, bringing down rates and causing repeated, severe budgetary shortfalls. Kansas's legislature is overwhelmingly Republican, but moderate GOP lawmakers joined with Democrats, overriding Brownback's veto of a bill they'd already passed once that would raise taxes again by $1.2 billion over two years. Eighteen of the state's 31 GOP senators and 49 of the 85 Republican members of the House voted against the governor.
The Washington Post does not miss a chance to suggest that the Kansas tax cuts was a fiscal assault on the poor:
Brownback argued that cutting taxes for households and businesses would stimulate the state's economy, and because more Kansans would be working and investing, there would be more income for the state to tax. But economic growth in Kansas has lagged behind national rates, and when the promised boom didn't materialize, the state was short on cash. Looking to close some of the gap, Brownback and the state legislature increased the sales tax in 2015, adding to the burden on the poor.
The sales-tax increase was an afterthought, put in place as the deficit, initially expectable from a tax cut, lingered on and made life uncomfortable for Republicans in Topeka. The "burden on the poor" argument is false, but we will have to put that aside for now (it is one of those topics we would want to return to later). In order to understand the lesson from the Kansas tax cuts, we have to turn instead to the spending side of the equation; is it possible that the deficit problems were caused by frivolous spending? Did lawmakers in the Sunflower State ignore their responsibility to minimize the lag in the Laffer effect?

The Tax Foundation suggests that Kansas did not at all have a spending problem after the tax reform. According to According to Henchman and the Scott Drenkard, the Foundation's director of state projects, General Fund spending has been flat in Kansas since the Brownback tax cuts went into effect.

There are just three problems with the Foundation's calculations: 

1. They break down spending per capita, thus implying that spending is not a problem because each Kansan should pay the taxes that fund "his" share of spending. This ignores the egalitarian design of state government taxes and, especially, spending. In plain English: the Kansas budget, just like the Wyoming budget, is not designed to balance on a per-capita basis. (This point has significant implications for neutrality-based tax reforms, implications that the Tax Foundation ignores. For lack of space in this article, we will have to return to them, too, in a later piece.)
2. They take inflation out of the picture. That is good when we try to estimate whether or not an economy is really growing, of if growth is just an inflation bubble, but it is a bad idea when dealing with government finances. Government, like taxpayers, lives in the real world where inflation - like it or not - is as integrated a part of life as time. Thus, deflated government spending figures tell us absolutely nothing about how that spending matches up with tax revenue or the performance of the economy as a whole.
3. Only the General Fund is counted. That, however, is less than 40 percent of total state spending in Kansas, and 56 cents of every dollar that the state pays for with in-state sourced revenue (not counting capital spending). 

Figure 1 gives us a better idea of government spending in Kansas:

Figure 1
Source: National Association of State Budget Officers

Total state government spending in Kansas has essentially tracked that of the nation as a whole. For 2007-2011, in-state sourced spending, which adds together the General and Other Funds, increased by widely varying numbers, reaching 11 percent in 2009. Due to a one-year drastic and anomalous spending cut, the average only reached 4.5 percent, though without that anomalous cut the trend growth was 7.4 percent per year, in current prices.  

After the reform, General and Other Funds spending again exhibited considerable volatility, with a trend growth of 4.7 percent per year when anomalous reductions are removed.

Herein lies a clue to the sustained deficit in the Kansas state budget. While the tax reform was correctly designed in that it emphasized growth generation, its ability to generate growth fell short of the spending increase that the state maintained after the reform. 

On top of that, Kansas experienced a notable, and frankly anomalous, decline in GDP growth. In 2007-11 the state's GDP expanded by 1.7 percent per year, adjusted for inflation; in 2012-16 that number fell to a flat one percent. 

During the same periods of time, the U.S. economy went from 0.4 percent growth to 1.9 percent. For further comparison, consider Illinois, where taxes were raised, not cut: -0.1 percent per year in 2007-11 and 1.1 percent per year in 2012-16. 

Does this suggest that tax cuts do not matter at all? No, it does not. In fact, putting low-tax Texas next to high-tax California dispels that myth:
  1. The California economy contracted by 0.1 percent per year in 2007-11, a period during which the Texas economy expanded by 2.2 percent annually;
  2. In 2012-16, California saw 3.1 percent growth per year while Texas handily outpaced them at four percent:

Figure 2

Source: Bureau of Economic Analysis

In conclusion: tax cuts, badly needed to secure the long-term prosperity of our state, can only be successful if preceded by structural, permanent spending reforms. Since we desperately need a downsizing of government here in Wyoming, we must start working on spending reforms. 

Now, kind of.

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