Tuesday, June 12, 2018

Tax Reform, Revenue and Tax Neutrality

The discussion about tax reform is gaining momentum here in Wyoming. After having failed to push through a straightforward tax increase of close to half-a-billion dollars, the Joint Revenue Committee has shifted footing and is now trying to disguise its tax increase as a "reform" of the tax system in our state. 

From a political, tactical viewpoint this shift is understandable. By talking about revenue neutrality and diversifying the tax base, the Committee can do the rhetorical equivalent of a card trick. While you are trying to keep your eye on the ace of spades, they cleverly mix it in to the deck and draw your attention to the jack of diamonds and queen of clubs instead. 

One example of this trickery is the re-emerging debate about a windmill tax: should windmills be taxed on par with other energy sources? If so, what metric should we use in order to achieve tax neutrality between different energy sources? 

As much as this is an important conversation in itself, it is a sidetrack to the real conversation about our tax system - and its purpose. Before we move ahead, therefore, we need to sort out three concepts in the context of tax reform: revenue neutrality, tax neutrality and tax competition. 

When a tax reform is guided by the pursuit of revenue neutrality, the purpose is to secure the same amount of tax revenue after the reform as government got under the old tax system. For example, if the tax reform lowers the sales tax by $100 it will raise another tax to create a new revenue stream of $100. 

It sounds simple enough to just switch revenue sources like this. For some reason, lawyers of all people are particularly fond of this concept... However, there is a major problem with the pursuit of revenue neutrality that has squandered many a well-intended tax reform throughout the history of big government. This problem has two parts, with the first being centered around the dynamic effects on the economy from different taxes. Put simply: one tax affects economic behavior differently than another. Property taxes do not affect private consumption nearly to the same degree as sales or income taxes do, which means that the dollar-for-dollar trade in revenue may look good in theory but will alter underlying economic behavior differently and thereby ruin the pursuit of revenue neutrality.

The second part of the problem with revenue neutrality is how to define the neutrality itself. What level of revenue are we going to try to maintain? Put more broadly, at what point in the business cycle do we estimate revenue neutrality? At the top of a growth period? At the bottom of a recession? 

A conventional answer from econometricians is "the structural budget balance" or some other term with the same meaning. For those of you who remember, back in the '80s and '90s it was popular to define revenue neutrality with reference to the laughably useless NAIRU concept. 

For those interested in the intricacies of the structural budget balance, I have explained elsewhere that the only route to a useful definition is statistical and dynamic in nature. However, this is not just a theoretical conversation: because of the conversation about tax reform, it has important practical meaning for Wyoming here and now. The fact that you can only define the structural budget balance in dynamic terms means that a tax reform aimed at revenue neutrality cannot be independent of the long-term growth trajectory of the state's economy. 

In other words, any tax reform striving for revenue neutrality will de facto have to build in dynamic, gradually shifting tax mechanisms into the tax system itself. We would have to have a gradual drift in taxation between different taxes, in order to adjust the tax system to the evolving economic structure and long-term growth of the Wyoming economy. 

I have never seen this done anywhere, but it is an intriguing idea worth exploring. If done, however, it should be under the strict condition that should guide any tax reform in Wyoming: spending reform first, then tax reform. The reason, repeated ad nauseam, is that any pursuit of revenue neutrality at a time with hundreds of millions of dollars in budget deficit will raise taxes on the Wyoming economy. Whichever way the Revenue Committee turns, they will be defining revenue neutrality such that new taxes will take more out of the private sector than cuts in old taxes give back. 

The same point applies to the discussion about "tax neutrality". Unlike revenue neutrality, which is about preserving a revenue stream for government, tax neutrality is about equal treatment of comparable economic activities. For example, a tax-neutral policy would put the same per-gallon tax on diesel, gasoline and ethanol as motor fuel, with adjustment for the energy content. 

In our case the discussion has been about windmill taxation and the creation of a severance tax on wind energy. The tax-neutrality argument in favor of a severance tax suggests that government should not pick winners and losers, and that the absence of a wind severance tax de facto picks wind as a winner. This is a valid argument and relevant in the context of a future tax reform. The problem is, as some have pointed out in the debate recently, that there are three paths to energy-tax neutrality: we create a new severance tax, thus raising overall taxation; we lower existing taxes and introduce a new one at somewhat lower rate than in the first case; or we remove existing taxes in order to adjust non-wind energy sources to where wind is today. 

Given the appropriate technical solution with adjustment for energy content, all three alternatives are equally relevant. The choice between them would be guided more by the pursuit of revenue neutrality and other considerations in a broader tax reform (such as economic growth) rather than strict pursuit of neutrality. This does not reduce the importance of the argument for neutrality - it only places it in its proper context. 

Sometimes, tax neutrality and "tax competition" are confused. While the two might look similar, there is an important difference in the purpose behind policies pursuing tax neutrality and tax competition. When a state considers the competitiveness of its tax system, the underlying question is whether or not lower and otherwise less burdensome taxes will attract investments and consumer spending that otherwise would go to other states. For example, will wind energy investments come to Wyoming if we tax the energy source comparably to, or even higher than, other states? 

Since tax competition is about attracting economic activity, not about neutralizing the influence of taxes on business decisions, it is a different guideline for tax reform than tax neutrality. That is not to say the two cannot overlap, but in cases where tax competition guides tax policy, the concern is almost without exception one of attracting economic activity - investments and consumer spending - that otherwise would have gone to other jurisdictions. 

While there can be overlaps between tax neutrality and tax competition, there is no such thing between the design of a competitive tax system and the pursuit of revenue neutrality. It is, simply, very rare to find a situation where a higher-tax jurisdiction attracts more investments and more consumer spending than lower-tax jurisdictions. 

Bluntly: either we secure tax revenue, or we secure economic growth.

To sum up,

1. Revenue neutrality is about preserving tax revenue for government. 
2. Tax neutrality is about minimizing tax distortions on competing private economic activities.
3. Tax competition is about attracting economic activity relative other tax jurisdictions. 
4. If, under a budget deficit, tax reform is not preceded by spending reform, the risk is always that "revenue neutrality" dictates an increase in taxation.
5. A tax reform cannot be guided by both revenue and tax neutrality on the one hand, and tax competition on the other. 

Thanks for a vigorous debate. Hope this helps moving us forward in the right direction.

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