Monday, June 18, 2018

That Income Tax Again

The battle over a state income tax continues. Reports Better Wyoming:
A leading state lawmaker told the Wyoming Legislature’s Joint Revenue Committee last week that the answer to reforming Wyoming’s tax code is simple: Wyoming should join the vast majority of American states and implement an income tax. “It’s clear as a bell that, if you want to diversify the tax base, we need a state income tax,” Rep. David Miller (R-Riverton) told his colleagues.
To the best of my knowledge, Representative Miller is still opposed to an income tax. However, the very mention of it in the context of tax reform is a reason for us all to be vigilant. There is also the possibility that Mary Throne becomes our next governor, and if that happens, all bets are off when it comes to taxes. 

Better Wyoming appears to agree that Miller is opposed to an income tax:
Miller said he also opposes this commonsense solution. “I, for one, do not advocate a state income tax,” Miller continued. “I enjoy the mineral industry paying all the bills.”
I suspect that the real story here is that Better Wyoming, which is pushing hard for an income tax, are trying to get a free ride on Representative Miller's back. I will leave it to him to duke it out with the liberals; what matters here is that the closer we get to the election in November, the more important the tax policy issue will get. 

As mentioned, there are two reasons to take the threat of an income tax seriously, regardless of what leading legislators have to say about it. First, the discussion in the Revenue Committee about a comprehensive tax reform inevitably opens up for a conversation about an income tax. This happens whether the Committee members like it or not. By talking about a revenue-neutral overhaul of our tax system, they put themselves in the position of having to defend why all other taxes are open for debate but not the income tax. 

It is, of course, good that no Republican seems to want to propose an income tax. Nevertheless, when we approach a tax reform from the angle of revenue neutrality, they condition their discussion by the pursuit of as much revenue as possible. That, in turn, means that if all other alternatives fail to deliver the revenue they want, they will inevitably have to have a conversation about an income tax.  

Proponents of an income tax know this, and will do their best to capitalize on the tax-reform conversation. 

It is a far better approach to tax reform to let it be preceded by spending reductions. That way, by the time the legislature gets to the tax reform issue, they will already have closed the budget deficit. This drastically reduces the need for a strict revenue-neutral tax reform, and thereby removes the threat of an income tax before the conversation about tax reform even starts.

The second reason to take the income-tax issue seriously is the gubernatorial race. As we get into the last leg of the GOP primary, the tax conversation will gain even more momentum. Even more so, in the lead-up to the November election, there will probably be quite a bit of distance on this issue between the Republican candidate and Mary Throne, making it one of the defining distinctions between the two. 

Throne is much more likely than any Republican to sign tax-hiking bills into law. As governor, she will put emphasis on revenue rather than spending reform; until she takes the tax pledge, we must assume that she is willing to sign a tax-reform bill that creates an income tax. Therefore, we cannot ignore the possibility that with her in the governor's mansion, the legislature will be more likely to consider taxes they would not consider with a conservative governor in office.

Fortunately, it is not that difficult to refute income-tax arguments. As for Better Wyoming, it does not help them in their campaign for an income tax that they get practically every fact wrong. In their article about Representative Miller and the Revenue Committee meeting, they get almost every fact wrong: 

1. It does not matter how many times they continue to say that the state budget passed in the 2018 session is the smallest in 15 years - it is simply not true.
2. They also suggest that the Revenue Committee were presented with a report from an economist whose conclusions concur with Better Wyoming's continuous drum beat for higher taxes in general and an income tax in particular. Again, fiction does not become fact just because you say so.
3. And expectably, they bring up that chart from the Economic Analysis Division saying that we only pay for a fraction of the government services we get. Again, a myth does not become truth just because Better Wyoming keeps repeating it.

These are standard arguments that income-tax proponents put forward from time to time. This time around, though, Better Wyoming has added a new argument to its roster. This one is not entirely fictional, just irrelevant:
Creating new jobs that attract people to Wyoming would increase the burden on our schools, roads, and other public services, he said. But there would be no mechanism to collect revenue from these new residents—such as an income tax—so our already distressed public infrastructure would face further strain. This is problematic for Gov. Matt Mead and other top state lawmakers who have made economic diversification a focus.
Contrary to what Better Wyoming is trying to say, we do indeed have taxes that produce revenue in proportion to the state's population. Sales and excise taxes are paid by consumers; when the number of consumers goes up and more people spend money in Wyoming, the state as well as local communities collect more revenue from sales and excise taxes. 

Likewise, when more people move to Wyoming, demand for property goes up. When demand for property goes up, so do property values. Over time, this increases revenue collected from property taxes. An increase in the population also motivates new construction of homes and businesses. When new property is added to a community, the property tax base expands. 

Just to give a couple of examples of how important these taxes are, the Census Bureau reports that in 2015 the state of Wyoming collected $811 million in general sales tax revenue. Other taxes yielded $1.2 billion, and that does not include severance tax revenue administered by the federal government (which in federal statistics is defined as "federal funds" or "federal aid to states").

In other words, we do indeed have revenue sources for government that accommodate to the size of the population. 

It is encouraging to see that Better Wyoming is worried about funding for our infrastructure. Perhaps they would like to join this blog in calling for toll funding of the I 80? That would go far in securing sustainable infrastructure funding for our state.

While we are waiting for our friends on the left to come around, it might be worth looking a little bit more in depth at the income-tax issue. Anyone who claims that our state can solve its budget deficit problem by means of a personal income tax must present his evidence in open court, so they can be properly vetted. This is especially true for those who - like Better Wyoming - appear to believe that higher taxes have no negative effect on the economy.

However, this burden of proof is not limited to left-wing pundits. State legislators who disguise their arguments for an income tax in rhetorical trickery about enjoying how the minerals industry pays the bills, must come clean and tell us whether or not they are willing to reform our state's tax system without any reforms to the spending side of the budget.

If the answer is "yes, we want tax reform without spending reform", then we know we can expect a significant net increase in the burden on Wyoming taxpayers. To get an idea of what this means, let us assume that the target for a reform is to raise revenue by $700 million to $1 billion per year; the current budget deficit is on a trajectory into those numbers, and given the static calculations underpinning the typical tax reform, we have to expect a "revenue neutral" reform to pursue higher tax collections in this bracket.

What kind of income tax would it take to close the budget gap from the revenue side?

The number to use for revenue calculations is the total taxable income in Wyoming as per the definition used by the Internal Revenue Service. This is also the definition that the IRS uses as base for the federal personal income tax. Using this definition, in 2015 Wyoming taxpayers earned a total of $16 billion that was subject to federal personal income taxes. 

Under static assumptions, i.e., disregarding negative multiplier effects, a flat state income tax

-at two percent would have collected $320 million in tax revenue;
-at four percent would have collected $640 million in tax revenue; and
-at six percent would have collected $960 million in tax revenue.

Some states have a multi-bracket, progressive income tax. As an example of what such a tax would look like, a three-bracket version with two percent on incomes up to $50,000, four percent up to $100,000 and six percent there above, would have yielded $828 million in 2015. For simplicity, though, we stick to the flat-rate tax for now.

The problem with these numbers is that they are built on the assumption that economic behavior does not change in response to the tax. Needless to say, we do indeed change our behavior in response to changes in taxation; any tax reform will have dynamic effects on the economy. It does not matter if the architects of the reform claim that it is going to be revenue neutral; to the best of my knowledge, there has never been a tax reform in an industrialized nation that has delivered on revenue-neutrality promises. Therefore, in order to get the full picture of the consequences of an income tax, we need to take into account its negative multiplier effects.

These effects are not just theoretical. An income tax will rob Wyoming families of money that they would otherwise have spent in their local communities. Based on the size of private consumption as share of the Wyoming GDP, we can calculate a consumption multiplier to give us a rough estimate of what those repercussions might look like. In 2015, 

-Wyoming GDP was $39.47 billion;
-Private consumer spending in our state amounted to $23.28 billion.

In other words, consumption absorbed 59 percent of GDP. Using this number, we can calculate a multiplier effect that will unfold as follows.* A flat personal income tax would reduce economic activity in Wyoming:

-by $800 million if the tax rate is two percent;
-by $1.6 billion if the tax rate is four percent; and
-by $2.4 billion if the tax rate is six percent.

The multiplier is linear so long as the tax is flat. This is no longer the case under a multi-bracket income tax, when, for example, a doubled tax rate will more than double the multiplier effect on private spending. 

Given that it takes two years, approximately, for consumption multipliers to work their way through the economy, the implementation of an income tax in 2019 would in theory fully affect our state by 2021. In practice, it could happen faster, but sticking to the two-year period as a default, we would experience a downturn that was about as long as the one we went through in 2014-2016.

To get an idea of what the downturn would do to the Wyoming economy, let us recap what our latest economic plunge meant:

-State GDP fell by $3.6 billion, or 8.7 percent, in current prices;
-The private sector lost 12,900 jobs, or 5.7 percent.

At a four-percent income tax, aimed at collecting $640 million per year, the effect on the Wyoming economy would, in theory, be almost half of what this downturn did to us. In practice, it would be bigger: an income tax is going to hit the state economy harder than a downturn in minerals, simply because it strikes all households and all communities across the state. Job losses are likely to be higher for this very reason.

There is also the outflow of wealthy residents whose mobility is significantly higher than that of middle-class families. This means a stronger negative effect on property values and higher-end consumer spending.

With all this in mind, a rough estimate would suggest that a four-percent flat income tax could cost our state about 8,000 private-sector jobs.

Keeping in mind that the revenue target for this tax is "only" $640 million, we have to add the possibility that a tax reform will try to recover up to $360 million by means of other new or higher taxes. One candidate is a sales tax on services, another an increase in property taxes, a third is the gross receipts tax. If we take these into account and simplify the reform effort into an all-out reliance on the income tax, we end up with the six-percent income tax. 

At this level, the macroeconomic repercussions are likely going to be far bigger than a simple, linear multiplier extrapolation as explained above. We could easily be looking at an economic downturn of the same magnitude as we went through in 2014-2016. If we split the tax increase over several taxes, the effect is more difficult to calculate in detail, but in the aggregate the impact will be approximately the same. All taxes eventually rob the same pockets.

Some proponents of higher taxes use the so-called balanced-budget multiplier to counter analysis such as presented here. Their point is that a tax dollar in to government is not a tax dollar out, but more than that. However, this objection is invalid here, simply because we are not operating with a balanced budget - we are trying to raise taxes to close a budget deficit. Therefore, there is not a single dime's worth of new government spending coming out of these higher taxes. 

All that the tax hikes do is drain the private sector of money that would otherwise be spent in local communities around the state.

The Wyoming economy cannot survive another downturn of the same magnitude as we experienced in the last few years. This is especially true if the downturn is not caused by a one-time decline in production, but a perpetual increase in the tax burden.

Thankfully, the resistance to new and higher taxes is growing among our gubernatorial candidates. They are also starting to have a conversation about spending reform. Is there any chance our legislative leadership might come onboard and join the conversation?

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*) Standard multiplier calculations use disposable income to find the propensity to consume; rather than doing that, we are going to stick to the 59-percent rate. The reason is that we also have to have a savings estimate - not too difficult - but also be able to identify out-of-state spending in Wyoming as well as Wyomingites' spending in other states. Normally, such transactions would fall under foreign trade statistics, but in an economy as integrated as the U.S. economy, with no practical barriers to consumer spending across state lines, there are no formal national-accounts products that equal balance of payments numbers at the national level. Estimates can be made, but the methodology is too complex and time consuming to warrant its application in this article. Therefore, for simplicity the multiplier estimates used here are based on consumption as share of GDP.

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