Tuesday, February 2, 2010

Beyond Measures 66 & 67: What Do We Do Now?


When the legislature convenes this week in emergency session, lawmakers are expected to address many of the taxing and spending issues raised during the campaign over Measures 66 & 67. Gov. Ted Kulongoski, for example, announced that if they don't do something about the kicker this session, he will order them back to Salem until they do. Lane Shetterly and Tony VanVliet, former Republican state representatives, in an editorial entitled “Where Oregon must go from here” argue that their main order of business ought to be fixing our “volatile revenue system that condemns us to repeat our long history of boom-and-bust budget cycles, spending on services in good times and making deep cuts when the economy turns sour.” The last Republican elected to state-wide office, former labor commissioner Jack Roberts writes that “the kind of fundamental tax and spending reform that the state badly needs” includes revising the kicker, addressing corporate and capital gains taxes, and removing the working poor from the tax rolls. Similarly, Chuck Shekatoff of the left-leaning Oregon Center for Public Policy Research offers a similar list: fixing the kicker, corporate-tax reform, and expanding “the Earned Income Tax Credit to help working families with children make ends meet.” Chuck’s rhetoric may be inflammatory and his facts slippery, but his policy agenda is eminently mainstream.

My point here is that a lot of people agree about what needs to be done, the real question is how? The surprising answer is that there is a fairly simple, cheap solution. By simple, I mean one that does not require extensive legislative or institutional change. By cheap I mean one that won’t cost Oregonians a lot of new money.

The first step is to take the sales tax off the table. There is just no point in talking about consumption taxes at this time. Not only are they a political non-starter, they are also probably a bad idea. My research shows that replacing the income tax with comprehensive goods and services tax like Australia’s or a value-added tax like Ontario’s (since we would be starting new, there is not much sense in talking about an old-fashioned retail sales tax like California’s or Washington’s), which was also as progressive as our existing income tax, would be equally volatile and probably nowhere near efficient enough to compensate us for the half-billion in additional personal income taxes we would have to send to Washington DC (state income tax payments can be deducted from income for federal tax purposes, but not sales taxes). The unavoidable fact is that, if one taxes flows (income or consumption) rather than stocks (wealth), revenue volatility is directly proportional to progressivity.

A revenue structure that depended 50/50 on taxing consumption and income (assuming marginal rates of about 5 percent on both), would be only slightly less efficient than a pure consumption tax and would generate a small portfolio effect – that is, it would reduce revenue volatility by about the same amount Measure 66 will increase it). I seriously doubt that this would represent sufficient advantage to justify sending roughly $250 million more a year to the IRS.

[See Thompson, Fred and Gates, Bruce, Betting on the Future with a Cloudy Crystal Ball: Revenue Forecasting, Financial Theory, and Budgets - An Expanded Treatment. Public Administration Review, Vol. 67, No. 5, pp. 48-66, September/October 2007. Available at SSRN: http://ssrn.com/abstract=1123736]

The second step is to take very seriously the proposal put forward by the Legislature's 2008 Task Force on Comprehensive Revenue Restructuring to achieve “virtual stability” by changing the way we forecast revenue and by amending our one-of-a-kind income tax kicker law. As Shetterly, who chaired the 2008 task force, and VanVliet explain, “[i]n May of every legislative session the state economist predicts how much revenue the state will collect over the coming biennium, and the Legislature pegs the state general fund budget to that number. If revenues come in more than 2 percent above the forecast, all of the excess revenue is ‘kicked’ back to taxpayers…. Predicting biennial state revenue within a 2 percent margin of error is nearly impossible. In fact, [the] task force determined that the actual range of accuracy over the past 20 years of personal income tax revenue forecasts has been more like 6 percent, above and below the forecast.”

Chile, which has the world’s most volatile revenue structure and like Oregon has a self-imposed ordinance requiring the enactment of a balanced budget, has found a way to deal with this conundrum. They have redefined the meaning of balance. Their solution is to balance the budget against a forecast based upon long-term revenue growth. The simple fact of the matter is that it is easier to forecast long-run revenue trends accurately than to forecast revenue growth one or two years into the future. Each year, economists in the Chilean Ministry of Finance calculate a sustainable rate of revenue growth based on the geometric mean of past revenue growth and Chile’s executive and legislative branches use that figure as the basis for expenditure planning (budgeting). If revenues come in above the long-term trend, they are kicked into a sinking fund, which can only be used to make up revenue shortfalls or to pay down the national debt.

In other words, Chile has a kicker that looks very much like ours, but theirs constrains the rate at which spending (including unsustainable tax cuts) can grow during booms and stabilizes spending during busts. It constrains spending during booms because the Chileans use a forecast that is consistent with long-run sustainability; ours isn’t. They can stabilize spending during busts, precisely because they put their excess revenues aside for a rainy day; we don’t. Moreover, because the money is safely locked up in a sinking fund, the government of the day cannot get its hands on it except when revenues fall below the forecast, and then only indirectly.

It would be fairly easy for Oregon to achieve the same kind of virtual stability. The legislature needs merely to amend the revenue forecast so that it grows at a sustainable rate and to stipulate that a rainy-day sinking fund would have first call on kicker funds. We don’t need to repeal the kicker; we just need to change what we do with the money.

This proposal goes farther than revenue task force’s, which also recommended changing where the money went, but only the first 6 percent above the forecast -- “Any excess revenue over the 6 percent cap would kick back to taxpayers just as it does today. And once the rainy-day fund has reached a limit of 10 percent of the general fund budget (which we determined would take about four years on average), kicker checks would once again be sent out just like they are now.” My concern is that 10 percent of the general fund budget is just not enough – it is, for example, less than half of the state’s current cash float.

My proposal also goes farther than the task forces in honoring what Shetterly and VanVliet call “the spirit of the kicker – to limit the Legislature's ability to spend every dollar during good times – while creating a viable fund that could be drawn on to help sustain crucial services during hard times. (This would also make tax increases during future downturns less necessary or likely.)” The task force proposal would allow bigger increases in spending during booms.

One point should be stressed here: the state would need to borrow to make up revenue shortfalls to make my version of “virtual stability” fully sustainable – the nature of sinking funds calls for withdrawals to be made gradually over time. I do not believe that it would be fiscally responsible to return the kicker to taxpayers if the sinking fund amounted to less than 100 percent of the state’s general obligation debt, plus a prudent surplus, perhaps10 percent of the general fund budget. Only when the rainy-day sinking fund is full, would returning the kicker to taxpayers be justified.

[See Dothan, Michael U. and Thompson, Fred, A Better Budget Rule (February 10, 2009). Journal of Policy Analysis and Management, Vol. 28, No. 3, pp. 463-478, Summer 2009. Available at SSRN: http://ssrn.com/abstract=1077555]

Is this legal; is it feasible? To answer these questions one has to think back to 2003 and measure 28.

Remember what the opponents of Measure 28 predicted would happen if it failed: nearly a billion dollars cut from the budget, a 100,000 people dropped from the Oregon Health Plan or more, tens of thousands of seniors and people with disabilities denied assistance; schools shut down all around Oregon, and thousands of dangerous criminals released from prison early, causing dramatic reductions in public safety and exploding crime rates.

Certainly, bad things happened when Measure 28 failed. The legislature cut $110 million from the DHS budget. As a result DHS made the following changes to the Standard Oregon Health Plan (OHP), affecting approximately 89,000 members:
• Added premiums of $6-$20 per month based on income.
• Expanded co-pays for office visits, labs, ED, prescriptions, hospitalization.
• Non-payment of premium resulted in 6 month “lock-out” from OHP.
• Eliminated coverage for dental, vision, outpatient mental health, substance abuse, and durable medical equipment.
• Temporarily (two weeks) eliminated prescription benefits.
Moreover, effective July 2004, OHP halted new enrollments; on August 1 it restored them.

According to DHS research about 45 percent of those affected by these policies dropped out of the program, 26 percent for over 5 months, compared with 13 percent and 3 percent of OHP members whose benefits were unchanged. This implies that 29-41 thousand members dropped out of OHP as a result of Measure 28, 20-24 thousand for 5 months or more.
• Those who lost coverage had higher unmet needs for medical care, urgent care, mental health care and prescription medications than those who remained members of OHP.
• Persons with chronic illness who lost coverage were more likely to report unmet health care needs than those who remained members of OHP.
http://www.omip.state.or.us/OHPPR/OHREC/Docs/Presentations/EARLYCohort03_04_ppt.pdf
http://www.oregon.gov/DHS/healthplan/data_pubs/ohpoverview0706.pdf

The Legislature also cut 10 percent of state school aid, causing 84 of the state's 198 districts to truncate the school year by 3 days or more. Six other districts cut days from the year, but not from the end. But it is also apparently true that In 2003-04, Oregon’s school districts accrued unrestricted general-fund balances of 15 percent of their annual revenues, or $526 million – nearly two times the cut in state aid.

Crime rates also increased. According to Oregon Benchmarks data total crimes were up 2 percent above the trend line in 2003 and 2004 and property crimes were up 4 percent;, although crimes against persons were down nearly one percent and behavioral crimes were unchanged.

These are serious consequences. But they are not the cataclysmic effects threatened by Measure 28’s advocates. Most of the devastating cuts to state programs that were predicted never happened. In the end, three-fourths of the spending cuts threatened did not eventuate.

Why? Because the state borrowed most of the tax shortfall that occurred when Measure 28 failed. The Oregon Constitution requires only that the governor present and the state legislature enact a balanced budget, which is what happened prior to 2003, taking into account the tax increases challenged by Measure 28. Since the legislature had enacted a balanced budget and a shortfall then nevertheless ensued, the state could legally borrow to make up the difference, which is precisely what happened. This kind of borrowing would be equally legal and feasible when Oregon experiences a revenue shortfall under a revised revenue forecasting process.

In at least one way, virtual stability would work better for Oregon than Chile. Funds obtained to meet shortfalls would be borrowed by the state at federally tax-exempt rates; the offsetting assets in the sinking fund would be invested at higher taxable rates.

The third step would be to do something about removing the working poor from the tax rolls. Oregon’s personal income tax is progressive. But Measure 66 gives us an opportunity to make it more so. Consider the following table:




What this table shows is that the average, effective state personal-income-tax rates for the bottom two quintiles of Oregon taxpayers is actually higher than their average effective federal personal-income-tax rates. This is because Oregon taxes the first $6,100 of taxable income for a couple filing jointly ($3,050 for a single filer) at a rate of 5 percent, the next $9,100 ($4,550) at a rate of 7 percent, and incomes over $15,200 and less than $250,000 ($7,600-$125,000) at a rate of 9 percent. When the top rate comes down from 11 percent to 10 percent, why don’t we also take that opportunity to index the top rate and eliminate the first two tax-brackets? We ought to be able to afford it.

The fourth step probably ought to include the creation of a special task force to take a look at local revenues.

Oregon is not a high tax state. It was a high tax state during the 1980s, when its combined state and local own-source revenue burden, measured as a proportion of personal income caused Oregon to rank between 3rd and 11th highest in the US.

But it isn’t a low tax state either, not at least when all forms of government revenue are considered. During the last decade its combined state and local own-source revenue burden ranked between the 20th and 29th highest in the country, on average right in the middle.

http://www.taxfoundation.org/taxdata/show/336.html

Oregon’s fall in the revenue league table is NOT due to the state’s failure to raise taxes in line with other states. During the 1980s Oregon consistently ranked near the top ten in terms of state government tax burdens; it still does (9th in 2008). One thing about volatile tax bases is that they are also income elastic, not merely in the short run (which causes revenue volatility) but also over the long run (trend). This means that the State of Oregon’s revenue tends to grow faster over the long run than in other states even without tax increases.

Oregon’s fall in the combined state and local own-source revenue league table is due entirely to reduced local property tax burdens. If one looks only at state and local “tax revenues,” because of Measure 5 and 47, Oregon now ranks in the bottom 10 (this is the basis for the claim that OR taxes are the 44th highest in the county). But Oregon’s local own-source revenue rank hasn’t dropped nearly as fast as its tax rank because local user charges and miscellaneous revenues have been growing faster here than in any other state since passage of Measure 5. Increases in local user charges and miscellaneous revenues have made up more than half of the local revenue lost as a result of retarded property-tax growth.

http://www.census.gov/govs/www/statetax.html
http://www.taxpolicycenter.org/briefing-book/state-local/revenues/index.cfm

The fifth step has to do with corporate and capital gains taxes. We aren’t ready for a task force to look at this issue, but Chuck Shekatoff proposes a reasonable starting point: “Oregon still needs corporate tax disclosure to figure out how to best reform the corporate tax system.” My own view is that we would be better off with a lower marginal tax rate and different system of apportionment, but we don’t really have the facts to judge. We could use more study, in order to more clearly understand potential outcomes of any proposed policy changes in this area. Meanwhile, we have enough to do dealing with the changes that clearly are needed without more study.

So till then, let’s leave well enough alone, and deal with what we know.

Fred Thompson, Director, Willamette University Center for Governance and Public Policy Research

13 comments:

Kari Chisholm said...

Wow. That's a long, but excellent, post.

Fred, a quick question: Over how long a period does Chile look back on past revenue growth to determine the future revenue growth?

Seems to me that this sort of long-term plan - stash away high revenues and save for low revenue times - comes from ancient wisdom.

Genesis 41, to be exact.

Chuck Sheketoff said...

It is nice to see that Fred no longer thinks Does Oregon Need a Rainy Day Fund? Like a Fish Needs a Bicycle in which he argued no state can save for a rainy day.

I'm not sure what he means by "slippery" but I do know his excerpts of the table produced by ITEP of income tax rates by income groups comes from an OCPP report, A Step Toward Balance which Fred chose not to cite.

OCPP has long advocated a larger rainy day fund. What Fred apparently doesn't know is that the recommendation by the Task Force and Shetterly is referring to the Oregon Rainy Day Fund and they chose 10 percent because that would be in addition to the Education Stability Fund, Oregon's other reserve fund. But Fred is correct that 15 percent is too low, especially with the spending limits they place on that.

I will now read up on Chile, as Fred's prior piece on the need for a stability fund being like a fish needing a bicycle gives me caution about swallowing his material hook, line and sinker.

Chuck Sheketoff said...

And Fred's suggestion "When the top rate comes down from 11 percent to 10 percent, why don’t we also take that opportunity to index the top rate and eliminate the first two tax-brackets?" would not be good policy. First, the top bracket goes down to 9.9 percent, not 10 percent. Second, it would not be targeted, giving even the wealthiest a tax break, too. It is a proposal similar to one pushed by Republicans in the legislature which we compared to an EIC expansion in No Contest. A better option is to increase the EIC.

Fred Thompson said...

Kari, thank you. Based upon my conversations with the guy who designed the system, Mario Marcel Cullell, they use any historic data they can get (which is only back to 1987), including month on month cash flows. see Marcel Cullell, M. (2001) Balance estructural del gobierno central: Metodología y estimaciones para Chile: 1987–2000. Dirección de Presupuestos, Ministerio de Hacienda, Dirección de Prespuestos, Santiago, Chile. http://www.cursoafp.50g.com/documentos/lecturasobligatorias/balanceestructural.BENAVIDES.pdf

Chuck, I apologize for not citing A Step toward Balance. I grabbed the table off Blue Oregon rather than tracing it back to its origins. That was careless of me.

As for Does Oregon Need a Rainy Day Fund? Like a Fish Needs a Bicycle, we never argued that no state can save for a rainy day. Many can. But our argument was not about those states, our argument was about Oregon: that it could not save enough in time to stabilize spending before the next downturn, so we ought to consider supplements. Our point was that if you are already under water, what you really need is a snorkel, not, a bike, although a bicycle is a very good thing.

Chuck, you are right that dropping the bottom two brackets from Oregon's personnel income tax table would reduce every family's state tax liabilities by about the same amount (it would increase high income families' federal tax liabilities more than others, tho). Consequently, the net effect would be to further increase the progressivity of the state's tax system, but not by as much as an increase in the state's EITC. But ask yourself, which of these options would be more likely or sustainable politicly speaking?

Let me stress here that I am a stability freak. There is almost no compelling evidence that increasing per-unit state spending increases performance in any area (e.g., student achievement or public safety), the same is true of the rate of increase in per-unit spending (in fact, the evidence seems to go the other way), but the evidence that unstable spending degrades performance in nearly incontrovertible. The fact of the matter is that i don't know what the mechanisms are that lead to these outcomes, neither does anyone else, but in the meantime their implications are clear.

Fred Thompson said...

Kari, I just read your post on Blue Oregon about the Kicker. Your focus on the workable and the practicable is completely sane. Good luck.

Chuck Sheketoff said...

Fred writes "There is almost no compelling evidence that increasing per-unit state spending increases performance in any area (e.g., student achievement or public safety)." It is hard to prove a negative, but I'd venture to guess that studies have or could show that increased spending on, say, Medicaid to cover more poor adults and children increases performance (e.g. better health outcomes; less cost shifting, lower emergency room use, etc.) and increased spending on outreach for food stamps (now SNAP) increased food stamp use, and that the increased admin costs associated resulted in improved performance (fewer hungry and food insecure). I imagine I could find other examples.

I also am a stability freak, and unlike the Oregon Business Association and other corporate groups, I have an unconditional commitment to improving our reserves to accomplish stability. Those who want to trade or bench the best player on the income tax team, the income tax on capital gains, in the name of stability, are misguided.

I probably need to re-read the full paper, but the abstract to Fred's paper on rainy day funds didn't just address Oregon. It reads in part "It seems, in fact, that any state that really needs a rainy day fund probably cannot afford one and that any state that
can afford a rainy day fund probably does not need one. Analyses that focus on averages or on individual states with stable economies and income inelastic tax
bases conceal this reality. States with very volatile revenue flows should consider counter cyclical borrowing as an alternative to building large cash balances."

Fred Thompson said...

Regarding Measure 66 and capital gains taxes, see http://www.nj.com/business/index.ssf/2010/02/nj_loses_70b_in_wealth_over_fo.html, which claims "More than $70 billion in wealth left New Jersey between 2004 and 2008 as affluent residents moved elsewhere, according to a report released by the Center on Wealth and Philanthropy at Boston College. The exodus of wealth, local experts and economists concluded, was a reaction to a series of changes in the state’s tax structure — including increases in the income ... and “millionaire” taxes." If true, Oregon's rates and its handling of capital gains may prove very costly in the long run. One reason for Oregon's fall in the tax league tables since the passage of Measure 5 is its relative increase in per capita income.

Chuck: Increased participation in a program like OHP increases benefits. That follows from the fact I reported about decreasing participation decreasing benefits. My statement expressly referred to per-unit performance, which would be in this case per participant.

Chuck Sheketoff said...

Fred, I'm glad you wrote "If true" as the study does not support the conclusion of the two orgs that paid for the study.

It’s important to point out that the actual report says nothing about a link between taxes and the migration of wealth from New Jersey. That’s only alluded to in the press release put out by those who paid for the report.

To draw conclusions about tax rates is outrageous, especially given that the study is pretty clear that there are a lot of interlocking factors going on – international migration, changing wealth patterns, etc. To imply - or conclude as the sponsors did - that there’s any sort of direct causal relationship with taxes would be ridiculous – which is probably why the researchers didn’t do it.

Moreover, it’s worth noting that NY, CT and PA all raised their income tax rates in 2004. So it’s a little bizarre for the sponsors to suggest that rich people in the NY-Philly area responded to New Jersey’s tax changes but ignored those in the other states.

See http://www.taxpolicycenter.org/taxfacts/Content/PDF/state_income_rates.pdf

Table 7 of the report shows CPS data on the reasons people left NJ in the 2004-2008 period. The two most common reasons for All Households are “other family reasons” and “new job or job transfer” and after that, housing seems to be a big push.

Among millionaire households, the single biggest reason is “new job or job transfer”—45%.

Note also that the study compares people moving into and out of the state and finds that “The heads of wealthy households entering New Jersey are younger, earn higher incomes, and are more frequently employed.” So it can’t really be about income taxes.

Bottom line, the study does not show what the article suggests it showed. The reporter got spun and apparently you went for the ride. Read the full report before suggesting, as you did in your comment, that it might foretell problems for Oregon.

Fred Thompson said...

On the political success of Chile's stabilization program, see http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2010/01/31/achieving-long-term-fiscal-discipline-a-lesson-from-chile/

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Fred Thompson said...

A colleague just reminded me that the 2001 federal tax reform partly restored the state sales tax exemption. If you itemize your deductions, you can reduce your taxable income for federal taxes by whichever is greater: your state income taxes or your sales taxes paid (but not both!). Since we have no sales tax, I had overlooked that change! Bad on me, thanks for the correction.

This means is that swapping the income tax for a sales tax would be pretty much a wash from the standpoint of federal tax liabilities. My comments about the federal tax consequences of a partial substitution still stand, however.

Patrick Emerson said...

Fred,

It is my understanding that the sales tax exemption is temporary and not a permanent part of the federal tax code. In fact it has to be renewed year to year. And the fact that it is one or the other is good for states like Oregon and Washington, but would make a mixed system less exportable.

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