Monday, February 11, 2013

Fred Thompson: Don't Fix What's Not Broken

While away in Brazil, Fred Thompson, helps keep the blog relevant by commenting on local issues. Thanks Fred! 

In a recent editorial entitled “Oregon dawdles while other states take action on taxes,” the editorial board of the Oregonian called for bold tax reform, concluding that we must find a way to balance “the progressivity Oregonians demand with the need for a broad revenue base.” To be honest, my gut instinct is to reject this advice. There is one point that almost all economists who study public finance agree on: other things equal, the most important efficiency attribute a tax system can have is predictability – up to point, whatever is, is right. Don't change things unless the change is clearly for the better.

In this instance, however, I have more to go on than gut instinct. A couple of former students and I did a ranking of state and local tax systems on the bases of fairness, adequacy, and efficiency. We were surprised to find that OR ranked #2 overall out of fifty-one. In other words, our tax system may not be perfect, but it’s not bad. Consequently, to the question, what would the ideal tax system for Oregon look like, I answer: a lot like the one we have now.

Our result was surprising because theory tells us that balanced tax systems have a lot of advantages and Oregon’s tax system is more unbalanced than most. Unbalanced tax systems are supposed to be bad because they increase revenue volatility and because they necessitate high marginal tax rates, which impose substantial deadweight losses on an economy. It turns out, however, that the volatility reducing portfolio effects of relying on multiple tax types are small. Portfolio effects result from the fact that various revenue sources are uncorrelated. But all major tax bases – income, consumption, wealth, real property values – turn out to be highly correlated, >.85. In practice, the tax designs actually found in the US reduce these correlations to between .60 and .70, but at the expense of reduced progressivity – equally progressive tax systems would be equally volatile. Besides, the real fiscal problem is spending volatility, not revenue volatility. As for deadweight losses, tax rates at the state and local level are simply too low to cause big inefficiencies. The implications of these facts are that the costs of balancing Oregon’s tax system would be outweighed by the federal tax penalty involved, not to mention the reduced progressivity and increased administrative costs that sales and transactions taxes impose.

To say our tax system is pretty good doesn’t mean that it is perfect. The main issues that I think need addressing have to do with the property tax, the personal income tax, and upgrading the state’s Department of Revenue.

The property tax is potentially a really good tax; it is also unpopular with voters, especially those who own their homes free and clear and who take the standard deduction on federal income taxes. We can and should make paying property taxes a lot easier and more convenient for those folks. That is something every jurisdiction that relies on the property tax ought to do. I find it astonishing that they fail to do so. Property tax problems specific to Oregon include assessment distortions and multi-jurisdiction compression. Property tax assessments and obligations ought to track market valuations more closely. A reasonable move in that direction would be reassessment at title transfer. Given our land use planning policies, increasing tax rates on land and reducing them on improvements might make a lot of sense. (I think that ALL land ought to be assessed and charged property taxes and discriminatory rates eliminated wherever possible, but this is probably too radical to contemplate.) Compression is a harder nut to crack. (A return to a levy-based as opposed to a rate based property tax system would do the trick, but this is also probably too radical to contemplate).

Oregon should impose a smaller personal income-tax burden on families with low incomes. My preference would be to reduce state personal income-tax rates on the first two brackets to zero. But reducing collections from the poor could be accomplished a lot of different ways, including increasing the state’s EITC. Actually, thousands of low-income individuals fail to file tax returns. In many of those cases more has been withheld from their pay than they owe. Moving to a taxpayer-passive administrative system for personal and corporate income taxes could fix this problem and also increase collections significantly, but that would necessitate a significant upgrade of Oregon’s Department of Revenue.

From a state and local perspective, escaping a jurisdiction’s tax net does not necessarily involve physical movement. It can be accomplished by “a mere stroke of a pen,” or a mouse click. This is especially true of corporations, which are legal fictions or constructs. But it is nearly as true for anyone with enough wealth to make tax arbitrage worthwhile. Relatively high marginal tax rates, which we have, call for more and better tax administration. We have too long ignored that fact in Oregon. As a consequence we allow excessive non-reporting and under-reporting of income and do a half-backed job of collecting taxes owed. This is basically an information management problem and it is a critical one.

The Department of Revenue needs to re-engineer its core administrative processes for all tax types. Modern information technology could reduce both the fixed and variable costs of gathering, entering, storing, organizing and searching data on the tax base, deductions, exemptions, credits and liabilities, and payments, which is fundamentally what the DOR does, but, right now, compared to what is needed or even some other states, let alone what is possible, not very well.


BJCefola said...

Could you elaborate on "spending volatility"? Also I'm surprised you didn't mention a more robust rainy day fund among possible improvements.

Fred Thompson said...

Of course, you are correct. A few years back, the Legislative Task Force on Revenue Restructuring came up with a perfectly reasonable solution to revenue volatility, which relied on changes in the way OR forecasts revenue (longer time horizon) and a beefed up rainy day fund. I supported their conclusions then and I support them now. Cash reserves (rainy-day funds) are needed to smooth spending. But spending (tax cuts and rebates as well as outlays) must be matched to anticipated cash inflows. Further, the more volatile one's revenue/income flow, the more attractive it is to use debt along with savings to smooth spending. This is one of those cases where a couple of differential equations really helps to make sense of reality.