The Oregon Budget Mess - Myths and Reality

In an otherwise very solid piece on the Oregon budget crisis by Harry Esteve in The Oregonian, there are a few high profile misfires.  I am most disappointed in this list which I think is misleading:

Eight reasons Oregon is in deep budget trouble
1. Recession: Unlike past economic troughs, this one was too deep, too vicious to muddle through with nips and tucks.
2. No sales tax: Our heavy dependence on income taxes to pay for schools and state programs leaves us vulnerable when jobs dry up.
3. Failure to apply spending brakes: Lawmakers went on a spree in 2007 that came back to bite them.
4. Dinky savings accounts: The state's first-ever rainy day fund, established in 2007, was all but depleted within two years.
5. Ballot measures approved by voters: Property tax limits, longer prison sentences, kicker rebates and mandatory parks spending leave little wiggle room when income stalls.
6. Public employee benefits: Most state employees get fully paid medical insurance. And the retirement system, despite rollbacks and changes for newer employees, still has old guaranteed returns and present retirement contributions that add up to soaring future costs.
7. Federal stimulus: It saved jobs for two years, but now it's going away and the economy did not recover fast enough to replace it.
8. The kicker: If the economy takes off faster than state officials anticipate, Oregon could be sending money back to individuals and corporations while cutting schools and services.

#1 is clearly correct, this is the worst recession since the great depression, there is no way to escape its downward pull.  But #2 is simply wrong.  As I have illustrated in this blog through a rather extensive bit of research, a sales tax would not solve anything as consumption and income are very highly correlated.  Sales taxes are almost as volatile as income taxes.  It is the shift away from property taxes that contributed most the the current volatility of state revenues - which is alluded to in #5.  [Though Ironically de-coupling property taxes from market values helped a tiny bit as the housing crisis hit] #6 is also misleading.  I don't know of a full accounting for all state employees, but the relatively generous benefits I get as a state employee are more than outweighed by the much lower salary I get relative to my peers.  I accepted a salary that was 25% below a competing offer when I moved back in 2006.  I had a very, very strong preference for living in Oregon, but we are at a competitive disadvantage amongst those without such preferences.

I do agree most strongly with #4 as you all well know.  In fact I think a good rainy-day fund built into the kicker would render the kicker question (#8) moot.   I think this is the #1 priority for the state legislature going into the next session.

Income Tax and the Current Economic Crisis

A while back I engaged in a whole series of blogs that tried to investigate the question: should Oregon have a sales tax? I learned a lot from that exercise. But due the particular quirks of the current economic crisis it just may be that we are very lucky to have what we have.

I have heard it stated, by no less than Oregon's Chief Economist Tom Potiowsky, that currently Oregon's revenues are in good shape relative to other states thanks to our reliance on income taxes. Contrast this with Washington which relies on sales taxes and is resorting to fairly draconian measures to deal with their budget crisis.

The basic theory is this: right now consumers are retrenching and consumption spending has dropped dramatically, aided in part by falling home values. Unemployment is rising, but not by nearly as much as consumption is falling. So, this time at least, we are fortunate to rely on income taxes and not sales taxes.

Is this theory supported by the facts? Perhaps. The BEAs national figures seems to support it - personal income is stagnating but consumption is plunging.

Of course, new data out today show Oregon's unemployment surging to 7.3% so this trend might not last for long. I don't think state personal income figures are out yet, so we'll have to wait and see.

Of course time can change everything as well, as we recover from this recession it may be that consumption spending picks up faster than incomes. But given the nature of the bubble that burst, it is hard to say. Also, if federal stimulus includes lots of job creation, Oregon might again be well positioned.

Food for thought. Comments?

Change Oregon's Tax System? - Guest Blogger

It is my distinct pleasure to welcome a guest blogger to The Oregon Economics Blog. Fred Thompson, Director of the Center for Governance and Public Policy Research and Grace and Elmer Goudy Professor of Public Management and Policy at the Atkinson Graduate School of Management at Willamette University, and a much more knowledgeable person than I about tax systems and Oregon's revenue system, has graciously accepted my invitation to chime in about sales taxes in Oregon. He wanted to wait until the end of my poll (and of course I kept extending it), but finally I closed the poll and here is Fred's Blog entry:

For three-quarters of a century, Oregon tax reformers have been almost monomaniacally obsessed with the chimera of the sales tax. And, while it would be nice if we could reduce state income-tax rates by adopting a well-designed consumption tax, preferably a comprehensive value-added tax with an income-contingent rebate, I don’t believe that this would be a panacea. Its benefits would be fairly small and its costs not insignificant. Moreover, I think the likelihood that we would actually be offered the option of a well-designed consumption tax is practically nil.

So why don’t we try to fix some real problems that have workable, practicable solutions?

One problem is that the existing personal state income tax hits a lot of poor people pretty damn hard. Oregon has a flat tax, which levies the same rate on household incomes above a statutorily determined level that varies with the type and size of the household. I think this is a pretty good tax. It meets the twin tests of adequacy and efficiency pretty well and, because of the design of various exemptions, exclusions and credits, turns out to be remarkably progressive. But its progressivity has been eroded somewhat over time as inflation has whittled away the value of the statutory exemption.

One simple fix would be a one-time boost in the exempt amount, combined with indexing it to inflation. Another simple, worthwhile fix would be to increase the EITC refund.

Of course, there is no such thing as a free lunch, Boosting the statutory exemption 50 percent would reduce state revenues about $400 million per annum and increase revenue volatility (greater progressivity almost inevitably means greater volatility).

Which takes us to our second problem. Oregon already has one of the more volatile revenue structures of any of these United States, which causes all sorts of nastiness as we move through the business cycle. The problem, however, is not revenue volatility per se but the nastiness that results from trying to adjust spending up and down to match current revenue flows. Why not fix the real problem? Doing so would in fact require a couple of fairly modest institutional changes. The first would be to base the state revenue forecast on the state’s long-term, sustainable rate of expenditure growth, given existing tax-structures and demographics, rather than short-term revenue growth. By sustainable, I mean making the forecast subject to the "no-Ponzi" condition, the requirement of intertemporal budget balance. The second would be to give the retirement of general-fund debt first priority for the use of Kicker funds.

To make up for some of the revenue lost in making the personal income tax fairer, we should fix the corporate income tax. Actually, this is something we ought to do anyway.

Right now what we have is the worst of both worlds – the statutory rate is relatively high and the tax is easy to avoid. The first condition gives businesses a motive for avoiding Oregon’s corporate income tax and the second the opportunity to do so. The statutory rate should be lowered and the apportionment system returned to one that weights the location of assets, employees, and sales equally in assessing state income-tax obligations.

These are all things that could be done this legislative session. Why not do them?

The Final Verdict: No Sales Tax in Oregon

Well, the final poll results are in and reflect the general split all along: A small majority prefer not to introduce a sales tax. I suspect that it has mostly to do with concerns of regressivity and the distrust of politicians to do enough to counter it. I concede that it would be a tough political fight, but I am also quite concerned about being such an outlier on income taxes. Still my support for the sales tax waned the more I got into the morass of the data. I would support a tax package that introduced the sales tax and reduced the income tax but also made it progressive. I think, however, the ability to deduct the income tax on federal returns is a pretty big counterargument, so I would not mind a relatively high income tax along with a small sales tax.

But my readers have spoken and I am beholden to them. I have tried my best to educate (while still keeping my job - meaning having to do the tax research in my spare time) and after delivering what I hope is a fair reading of the evidence and arguments, my readers have filed to find convincing the arguments for the tax. Thus I consider the case closed. If readers of The Oregon Economics Blog don't think it is good for Oregon, than it is not.

Thanks to all who participated in the poll.

A Final Treatise on Sales Taxes

In previous posts I have examined a number of aspects of sales taxes and looked for evidence that would shed light on the actual experience of sales taxes and different tax mixes. Unfortunately, the empirical evidence is scant and not terribly informative. This is not too much of a surprise as it is a very challenging research problem, you have to control for all of the things other than taxes that might affect state revenues, investment, employment, etc. and doing so is virtually impossible. It is frustrating, however, but as an economist I have a fall back: economic theory which can give some insight into expected affects of tax structure changes. I am now in a position to summarize what I have learned and what I now think about sales a sales tax for Oregon and why.

Before that, however, I have a few loose ends to fill in. The first is what George Zodrow of Rice University (who very generously sent me a copy of his book, “State Sales and Income Taxes: An Economic Analysis”) calls the "exportability" of a tax system: how well a state can export its revenue burden to residents of other states. Income taxes, as I said before have the nice feature of being deductible on federal tax returns (sales taxes have been added too in the past as a temporary measure, but you have to choose one or the other, so if we are talking about adding a sales tax along with income taxes, we loose a bit of the exportability). Deducting income taxes on federal returns shifts the burden a bit to residents of other states. But a lingering question is whether sales taxes can be good in the exportability criterion from the fact that non-residents spend money in Oregon.

I think Zodrow says it best:

The sales tax on consumer goods can be exported to the extent that such goods are purchased by out-of-state residents – primarily tourists and business visitors. This is not likely to be an important source of revenue for most states. In any case, if opportunities for tax exporting in this area are deemed to be significant, they can be exploited through the use of special taxes on hotel/motel occupancy, car rentals, and, to a much lesser extent on entertainment and admission to amusements.

To this I would add that a gas tax is also a big area in which we exploit these opportunities to export our taxes. Dean Runyan Associates does the Oregon State Travel Impacts studies for the state and I looked at their estimates. First, they report that many locales charge an occupancy tax for hotel/motel rooms – though these are local taxes, not state. They also report that food and retail spending together make up less than 40% of visitor spending. But in 2006 they estimate a total in excess of $7 billion spent in Oregon by out of state visitors – so perhaps there is room for some more specific taxes if not a sales tax in general, though we must be mindful that we are very dependant on tourism in this state and we would not want to impact it too much.

This brings me to another point, if sales taxes are enacted; will it hurt the tourism and retail sectors hard? I feel pretty strongly that they would not. I think the price elasticities would be low due to the fact that we would probably have a sales tax on the low end in the national spectrum, so we would not be abnormally expensive.

On the other hand, abnormally high tax incidences do worry me for the very same reason. So Oregon’s income tax rate, essentially the highest in the nation, worries me a lot. I have tried to
find evidence of the impacts and I have seen estimates of lower investment, job losses and increased expense for employers who have to compensate for the tax difference but overall impact on the economy is, in my mind, difficult to assess and I remain unconvinced by the evidence. But I am pretty strongly influenced by economic theory, however, which suggests that this should matter in investment and employment decisions.

Volatility is, as I said at length before, not reason enough to support a sales tax, as not much is necessarily gained by such a tax. The only real answer to volatility is either a rainy day fund, or (as was pointed out to me by Fred Thompson) allowing the government to engage in deficit spending during bad periods. The latter strategy has the appeal of not over saving which is inefficient. Equity is a concern, but income taxes have been shown to be a poor way to achieve redistributive goals (and may in fact be impossible because labor markets adjust). It is through ex-post transfers that equity gains are made in general, but we would have to be ready to devote a good portion of any sales tax to such an end if we are to avoid making our tax system more regressive.

So in the end, where do I stand? Well I would like to see a sales tax to lower the income tax incidence in Oregon. I would support it only if there were adequate exemptions and transfers that could assure we do not add regressively into the tax system. I would also like to see some type of permanent rainy day fund or the allowing of deficit spending. I think we could stand to gain much as a state in terms of investment and job creation from the lowering of the income tax and that boom and bust cycles in state spending are very inefficient. Any exportability we get from a sales tax will be countered by the loss in exportability from the lower income tax, and I don’t expect much in terms of volatility reduction except perhaps in extended downturns. I do think that, all else equal, diversification of revenue streams is a decent goal, but, more importantly, I think we should avoid being an outlier in any one tax dimension in the US.

Note on Tax Poll

Yes, I have done it again - extended the voting. But I am keeping track of the final intial vote: 45 for / 56 against the sales tax. I will post more next week about it and perhaps this ratio will change.

Evidence on Sales and Income Taxes on State Economic Growth

A while back I clipped this quote from a survey of academic papers on state taxes:

“The Effect of Personal Income Tax Rates on Individual and Business Decisions - A Review of the Evidence”
By Mark Rider

Andrew Young School of Policy Studies
International Studies Program Working Paper 6-15

“…there is a large body of evidence that high state [personal income tax] rates have a negative effect on business and individual decisions and thus slow the growth of state employment and personal income. Consequently, states must use care in setting state [personal income tax] rates to make sure they are not out of line with those of their neighbors and other competitor states.” (page iv)

This was quite intriguing and so I started a process of tracking down that papers cited to support that claim. I was left a bit disappointed in the results. This argument seems to be based on an assumed causal link that is speculative: high personal income taxes cause higher wages to compensate, higher wages deter new investment and dissuade businesses to locate there, and finally this causes slower growth. Overall, I found the claims in the paper not always accurate or reliable. An example of one dubious claim is this: "Helms (1985) reports evidence that state tax burdens significantly reduce state growth rates." This is not correct. Helms finds this to be true only when states use tax revenues to fund transfer payments, it is not true when states use tax revenues to fund public services.

In general there is a consensus that overall tax burdens matter somewhat to state growth, but the degree to which growth is sensitive to overall tax burden is a matter of some debate, mostly because the problems of really testing this in a meaningful way. Two careful papers, the Helms paper referenced above and a subsequent paper from two U of O economists suggest that when tax revenues are spend on public investment the negative effect of state taxes disappear or even reverses ( Mofidi and Stone, 1990). But what really matters to the discussion about Oregon is the evidence on the composition of state taxes on growth. Here the evidence is scant and scattered. for the purposes of this post I will present a few snippets of what I have found so far from my survey of the literature on state taxes and growth. One paper that is a little old but intriguing tests whether specific taxes (corporate, personal income and sales) has an affect on subsequent employment growth. There are some methodological issues, but the results are provocative:

"JOBS AND TAXES: THE EFFECT OF BUSINESS CLIMATE ON
STATES' EMPLOYMENT GROWTH RATES"

by MICHAEL WASYLENKO AND THERESE McGUIRE

National Tax Journal, Dec85, Vol. 38 Issue 4, pp. 497-511.

"The results here confirm that for the wholesale trade, retail trade and finance industries the size of the personal income tax may have an important indirect effect on employment growth. Moreover, the coefficient on wages is also statistically significant in these three industries. If part of the higher income taxes is borne by firms in the form of higher wages, these personal income tax rates also have a direct effect on employment growth in these three industries." (p. 506)

They also find that corporate and sales taxes have no measurable affect except for sales on employment in wholesale trade.

Three related papers by Carroll, Holtz-Eakin, Rider and Rosen investigate the effect of personal income taxes on entrepreneurship activity in the US, using the 1986 Tax Reform Act as a natural experiment and find that higher personal income taxes suppress investment and employment by entrepreneurial firms. However, this is done in isolation, so again does not specifically address the mix of taxes.

Finally, evidence on out-migration and personal income taxes shows little of what I would consider strong evidence positive correlation, but there does seem to be strong evidence that higher wages compensate for higher tax burdens and there is very good evidence that business location decisions and foreign direct investment decisions are sensitive to local wages.

So what is a lay reader of my blog to conclude? Sadly the received evidence does not say anything too clear about the effect of tax composition. Person income taxes appear to have perhaps a slightly higher correlation with employment growth and lower entrepreneurial activity and less investment from outside the state and country. The extent to which shifting a chunk of that burden to sales taxes would ameliorate the problem is still far from clear. Still, I think there is enough evidence to suggest that we may not be doing ourselves any favors by being an exceptionally high income tax state.

Tax Poll

Just a note: Since I have been lax in posting on taxes, I am extending the poll closing date until the end of the month.

Getting Back to Taxes

Before I get started, apparently Mike Huckabee has a national tax plan that is interesting in that it proposes replacing the national income tax with a national sales tax. Some economists think this is a good idea in theoretical terms. My readers, I think, are already more well-informed about the evidence than is Mr. Landsburg, but he makes an interesting and sometimes very curious argument - one with a lot of holes in my opinion. I am not the only one. This is the same economist who claimed he bawled out a elementary school teacher for suggesting to his child that recycling is a good thing, claiming that he taught his kids not to recycle because he loved trees. His argument was that recycling lowered demand for trees and thus we should expect fewer trees - forgetting perhaps that what most people care about are not commercial tree farms but old-growth and wilderness areas, but I digress. Safe to say that I am not part of the Steven Landsberg fan club - I think he is an extraordinarily lazy thinker.

Now, getting back to my old posts on a state sales tax. I understand that sales taxes may be as volatile in the short-run as income, but income taxes are still more sensitive in the long-run. Does the long-run matter? I argued before that it does, but now I would like to take that a step further and bring in a stylized fact: Oregon is a high unemployment state. Here is a graph from the Oregon Employment Department.



Not only do we see Oregon as a high unemployment state but notice how much worse the downturn of 2001 - 2004 was on Oregon's Unemployment than the national average. So if we are worried about significant and sustained shortfalls in the revenues of the state government - you can see clearly why relying so heavily on an income tax was so costly for the state, and why I am pressing the long-run elasticity as a very significant number.

The related question also becomes: how much does Oregon's high income tax rate contribute to this high unemployment rate? I don't know the answer, but I am sure it is not zero. It may well be not terribly significant, but I am a bit worried about the connection and the data suggest a correlation at least. (Remember to be careful about this kind of evidence though, it could be that high taxes come about as a result of poor economic performance as states struggle to fund essential services) I will leave you all with some interesting maps from the Bureau of Labor Statistics. These are Unemployment rates by state, 2000-2006. Darker shading means a higher unemployment rate. Notice something about Oregon? It had higher unemployment, and took longer to recover than almost every other state. This could be purely coincidental, but it is worth further investigation.

Long-Term Stability of Sales Taxes - An Example

As I have said, the empirical evidence on sales tax volatility has shown sales taxes to be not significantly less volatile than income taxes in the short-run. These estimates come from deviations around a trend. So sales tax revenues seem to stray from their long-run trends about as much as income taxes do. Income taxes have steeper trends though, meaning they tend to rise faster then do sales tax revenues as aggregate incomes increase. The best estimates I have seen are about a 1.8 long-run elasticity for income taxes and a 0.8 elasticity for sales (see this post). Many public economists argue that short-run volatility is what we should be focusing on - how quickly to the revenues crash due to a sudden downturn in the economy - and I agree that this is an essential component. However, I also think the long-run elasticities are very important as well and have said so, but perhaps have been not as clear as I would have liked as to why. The basic point is that since income tax revenues grow faster in the long-run, they will slow down faster as well when income growth slows down.

To make this point more clearly using a real recent episode in Oregon's economic history, I did a quick little back-of-the-envelope calculation based on the actual State of Oregon quarterly personal income figures from the Bureau of Labor Statistics. First off, understand that, in general, aggregate personal incomes increase over time due to inflation, population increases, productivity improvements, etc. So long-run trends in incomes are always positive as are tax receipt growth figures. But in 2001 and 2002 Oregon experienced a very significant slow down of income growth, so I decided to see what receipts of the two types of taxes would look like using those national estimates of elasticities. Based on the average growth rate over the period 1987 to 2007 we could have expected personal income to grow by about 9.2% over that two year span (2001-2002), in reality it grew 3.6%. So from the estimates elasticities we find that based on these expectations v. reality figures, income tax revenue would have fallen about 10% below 'normal', while sales tax revenue would have fallen 4.5% short of 'normal'. This seems quite a significant difference. Of course you can make the opposite argument as well, that once personal incomes started growing at normal rates again the income tax would have more quickly regained the lost revenues than would a sales tax. But, it would have more ground to make up anyway. So though I think the short-run is quite important, I think this long-run differential is important too.

Finally, two comments on the previous post. First, a few people, I think, misunderstand the quote from the Feldstein and Wrobel paper. It does not say anything about whether a progressive tax structure is good or bad - it simply says that the US job market is quite fluid and so employers have to compensate for high taxes. Full stop. So if your aim is to reduce inequality in a state through a highly progressive income tax, it won't work. It has nothing to say on whether inequality reduction is a good goal, or on who should or shouldn't pay tax, or whether the relatively wealthy should pay more, etc. I found this an absolutely fascinating paper - who would have thought that the US job market is that fluid, or that employees respond so strongly to net incomes, not just gross? Wow. But I guess the fact that I find this so fascinating is why I am an economist that does not get invited to many parties...

Second, if you care about poverty and unemployment you should care deeply about economic growth.

Some Snippets of Economic Research on Taxes

Sure to enlighten and enrage, I offer them without comment at this point. Food for thought.

“The Effect of Personal Income Tax Rates on Individual and Business Decisions - A Review of the Evidence”
By Mark Rider
Andrew Young School of Policy Studies
International Studies Program Working Paper 6-15

“…there is a large body of evidence that high state [personal income tax] rates have a negative effect on business and individual decisions and thus slow the growth of state employment and personal income. Consequently, states must use care in setting state [personal income tax] rates to make sure they are not out of line with those of their neighbors and other competitor states.”

Page iv.

“Tax Policy and Entrepreneurial Entry”
By William M. Gentry; R. Glenn Hubbard
The American Economic Review, Vol. 90, No. 2 (May, 2000), pp. 283-287.

“While progressive taxation could in principle encourage entry via insurance for risk-averse entrepreneurs through the tax system or through offering greater incentive to avoid taxes on self-employment income, we find no evidence to support such channels. Our empirical results imply a significant increase in entrepreneurial entry when tax rates are less progressive; whether such encouragement is efficient (that is, stimulating the most talented entrepreneurs) is a topic for future research.”

Page 283


Can state taxes redistribute income?
By Feldstein, Martin & Wrobel, Marian Vaillant
Journal of Public Economics, Vol. 68(3), (June1998), pp. 369-396.

Abstract

“The evidence presented in this paper supports the basic theoretical presumption that state and local governments cannot redistribute income. Since individuals can avoid unfavorable taxes by migrating to jurisdictions that offer more favorable tax conditions, a relatively unfavorable tax will cause gross wages to adjust until the resulting net wage is equal to that available elsewhere. The current empirical findings go beyond confirming this long-run tendency and show that gross wages adjust rapidly to the changing tax environment. Thus, states cannot redistribute income for a period of even a few years. The adjustment of gross wages to tax rates implies that a more progressive tax system raises the cost to firms of hiring more highly skilled employees and reduces the cost of lower skilled labor. A more progressive tax thus induces firms to hire fewer high skilled employees and to hire more low skilled employees. Since state taxes cannot alter net wages, there can be no trade- off at the state level between distribution goals and economic efficiency. Shifts in state tax progressivity, by altering the structure of employment in the state and distorting the mix of labor inputs used by firms in the state, create deadweight efficiency losses without achieving any net redistribution of income.”


“The Effect of State and Local Taxes on Economic Growth: A Time Series--Cross
Section Approach”
By L. Jay Helms
The Review of Economics and Statistics, Vol. 67, No. 4. (Nov., 1985), pp. 574-582.

Abstract

“Results based on pooled time series and cross section data are presented, which indicate that state and local tax increases significantly retard economic growth when the revenue is used to fund transfer payments. However, when the revenue is used instead to finance improved public services(such as education, highways, and public health and safety) the favorable impact on location and production decisions provided by the enhanced services may more than counter balance the disincentive effects of the associated taxes. These findings underscore the importance of considering the incentives provided by a state's expenditures as well as by its taxes.”

Tax Reform in Oregon: A Research Agenda

So far I have discovered that revenue stability may be aided marginally by a sales tax during extended downturns in the economy, but that short-term volatility is generally not much better and may even be worse than income tax revenue. So I am now pretty well convinced that if decreasing volatility it the main motive, sales taxes don't appear to be much of an answer. I do believe they can add, largely through diversification, slightly more stability to the tax structure, but this is not likely to reduce overall volatility significantly. Also, sales taxes are regressive and even with exemptions of things like food and medicine they remain recessive. The only way to preserve a non-regressive tax structure is through the implementation of other methods like tax credits or graduating the income tax. I certainly don't believe, and never have, that a sales tax should replace the income tax. My working hypothesis is that a lower income tax with a sales tax is beneficial to Oregon and I am trying to see how that hypothesis fares.

My goal here is only to explore the economic aspects of tax reform, not political aspects, so I will not digress into questions of political motives, political viability, etc. I wish only to see if economic theory and empirical evidence supports the notion that tax reform could be potentially beneficial to the Oregon economy. Though I started this series of posts with the statement that I thought sales taxes would be a good addition to the tax structure, I have no particular bias, and if, after subsequent research, I find that the supporting case is weak, I am just as happy with that conclusion as any other.

Now that my toe is wet, it seems I have a lot more work to do. Here are a list of pertinent economic questions that seem important to explore, to the extent possible, to help figure out what is best in terms of tax reform (in no particular order):

-How sensitive are personal and business location and investment decisions to high income taxes and high sales taxes?

-How big a portion of sales tax revenue would be generated from tourist dollars as opposed to 'domestic' spending (i.e. is there a free lunch)?

-Is there a relationship between tax progressivity and economic growth?

-Is there relationship between tax systems and overall tax rates and economic growth?

-Is there a dead weight loss associated with the difficulty of consumers and businesses having to deal with transactions with sales taxes?

More questions will arise, but if there are others you can think of in the interim, do chime in. 'Tis the holiday season, but I shall try to start delving into the research soon and shall report on what I find whenever I have something of any importance.

Sales Taxes: Lessons Learned so Far...

I had been avoiding posting about Oregon's revenue system for quite a while now because I have a real job and spending time digging into the evidence on tax systems was not a high priority. However, the opinion piece in the Oregonian by Scott Bruun finally prompted me to make a first foray into the debate and I considered a kind of commitment device to finally get my hands dirty. So I decided to start a discussion and over the next month or so I could start to see what the evidence was. After all I have only three readers and they are all pretty patient. Then comes Jeff, who throws gasoline on my nice slow burning fire, and here I am, spending half the night looking at income/sales tax revenue elasticities! Thank you and curse you Jeff Alworth!

So first lesson: a blog is a public forum and so you had better be prepared to engage the public.

But, now that I have looked at a number of studies and have updated my knowledge from my policy student days (gosh, can it really be 15 years ago already?) I am left with two conclusions about the variability of sales taxes.

Second lesson: sales tax revenue is not significantly less volatile than income taxes in the short run and may, in fact, be more volatile.

In a number of studies, short run volatility is actually greater for sales than income tax revenue. Its volatility can change depending on the exemptions and other specifics of the tax, and for some states it is quite stable while in others it is quite volatile, but overall the evidence is simply not there to support the lower volatility claim. What this means is that is the case of short-run income shocks the state is potentially as bad off or worse off with a sales tax.

There is, however strong and consistent evidence that the long-run income elasticity from sales taxes is lower than income. This is not questioned anywhere in the literature, but the interpretations differ. The evidence cited in a previous post show a a fairly significant difference between long-run elasticities for sales and income taxes. This is argued to be largely reflective of the growth rates of the two taxes as incomes in general grow and does not tell us that much about stability. (Which, by the way, is one reason fiscal conservatives don't like income taxes as they grow too fast in their view) In other words, it is argued that this is mostly an indication of a trend and not about variability around that trend. But I am not entirely convinced: it does inform us about, for example, the effects of an extended recession - suppose a three year span of low state income (sound familiar?) - a sales tax should fall less severely in that case.

Third lesson: a sales tax might mitigate the downturn in government revenue during an extended downturn in the economy.

So what does this tell us? Well, it probably says that volatility itself should not be a determining factor in choosing a sales tax. How likely are short-run fluctuations v. long-run downturns and how much each matter seem to be pertinent questions. Oregon has been severely hurt by extended slowdowns of the economy but has also struggled with more short-term economic variation as well.

Forth lesson: with whatever revenue source you have, excepting somewhat property taxes, there is going to be significant volatility.

Whether income or sales are more or less volatile in the short- and long-runs, the essential fact is that they are both volatile and mechanisms for smoothing, rainy-day funds if you will, are necessary if the government really wants to reduce volatility significantly. Sales taxes will not do it. A rainy day fund requires restraint when revenues are high and a reserve to draw on when times are good.

So finally what I am left with is a belief that diversification of revenue sources may help somewhat but that volatility is simply not a particularly compelling case for sales taxes.

Sales Tax Poll

As I prepare my magnum opus on sales taxes, it is time for another poll. I would like to know if you think Oregon should have one. My opinion is already known, but I would like to know yours - my faithful three readers. Winter quarter is on its way, so I am going to keep the poll open for a few weeks to allow the fresh and unencumbered minds of OSU undergrads to weigh in as well.

Vote over there on the right, and comment here.

The Time for Tax Reform in Oregon is Now

I am going to use the opportunity of an opinion piece by Scott Bruun in today's Oregonian to finally talk about something I have been putting off for too long: the state's tax system. Or more to the point: why does Oregon not have a sales tax? The basics are pretty well known to most people by now: Oregon relies heavily on income taxes to fund its government and income taxes fluctuate widely with economic cycles. This cyclical revenue stream lends itself to inefficiencies, prohibiting many long-term investments, forcing closure of half-done programs and causes uncertainty that leads to underinvestment in general. Oregon does not have a sales tax. Sales taxes are sometimes characterized as regressive, but with exemptions of common necessities like food, clothing and medicine sales taxes can be made neutral or even made progressive with means-tested tax rebates. It is simply not at all hard to make sales taxes progressive. More importantly, the incentives with sales taxes are toward greater savings and investment and lower consumption. This is a good thing for the economy. But the best part is that sales tax revenues are much more stable than income taxes. Certainty in tax revenue leads to better planning, better investments and thus better government for Oregon.

Now, the obvious rejoinder is that a sales tax will hurt Oregon retail businesses. First, I don't think that elasticities will be that high to cause much of a reduction in revenues, but whatever reductions there are could easily be offset by a business credit. However, I don't really think this will matter that much in the end to businesses. Look at all of the states that have sales taxes, some go as high as 9% and over, and I don't see much correlation in the health of the economy, the presence of retail businesses and such with the tax rate. To put it another way, do you think that Oregon would look much different today if there had been a sales tax in place 50 years ago? Perhaps we would have better schools and such, but I doubt the retail climate would be much different. But I will search for evidence of the effect of sales taxes on businesses and report what I find when I do a post just on sales taxes soon.

So why all this talk about investment and efficiency? Well, economists know that uncertainty means risk and risky investments require higher rewards. Thus if you increase the risk and keep the reward the same, investment will suffer. So, suppose you think about funding an early intervention program that takes at risk youth during their high school years and tries to keep them out of trouble by offering counseling, after school activities. This might be a great deal for the state, leading to less burden on the criminal justice system, the state health insurance plan for children and increasing college enrollments. But suppose that after two years the plan runs out of money due to a downturn in state revenues. Two years is not enough to see one cohort through high school and so the program has no measurable effect. Well, if you are thinking of funding this program and know that there is a reasonable probability that the funding will fall through, leading to a waste of the initial investment you may devote the money elsewhere even though, if funded, the state will actually save money in the end. Funding and defunding programs is a waste of money and many good programs would end up saving the state in the long run. This is why I think such instability in the state's revenue stream is such a problem and should be fixed.