Fred Thompson: Why Are State Corporate Income Taxes Disappearing?

Fred Thompson checks in with the first of a two-part post.  I'll post the second one next week.

They are.

https://plot.ly/~governing/692.embed

But why? The easiest explanation to discard is that, in a race to the bottom, states have reduced corporate income-tax (SCIT) rates. They haven’t. Marginal SCIT rates have been more or less constant for more than 30 years.

Me? I attribute the decline in SCIT to increased tax avoidance/evasion. Tax avoidance/evasion isn’t a new enterprise, but its direction and focus changed dramatically after 1980 and it has been growing in size and sophistication ever since. The simple fact is that it is ridiculously easy for multi-state businesses to shelter profits from SCITs, reporting them where state corporate income-tax rates are low (in states like Nevada or Washington) and avoiding them in high-tax states (like Pennsylvania or Iowa). These days, this can be done with a couple of mouse clicks (and some accounting and legal legerdemain). Unfortunately, it’s hard to fix tax avoidance/evasion mechanisms or even say which ones matter most at the state level. Multi-state businesses are not required to publicly report the income taxes they pay in each state, just the total.

However, we know the nation’s output-weighted average state corporate tax rate is about 7 percent, while the average state corporate income-tax rate paid by profitable Fortune 500 C-corps is less than half that, which is a lot of avoidance, if not evasion.

Many of our colleagues deny that the massive decline in the weight of state SCIT revenue (which is itself unquestioned) is due to increased tax avoidance/evasion. They note that enactment of the pass-through provision in 1986 and its subsequent expansions have fundamentally transformed the business landscape in America, leading to a decline in C-corporations relative to pass-through businesses.

Under the U.S. tax code the profits (income) of publically held or C-corps are taxed twice, first through corporate income taxes and then again through personal income taxes on dividends and capital gains. Other businesses – individually, family, or employee owned – are all eligible for pass-through status, meaning that their income passes directly to their owners’ personal income tax returns, as are most partnerships (these businesses are not necessarily small; there are nearly 1,000 of them in Oregon with over 100 employees).  As a result, the owners (shareholders) of C corps tend to pay higher tax rates on their businesses’ profits than do the owners of other businesses. That is generally also true at the state level. It is almost certainly the case in Oregon.

Consequently, pass-through businesses now account for more than 50 percent of all business income in the U.S., triple what it was in 1986. In fact, there are only about 3,500 large publicly traded companies in the U.S., down from more than 5,000 in the mid-80s. This goes a long way to explaining the relative decline in the importance of the federal corporate income tax vis á vis personal income tax receipts.

However, if that were the whole story, the decline in the relative importance of state corporate income-tax revenues would have been proportionate to the relative decline in the federal corporate income tax. Instead, it has fallen nearly twice as fast. Or, perhaps, more clearly, since 1990 total federal corporate tax revenues have grown about as fast as C-corp profits; total state corporate tax revenues have grown only half as fast. As a consequence, state corporate income-taxes now account for less than 2 percent of annual state revenues nationwide, down from 2.7 percent in the decade of the 1990s and 3.5 percent in the 1980s. In Oregon, the proportional decline has been less dramatic, from 1.8 percent of total state revenue, to 1.9 percent, and now 1.4 percent, according to Governing Magazine.

The decline in the relative contribution of Oregon’s CIT is proportionally less than in most states, especially places like Connecticut, Louisiana, Michigan or Ohio, where real corporate income revenues actually declined by more than 50 percent after 1990, but it still looks to be significant (although, in reality, probably not, since GM evidently excluded revenue from turnover taxes from its figure – see my next post).

Others of our colleagues are more conspiratorially minded. They tend to hold to an older view of corporate income taxes, which posits that the incidence of the tax is entirely shifted to other, less mobile, factors of production (labor and real property). Consequently, it follows that states should not tax corporate income, that, to avoid adverse effects on investment, output, and employment, it would be better to tax labor/land directly. While this view cannot be entirely ruled out as a theoretical matter, it’s wholly inconsistent with the best empirical evidence. For that reason, most tax economists now reject it.

Nevertheless, it might be noted, that, under this view, state elected officials choose to tax corporate income only because they are forced to by popular sentiment ("I pay taxes, but big companies get away Scot free?"). Bizarrely, some of those who hold this view assume a level of rationality on the part of state tax authorities that beggars all belief: they adopt high statutory tax rates to appease the public, but consciously mitigate their effects through special tax breaks. Hence, one observes persistent high state corporate income tax rates along with diminished collections.

However, as the Governing Magazine. article clearly shows, the scale of SCIT tax breaks is nowhere close to accounting for the relative decline in SCIT revenues. If nothing else, that should put paid to this particular conspiracy theory.

If I am right, tax avoidance/evasion is at the heart of the problem of the mystery of declining SCIT revenue, what can be done about it? I offer one answer in my next post.

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No, I don't know why the blog's background has suddenly turned to light gray and, no, I do not know how to fix it.  Maybe it is a sign that it is time for an overhaul...


Update!  Okay, so now there is the Earth.  Upgrade complete.  Like a whole new site...

The Tricky Problem of Child Labor

On NPR this morning there was a report on an Amnesty International report on the child cobalt miners of DR Congo.  Families can dig their own mines in mineral-rich DRC.  Often, apparently, all or many members of the families take part in this household production, including children.  The report suggests that this is a bad thing, that children should not be involved in mining and should instead be in school.

On the face of it, this all makes sense.  Children are not old enough to make these decisions for themselves and society must protect them.  Mining is a difficult and dirty task, not suitable for small children.  School is where they should be.

But this ignores the fact that most parents in the world want what is best for their children and would prefer that they do not work.  But if it comes to the stark choice of having the child work or not feed the family, families are forced send their children to work.

Ironically, by calling on Apple, Samsung and Sony to ensure no children are used in the mining of the cobalt used in their products might be condemning these families to a worse fate - making these kids worse off not better.

This was the point of a seminal paper by Basu and Van in 1999, only if, by banning child labor does the overall supply of labor decrease so much that adult wages rise enough to compensate, does a ban actually improve the welfare of the children.  And if the local schools are poor - as they often are in rural parts of low-income countries - there maybe little benefit to sending children to them.

Much of my work over the last decade and a half studies the consequences of children working so I am acutely aware of the problem.  Enough to know that calls to ban child labor, though well-meaning, are often misguided.  I prefer focusing on investments in education and social safety nets to create a situation where families have enough consumption to survive and where sending kids to school is a good long-term investment.   Besides, bans are often essentially toothless without  real enforcement, something that low-income countries do not have the resources to do.  Better to focus on the incentives that cause children to work in the first place.

Fred Thompson: Kickers Redux

Fred Thompson once again keeps the blog alive with another insightful piece.

Patrick Emerson and I have written about the Kicker and its folly often here at the Oregon Economics Blog. In what is otherwise an arguably exemplary state and local tax system, Oregon’s kicker is an embarrassment, or, more correctly, the legislature’s unwillingness to deal with it is simply shameful.

As it happens the kicker isn’t entirely unique to Oregon. At least six other states – Colorado, Massachusetts, Missouri, New Hampshire, North Carolina and Oklahoma – have “triggers” that automatically impose tax cuts (i.e., give refunds, credits or a reduction in rates to taxpayers or businesses) whenever cash inflows (real or expected) exceed planned outflows. Moreover, Michigan’s Governor, Rick Snyder, recently signed a bill that will automatically roll back personal income-tax rates whenever state revenue exceeds 1.425 times the rate of inflation, although not until 2023.

All of these measures have a similar justification: the widespread belief that governments are myopically imprudent, that when times are flush they will spend like drunken sailors, thereby creating irresistible pressures to raise taxes when times are tight to maintain otherwise unsustainable current service levels. Moreover, automatic cuts are apparently politically appealing. They promise tax cuts for voters, but grant them only when there is enough cash to pay for the cut.

From this standpoint, Oregon’s kicker could be worse. It goes into effect retrospectively, when actual cash inflows exceed the budget forecast. In Oklahoma, the kicker is prospective, based on the revenue forecast itself. This year Oklahomans, like Oregonians, will get a big refund. Unfortunately, forecasts are not reality. Oklahoma’s actual revenues are insufficient to cover both its budget and the automatic tax cut. Moreover, Oklahoma has a very strict balanced-budget law. It must bring its cash outflows into line with inflows during the current year and it is prohibited from borrowing (even from itself) to do so. In this instance, the automatic trigger caused precisely the problem it was supposed to fix.

Economies are cyclical; revenues are too. That’s not necessarily a bug. The problem is stabilizing spending, but, as the Legislative Task Force on Restructuring Revenue and Governor Ted Kulongoski’s reset team recognized, the solution is straightforward: avoid myopic imprudence, i.e., grow spending at a sustainable rate, using saving and, when necessary, borrowing, to smooth out spending. Were the legislature less pusillanimous, repeal of the kicker law would allow this solution to be put into effect without a foreseeable need for borrowing (actually, given my druthers, I would base the revenue estimate on a sustainable, long-term growth rate, use the kicker – revenues in excess of the estimate – to automatically pay down state debt/build a sinking fund, and rely on borrowing whenever actual revenues dropped below the revenue estimate, but that is a slightly different story).

It might be noted that other states have found the political cojones to repeal automatic triggers. According to Governing Magazine, the trigger trend began in California, but was laid to rest during the Schwarzenegger administration. More recently, thanks to their Governor Brown, California voted Proposition 2 into law. Proposition 2 amends the California Constitution to require that the Governor make mid-term spending and revenue targets part of the state budget process, requires the state to set aside revenues each year – for 15 years – to pay down specified state liabilities, and substantially revises the rules governing the state’s rainy day fund. In other words, California’s legislature did pretty much what Oregon’s has consistently refused to do. They referred a measure aimed at making state and local spending sustainable to the citizenry. On November 4, 2014, 70 percent of the electorate voted in its favor. It is downright shocking when California exhibits greater fiscal responsibility than Oregon.

Fred Thompson: Raising Oregon’s Minimum Wage to $15?

Fred Thompson checks in again with this piece (I should really start calling this the "Fred Thompson Economics Blog). Thanks Fred for keeping this blog alive!

Recently Chuck Sheketoff of the Oregon Center for Public Policy addressed a barrage of questions to the opponents of raising the Oregon minimum wage to $13.50 and, then, $15. Like a good attorney he asked only questions he knew and liked the answers to. Some of the questions he didn’t ask are:

1. Who do minimum wages hurt? Someone pays. Who are the net losers, and by how much?

2. How much do they increase the earnings of lower-wage (<$20 per hour) workers and for how long?

3. Do employers reduce employer benefits or the quality of working conditions when minimums are increased?

4. Do higher minimum wages enhance productivity and, if so, why and how much?

5. Do they attract more qualified/more productive workers into the low-wage labor pool, permitting employers to be more selective and, if so, who gets displaced?

One thing that we know for certain is that the effects of moderate minimum-wage boosts on total low-wage employment, when and where the economy is healthy, are trivially small, maybe non-existent. What happens in the macro-economy, boom or bust, swamps the direct effects of minimum-wage increases. Consequently, Chuck’s claim that “a substantial minimum wage increase can go hand-in-hand with solid economic growth” is undoubtedly true.

Moreover, even the direct employment effects that we have observed from minimum-wage hikes are vanishingly small. Statutory wage minimums work like taxes on low-wage labor, with their proceeds paid directly to low-wage workers and most of their costs shifted forward to consumers in the form of higher prices. This might have two kind of effects on the demand for low-wage labor: an income effect, since consumers wouldn’t be able to afford to buy as many goods and services as before (more or less fully offset in the aggregate by the wage increases), and a substitution effect, as consumers shift away from goods and services whose relative prices have increased as a result.

Consequently, moderate increases in the minimum wage should raises the price of some things, e.g., services produced by the hospitality industry, although, in the case of a 30% increase in the minimum wage, probably by less than 3%, and also perhaps cause folks to substitute away from sit-down restaurants, and toward fast-food restaurants. Nevertheless, so far as the food preparation and service industry is concerned, about 80,000 workers, it would be really surprising if the net, one-time reduction in jobs caused by Oregon’s current minimum wage were 1,000, statewide, This is the case primarily because labor costs represent less than 40% of the total cost of sit-down hospitality services and 25% of take-out food service. Moreover, while Oregon’s minimum wage is 27 percent above the national rate, its median wage for food preparation and service occupations is only 5.5 percent higher ($9.60 compared to $9.10 nationwide in 2014). More broadly, the scale of this effect is undoubtedly far higher for food preparation and service occupations than in most other Oregon industries that hire large numbers of minimum wage workers, e.g., retail, where the low-wage, labor-added component is typically ≥ 10%.

There is one industry, however, where one might see an effect, if one is to be found: child-care. The minimum wage is the median hourly wage in the child-care industry in most states. Moreover, wages and salaries account for more than 60% of the cost of service in this industry. Not surprisingly, Oregon, with one of the nation’s highest minimum wages, also has the highest child-care cost in the nation. Oregon has about 15K child-care workers. If Oregon’s current minimum wage has a discernable effect anywhere, it should have one here.

This also points to another consideration often omitted in these discussions: the effects of an increase in the minimum wage, both for good and for ill, depends less on the existing minimum wage than on median wages in low-wage occupations. Oregon’s minimum wage has raised median-wages in food preparation and service occupations about 6% compared to the rest of the country; in child-care, the effect is more like 25%. This is relevant to the chuck’s claim that Oregon has previously made big jumps in our minimum wage previously (42% in 1989 vs. a 43% proposed increase today) without harming the economy. The last time Oregon did so, its state minimum wage was the same as the national minimum; it is now 27% higher.

From this standpoint, an increase to $13.50, let alone $15, would at this time be entirely unprecedented. We might end up in a very good place, but we have no real basis for drawing such a conclusion.

Moreover, contrary to Chuck’s claim, the fact is that, over the next couple of years following the 1989 minimum wage boost, Oregon unemployment increased substantially (just as it did in the rest of the US). Eventually, the economy picked up, but ever since, Oregon’s unemployment level has exceeded that of the US, despite faster GDP growth overall. Of course, the 1990-92 recession, not the increase in the minimum wage, caused the fall in employment. But there is some evidence of a possible link between Oregon’s 1989 minimum-wage hike and the persistence of higher levels of unemployment after the recession, i.e., evidence that the timing of minimum wage hikes matters, not just their size.

Some might argue, therefore, that, before taking a leap into the dark, it might be better to see how things work out in Seattle, Los Angeles, and Chicago. But such caution mostly applies to giant leaps. A minimum-wage boost to $13.50 is not really a giant leap: we are talking about a >$2 billion shift in a >$150 billion economy (with the net gain to below-median-income households of $200-$600 million).

Of course, from a welfare standpoint, it is too bad that the attention given to boosting minimum wages isn’t focused on policies that are better targeted at low-income families and the working poor: the preservation and expansion of the social safety net, especially foodstamps, aid to needy families, and unemployment benefits. There is clear, unambiguous evidence that these policies materially improve the welfare of low-income households. Moreover, states that pursue these policies have lower rates of infant mortality, less crime, higher earnings, and better education outcomes. There is even some evidence that these policies are associated with greater social mobility, which is evidently not the case for minimum wage policies.

It’s also too bad that those who are primarily concerned with the working poor don’t concentrate on the expansion of Oregon’s earned income-tax credits (EITC) or on increasing participation of Oregonians in the federal EITC. Unlike minimum wages, these programs target their benefits exclusively to the working poor and are implicitly financed by personal income taxes, which are progressive at both the federal and state level, rather than consumption, which is not. Indeed, the net-gain to low-income Oregonians from boosting participation in EITC to 100% (i.e., if all of those eligible to participate did so) might be as much as half the gain to low-income households from the proposed minimum-wage boost.

Because the most important reason for under-participation in the EITC is the failure to file a tax return, which, as a result of withholding, leads to over collections from low-income taxpayers of up to $200 million per year in Oregon and probably a comparable amount in federal income taxes, we could be talking about net gains to low-income households from fixing EITC participation that are actually larger than those of a minimum-wage boost.

The policies are not inherently rivals (indeed, a good case can be made that they are complements). We could do both; but we probably won’t. In this case the not-so-bad looks like the enemy of the pretty-good. I’m not against increasing the minimum wage, but we could do better.

Fred Thompson: The OTIM: New & Improved

Fred Thompson with another dispatch:

I had thought about making this month’s contribution to Oregon Economics on the looming teacher shortage in Oregon or the misunderstandings reflected in the public reaction to the Secretary of State’s audit of the $3 billion that citizens and businesses owe the State, but when I went looking for numbers to back up my analysis on the first topic I found I was too late to say much of anything new. Educators have been predicting a crisis for the past two years and even PBS has covered the topic, although they haven’t taken account of the implications of improving job prospects elsewhere for teacher recruitment and retention. As for responding to the audit’s reception this is probably not the best place for that.

Consequently, I decided to comment on the Legislative Revenue Office’s (LRO) roll out of the updated Oregon Tax Incidence Model (OTIM), which was presented by LRO’s head, Paul Warner, to the House Interim Revenue Committee during legislative days at the end of September. I’ll briefly describe the model and the simulations run by the LRO for the committee, showing how OTIM works. (Disclosure, I am a member the Oregon Tax Incidence Modeling team’s academic advisory board.)

Paul Warner Testifying

The Oregon Tax Incidence Model is dynamic, general-equilibrium, simulation tool based on a dynamic-scoring model developed for the California State Department of Finance, modified by the LRO and academics from Oregon State University and the University of Washington. OTIM sits on an Impact Analysis for Planning (IMPLAN) software platform, using current (2012) state-level data from the Departments of Revenue and Employment. The model estimates the long-term equilibrium effects of tax changes on state income and output in aggregate and by industry, state, local, and federal tax revenue, and tax incidence by income group. The recent update is the first comprehensive overhaul of the OTIM since 2001.

The LRO reported on the simulated effects of three “revenue-neutral” tax changes. The first looked at the effects of adopting a 0.4 percent gross-receipts tax like Ohio’s Commercial Activities Tax, offset by an increase in the personal-income-tax standard deduction to $14 thousand for a single person and $28 thousand for a joint return. The second looked at a 0.5 percent gross-receipts tax offset by a ‘homestead property-tax exemption” of $125 thousand and the third at restoring property tax assessments to Real Market Value (the situation prior to the enactment of Measure 47) offset by a ‘homestead exemption’ of  $200 thousand. All three of these changes would almost certainly tend to make Oregon’s state and local tax system, arguably the most progressive/least regressive in the nation, even more progressive. However, I’ll focus on the first of the simulations because its results are probably more reliable than are the other two and, in any case, more defensible, since they are, in fact, pretty straightforward.

The following Table shows the gross effects (in millions of dollars) of a gross-receipts tax, offset by an increase in the standard deduction.

Note that the main effect is to increase economic activity, although not by a lot. This is primarily a result of a redistribution of income to households with higher propensities to spend and, thereby, somewhat increased aggregate demand. Since the model starts where we are now, i.e., with some economic slack, it predicts that the tax changes will result in increased economic activity rather than higher prices.

The distributional consequences of this change are shown in the following graphics. They reflect the design of Oregon’s existing personal income tax system and the effects of a gross-receipts tax under the proposed changes. They are fairly noteworthy.

What’s a gross-receipts tax? Ohio’s commercial activity tax (CAT) is, for example, a tax imposed on gross receipts from all business activities, including most commercially provided services. The CAT applies to most businesses located within the state and also to out-of-state businesses that have ‘minimum contacts’ with the state, but not to non-profit organizations, governmental entities, public utilities, dealers in intangibles, financial institutions, or insurance companies. While not exactly sales taxes (gross-receipts taxes are levied at each stage in a product or service’s value chain creating effective rates for some goods that are many times higher than others), it is not unreasonable to treat gross-receipt taxes as if they were (as does the OTIM) or to presume that their cost will fall entirely to consumers, more or less proportionally to purchases of goods and services that are subject to the tax. The income-tax consequences of increased standard deductions are estimated directly from household tax records, understanding that most high-income taxpayers will continue to itemize rather than take the standard deduction. Hence, like everyone else, they will pay their share of the gross-receipts tax, but would not benefit from the personal-income-tax break (that is also true of low-income households, since they seldom pay income taxes under the status quo).

This is both useful and reliable information. Perhaps the most important point made by the OTIM is that the benefits produced by this tax change are due entirely to the increase in the standard deduction. It also tells us that paying for such a tax cut by gross-receipts tax would not wipe out its gains altogether. Nevertheless, it’s also clear that the net effect would be fairly small.

Moreover, there are policy relevant tax facts that the OTIM doesn’t address. In this case, no estimate is made for the increased administrative cost associated with collecting a new tax. Chances are that the incremental cost would not exceed increased collections, but that is by no means certain (and, in any case, this increase depends on the persistence of a sluggish economy). Furthermore, the model is silent about the dead-weight efficiency costs (compliance and misallocation of resources) a gross-receipts tax would impose upon the economy. Based on Washington’s dissatisfaction with its gross-receipts tax, it is not unreasonable to assume that these are significant, if not necessarily substantial.

Finally, the OTIM is a computational dynamic model, not a stochastic one. It doesn’t tell us what the effect of tax changes will be with respect to the volatility of the economy (in this case almost certainly trivial) or on the volatility of revenues. One thing we know for certain is that revenue volatility is driven primarily by the progressivity of the tax system. This change would make the tax system more progressive, ergo it should increase revenue volatility. That’s not necessarily a bad thing, of course, but it has implications for expenditure smoothing via saving or borrowing that should be addressed prior to a move in this direction.