Avoid ‘naked tax cuts with none of the pay fors’ (Guest post: Oklahoma Economic Report)

This article originally appeared in State Treasurer Ken Miller’s monthly newsletter, the Oklahoma Economic Report.

At the dawn of a new legislative session, current government expenses once again exceed expected revenues and agencies are lining up with $2 billion in additional requests. Policymakers and the public are questioning whether Oklahoma taxes too little or too much, if the state has the right mix of taxes, and what the state should or should not be incentivizing through tax policy.

For years, the discussion about Oklahoma’s tax structure has focused on eliminating the income tax. Mostly ignored is how to replace the more than one-third of state revenue it generates. Nine states don’t tax personal income. Only one state, Alaska, eliminated the personal income tax, but it did so by depending almost entirely on oil and gas industry taxes. Two no-income tax states – Florida and Washington – have higher tax burdens than some income-tax-assessing states, including Oklahoma, according to the Tax Foundation. Tax burden is defined as the collective weight of all taxes levied on an individual.

Tax structures, the sources of taxation and their relative weight, reflect states’ natural endowments, as well as cultural and political preferences. For example, the Tax Foundation lists Oklahoma’s property tax burden at one-third that of no-income-tax Texas. Oklahoma’s personal income tax rate falls near the middle of those states that collect it. Two categories show Oklahoma as an outlier with the fifth highest sales tax rate in the nation and the second lowest property tax collections per capita.

These rankings suggest there could be room to re-balance Oklahoma’s taxes, perhaps resulting in a structure that is lower, broader and fairer. But recent history shows that comprehensive tax reform is difficult to achieve. A 2001 study conducted for Governor Frank Keating and legislative leaders suggested that to eliminate the personal income tax, the state would have to expand the state sales tax base by taxing services, and/or create new revenue sources, including a state property tax.

[pullquote]Under this no-income-tax race-to-the-bottom scenario, states would continually work to undercut each other’s income tax rates, ultimately leading to no competitive advantage.”[/pullquote] A decade later, another study commissioned by Governor Mary Fallin proposed a 10-year plan to reduce and ultimately end the state’s personal income tax. The task force suggested offsetting the loss of a “substantial source of revenue” by eliminating credits and exemptions or finding new revenue streams – again proposing a sales tax on services or a state property tax.

The panel listed two options for phasing out the income tax without new revenue: identify upfront spending cuts equal to the revenue reduction, or limit appropriations to 90 percent of certified revenues, with five percent dedicated to an income tax reduction fund to allow spending cuts to be phased-in over time. Comprehensive tax reform has proven illusive, while tax cuts without offsets have been embraced. Oklahoma’s income tax rate now sits at 5.25 percent and will drop to five percent next January. A trigger waits in the wings to bring it down another 0.15 percentage point contingent on future revenue growth.

Even with Oklahoma income tax rates coming down, some policymakers and advocates are intent on going much further, believing that states taxing income is unacceptable. Oddly, those ideologically against taxing income at the state level seem to be for it at the federal level. Notably, Art Laffer and Grover Norquist both advocate for a flat federal income tax.

Nonetheless, the no-income-tax argument uses competition among the states for jobs as its main selling point. This argument is akin to states using tax incentives to gain competitive advantage. Today, all states would be better off if they had not veered from free market principles and the game had never begun. But, 50 dominoes have already fallen, leaving states with less revenue and little artificial competitive advantage.

Under this no-income-tax race-to-the-bottom scenario, states would continually work to undercut each other’s income tax rates, ultimately leading to no competitive advantage, no income tax revenue, and a less diversified and balanced revenue structure. Advocates of exempting personal income from taxes can learn from the Kansas experience. In 2012, Kansas cut its top income tax rate from 6.45 percent to 4.9 percent. With the start of 2015, the tax rate fell to 4.6 percent, and will eventually reach 3.9 percent.

In 2013, faced with plunging revenue collections, Kansas reduced a scheduled sales tax rate decrease to help cushion the impact of the income tax cut. Unable or unwilling to offset reduced revenue with additional budget cuts, the state is now implementing less than ideal fiscal practices to keep government operating. Governor Sam Brownback plans to transfer funds dedicated for highways, sweep various other accounts, raise sin taxes and reduce the state’s scheduled payments to the retirement system. Fallout from the Kansas tax cut experiment has also resulted in a downgrade of the state’s credit rating.

Still, some are heralding the Kansas tax cut plan as a success, even as Brownback adjusts his position. He was narrowly re-elected in November with less than 50 percent of the vote after campaigning on his tax cut package, but is now distancing himself from the policy.

Recently, Brownback reaffirmed his commitment to eliminating the state income tax, but conceded the tax cut he signed was not the one he wanted. “I proposed a flat tax with a small budget accelerator. What I got from the Legislature was a naked tax cut with none of the pay-fors.” he said.

Supporters of Kansas’ tax policy contend that the state’s growing economy is proof the tax changes are achieving their intended effect. But even the economies of states with the highest tax burdens grew as the nation recovered from the recession. And Oklahoma’s per capita income growth has surpassed that of every non-income tax state over the five-year period ending 2013, including fellow energy producing states Texas and Wyoming. Clearly, a growing economy is attributable to more than just income tax rates, as evidenced by J.P. Morgan Chase’s December warning that Texas was at risk of slipping into a regional recession due to depressed oil prices.

Tax policy varies in every state, and is more complex than any individual tax. While some philosophically oppose taxing income, the fact is taxes are necessary to provide the services the public demands.

Oklahoma is currently facing a $300 million budget hole, which is likely to deepen. [Editor’s Note: The budget hole is now more than $600 million.] Many have agreed there are structural budget problems with the way the state appropriates its dollars. The silver lining of the current budget situation may be that it finally forces comprehensive tax reform. But if not, perhaps it will at least discourage additional “naked tax cuts with none of the pay fors.”