Learning from the crisis (3): Putting multi-year revenue commitments on hold

On January 1^st, tax cuts with a revenue impact exceeding $100 million, which include the full repeal of the state’s estate tax and a steep increase in the standard deduction, will take effect in Oklahoma.  Do these tax cuts reflect our priorities at a time when budget shortfalls are leading to layoffs of school personnel, cuts in Medicaid benefits, and the closing of treatment facilities for people suffering from mental illness? If Oklahoma legislators, and the voters they represent, were asked to make these choices today, most would likely decide to target scarce resources to limiting the magnitude of cuts. But because of multi-year revenue commitments made by the Legislature several years ago, during very different economic and fiscal circumstances, these tax cuts will take effect automatically next month.

As state leaders grapple with the short-term challenges of bringing the budgets for this year and next into balance, it is not too early to draw lessons from the current state fiscal crisis to design policies that will allow us to respond better the next time the economy falters. This post, the third in a series that will recommend changes to our budget and tax system, looks at options for putting multi-year commitments on hold during downturns. Our first post recommended enhanced and expanded budget forecasting; the second looked at strengthening reserve funds. The final piece will consider tax expenditures. Our proposals are all intended to enhance the Legislature’s ability to manage budget downturns without having to implement deep cuts to vital state services or enact tax increases.

Time-delayed tax cuts and spending obligations enacted several years ago include the following:

• In 2006 the Legislature increased the standard deduction from the state personal income tax over four years. The last and largest of the phased increases takes effect in tax year 2010 and will reduce tax revenue by almost $100 million in FY ’11 and every year after.
• The same 2006 tax cut law also phased in reductions in the top income tax rate. The rate has fallen from 6.75 percent to 5.50 percent. It is scheduled to be reduced to 5.25 percent in the first year in which revenues are forecast to increase by four percent or more, likely in FY ’12. This will reduce revenue by over $100 million per year.
• In 2006, the Legislature also voted to phase out the estate tax. The tax ends for deaths after December 31, 2009. While estate tax returns will still flow in over the next year, the elimination of the tax reduces revenue by close to $30 million starting in FY ’11.
• Also in FY ’06, the Legislature created the Rebuilding Oklahoma Access and Driver Safety (ROADS) program. It was funded by reapportioning a growing amount of tax revenue from the General Revenue Fund to the ROADS fund. This will reduce GRF revenues by an additional $30 million each year from FY ’11 through FY ’13 and in later years.
• In 2007, the Legislature created a permanent funding source for the OHLAP scholarship program, known as Oklahoma’s Promise. Each year the Regents for Higher Education are required to estimate the cost of this program and the Board of Equalization is required to set aside funding before any other state function is funded.  It is likely that by FY ’13 more funding will have to shift from the General Revenue Fund to Oklahoma’s Promise.

Cumulatively, these already-adopted revenue changes are estimated to cost some $300 million by FY ’13. At a time when revenue collections are falling or struggling to rebound to pre-downturn levels, these obligations decided by prior Legislatures will require deeper cuts to core budgets and delay the restoration of programs and services.

There are two approaches that could help avert future occurrences of this situation. The first would be for the Legislature to make all future phased-in tax cuts and earmarked revenue allocations contingent on sufficient revenue growth and a return to pre-downturn budget levels. There are precedents for this kind of approach, including the trigger mechanism in place for the impending cut in the top income tax rate to 5.25 percent. Triggers should become standard practice, and the trigger should be tied not only to year-to-year revenue growth but also to revenues returning to pre-downturn levels. Otherwise, we are likely to see a situation where tax cuts will kick in during the first year of a recovery, when service levels are still far from having been fully restored.

A more comprehensive approach to aligning revenues and spending obligations would be to adopt some form of pay-go provision, as is currently required for federal legislation. Under pay-go, all new tax cuts or spending commitments must be budget neutral, meaning they must be fully paid for with spending cuts or new revenues over a multi-year period, unlike currently, where tax cuts, tax credits, and spending obligations can have significant back-loaded fiscal impacts. Such a requirement would promote fiscal discipline and help minimize the severity of the long-term fiscal gap, where annual revenue growth is inadequate to fund the ongoing cost of services.  Best of all, perhaps, pay-go would mean that the hard choices of aligning revenues and expenditures could not simply be left for the next legislature to deal with.