Tax cuts and consequences

Plunging state tax collections are wreaking havoc on the state budget and having increasingly painful effects on public services in Oklahoma. Initial estimates were for tax collections for the current year, FY ‘10, to be more than $600 million below the prior year. Three months into FY ‘10, General Revenue  (GR) collections are already almost $400 million below estimate.  Even assuming the economy begins an immediate recovery, we are forecasting that this year’s GR collections will come in at least $1. 5 billion, or 25 percent, below levels in the year preceding the downturn (FY’08).

This acute drop in revenue collections has set off a debate among politicians, editorial boards, and others about whether tax cuts approved by the Oklahoma Legislature during the economic boom years of the mid-2000s are to blame. During those years, the Legislature voted to cut the top income tax rate from 6.65 percent to 5.25a percent, greatly expand the standard deduction, increase exemptions on retirement income, and phase out the estate tax, among other changes. Many of the tax cuts were backloaded – they were structured so as to phase in over a number of years, so that the full fiscal impact of the cuts would not be felt until at least FY ‘11.

Are the tax cuts responsible for today’s budget woes? The Tulsa World says they are, while The Oklahoman emphatically says they are not. Our own view is that the truth lies somewhere in between. On the one hand, there can be little doubt that Oklahoma would now be experiencing serious fiscal woes regardless of what tax policies had been enacted prior to the downturn. States across the nation are facing staggering budget deficits, including those that cut taxes minimally or not at all when their economies were strong. Yet, we contend that the tax cuts have contributed to the severity of the budget crisis and may make it harder for decimated budgets to recover.

What may be even more harmful is if, once revenues begin to rebound or even before, the calls for further tax cuts are again sounded in Oklahoma. If so, we hope that the role that deferred tax cuts approved during a time of robust economic growth are having in compounding revenue shortfalls and exacerbating budget cuts during a severe economic downturn will at least serve as a cautionary experience for tomorrow’s elected officials.

There are lessons that should be taken regarding the consequences of tax cuts adopted in earlier years. First, as we showed in this brief from 2008, income tax cuts greatly dampened state revenue growth prior to the economic downturn. As a result, state revenues grew by less than 0.5 percent in FY ‘08 (see the chart below) and the Legislature was forced to adopt a flat, stand-still budget in FY ‘09. This meant that before the economic downturn hit Oklahoma, most agencies had already pulled hard on their belts to make up for not being funded to cover rising employee retirement and health care costs, general inflation, or growing caseloads. The premature onset of tough budget times has made it much harder for agencies to absorb 5-7 percent cuts to their initial FY ‘10 appropriations, and monthly 5 percent mid-year cuts, without cutting into the bone of core staffing and public services.

Secondly, time-released tax cuts enacted several years ago are still kicking in during the economic downturn.  A final cut in the top income tax rate – from 5.5 percent to 5.25 percent – remains on the books to take effect as soon as revenues are projected to grow from one year to the next by more than 4 percent. Our projections suggest that this tax cut, with a revenue impact exceeding $100 million, will be triggered in 2011, well before appropriations have returned to pre-downturn levels. Unless the Legislature acts to defer or repeal this provision, this final phase-in of tax cuts enacted in 2006 will hinder our ability to restore budgets to levels at which agencies are able to effectively deliver services.

There will be time for a fair debate about the right levels of taxes and public services, and the best paths to the state’s prosperity. As we engage in this discussion, let’s hope we remember the lessons of our current situation: policy decisions have complex and long-term consequences.