The Revenue Situation in Oklahoma Gets Real – Again

How good economic intentions led to fiscal hell in Oklahoma

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The state budget situation in Oklahoma continues to deteriorate.  The story of how we got here would probably be considered a work of fiction excepting the fact that it actually happened.  And it is not over.

It would probably be useful to have an encyclopedic recounting of each detail, but this blogger has no time, budget, or staff for such a review.  It seems obvious enough that there are several major factors that combined resulted in the budget crises we now face.

FACTOR I
A reliance on an economic “assessment” which has not proven out in practice while further claiming, incorrectly, that the study predicted revenue growth even though taxes were cut.  The study predicted a manageable reduction in state income combined with economic growth.   The economy would grow, but we we would lower total tax revenues than we would have if taxes had stayed at the same levels.

FACTOR II
The economic assessment did not correctly gauge the impact of the petroleum industry on the state economy.  The assessment also did not consider the impact (or possibility) of new tax cuts/credits for petroleum exploration.
Consider the effect of cutting oil and gas separation taxes which is intended to increase drilling activity, and related  employment, personal income, and business profits combined with cuts in income and corporate taxes and new tax credits (tax credits=refunds) that negate the expected growth in state revenue due to economic growth.

FACTOR III
There was an assumption that the price of oil and gas would either continue to rise or stay near historical highs. This has vexed Oklahoma before.

FACTOR IV
Tax cuts were to system of estimating revenue that has a poor track record.    (That is an understatement.)  The resulting trigger cut taxes in spite of a revenue failure.

FACTOR V a
There was an assumption that cutting taxes in a state the size of Oklahoma could separate us economically from the rest of the country.   There is nothing further in this blog post about this point.  But it seems like the price of oil has a lot more impact on the state GDP than any tax cuts.  Fiscal policy that seems like a good idea with a huge federal budget that is deeply in debt may not work out so well in a state with a balanced budget constitution that is a minor part of the national GDP.

So let’s begin.

Some History

During the Reagan administration, Arthur Laffer, PhD, became nearly a household name.  It was all about supply-side economics and the Laffer curve.   Before the Reagan income tax cuts the top marginal rate was 50%.  It was not uncommon for business persons to park money in “businesses” that would earn no money or even lose some in a given calendar year to keep from paying half the profits in taxes.   There were various names for this practice. One was “tax shelter.”   I visited with a highly successful professional trumpet player who said when he reached the 50% rate he just quit taking gigs for big bucks and just took gigs that seemed like fun.  Or not.    Regardless of whether one is a Reagan fan or not, these sorts of “tax shelters” are not nearly so common now.  The top tax rate was cut and the standard deduction was raised.. This cut taxes for the wealthy but also took millions of people in poverty completely off the income tax rolls.  The economy did grow, but many numbers have been crunched and the effect of the changes in the tax code on economic growth at the time is still in dispute.   This was the basis of supply-side economics (if you are a fan) and trickle-down economics (if you are not.)

Ben Stein, in his famous “bad teacher” appearance in Ferris Bueller’s Day Off, actually lectures about supply-side economics and the Laffer Curve.   According to the principal behind the Laffer  Curve, there would be a diminishing return of tax revenue as tax rates were increased.  One the top of the curve was reached any increases in tax rates would actually result in less tax revenue.   It is important to note that this is accurate.  There is a point at which taxes depress business activity to the point that increases will bring in less revenue.    In the toxic area of the Laffer curve, cuts in taxes will then result in more tax revenue.   This is not disputed.

FIRST ISSUE

It is hard to imagine, however, that anyone in their right mind would believe that an income tax of less than ten percent would be in the toxic area of the Laffer curve.  And it would be reasonable to assume the reverse of the Laffer equation.  As the income tax percentage is reduced, each further reduction would have a diminishing stimulus effect on the economy.   As the tax decreases there is less economic stimulus in the cut.  And with less increase in economic activity there is less likely to be increased tax revenue to offset the cut.  Thus the continued cut in the income taxes accompany greater budget problems.

Thus some true supply-side believers make a false assumption that cuts in taxes always 1. increase growth and 2. always increase the amount of taxes collected.   Remember, the increase in either growth or tax revenue would need to consider inflation and population growth to be truly an increase.  In fact, given current tax rates in Oklahoma cutting taxes means less revenue.   We have seen this. It is just that simple.

Laffer did a well-publicized study that compared the nine states with no income taxes with the nine states with the highest income taxes.   Economists have been highly critical of both the methodology and the conclusions of this study.  Here is one example.  Laffer claims greater population growth for states with no income tax.  However, he did not use the percentage of population growth in his study.  He used raw population numbers.   And he did not allow for other factors.  For instance, Texas and Florida are two large states with no income taxes and the population of the USA has been shifting to the south. Using raw population numbers instead of percentages these two large states seriously skewed the population growth figure comparison.  This is hardly a good basis for government policy decisions.   If you are up for reading some lengthy analysis check here.  There is little reason to believe the eliminating income taxes would automatically create an economic boon.   And, as we have seen, it has not.

There was also a study by Laffer et al that specifically examined the economic benefit of eliminating the state income tax in Oklahoma.   I have a copy  of this study, “Eliminating the State Income Tax in Oklahoma: An Economic Assessment”  on the hard drive of my computer.   You can find a copy here.   If you are a politician involved in the tax cut decision, you should look at the predictions of how cutting the income tax over time and see if they are on the mark.   (They are not.)

It is interesting to note that Laffer et al did NOT predict that tax collections would increase if the income tax was eliminated. You have to read very closely because there is some obfuscating language.   Can you see what they did here?

Additionally, while the individual income tax currently
raises more than one-third of total tax revenues
in Oklahoma, the dynamic revenue benefits created
by the accelerated economic growth recaptures
about one-half of the static revenue losses. Thus,
while appropriated revenue growth would be slower
under the proposed tax reform than it would be under
the baseline scenario, total appropriated revenues for
the state would grow over this time period.
(Eliminating the State Income Tax in Oklahoma:  An Economic Assessment
Oklahoma Council of Public Affairs and Arduin, Laffer, and Moore Econometrics, Page 1, November, 2011) 

Some in the state still claim that tax collections initially increased, but again, Laffer et al did not predict this. Indeed, the increase in tax collections was fueled (sorry) by oil prices. By the time one factors in the increase in population, the (albeit minimal) rate of inflation, and the impact of the price of petroleum industry, it is safe to say that Laffer was at least partially right. We cut taxes and got less money.     I asked an economist friend to look this study over.  He did not take it seriously.   He said, “He cheated on the math.”  I asked what that meant, and he said that Laffer added numbers together that were not the “same thing.” As in adding apples and oranges.   This assessment was soundly debunked by economists in the state.  The proponents of the assessment said the criticism were motivated by fear their budgets would be cut.  But their was no substantial refutation of any criticism of the methodology of the assessment.

Laffer 1
Ibid, also page 1.  Note that our shortfall for this next year is predicted to be twice the amount predicted by this paragraph.  Is it  because of energy?  Some of it is!  But ignoring the impact of oil in Oklahoma is (taking a breath and avoiding sarcastic analogy) a serious error.  And we are suffering from this error.

SECOND ISSUE   

Please note that this “assessment” seems to assume that other tax rates remain the same as the income tax is eliminated.  There are several problems with this.  First, it is a well-known fact that other taxes have indeed been cut since the process of reducing the state income tax was begun.  Oil and gas severance taxes have been cut.   The death tax is gone.  And some of the tax rebates for energy production were passed during the “income tax cut” time.  Wind energy taxes passed during this time are probably going to be repealed.  This is probably a good thing.  Other energy tax credits remain in place.   While following the Laffer prescription with income taxes, we engaged in other tax cuts as well.   This most certainly has aggravated the situation.  Stated plainly, the income tax cuts did not have the predicted increase in economic activity and the additional tax cuts meant even less state revenue for funding even basic services.    Please note:  It is possible to point out specific statistics at specific times that indicate wonderful economic growth in Oklahoma.  But the sorry state of state revenue collections which continually fail to meet predictions puts the lie to all of the wonderful claims about the positive impact of tax cuts and credits on the  Oklahoma economy

Flip this in the other direction:  Assume that the reduction in  severance taxes to as little as 1% for some production actually increased economic activity.  It may have to a degree.  Perhaps it increased exploration and therefore employment.  But since income taxes were also cut, the increased employment does not bring the expected increase in income tax revenue.  The frenzy of tax cuts has merely resulted in continued revenue failure.

THIRD ISSUE
It is never a good governing policy to assume that revenue from natural gas and oil production will be a steady source of income.   We should know this in Oklahoma, but each generation seems to have to learn it all over again.  The price of oil fell off the cliff from December 2014 to January 2015.    And it became obvious that without an oil price of $100/barrel there was no real increase in state tax revenues to be had from cutting income and other taxes.

FOURTH ISSUE

Finally, we need to at least admit that our process for estimating tax revenue in Oklahoma is broken.  The estimates of revenue frequently miss the mark by more than ten percent.    This is doubly important because Oklahoma’s tax cut process used the estimate of revenue to trigger tax cuts rather than the actual revenue.   That is how we cut taxes for this fiscal year even though we are currently in a revenue failure.  The predicted increase triggered the tax cut even though there was actually no increase.

This is not a politically sexy issue, so it appears that little will be done about it.  But it seems like both conservatives and liberals would be interested in knowing how much revenue we could reasonably expect.

The summary of all this?  Active management of the situation is required.  We have already cut spending far more than anyone realistically expected.  It is time to accept the fact that the path we are on leads to a very bad place for the entire state.    And it is time for people who have accepted this fact to step up and be heard. Those who are in OKC trying to fix all this need some cover.

We have based our state government on national political issues rather than on our own unique situation.

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