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Economic Analysis: Nothing Dynamic About the Kansas Experiment So Far

Posted on December 1, 2014 by Martin A. Sullivan

On May 22, 2012, Kansas Gov. Sam Brownback (R) signed into law the largest tax cut in state history, reducing revenue by an estimated 13 percent. "Our new pro-growth tax policy will be like a shot of adrenaline into the heart of the Kansas economy," he said. "It will pave the way to the creation of tens of thousands of new jobs, bring tens of thousands of people to Kansas, and help make our state the best place in America to start and grow a small business."

The new law cut the two top individual rates from 6.45 and 6.25 percent to 4.9 percent. The lowest tax rate (for individuals with taxable income below $15,000 and married couples with less than $30,000 of taxable income) was cut from 3.5 percent to 3 percent. It totally eliminated income tax on income of passthrough businesses and self-employed individuals.

Originally, Brownback did not want such a large tax cut. His initial plan called for rate reductions that were paid for by eliminating almost every itemized deduction and tax credit in the Kansas tax code and by making permanent a previously enacted temporary sales tax increase. But the Kansas House left out most of Brownback's revenue increases. The Senate was just about to kill the bill when Brownback pleaded with the upper body to pass something so that a deal could be hammered out in conference.

At the governor's behest, senators passed a placeholder bill that turned out to be even more generous than the House version. Then in a double cross to senators who expected to get another bite at the apple, the House passed the Senate bill and Brownback signed it. So instead of a Reagan-style 1986 tax reform, Brownback got a Reagan-style 1981 mega-tax-cut. (Prior coverage: State Tax Notes, June 4, 2012, p. 680 2012 STT 107-1: News Stories.)

The tax plan took effect in January 2013. So far there is no indication in either the tax receipts data or economic data that there have been any positive effects on the Kansas economy.

 

Figure 1.A

 

Estimates of Total General Fund Revenue for Fiscal 2014

 

(in billions)

 

 

 

 

Source: Kansas Legislative Research Department and Kansas Division of the Budget, consensus revenue estimates, available athttp://budget.ks.gov/cre.htm.

 

Figure 1.B

 

Changes in Estimated Fiscal 2014 General Fund Revenue

 

(in millions)

 

 

 

 

Source: Figure 1.A and descriptions of legislation by the Kansas Legislative Research Department.

 

Figure 2.

 

Difference of Actual From Final Estimate of

 

Total Revenue Since 1995

 

 

 

 

Source: Kansas Legislative Research Department, "SGF Receipts Estimates for FY 2015, FY 2016, and FY 2017," Nov. 17, 2014.

 

Figure 3.

 

Employment Growth in Kansas and Neighboring States

 

 

 

 

Source: Bureau of Labor Statistics, "Regional and State Release Tables, Table 5." Employees on non-farm payrolls by state and selected industry sector, seasonally adjusted, available athttp://www.bls.gov/sae/#tables.

The First Year

 

 

To assess the impact of the 2012 legislation on Kansas revenues, this article focuses on revenues for fiscal 2014. It is the first fiscal year in which the tax cuts were in effect the entire time. Because that fiscal year ended on June 30, we have actual totals with which we can assess the accuracy of the estimates.

Figures 1.A and 1.B track the history of official estimates of general fund receipts for fiscal 2014. Figure 1.A shows that before passage of the 2012 tax legislation, estimated total receipts for fiscal 2014 were $6.23 billion. The tax cut reduced estimated receipts by approximately $800 million, to $5.43 billion. The last data point in Figure 1.A shows actual receipts for fiscal 2014, which ended on June 30 of this year. Figure 1.B shows the changes in the estimates in Figure 1.A. Over the period from passage of the bill to the close of fiscal 2014, there have been several noteworthy changes in the estimate.

First, in 2013 Kansas enacted two laws that increased estimated revenue in fiscal 2014 by $431 million. The larger of these two bills made small cuts in tax rates, but these cuts were more than offset by some reduction in the value of itemized deductions and a permanent increase in the sales tax rate.

Second, because the revenues for the first nine months of the fiscal year accumulated at a far faster rate than expected, estimators increased their estimate by $103 million in April 2014. At this point there was some reason to hope that the Sunflower State's financial situation might be headed in the right direction.

But then suddenly it soured. April receipts were $90 million below the revised forecast. Then May receipts were $185 million below forecast. And for the final month of the fiscal year, receipts were $59 million below forecast, bringing the total shortfall for the fourth quarter to $333 million. Of this amount, $307 million was because of unexpected declines in individual income tax receipts.

The size of this estimating error is highly unusual, especially in a non-recession year. Figure 2 shows for the last two decades the difference between actual total receipts and the final estimate of total receipts as a percentage of total annual receipts. The error of 5.6 percent is the largest in 20 years. The error for individual income tax receipts as a percentage of the total year's individual receipts is 12.2 percent (not shown in the figures). The fourth-quarter error for individual income tax receipts as a percentage of estimated fourth-quarter receipts is 38.2 percent.

The $578 million difference between the $6.23 billion of revenue estimated before the tax cut and the actual revenues of $5.65 billion can be divided into two parts: the net cumulative estimated changes in revenue of $355 million due to tax law changes and the remaining cumulative $223 million shortfall not attributable to legislation and not anticipated in April 2012.

If by some miracle all the revenue estimates were correct, this second component would be zero. There are many possible reasons for the forecasting errors, but three are most important for assessing Brownback's tax policy.

 

Figure 4.

 

Personal Income Growth in Kansas and Neighboring States

 

From 2012:Q4 to 2014:Q2

 

 

 

 

Source: Bureau of Economic Analysis, "Personal Income by State and Region," available athttp://www.bea.gov/newsreleases/regional/spi/sqpi_newsrelease.htm.

 

Figure 5.

 

Real GDP Growth in Kansas and Neighboring States in 2013

 

 

 

 

Source: Bureau of Economic Analysis, Table 1. "Real GDP by State, 2010-2013," available athttp://www.bea.gov/newsreleases/regional/gdp_state/gsp_newsrelease.htm.

 

Figure 6.

 

U.S. Total and Kansas Capital Gain Realizations

 

(in billions)

 

 

 

 

Source: Congressional Budget Office, available athttp://www.cbo.gov/publication/45010; IRS Statistics of Income division, available athttp://www.irs.gov/uac/SOI-Tax-Stats-Historic-Table-2; and author's estimate.

Economic Growth?

 

 

First, the shortfall may be caused by an economy performing worse than expected. This would be an especially damaging assessment of Brownback's policies because the tax cuts were supposed to do the opposite.

Figure 3 shows employment growth in Kansas over various periods since passage of the Brownback tax cuts. Regardless of which time period is used, the data all tell the same story. Kansas's employment growth has been significantly less than that of three of its four neighboring states and significantly below that of the entire United States.

Figure 4 shows growth in personal income from the fourth quarter of 2012 to the second quarter of 2014 for Kansas, its four neighboring states, and the United States as a whole. The rate of personal income growth has been lower in Kansas than for all of its neighboring states and for the United States as a whole.

Figure 5 shows inflation-adjusted GDP growth for a single year -- from 2012 to 2013 (the latest data available). By this measure Kansas performs slightly better than the national average but significantly worse than three of its four neighboring states.

Overall, the available data indicate that since Brownback's tax legislation took effect in 2013, the Kansas economy can be considered to have underperformed relative to the U.S. economy as a whole and to most of its neighboring states. There is certainly no indication yet of a positive supply-side effect.

In response to reports of tepid growth of the Kansas economy, Brownback and his supporters argue that positive supply-side effects do not occur immediately. Conceptually, this view makes sense. If businesses are going to migrate into the state and individuals are going to rejoin the workforce as a result of the rate cuts, this will all take time. And we certainly should expect effects in the long run to be larger than those in the short run.

But some supporters of Brownback's tax cuts argued that the effects would occur quickly. For example, in 2012 the Kansas Policy Institute used two different models and predicted that the tax cuts would have offsetting revenue increases from economic growth in fiscal 2014. Using one model, it was $87 million, and using the other model, it was $108 million. Also in 2012, conservative economists Arthur Laffer and Stephen Moore wrote:

 

The quality of schools also matters as does the state's highway system, but it takes years for those policies to pay dividends, while cutting taxes can have a near immediate and permanent impact, which is why we have advised Oklahoma, Kansas, and other states to cut their income tax rates if they want the most effective immediate and lasting boost to their states' economies. ("Taxes Really Do Matter: Look at the States," the Laffer Center, Sept. 2012, p. 17.)

 

New Loophole?

 

 

A second possible cause of estimating errors is that the complete exemption of passthrough income -- which includes Schedule C income of self-employed individuals -- has unleashed a larger than expected shift in the status of workers from employee to independent contractor. Kansas does not publish detailed return data that would enable us to see if any significant shifts from wage to Schedule C income occurred in 2013. State-level data from the IRS Statistics of Income division for 2013 will not be available until the autumn of 2015.

Weak Capital Gains?

 

 

A third explanation of the forecasting errors is that the widely anticipated increase in federal capital gains rates in 2013 (from 15 percent in 2012 to 23.8 percent for higher-income taxpayers) caused many individual taxpayers to shift sales of assets from 2013 to 2012. This could have resulted in an unexpected decline in Kansas capital gains realization in 2013. Nick Jordan, Kansas's secretary of revenue, offered this explanation to the public in a May 30 press release 2014 STT 85-25: State Announcements and News Releases. This acceleration of capital gains has been noted at the federal level by the Congressional Budget Office  and at the state level by the Rockefeller Institute 2014 STT 89-7: Other State Documents.

As already noted, state-level data for tax year 2013 will probably not be available from the SOI division until the autumn of 2015. So we will not know if capital gains in Kansas were abnormally low in tax year 2013 until then. We are looking for an explanation of a $223 million shortfall. If all Kansas capital gains are taxed at 4.9 percent, capital gains realizations would have to have been unexpectedly low by $4.6 billion to explain the entire shortfall.

Figure 6 shows Kansas capital gains from 2002 through 2012 (as reported on federal returns to the SOI division) and total U.S. capital gains through 2013 (as reported by the CBO). The figure for 2013 is a CBO estimate. Through 2012, the two series track each other closely. If that relationship continued into 2013 and the CBO estimate turns out to be approximately correct, it is reasonable to assume that the number in which we are most interested -- Kansas capital gains realization in 2013 -- will mimic the CBO's estimated 38 percent reduction from the 2012 level. In that case, Kansas capital gains realizations would be $2.6 billion in 2013.

The CBO estimated pattern of realizations -- with the bulge in 2012 -- is consistent with the story that some investors sold assets in 2012 instead of 2013 in anticipation of rising capital gains rates. If this acceleration of sales did not occur, the actual 2012 figure would be lower and the estimated 2013 figure would be higher. If we remove the bulge and assume a generally rising path of capital gains realizations (because of a rising stock market), capital gains realizations in 2013 would have been about $550 billion -- about 18 percent lower than in 2012. If Kansas capital gains realizations in 2013 turn out to be 18 percent lower than they were in 2012, this would be about $3.4 billion. In that case, the reduction in capital gains realizations in fiscal 2014 because of the shifting in anticipation of rate changes is about $800 million. The corresponding amount of revenue, about $40 million, would explain less than one-fifth of the $223 million shortfall in fiscal 2014.

Unexpectedly low capital gains realizations probably played some role in the revenue shortfalls for fiscal 2014, but this phenomenon almost certainly was not the leading cause of the shortfall. When detailed tax return data for 2013 become available in 2015, a more precise evaluation will be possible.

Looking Ahead

 

 

The viability of Brownback's 2012 tax cut was a central issue in the November gubernatorial election. Despite the large revenue shortfalls and credit rating downgrades by Moody's Investors Service in April and by Standard & Poor's in August, Brownback won reelection by a 4 percentage point margin (50 percent to 46 percent) over House Minority Leader Paul Davis (D). This was, however, a considerably less favorable result than the 63 percent to 32 percent victory Brownback enjoyed when he was first elected in 2010. Unless the Kansas economy picks up, it is safe to say Brownback will no longer be in the top tier of Republican governors contending for that party's presidential nomination in 2016.

The latest estimates released by the Kansas Legislative Research Department show that the state will run out of money sometime in mid-2015, one year earlier than forecast only a few months ago. So right off the bat in January there will be a knock-down, drag-out budget battle in Topeka. The governor and conservative Republicans will be pushing for spending cuts. Democrats and moderate Republicans will be pushing for more revenue.

Politicians and the general public are quick to give credit or blame for changing economic conditions to previously enacted tax legislation. Because so many other factors influence economic growth, economists know this type of time series analysis is often of questionable value in determining the economic effects of taxes. Yes, all other things equal, if a tax cut was followed by a surge in growth, we could say taxes are an important factor in the economy. But all other things -- like interest rates, oil prices, the stock market, exchange rates, consumer confidence, etc. -- are never constant.

The Kansas supply-side experiment is a work in progress. Republicans in other states that are considering tax cuts are watching closely. To date there is little to suggest that the hoped-for growth effects from tax reform have materialized on Kansas. But because of the lags in collecting data and because the effects may not be seen for several more years, the jury is still out.