Thursday, June 22, 2017

What Can the Kansas Tax Cut Experiment Teach Us About Tax Reform?

President Trump has been looking to make tax cuts a major part of his tax reform plan. For Trump's critics, the tax cuts that Trump is proposing look like a huge gift to the top 1 percent. There has been considerable debate as to whether his tax cuts would work. Fortunately for those who are public policy wonks, there is a case study that can provide some insight: the state of Kansas.

As of July 1, 2012, the state of Kansas enacted HB2117, which was the State's largest income tax cuts in history. HB2117 had multiple provisions, including reducing the top income tax rate from 6.45 percent to 6.25 percent, reduce the lower income tax rate from 3.5 percent to 3 percent, and eliminate the income tax for hundreds of small business owners throughout the State. What makes this newsworthy is that a little over two weeks ago, the Kansas House and Senate overrode Governor Sam Brownback's veto and undid his five-year experiment. Why did Republicans side against Brownback? They believed that the tax cuts were causing budgetary shortfalls, which is why the Kansas income tax is to now increase. This has ramifications not just for the state of Kansas, but also for the U.S. federal government because it is being used as a case study on how tax cuts make for lousy public policy. What I would like to examine here is the success of the Kansas case study and how informative it can be for future tax cuts.

But first, a bit of economic theory on tax cuts. For those who propose tax cuts, the idea is twofold. On the supply-side, it will provide those with capital to incentivize further economic growth (e.g., Akcigit et al., 2015; Moretti and Wilson, 2017). On the demand side, lower taxes provides higher take-home income, which means more money for consumption, investment, or savings. I discussed trickle-down economics last year, and a) it is not an idea or philosophy advocated within the economics discipline, and b) those who advocate for free markets advocate for cutting taxes for everyone, not just the rich. The economic theory of tax cuts comes with another facet known as the Laffer Curve. The theory behind the Laffer Curve is that there is a taxation rate that optimizes tax revenue. The issue with the theory is that we don't know what that amount is, which can potentially shift based on tax type and other factors. This can also mean that if the tax rate is too high, then a lower tax rate could theoretically increase tax revenue. Also, the growth maximizing point is lower than the revenue maximizing point. Now that we have the theory out of the way, did Kansas' tax cuts do the trick?

Let's take a look at some economic metrics. Kansas unemployment dropped from 5.6 percent to 3.7 percent since the legislation began. This is good for Kansas in the sense that their unemployment is below the national average. On the other hand, the labor force participation rate decreased from 69.1 percent to 66.7 percent, which puts a damper on the low employment rate. Also, Kansas' GDP growth is smaller than that of surrounding states (see below), which doesn't bode well. The Kansas Policy Institute (KPI) released a report in January refuting why we should use geographical proximity as the basis for comparing other states. When comparing Kansas to states that are similar to Kansas economically, the KPI found that Brownback's tax cuts have had a positive effect on job growth.

A couple of counterpoints on the taxation bit. One is that tax revenue did not decline while the tax cut experiment was taking place (see Fed Reserve below). Furthermore, the State of Kansas increased the sales tax from 6.15 percent to 6.5 percent in 2015. Looking at private sector job growth in Kansas, jobs were growing until shortly after the sales tax increase took place, which was three years after the income tax decrease took place. Even with these income tax cuts, there is still an overall increase in tax revenue because of the sales tax increase. More to the point, Kansas state tax is small in comparison to federal tax burden, which means the effects of the income tax cut are probably going to be more modest than a major cut in the federal income tax.

There have been complaints about how the tax cuts did not cut budget deficits. With the exception of 2013, government spending has increased. As the chart from Tax Foundation below shows, per capita government spending stayed stagnant over the years. It shouldn't be a surprise that there was an increase in deficits. If the income tax cuts are not offset by spending cuts or tax increases, of course there will be an increase in the deficit. It's basic mathematics. Deficits also have an effect on savings, which in turn, have an effect on the worth of capital (Gale and Samwick, 2014). This happens because as long as the government has debt, it will need a way to pay of the debt. If it cannot tax, the government would have to borrow, which means driving up the interest rate and driving the economy into the ground. This is why it is important that a tax cut doesn't exacerbate government deficits.

On top of the budget deficits, the Kansas experiment included an exemption for pass-through entities (i.e., businesses taxed with individual income tax instead of corporate tax), which even the pro-tax cut organization Tax Foundation thought went too far because it would encourage tax evasion and reduce tax revenue.

Between increased government spending, tax exemptions, and other tax increases, the Kansas experiment is not a rebuke or refutation of supply-side economics or fiscally conservative policy. Kansas reminds us of a few things:

  1. An economy responds to much more than just tax cuts, especially meager ones.
  2. Tax cuts aren't inherently bad, but they can do damage if poorly constructed.
  3. The effects of reduced taxes can take a while, which is why looking five years after the fact is preliminary at best. Arthur Laffer, the creator of the Laffer Curve, thinks it would have taken ten years for the benefits to fully exist. As an example, one could argue that the Reagan tax cuts from the 1980s took until the 1990s to take effect, which subsequently affected the 1990s tech boom. With the Kansas experiment cut off short, we will never know either way. 
  4. Most importantly, tax reform cannot simply be reduced to mere tax cuts.
In 2012, a a panel of expert economists at the University of Chicago were asked whether a cut in income tax would lead to GDP growth. Interestingly, a plurality found that cutting income taxes would translate into greater GDP growth, which is good news considering that is the primary purpose of tax cuts. On the other hand, there were a number of economists on this panel who were uncertain.

Why are there economists who are uncertain about the effect of tax cuts on the GDP? Because tax cuts are not inherently a solution. Don't get me wrong: high taxes are decidedly burdensome. Two prominent economists (one of whom worked in the Obama Administration as a top economic advisor) found that a 1 percent increase in taxes translate into a 3 percent decrease in GDP over three years (Romer and Romer, 2010, p. 764). Another study illustrates how GDP growth relatively accelerates as a result of the tax cut (Taylor and Taylor, 2014). This 2012 study from the Tax Foundation also illustrates empirical studies that show how higher taxes adversely affect growth (although to be fair, the Left-leaning Center for Budget and Policy Priorities finds that state income tax cuts do not spur economic growth).

At the same time, tax reform is more than the tax rate. Tax reform is about such things as who and what is being taxed (e.g., broadening the tax code, shifting from a progressive income tax to a progressive consumption tax, having the tax cuts be for lower-income individuals instead of [or in addition to] the 1 percent [Zidar, 2015]), simplifying the tax code, which taxes are being lowered or raised, how the tax cut is being financed, and whether deductions are eliminated.  The centrist Brookings Institution found that tax cuts could work, but work best if they are accompanied by spending cuts [or minimal increases in the budget deficit] (Gale and Samwick, 2016). Brookings also points out that for the United States, tax cuts did not work out because the federal government would accompany tax cuts with increased spending (Gale and Samwick, 2014).

The lesson from Kansas is not that tax cuts are bad. The lesson is the following. Tax cuts work when they are properly offset with spending cuts and/or other tax increases, which does not happen nearly as often as it should. Tax cuts can work if there are not gaping loopholes and exemptions. Lower taxation rates can and do help when done right. While taxes have the potential to be distortionary and cause economic pain, they are not the only economic force in play. There are regulations, government spending, demographics, structural labor market shifts, monetary policy, other states' policies that have spillover effects, and technological development, amongst others. Ultimately, there are right ways and wrong ways to implement a tax cut, and even then, other economic forces could mitigate the economic growth that ought to come with tax cuts. Tax cuts are not a cure-all for tax reform, but at the same time, tax cuts leave taxpayers with more money and the potential to enhance economic growth when done right.

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