October 6, 1995

Making Tax Decisions in a Vacuum

by Robert J. Kleine, Vice President and Senior Economist

Last week the House Fiscal Agency (HFA) prepared an analysis, under a number of different scenarios, of the potential effect on the budget of several tax cuts currently being discussed by the legislature. This analysis has been assailed by several legislators who argue that the HFA projections do not take into account the economic activity generated by tax cuts and also that such projections are always wrong. According to Rep. Kirk Profit (D-Ypsilanti), economic forecasts are worth no more than weather forecasts.

It appears that Representative Profit would like to make tax policy without the benefit of information about the potential effect of the tax changes. It is irresponsible to enact changes without developing some estimates, or projections under likely scenarios, of the effect on the budget, the taxpayer, and the economy. Of course, such estimates and projections (and there is a difference), may be wrong, but a careful analysis of projections made by the fiscal agencies over the last 25 years will show a considerable degree of accuracy.

The assertion that the projections should be "dynamic" rather than "static," to account for the effect of tax cuts on the economy, also is being made by many Republicans at the national level . The dynamic approach has not even been accepted by the Congressional Budget Office, the director of which was recently appointed by the Republican-controlled Congress. There is even less reason to accept this type of analysis at the state level, as almost all states are required to have balanced budgets. Cuts in state taxes almost always result in offsetting expenditure reductions, resulting in no new infusion of money into the economy. At the federal level increased economic activity can be produced by deficit spending.

If one assumes that state tax cuts do result in increased economic activity, and I believe that this does occur in certain situations, it never can be sufficient to pay for the tax cuts. For example, the Department of Treasury estimates that the proposed change in the single business tax apportionment formula will cost about $290 million annually after it is fully implemented in five years. To pay for itself, this tax cut would have to generate about a $3 billion increase in the state tax base. Based on the average income per wage and salary job (1994 data), this would require the creation of about 100,000 new jobs. The entire Michigan economy has produced that many jobs only three times since 1980. A more reasonable expectation is about 5,000 jobs ($290 million represents only .13 percent of Michigan personal income), which would produce about $15 million in tax revenue, reducing the cost of the tax cut to $275 million.

State tax cuts do not come close to paying for themselves. The reason state revenues have been increasing and exceeding estimates, even after tax rates and bases have been cut, is that the economy has been stronger than expected, largely due to the strength of the automobile industry. There are clear signs that the economy is slowing down; at some point there will be another recession. At that time revenues could even decline, as happened in FY 1990–91, and then any tax cuts will appear to cost more than estimated. Rep. Don Gilmer (R-Augusta) is correct: Caution is in order, or the hard-earned fiscal gains of the last four years will be squandered.