Bacon's Rebellion

James A. Bacon


 

Baconometer

 

Fried

Volatile States, Volatile Budgets

 

Yes, Virginia, the Commonwealth can grow its way out of its budget straightjacket. What the state needs, says GMU prof Mark Crain, is not more taxes but more predictable revenue.


 

Mark Crain, an economics professor at George Mason University, views the current debate over tax reform in light of Virginia's long-term economic performance. Between 1970 and 1999, according to his recent book, Volatile States, the inflation-

adjusted per capita income of Virginia residents increased by an average of 1.97 percent per year. That was the seventh-fastest growth rate among the 50 states.

 

In 1970, Virginians ranked 30th among the 50 states in terms of personal income per capita. By 1999, the Old Dominion had moved up to 14th place.

 

When the General Assembly convenes in January to address the state’s critical problems – education, transportation, Medicaid and the rest – legislators should be thankful for the prudence of their predecessors who crafted the tax and regulatory climate that made possible such a powerful performance. Superior growth has deepened the tax base, giving the Commonwealth far more resources than it would have had otherwise to grapple with today’s seemingly intractable budgetary challenges.

 

Had Virginia grown at the median rate, similar to that of Missouri or South Dakota, incomes would have increased only 1.53 percent annually over the same period. A mere 0.44 percent difference may not sound much, but over 30 years it means that Virginians would be earning roughly 13 to 14 percent less than they do now. Translated into tax revenue, slower income growth would have yielded $3 billion to $4 billion less in revenue.

 

Talk about structural budget deficit! If it seems impossible to make ends meet now, think how hard it would be if the state had only $22.5 billion to work with instead of the actual $26 billion.

 

Virginia’s stellar economic performance was no accident, says Crain. Among the factors contributing to the state’s prosperity is its stable tax structure and relatively low level of overall taxation. Over the 1969-1998 period, Virginia had the 11th lowest marginal tax rate of all the states. Crain gets very nervous when he hears people talking about “reforming” Virginia’s “antiquated” tax structure.

 

“It’s bizarre that everybody’s saying we’ve got to reform the tax system,” Crain says. “It worked great for 30 years, now, all of a sudden, the whole thing’s antiquated, a 300-year-old relic of the agrarian economy.” Virginia is experiencing a cyclical downturn in the economy, and people are panicking. “If you think the problem’s bad now, wait until they fix it.”

 

Crain published Volatile States earlier this year, before Gov. Mark R. Warner announced his intention to make tax restructuring a major issue in the 2004 legislature. Crain puts no partisan spin on his findings. Indeed, he mailed copies of his book to the governor as well as to key Republican legislators like Speaker of the House William Howell and Senate Finance Chairman John Chichester in the hopes that it might influence their thinking.

 

Likewise, I interviewed Crain last week, before the governor unveiled the specifics of his plan, which involves raising some taxes, cutting others and closing loopholes in a package designed to net about $500 million more in revenue per year. My interest, like Crain’s, is not to score political points but to articulate enduring principles for shaping Virginia’s state budget and tax code.

 

Crain’s research is rich with insights – far too many to enumerate here. For those who are interested in reading more, you can order his book at Amazon.com. (Be forewarned. The book, published by an academic press, will set you back $50. Plus, it’s loaded with statistical analysis, which makes pretty tough reading. But for students of state government, the effort will be amply rewarded.)

 

Two broad conclusions stemming from Crain's research seem especially pertinent to the debate that's shaping up over Virginia’s budget and tax structure.

 

  1. Even a seemingly modest change in a state's economic growth rate can have dramatic effects on the size of its tax base over a long period of time. If raising taxes to meet next year’s budgetary challenges slows economic growth, it can jeopardize the state’s fiscal health a decade from now.

  1. The stability and predictability of a state’s revenue stream is insufficiently appreciated. Predictability abets long-term planning, which allows government to restrain spending.

As Warner, Howell, Chichester and others hammer out the next biennial budget, they should heed these principles.

 

Rather than fixating on how to raise more revenue, law makers should focus on achieving more stable revenue. If a predictable revenue stream makes it possible to run government more efficiently, as Crain’s work indicates it does, the resulting savings will free up resources for important initiatives without putting economic growth at risk.

 

After 30 years of steady growth, the U.S. economy decelerated markedly in the 1970s. Economists have advanced numerous theories to explain the slowdown, but none is entirely convincing. That may be, Crain suggests, because the critical changes occurred not at the national level but at the state level. “We often talk about the ‘national’ economy or the ‘U.S.’ economy, but there are huge differences among the states in economic performance.”


A close look at the numbers shows that the slowdown in income growth was concentrated in roughly 22 states. Departing from the “national” pattern, the economies of 28 states -- Virginia among them -- showed no appreciable deceleration in the last quarter of the 21st century, Crain observes.

 

The differences in growth rates led to a dramatic reshuffling of income and wealth creation in the U.S.

 

(In the table below, Crain ranks the per capita income growth rates of all 50 states from 1969 to 1999 using two different methods -- the least squares method and the continuous compounding method -- of calculating the growth rates.)

 


Real Per Capita Income

Growth Rates

(1969 to 1999)
 

Least Squares

Compounded

 

Growth

rate (%)

Rank

Growth

rate (%)

Rank
New Hampshire 2.14 1 2.03 9
Connecticut 2.11 2 1.95 13
Massachusetts 2.11 3 2.07 7
North Carolina 2.10 4 2.15 1
Georgia 2.05 5 2.14 2
Tennessee 2.04 6 2.13 3
Virginia 1.97 7 2.04 8
Alabama 1.97 8 2.03 11
South Carolina 1.90 9 2.02 12
New Jersey 1.89 10 1.83 17
Rhode Island 1.79 11 1.71 24
Mississippi 1.79 12 2.12 4
Arkansas 1.78 13 2.08 6
Maine 1.77 14 1.81 18
Vermont 1.75 15 1.73 21
Minnesota 1.74 16 1.94 14
Colorado 1.70 17 2.11 5
Maryland 1.69 18 1.77 20
New York 1.67 19 1.61 33
Florida 1.63 20 1.71 23
Louisiana 1.62 21 1.83 16
Kentucky 1.62 22 1.81 19
Pennsylvania 1.59 23 1.67 28
Texas 1.53 24 1.87 15
South Dakota 1.53 25 2.03 10
Missouri 1.50 26 1.63 31
Washington 1.48 27 1.63 32
Nebraska 1.46 28 1.70 25
Delaware 1.43 29 1.41 43
New Mexico 1.42 30 1.66 30
Wisconsin 1.37 31 1.58 36
Kansas 1.35 32 1.68 26
Indiana 1.35 33 1.46 40
Illinois 1.34 34 1.51 39
West Virginia 1.34 35 1.66 29
Ohio 1.33 36 1.40 44
Oregon 1.32 37 1.59 35
Utah 1.30 38 1.67 27
Arizona 1.28 39 1.54 37
Michigan 1.25 40 1.33 46
Oklahoma 1.23 41 1.33 46
Iowa 1.18 42 1.44 42
Nevada 1.15 43 1.37 45
Idaho 1.13 44 1.44 42
California 1.09 45 1.23 48
Hawaii 1.01 46 0.96 49
North Dakota 1.00 46 1.72 22
Wyoming 0.95 48 1.61 34
Montana 0.88 49 1.29 47
Alaska 0.33 50 0.94 50

Source: Volatile States, Table 1.4, page 13.


 

"The Virginia economy stacks up really well by almost any gauge you use," Crain says. "In terms of income per capita and income per worker, we moved from towards the bottom to one of the top. We performed well both absolutely and compared to other states."

 

Virginia fares well by another, less commonly recognized measure: income volatility. In some states, incomes tend to fluctuate more widely in good times and bad than in others. Crain's research shows that states with more volatile incomes tend to have higher per capita incomes. He theorizes that employees compensate for the greater uncertainty of their paychecks by demanding higher higher pay.

 

Virginia is an anomaly. The Old Dominion is blessed not only with a relatively high per capita income but with among the most stable incomes in the country. Indeed, by one measure, calculated by using the Regression index, Virginia gets the top ranking in the country.

 

"That makes us pretty desirable, and something we'd like to preserve," Crain says. "Compared to the other 50 state economies, our living standards are both high and stable."

 

In Volatile States, Crain did not endeavor to prove the point that low-tax states tend to out-perform high-tax states. He takes it as a given that "Virginia's penchant for a low, flat and stable tax structure provides a constructive environment for business investments, job creation and rising living standards."

 

Crain's contention is backed by numerous studies, including a 2002 report issued by the American Legislative Exchange Council. The paper compared the economic performance between 1990 and 2000 of the 10 highest-tax states with that of the 10 lowest tax states. The low tax states not only experienced double the rate of job creation but 60 percent stronger per capita income growth.

 

Differences in tax rates do not, of course, explain all variations in long-term economic performance between the states. A casual inspection of the table above will show that states whose economies were dependent upon farming and natural resources -- from Iowa to Alaska -- were particularly likely to have suffered slow income growth during three decades of declining commodity prices. Likewise, high-tax states such as Connecticut and Massachusetts seemingly defied the odds by turning in outstanding performances as well.

 

Crain's choice of a 30-year time frame may obscure important shifts that took place in the 1990s as the country began shifting to a knowledge-based economy. States blessed by high education levels, strong university R&D programs or allure to the so-called "creative class" may well have prospered in the face of high taxes.

 

It's possible, in theory, that Gov. Warner's proposal to boost spending on education and university research will give Virginia's economy a Knowledge-

Economy booster that might offset the deleterious effects of higher taxes. In theory. But supporters have cited no studies backing up such a proposition. Until they do, tax-increase advocates have the burden of proof to show that their proposals won't hurt the long-term performance of Virginia's economy.

 

The case for raising more revenue weakens considerably when we consider the merits of an alternative tax-reform strategy: making revenues more stable and predictable

 

Crain makes the case that reliability is one of the most important attributes of a good tax system. As he writes in Volatile States: "Greater instability in tax revenues contributes to spending instability that impedes the efficiency of long-run state government operations."

 

Crain thinks this may be the most important insight of his book. Tax-cutters typically talk about "fraud, waste and abuse" in state government spending. But the real problem isn't the stuff of the "Fleecing of America" TV news exposes -- it's the way budget fluctuations disrupt intelligent, long-term planning. Uncertainty, Crain says, is the enemy of efficiency.

 

When revenues plunge, politicians whack programs with little regard to the long-term consequences. Arrangements that would have been efficient under a budget-growth scenario would be inefficient under a retrenchment scenario.

 

"Imagine you're a university president," says Crain. "You plan down the road five years. You anticipate growth, lay the framework, put plans and processes into place, contract out the lunch service, the parking spaces, the payroll administration, and then the rug gets jerked out from you. All of a sudden, none of what you've done makes sense any more."

 

When budgets are unpredictable, people make miscalculations. Closing the DMV offices was a classic case, Crain says. "Shut down the offices --  then three months later open them back up. That must have cost a fortune."

 

Unexpected budget surpluses are almost as bad, Crain argues. Virginia ran a $750 million budget surplus one year during the Gilmore administration. Instead of funding one-time projects, legislators channeled much of the money into ongoing programs. "Once it gets built in, it becomes an entitlement -- very hard to take away."

 

The train of logic is very simple: Revenue stability = more efficient government = budget savings = more money for priorities like roads, education and Medicaid.

 

As Crain's research shows, some taxes are more volatile than others. A diversified tax base tends to be less volatile than a tax dependent upon a single source, such as sales or income. One good place to start thinking about tax reform is to study how proposals might affect the volatility of state revenues. Lowering the sales tax on food, for instance, will make sales-tax revenues more dependent upon sales of highly cyclical consumer goods. Warner's proposal may make sense from a "fairness" point of view, but may have unintended consequences from the vantage point of revenue stability.

 

Crain also contends that Virginia's revenue forecasting process, which filters U.S. economic projections through a state econometric model in a top-down process, is flawed. The model overlooks one major fact: Over the past 30 years, Virginia's economy has increased 30 percent faster than the U.S. economy. Thus, the forecasts tend to be conservative and result in budget surpluses. Surpluses are more fun than deficits -- it's easier to spend money than to take it away -- but they still result in a misallocation of resources. Especially if they encourage governors to seek tax increases.

 

Virginia's financial situation is brightening perceptibly month by month. In October, reported Secretary of Finance John Bennett, General Fund revenues increased $83 million above the amount collected the same month the year before, a 10.2 percent increase and well in excess of the 4.6 percent estimate this year's budget is based on. If revenues continue to exceed estimates by the same margin, the state could find itself racking up a surplus at the rate of $40 million per month -- an amount almost equal to the taxes Warner wants to raise.

 

Between Crain's research and the improving fiscal outlook, the case for a tax increase will get harder to make with each passing month. Virginia's tax system really isn't broken. Economic growth will generate revenues sufficient to address many, though not all, of Virginia's pressing problems. If lawmakers would focus on fine-tuning the stability and predictability of the tax system, the Commonwealth would be well served.

 

-- December 1, 2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fire back!

 

You can berate Bacon at jabacon@

baconsrebellion.com

 

Or read his profile here.

 

 

 

 

 

 

 

 

 

 

 

 

 

More Reaction to

Gov. Warner's Tax Reform Package

in this issue...

 

Doug Koelemay

Litmus Test

 

Taxes have been the key test for Republican candidates in their rise to majority, but responsible governance is the new challenge.

 

Patrick McSweeney

Out of Hiding

 

Now we know why Governor Warner didn't want to talk about taxes before the November elections: He's just proposed one of the biggest tax hikes in Virginia history.

 

Paul Goldman

White Men Can't Jump...


But they can cook -- books, that is. Goldman dissects Gov. Warner's tax plan, showing how all the fun stuff is front-end loaded, while the bad stuff comes after he's gone.

 

Barnie Day

Warner Comes out Swinging

 

The governor's bold tax-reform proposal faces long odds in a legislature dominated by the GOP.  But, if passed, it would fund his pro-education platform and bolster his national profile. 

 

Peter Ferrara

Can You Say "Taxes" in Swedish?

 

Mark Warner has showed his hand as a welfare-

state liberal. State spending in Virginia is running unchecked, but he still wants to implement a $1 billion biennial tax increase.