Legislative Analyst's Office
February 22, 1995

The Governor's Tax Proposal

How Will the Economy Be Affected By the Tax Proposal?

There is little debate that the proposed tax reduction would benefit most taxpay ers, and the state's economy would profit from individuals and businesses investing or spending their tax savings in California. The question that remains, though, is how much net economic stimulus can we expect from the tax proposal, especially when offsets are considered.

Some Stimulus Will Occur

Behavioral and Dynamic Feedback Effects. The topic of behav ioral and dynamic feedback effects relates to the revenue impacts that tax law changes produce in addition to their direct static revenue impacts. Static revenue analyses assume that economic activity is unaffected by tax law changes. In contrast, dynamic analyses recognize that tax law changes can result in both (1) direct behav ioral responses by individuals, businesses and governments, and (2) feedback effects. Feedback effects occur because direct effects trigger further behavioral responses. For example, in the case of a gasoline tax increase, a static analysis would assume a revenue gain based on current levels of gasoline consumption. Alternatively, a dynamic analysis might predict less of a revenue increase, because of behavioral changes that could reduce gasoline consumption, such as driving less, and feedbacks, such as reduced spending on other goods after paying more for gasoline.

Increased After-Tax Income Will Encourage Growth. All else constant, increasing the amount of after-tax income individuals and businesses receive will tend to stimulate economic growth. A significant portion of the increase in individual after-tax income can be expected to go toward consumption. In addi tion, part of the tax savings will go towards investments by businesses and individu als, another form of spending, and some will go into savings. All of these responses can stimulate economic growth, directly or indirectly. However, the size of impact will vary according to the specific use of the funds.

How Much Growth Will Occur? There is considerable debate among economists regarding the fiscal and economic impacts of tax law changes, especially at the state-local level. One important reason involves the types of govern ment spending that tax reductions displace, including how the public values the resulting cutbacks, and subsequently how much of the tax savings will go towards activities in the state that actually stimulate economic growth. Some research has concluded that these effects can be significant, while other studies conclude that the net impact is minimal. Other studies have concluded that state-local tax policies can definitely affect the behavior of certain individual taxpayers, but in the aggregate have much less identifiable or significant effects.

To date, state governments have rarely attempted to quantify feedback effects of state tax law changes on their economies or on their revenue collections. Revenue analyses done in California by the FTB, the Board of Equalization (BOE), and the DOF, have to varying degrees attempted to consider certain direct behavioral responses in evaluating tax law changes, but have not in the past comprehensively evaluated the dynamic feedback effects of such changes. The FTB in particular does estimate the effects of direct behavioral responses using various modelling ap proaches and assumptions; therefore in this respect, its estimates are not static. Existing law adopted in 1994 now requires the DOF to incorporate dynamic effects into its revenue analyses under certain conditions and when reasonable. Our office has a similar requirement, but only for tax law changes proposed in the budget. Initial steps have been taken toward developing methodologies to meet these requirements. For example, the DOF has requested funds in the 1995-96 budget to pay for contract work and staff in this area. At present, however, a proven tool for accurately estimating dynamic feedback does not exist, either in California or elsewhere.

In an effort to see whether we could draw any conclusions about what the dynamic feedbacks of the Governor's tax proposal might be, we conducted a review of what 25 other states had seen happen when they made major changes to state taxes in the past. Figure 16 summarizes what other states told us were their experiences with major tax law changes in the past 15 years. The bottom line is that little is known regarding dynamic feedback effects. Of those states that have attempted to conduct dynamic analyses, only Massachusetts has completed more than a few. And, even in this case, validating the results of this work and other static analyses is often difficult because states do not conduct retrospective analyses. (A retrospective analysis looks back at tax law changes and measures what their effects actually were.) While states are interested in discerning the dynamic feedback effects of tax law changes, many factors (including those in Figure 16) have precluded them from doing so.

Offsets Also Will Occur

Any feedback effects that occur from the Governor's tax proposal will be miti gated by several offsetting factors. The most significant are off sets resulting from various leakages. For example, many corporations doing business in California have multi-state or multi-national operations; thus, a tax reduction might be used by certain companies for investments and activities outside of California, reducing the feedback effects on revenues here. Likewise, if the funds are saved, they might end up financing economic activities elsewhere, given the national and international nature of our capital markets today. And, as earlier noted, additional offsets would occur if the state cuts spending in certain areas to pay for the tax reduction. For example, some individuals and businesses might have to use tax savings to supple ment activities that the state has chosen to cut-back, partially offsetting the positive impact of the tax cut on the economy.

Difficult Decisions Would Need to Be Made

As the Task Force noted, under a top-down budgeting approach, many hard choices would have to be made with a tax cut in place because of restricted revenue growth. Decisions would have to be made to cut certain program areas, and the state could be faced with ongoing tight budgets.

One-Third of New Revenues Would Be Lost. In Part One, we discussed what the budget pressures might be with the tax proposal in effect. We estimated, and Figure 17 shows, that of the $24 billion of cumulative new resources between 1995-96 and 1998-99 under a moderate-growth scenario, nearly one-third would be redistributed back to taxpayers through the tax proposal. After distributing revenues for Proposition 98, debt service, and employee retirement, about one-fourth of increased revenues would be left for other program areas. The Proposition 98 amount is about $3.9 billion less than what it would be absent the tax cut because, under existing law, educational spending declines with reductions in General Fund revenues.

This estimate did not include the establishment of a budget reserve fund, nor the impact of certain factors, such as the renters' credit, which is scheduled to go back into effect in the future. It also implicitly assumes the state will win several costly lawsuits currently being appealed. Thus, this analysis probably overstates the actual amount of resources available for other programs. It is likely that with the tax proposal in effect, the state would face tight budgets in the years to come.

Should Other Alternatives Be Considered?

The Governor's tax reduction proposal is but one method for reducing the state's tax burden. Figure 18 (see next page) shows several of the many different other tax-related policy choices that could be considered, depending on the objective or desired outcome.

One would be lowering other tax rates, such as the state sales tax rate. This would affect essentially all Californians and have its own effect in terms of changing the distribution of the tax burden. Fundamental changes in the PIT bracket structure also could be considered, such as by eliminating certain brackets or establishing a flat tax. These options would also redistribute the tax burden. In both cases, revenues would decline and the progressivity of California's overall tax structure would change.

Broadening the tax base in order to lower tax rates also could be considered, such as a value- added tax (VAT) or a similar consumption-based tax. These again would change the distribution of the tax burden. The existing sales tax also could be applied to certain services. Another less sweeping possibility involves modifying or eliminat ing certain existing tax expenditure programs (TEPs), so as to broaden the tax base and thereby allow for rate reductions. By reducing the amount of TEPs, the tax burden could be eased for those taxpayers who do not currently qualify for them.

Thus, the Governor's tax proposal is but one of many options for changing the existing tax structure and providing for a tax reduction that changes the tax burden. In evaluating the Governor's tax proposal, or any alternative proposals, the Legisla ture will need to first decide what its fundamental tax policy objectives are, and then what types of tax changes, if any, are needed to best achieve these objectives. The fiscal and distributional consequences should be examined to ensure that they are consistent with legislative objectives, such as the desired mix of public versus private spending in the state.

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