Tag Archives: IRS

State tax refunds and limiting spending growth

This fall eligible Alaskans will be receiving a check of $1,100 from their state government. Although the amount of the check can vary, Alaskans receive one every fall – no strings attached. Other state residents are probably more familiar with IRS tax refunds that come every spring, but this “tax refund” that Alaskans receive is unique. It’s a feature that residents have benefited from for decades, even in times when the government has experienced fiscal stress. Considering the state’s unique and distressed budget situation that I’ve described in an earlier post, I think it warrants a discussion of the fiscal viability of their refunds.

A narrow tax base reliant on volatile revenue sources, restricted funds, and growing spending are all factors that made closing Alaska’s budget gap this year very difficult. It even contributed to pulling down Alaska from 1st in our 2016 ranking of states by fiscal condition to 17th in our 2017 edition. Given this deterioration, it will be helpful to look into how and why Alaska residents receive dividend payments each year. There is no public finance rule that says giving refunds to residents is fiscally irresponsible, but there definitely are better ways to do it, and Alaska certainly hasn’t proven to display best practices.

Another state that we can look at for comparison is Colorado, which has a similar “tax refund” for residents but is structured very differently. Colorado’s Taxpayer Bill of Rights (TABOR) requires that higher than expected tax revenues each year be refunded to taxpayers and acts as a restraint on government spending growth. In contrast, Alaska’s check comes from the state’s Permanent Fund’s earnings that are generated from oil severance taxes each year, and acts more like a dividend from oil investment earnings.

Are distributing these refunds to taxpayers fiscally responsible? I am going to take a deeper look at these mechanisms to find out.

First, Alaska’s refund.

The figure below displays Alaska’s Permanent Fund checks since 2002 overlaid with the state’s revenue and expenditure trends, all adjusted for inflation. The highest check (in 2015 dollars) was $2,279 in 2008 and the lowest was $906 in 2012, with the average over this time period being about $1,497 per person. Although the check amounts do vary, Alaska has kept on top of delivering them, even in times of steep budget gaps like in 2002, 2009, and 2015. The Permanent Fund dividend formula is based on net income from the current plus the previous four fiscal years, so it makes sense that the check sizes are also cyclical in nature, albeit in a slightly delayed fashion behind oil revenue fluctuations.

Alaska’s dividend payments often end up on the chopping block during yearly budget debates, and there is growing pressure to at least have them reduced. Despite this, Alaska’s dividends are very popular with residents (who can blame them?) and probably won’t be going away for a long time; bringing a new meaning to the Permanent Fund’s name.

The Alaska Permanent Fund was established in 1976 by constitutional amendment and was seen as an investment in future generations, who might no longer have access to oil as a resource. Although this may have been decent forward-thinking, which is rare in state budgets, it does illustrate an interesting public finance story.

Alaska is a great example of a somewhat backwards situation. They generate high amounts of cash each year, but because of the way many of their funds are restricted they are forced to hoard much of it, and give the rest to citizens in the form of dividends. If a different state were to consider a similar dividend before dealing with serious structural budget flaws would be akin to putting the cart before the horse.

Luckily for Alaskan dividend recipients, there are many other areas that the state could reform first in order to improve their budget situation while avoiding cutting payments. As my colleague Adam Millsap has recommended, a fruitful area is tax reform. Alaska doesn’t have an income or sales tax; two of the most common sources of revenue for state governments. These are two potentially more stable sources of income than what the state currently has.

How does Colorado’s “tax refund” compare?

Colorado’s Taxpayer Bill of Rights (TABOR) has a feature that requires any tax revenue growth beyond inflation and population growth be refunded to taxpayers. It was adopted by Colorado voters in 1992 and it essentially restricts revenues by prohibiting any tax or spending increases without voter approval.

A recent example of this playing out was in 2014 when the state realized higher than expected tax revenues as a result of marijuana legalization. At the point of legalization, the plan was to direct tax revenues generated from the sale of marijuana towards schools or substance abuse program funding. But because of the higher than expected revenues, TABOR was triggered and it would require voter approval to decide if the excess revenues would be sent back to taxpayers or directed to other state programs.

In November of 2015, Colorado voters approved a statewide ballot measure that gave state lawmakers permission to spend $66.1 million in taxes collected from the sale of marijuana. The first $40 million was sent to school construction, the next $12 million to youth and substance abuse programs, and the remainder $14.2 billion to discretionary spending programs. A great example that although TABOR does generally restrain spending, citizens still have power to decline refunds in the name of program spending they are passionate about.

 

The second figure here displays TABOR refunds compared with state revenues and expenditures over time. Adjusted for inflation, checks have varied from $18 in 2005 to $351 in 1999, much smaller than the Alaska dividend checks. TABOR checks have only tended to be distributed when revenues have exceeded expenses. The main reason why checks weren’t distributed between 2006 and 2009, despite a revenue surplus, was because of Referendum C which removed TABOR’s revenue limit for five years, allowing the state to keep collections exceeding the rule. The revenue limit has since been reinstated, but some question the effectiveness of TABOR given an earlier amendment in 2000 which exempts much of education spending from TABOR restrictions.

The main distinguishing factor between Colorado’s refund and Alaska’s Permanent Fund dividend is that the former also acts as a constraint on spending growth. By requiring the legislature to get voter approval before any tax increase or spending of new money, it implements automatic checks on these activities. Many states attempt to do this through what are called “Tax and Expenditure Limits” or TELs.

The worry is that left unchecked, state spending can grow to unsustainable levels.

Tax and Expenditure Limits

A review of the literature up to 2012 found that although the earliest studies were largely skeptical of the effectiveness of TELs, as time has passed more research points to the contrary. TELs can restrain spending, but only in certain circumstances.

My colleague Matt Mitchell found in 2010 that TELs are more effective when they (1) bind spending rather than revenue, (2) require a super-majority rather than a simple majority vote to be overridden, (3) immediately refund revenue collected in excess of the limit, and (4) prohibit unfunded mandates on local government.

Applying these criteria to Colorado’s TABOR we see that it does well in some areas and could improve in others. TABOR’s biggest strength is that it immediately refunds revenue collected in excess of the limit in its formula, pending voter approval to do otherwise. Automatically refunding surpluses makes it difficult for governments to use excess funds irresponsibly and also gives taxpayers an incentive to support TABOR.

Colorado’s TABOR does well to limit revenue growth according to a formula, rather than to a fixed number or no limitation at all. The formula partially meets Mitchell’s standards. It stands up well with the most stringent TELs by limiting government growth that exceeds inflation and population growth, but could actually be improved if it limited actual spending growth rather than focusing on tax revenue. When a TEL or similar law limits revenues, policymakers can respond by resorting to implementing more fees or borrowing. There’s some evidence of this occurring in Colorado, with fees becoming more popular as a way to raise revenue since TABOR’s passing. A spending-based TEL is more difficult to evade.

Despite its faults, Colorado’s TABOR structure appears to be doing better than attempts to constrain spending growth in other states. The National Conference of State Legislatures still considers it one of the strictest TELs in the nation. Other states, like Arkansas, could learn a lot from Colorado. A recent Mercatus study analyzes Arkansas’ Revenue Stabilization Law and suggests that it is missing a component similar to Colorado’s TABOR formula to refund excess revenues.

How much a state spends is ultimately up to its residents and legislature. Some states may have a preference for more spending than others, but given the tendency for government spending to grow towards an unsustainable direction, having a conversation about how to slow this is key. Implementing TEL-like checks allows for spending to be monitored and that tax dollars be spent more strategically.

Alaska’s Permanent Fund dividend is not structured as well as Colorado’s, but perhaps the state’s saving grace is that it has a relatively well structured TEL. Similarly to Colorado’s TABOR, Alaska’s TEL limits budget growth to the sum of inflation and population growth and is codified in the constitution. Alaska’s TEL doesn’t immediately refund revenue that is collected in excess of the limit to taxpayers as Colorado’s TABOR does, but it does target spending rather than revenues.

Colorado’s and Alaska’s TELs can compete when it comes to restraining spending, but Colorado’s is certainly more strict. Colorado’s expenditures have grown by about 55 percent over the last decade, while Alaska’s has grown approximately 120 percent.

The Lesson

Comparing Colorado and Alaska’s situations reveals two different ways of giving tax refunds to residents. Doing so doesn’t necessarily have to be fiscally irresponsible. Colorado has provided refunds to residents when state revenues have exceeded expenses and as a result this has acted as a restraint on over-spending higher than expected revenues. Although Colorado’s TABOR has been amended over time, its general structure illustrates the effectiveness of institutional restrains on spending. The unintended effects of TABOR, such as the increase in fees, could be well addressed by specifically targeting spending rather revenue, like in the case of Alaska’s TEL. Alaska may have had their future residents’ best intent in mind when they designed their Permanent Fund Dividend, but perhaps this goal of passing forward oil investment earnings should have been paired with preparing for the potential of cyclical budget woes.

You tell me it’s the institution…

When scandals erupt, the human tendency is to look for some nefarious person wearing a black hat and blame them. However psychologically satisfying this may be, it is not particularly helpful. It offers no constructive solution to avoid future problems, other than to be “ever-vigilant” against bad behavior.

In contrast, law professor Victor Fleischer’s take on the unfolding IRS scandal is a nice example of a more-useful reaction, one that focuses on the institutional factors that made the scandal likely to happen in the first place:

The root of the problem is poor institutional design, not a political conspiracy. Current law forces the I.R.S. to enforce a vague set of campaign finance laws that have next to nothing to do with raising revenue.

It is constructive to apply Fleischer’s approach to another unfolding scandal. In the past few weeks, the press has reported that the FBI is investigating Virginia Governor McDonnell for his ties to a major donor, Jonnie Williams. Williams, described by McDonnell as a close family friend, paid for the food at McDonnell’s daughter’s wedding reception and loaned the first family his fancy sports car for a day. In the last few years, the governor and the first lady seem to have given Williams’s company, Star Scientific, free promotion. For example, in August of 2011, McDonnell appeared at an event promoting Star Scientific at the Executive Mansion. And in June of 2011, the first lady flew to Florida to tout the company’s product, a dietary supplement.

The inquiry apparently began out of concern for the possibility of a quid pro quo: perhaps the governor and the first lady offered this free promotion in exchange for political and personal favors? For their part, the governor and first lady have maintained that it is their job is to promote Virginia businesses.

Indeed, the state legislature seems to think this is part of the governor’s job. Over the years, legislators have given the governor a host of tools to offer exclusive privileges to particular businesses. For example, the Governor’s Opportunity Fund “is a discretionary incentive available to the Governor to secure a business location or expansion project for Virginia.” There’s also the Governor’s Agriculture and Forestry Industries Development Fund. This too gives grants “at the discretion of the Governor.” You can read about these and other programs at the “business incentives” section of the Virginia Economic Partnership website. There, you will see that privileges include subsidies, matching grants, in-kind donations such as training, corporate and individual income tax credits, sales and use tax exemptions, property tax exemptions, and various financing programs. (In the case of Star Scientific, the governor seems not to have availed himself of any of these programs. Instead, he and his wife seem to have simply talked favorably about the company, just as they frequently talk favorably about other Virginia businesses.)

Presumably legislatures give governors the authority to grant special favors to firms because they believe these favors benefit the state. But the evidence that targeted incentives lead to any sort of widespread prosperity is quite scant. And as my research has emphasized, privileges lead to a host of economic problems because they undermine competition, encourage wasteful privilege-seeking, and put politicians rather than consumers in charge of allocating capital and resources.

But the Virginia story illustrates another cost of privilege: it inevitably invites questions of impropriety. The fact is, it is very difficult to devise objective criteria for dispensing privileges to particular firms. So one doesn’t have to look very hard to find apparently subjective decisions: Was Solyndra awarded half a billion taxpayer dollars because it had a superior business model? Or was it given money because green energy is politically popular and the vice president wanted to host a ribbon-cutting ceremony there? Did the Administration offer trade protection to domestic solar panel makers because the Chinese were engaged in “unfair competition” or because domestic solar panel manufacturers are politically powerful and well-connected?

I don’t see how these questions could possibly be answered definitively. Instead of trying to pretend that they can be, we should change the institutions that inevitably give rise to charges of impropriety. We should stop presuming that an elected official’s job description includes the promotion of particular businesses. If we stop asking politicians to pick winners and losers, there will be no more scandals about whom they pick.

Full disclosure: A few years ago, Governor McDonnell appointed me to serve on Virginia’s Joint Advisory Board of Economists. Once a year I travel to Richmond and offer my opinion on the state’s economic and fiscal forecasts. I am not compensated for my participation.

Another Look at Income Mobility

Back in December I did a post on income mobility. I used data from a 2007 Treasury Department study that followed actual individuals over time (most press treatments of the subject fail to do that). At the time, I could not find the link. My colleague, Seth Goldin, however, recently dug it up. So I’m reposting the entire post below, now with a working link.

Before I get to that, though, here is an illuminating video by Professor Steven Horwitz of St. Lawrence University. He addresses the same subject with a different dataset. Yet he arrives at the same conclusion:

Here is my updated December post:

Every so often, the Census releases new data on income inequality. Typically, the numbers look something like this:

Pretty bad, huh? The chart, derived from data in a Census report, seems to show that the rich are getting richer while the poor are basically stagnating. 

Unfortunately, these numbers are not particularly helpful in describing what is actually happening. The problem is that they show a snapshot of groups over time. They do not, however, tell us how individuals’ incomes have changed over time. Maybe people who were in the bottom 20% in 1996 were no longer in the bottom 20% by 2005?

To see the problem, imagine the story were not about income inequality but about mathematical proficiency. Imagine that you saw the following data (which I completely made up).

 

Here we see that 12th graders grew more proficient in trigonometry over time. But, sadly, 6th graders seem to have been left behind. Few of them knew trig in 1996 and only a slightly larger percentage knew it 9 years later. But wait. Those people who were in 6th grade in 1996 grew up. By 2005, they were out of high school. Wouldn’t it make sense to follow individuals and see whether they knew more trig 9 years later?

We can apply this same line of thinking to the often-cited numbers on income inequality. And when we do, we see that the first chart above really isn’t helpful at all. 

Is there a better way? Yes. Consider a Treasury study from a few years ago. It is called “Income Mobility in the U.S. from 1996 to 2005.” Instead of checking in with groups over time, it used IRS data to follow the same people over the course of nine years. The results were quite different than those presented by the first chart.  

 

Among those who were in the bottom 20 percent of earners in 1996, their average incomes had increased by 233 percent just nine years later. Using the IRS data, it appears that low-income people experienced pretty significant income growth from 1996-2005. A totally different picture, huh?

As far as I am concerned, the important thing is to have a dynamic and growing economy with plenty of opportunities for those who are the least well-off among us. We can debate about whether or not ours is that sort of economy—especially given the current economic climate—but a simplistic analysis of income groups gives us very little information on this score.

What is Happening with Income Mobility?

Every so often, the Census releases new data on income inequality. Typically, the numbers look something like this:

Pretty bad, huh? The chart, derived from data in a Census report, seems to show that the rich are getting richer while the poor are basically stagnating. 

Unfortunately, these numbers are not particularly helpful in describing what is actually happening. The problem is that they show a snapshot of groups over time. They do not, however, tell us how individuals’ incomes have changed over time. Maybe people who were in the bottom 20% in 1996 were no longer in the bottom 20% by 2005?

To see the problem, imagine the story were not about income inequality but about mathematical proficiency. Imagine that you saw the following data (which I completely made up).

 

Here we see that 12th graders grew more proficient in trigonometry over time. But, sadly, 6th graders seem to have been left behind. Few of them knew trig in 1996 and only a slightly larger percentage knew it 9 years later. But wait. Those people who were in 6th grade in 1996 grew up. By 2005, they were out of high school. Wouldn’t it make sense to follow individuals and see whether they knew more trig 9 years later?

We can apply this same line of thinking to the often-cited numbers on income inequality. And when we do, we see that the first chart above really isn’t helpful at all. 

Is there a better way? Yes. Consider a Treasury study from a few years ago. It is called “Income Mobility in the U.S. from 1996 to 2005.” I downloaded a copy a few months ago. Strangely enough, it seems not be available at the Treasury site anymore (please email if you have a working link or know the story behind this). In any case, instead of checking in with groups over time, it used IRS data to follow the same people over the course of nine years. The results were quite different than those presented by the first chart.  

 

Among those who were in the bottom 20 percent of earners in 1996, their average incomes had increased by 233 percent just nine years later. Using the IRS data, it appears that low-income people experienced pretty significant income growth from 1996-2005. A totally different picture, huh?

As far as I am concerned, the important thing is to have a dynamic and growing economy with plenty of opportunities for those who are the least well-off among us. We can debate about whether or not ours is that sort of economy—especially given the current economic climate—but a simplistic analysis of income groups gives us very little information on this score.