How Does Tax Reform Change a State’s Fiscal Health?

During the recent midterm elections, many states and localities had more at stake than just their open congressional seats. According to the Tax Foundation, there were 49 state and local tax initiatives on the ballot, 30 of which passed. The approved initiatives range from Portland implementing a tax on retail sales for clean energy projects to Arizona choosing to ban sales taxes on services. It’s too soon to know exactly how these changes will play out, but their passing does provide a helpful moment for us to reflect on state tax reforms of the past. Many of the recently passed ballot initiatives merely allow policymakers to move forward on certain options and are not substantial enough to be considered significant tax reforms, but the economic principles behind analyzing both are still the same. Taxes matter. They not only impact how businesses and individuals interact in the economy, but they can either make or break a state’s budget.

That’s why we expanded on the fiscal implications of tax reform in this year’s Ranking the States by Fiscal Condition report. You simply can’t talk about state fiscal health without talking about tax reform, and vice versa.

Tax reforms can be evaluated according to many different criteria: on economic, equity, transparency, collectability, and revenue production grounds. In the context of fiscal health, however, we primarily focus on how major tax reforms have affected the ability of states to match their revenues with expenses over time. We also looked at each state’s tax revenue and expense trends relative to state personal income over time.

What we learned in the report can be explained by highlighting primarily two states. North Carolina and Kansas are two important examples of two different approaches to tax reform. One approach (North Carolina) lowers rates, broadens tax bases, simplifies the tax code, but doesn’t move forward without making sure the expense side of the budget equation is taken care of. The other approach (Kansas) cuts taxes drastically without offsetting losses in revenue with spending reform. Other states, including Michigan, Rhode Island, and Utah, also provide tax reform lessons, but their reforms are more similar to North Carolina’s approach than to Kansas’s.

The North Carolina Approach

Between 2013 and 2017, North Carolina undertook a series of tax reform measures. In 2013, the state changed its personal income tax from a three-bracket structure to a flat rate of 5.75 percent. It also cut its flat corporate tax rate from 6.9 percent to 5 percent, limited or eliminated dozens of tax exemptions, expanded its sales tax base, and repealed its estate tax.

What’s more, North Carolina has been able to not only slow the growth of its expenses, but lower them in some years, which is no small feat for any state. From 2006 to 2016, North Carolina’s total revenues have grown at about 1.4 percent per year, while expenses have grown at about one percent per year. Much of this expense growth, however, took place between 2007 and 2010. After years of consistent expense growth, in 2011, North Carolina’s expenses declined 3.8 percent. They continued to decline at about this rate until 2014 when they declined by an incredible 6.7 percent.

North Carolina’s expenses went from being 13 percent of state personal income in 2010 to 10 percent in 2016. Several factors went into this.

In addition to the tax rate and base changes, North Carolina eliminated several corporate tax expenditures. Before the reform between 2003 and 2009, the state provided more than $6.7 billion in economic development incentives. Since many of their special incentive packages had proven unsuccessful, the state allowed many tax credits to expire, including the especially generous film credit. Additionally, North Carolina implemented a series of unique tax triggers that would further lower corporate tax rates beyond the original reform package only if the state’s revenue hit specific targets. These tax triggers were achieved in both years that they were planned for, in 2015 and 2016.

The net effects of these changes have been positive for North Carolina. Revenues have only fallen short of expenses, specifically by five percent, in one year. But that occurred in 2008, most likely as a result of the recession. The state implemented its tax reforms between 2013 and 2017. Since the implementation of these reforms, North Carolina has been able to improve its operating position so drastically that revenues exceeded expenses by 12 percent in 2016. This was the second best operating position that year, coming behind only Nevada.

North Carolina’s net position has also improved, with its surpluses increasing from $296 per capita in fiscal year 2013 to $530 per capita in fiscal year 2016. This is especially impressive considering that most states experienced deficits in 2016, at an average of $72 per capita.

North Carolina’s tax reforms were effective from a public finance perspective because legislators also focused on controlling expenses. Utah and Indiana have similarly implemented reforms that reduced tax rates and broadened tax bases. Their experiences have been more nuanced, but in general, their ability to pair tax reform with lower expense growth has contributed positively to their operating positions.

The Kansas Approach

Kansas lowered its tax rates and narrowed its tax base in 2012, running against the recommendation of prioritizing tax-system efficiency that many economists make. This reform was not coupled with any reductions to spending substantial enough to offset lost income, and it also included a pass-through exemption for the income of sole proprietorships that narrowed the state’s tax base while encouraging tax avoidance.

Unlike North Carolina’s approach, Kansas’s approach did not slow expense growth. Between 2006 and 2016, expenses have grown at about two percent per year, while revenues have only grown 0.4 percent per year. Most of this expense growth occurred leading up to the reform in 2012. The post-reform growth in expenses was slightly slower than before the reform, but still not quite enough to make up for the loss in revenues from the reform.

Although revenues grew at about 0.4 percent per year over the whole period we studied, it’s helpful to break this down to see how revenues grew both before and after the reform. Leading up to the reform, revenues were growing steadily, at about 2.8 percent between 2006 and 2011. Between 2013 and 2016, however, revenues declined by about 1.5 percent on average. This decline in revenues paired with continued growth in expenses has placed an increasing amount of pressure on Kansas’s budget.

Overall, the effect of Kansas’s reforms has been revenue negative. Kansas’s operating position worsened following the reform. In 2014, for the first time since the recession, the state was unable to cover expenses with revenues. This also led to the state generating deficits of $77 and $283 per capita in 2015 and 2016, respectively.

Sometimes Change Is Incremental

The effects of a state’s tax reform on revenues depend on the design of the reform and its implementation. Base-broadening increases the overall efficiency of a tax system by reducing the distortionary effect of taxes on decision-making. North Carolina illustrates the benefits of pursuing this type of approach when it is paired with financially responsible approaches to spending.

No state wants to be in Kansas’s position (except, maybe, for states in even more calamitous positions like Illinois). The state experienced persistent shortfalls following their tax reform in 2012 and although the state is in a slightly better position today, it risks more shortfalls in the future if it does not prioritize fiscal prudence. The state implemented some tax increases to help make up their post-reform budget shortfalls, but the idea of returning to tax cuts paired with proposed spending increases have reemerged in the state. Policymakers interested in avoiding more fiscal distress should be wary of repeating the mistakes of their past.

The difficulty with tax reform is that many try to approach it with grandiose reform packages created with the hope of fixing all of the state’s problems. But creating sound tax policy requires balancing many different criteria, and it is tricky to do this all at once. Although North Carolina’s reform was quite successful, it’s rare that a state is able to conduct such a significant overhaul of its tax system. Sometimes progress is more incremental and accomplishes just as much over time, as Nicole Kaeding and Jeremy Horpedahl of the Tax Foundation have pointed out. Implementing small reforms over a span of several years can prove just as effective for improving your fiscal health and is sometimes more politically palatable, as was the case in Indiana.

Whether your state is attempting to improve its tax system through a one-time overhaul or through a series of incremental changes, the principles of sound tax policy persist. With even more tax activity expected in 2019, reformers should keep these principles in mind. Those hoping to make incremental progress with the recently passed ballot initiatives can still be optimistic, as long as they are moving forward with their state’s fiscal health in mind.