John Locke Update / Research Brief

Tax Reform in Kansas and North Carolina (Again)

posted on in Fiscal Insight, Spending & Taxes
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Federal tax reform has turned attention again to reforms in Kansas and North Carolina over the past five years. North Carolina’s success is well-documented by the John Locke Foundation, the Tax Foundation, and others. Critics from the Left and Right view Kansas, which reversed course and raised taxes this year while North Carolina continues to lower rates, as an example of what not to do.

The Kansas quagmire owes to a number of factors, but not the ones that get the most attention. Taxes and regulation matter but mostly in their influence among competing forces on population, investment, and innovation. Global and national market conditions can thwart the best policies. Changing political conditions can create additional headwinds to passing good policy. Kansas faced a combination of challenges that North Carolina did not and the nation would not.

Population

Kansas does not bring people in.  The exception was a few years in the mid-2000s to employ individuals to drill for gas and oil. Slow population growth means slow labor force growth, so it’s not surprising that employment has not grown rapidly. Slow population and labor force growth limit the economic potential of the state as much as they reflect the opportunities available.

Commodity Prices

In 2012, agriculture and mining were 6.4 percent of the Kansas economy. By 2017, their share was down to 2.6 percent.

The price of wheat collapsed over two years from over $8.00 per bushel in September 2012 to a low of $3.34 September 29, 2014. Corn prices fell from over $7.00 per bushel to less than $4.00 per bushel. These two crops account for one-fifth of total agricultural revenue for Kansas. Cattle provide three-fifths of the state’s agricultural revenue, and prices climbed from roughly $120 per head as high as $168 between 2012 and 2014. Unlike grain, which has not yet recovered, beef and cattle prices began falling again in 2015 and are now back to levels in 2011 and 2012. The agriculture sector in 2013 was an $8 billion industry for Kansas but began contracting in 2014 and is back to levels last seen in 2007, which is sixty percent smaller than when tax reform passed.

Kansas briefly received attention from oil companies seeking to tap reserves in Oklahoma, but they began to retreat in 2013 and mining as a whole is half the size it was in 2012 and smaller than it has been in more than a decade.

Forecasts

With the collapse in oil prices, Kansas lost $100 million in severance tax revenues legislators had counted on to offset reductions in other tax rates. Severance tax revenues for the General Fund fell from more than $125 million in FY 2014 to $22 million in FY 2016. Revenue estimates were already overly optimistic, and severance tax volatility made forecasting even more difficult. Governor Sam Brownback convened a working group to recommend changes to the budget office and legislative fiscal staff who forecast revenue for the fiscal year (FY). One recommendation was to move the final forecast from April 1, before the April 15 deadline for filing taxes, to May 1, to incorporate more accurate income tax receipts, which has been common practice in North Carolina.

Spending

Bad forecasts may have led policymakers to be more sanguine about the effects of tax reform and spend more than they had available. The state Supreme Court piled on with demands for to return to the old school funding system that ensured spending would increase for each school district every year. Gov. Brownback and the legislature in 2015 provided block grants that did not reduce funding for schools but did not guarantee higher spending from one year to the next. They hoped to develop a new funding formula within two years, but the Supreme Court short-circuited the process.

Spending would have needed to shrink 8.5 percent since the tax changes took effect, which would have had to come from areas other than the two largest items in the budget. School funding grew in response to the Supreme Court, and Medicaid was already in the midst of reform while being inundated with new enrollees.

Legislators in 2015 brought in the consulting firm Alvarez and Marsal, which had recommended efficiencies in Louisiana, to find savings in Kansas government. The firm made scores of recommendations to save $2 billion over five years. Some changes were implemented by the executive branch, but nothing made it into law.

Tax changes

The 2012 tax plan itself was intended to be a combination of rate reductions and tax code simplification much like North Carolina adopted in 2013. By the time it passed, however, the plan was a larger reduction in revenues with few offsetting simplifications of the tax code. Despite this, one of the biggest criticisms of the Kansas tax reform has been aimed at a change that did not lead to more tax avoidance. Sole proprietors and other forms of business whose earnings are taxed as pass-through income to the owners were able to pay lower taxes than wage earners or corporations that keep their income and pay dividends. The revenue estimating task force concluded that there was no evidence businesses or individuals were creating or converting business structures faster than before tax reform.  But the legislature repealed it anyway as part of a broader tax hike in 2017. Even with its tax cuts, Kansas never was able to improve significantly on the Tax Foundation’s State Business Tax Climate Index, where it was ranked 25th in 2012 and 23rd in the latest edition.

North Carolina’s experience

In contrast to Kansas, North Carolina climbed to number 11 in the Tax Foundation index from 44 in 2012. North Carolina has advantages that make it more like the nation as a whole compared to Kansas. North Carolina attracts businesses and families from other states to its major metropolitan areas, the mountains, and the coast. Revenue estimates have tended to be conservative, which has helped keep spending from racing ahead, and legislative leaders have made restraint a hallmark of their budgets. The state’s economy has not been subject to the same volatility of commodity prices as Kansas, thanks to its past diversification. Tax cuts have been phased in with escape valves in case revenues failed to meet expectations and with other changes to replace special tax breaks with a large standard deduction for individuals.

Federal tax reformers can learn some important lessons from the contrasting experience of the two states. First, if the economy is not entirely subject to tax policy and weak markets can derail the best plans. Second, cuts alone are not a great plan. Businesses and individuals need simpler tax rules with consistent rates and fewer ways to pay more or less based on government’s preferred actions. Finally, slower government spending is essential to the long-run sustainability of government finances.

Joe Coletti is a senior fellow at the John Locke Foundation focused on fiscal policy issues. He previously headed the North Carolina Government Efficiency and Reform initiative within the Office of State Budget and Management, which led to… ...

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