by Robert Kleine, Vice President and Senior Economist

This Advisor examines the effect of Governor Engler’s proposed tax cuts on the state economy, tax system, and budget.


Tax cuts are in vogue, due partly to Republican ascendancy to power and partly to the strength of the economy, which is generating larger‐​than‐​expected increases in government revenues. In addition to proposed tax cuts at the federal level, at least 30 states are expected to cut taxes in 1995. This represents an acceleration of the trend that began in 1994, when 21 states reduced taxes by about $1.6 billion (net), or 0.5 percent of revenue. (This does not include the $700 million Proposal A tax cut in Michigan, as local rather than state taxes were reduced.)

This was the fourth year since 1964 that state taxes were reduced — 1978, 1979, and 1985 being the other three. The largest cut was 2 percent in 1978. The 1995 tax cuts, although expected to be widespread, are not likely to exceed one percent of state revenue.

Although tax cuts in many states can be justified by excess revenues, and in Michigan’s case cuts are required by the constitution (at least for FY 1994 – 95), states enacting large tax cuts may create future fiscal problems because economic growth will slow down (most likely in 1996) and the federal government is likely to reduce aid to states sharply, particularly if a federal balanced budget amendment is adopted.

In addition, proposed federal tax cuts such as preferential treatment of long‐​term capital gains, individual retirement accounts, and depreciation of business property would reduce state revenues, as most states conform to some degree to the federal tax code. Another potential problem for states is that federal officials may seize on state tax cuts as an excuse for cutting federal aid, assuming states are in a strong financial position and that tax cuts leave more room for future tax increases.

Federal Aid

State and local governments will receive an estimated $231 billion in federal aid in FY 1995 — of which about 89 percent goes to states. The largest share (44 percent) is for health programs, primarily Medicaid. The other components are welfare and housing (23 percent); education, training, and social services (15 percent); transportation (9 percent); and miscellaneous (7 percent).

How much will the budget have to be cut to achieve a balanced budget by 2002? The Congressional Budget Office estimates a deficit of $319 billion and federal outlays of $2.209 trillion in 2002. If tax increases are tabled and spending is reduced across the board, spending would have to be cut 14.4 percent. However, interest on the debt cannot be reduced, and Social Security and defense appear to be off the table. These three programs are estimated to cost $1.081 trillion in 2002. Therefore, to reach balance the remainder of the budget would have to be reduced by about 29 percent. A cut in federal aid of 29 percent this year would amount to $67 billion. For comparison purposes, total state tax revenue is about $390 billion. Michigan’s share of this $67 billion reduction would be $2 billion.

Governor’s Tax Cut Plan

The consensus revenue estimating conference held in January agreed that state revenue in FY 1995 will exceed the constitutional limit by $297 million. The constitution requires that if the limit is exceeded by more than one percent ($185 million in FY 1995), the excess must be returned to the taxpayers pro rata based on the income tax and SBT liability. The refund must be made in the fiscal year following the year in which revenue was determined to exceed the limit, in this case, in FY 1997.

Governor Engler, however, has proposed reducing revenue in FY 1995 to insure that the limit is not exceeded. The governor proposed three permanent, major adjustments to the tax system to reduce revenues by about $190 million in FY 1995 and about $1.55 billion over five years (since increased to $1.7 billion by Senate amendment). (See Exhibit 1.)

The proposed changes are (1) increase the personal income tax exemption for each individual from $2,100 to $2,400 immediately and to $2,500 in 1997 and index the exemption for inflation; (2) eliminate unemployment insurance, workers’ compensation, and Social Security payments from the SBT base; and (3) increase the intangibles tax exemption from $5,000 for a single return and $10,000 for a joint return to $8,000 for a single return and $16,000 for a joint return immediately and then phase out the tax with a 25 percent cut in 1995 and complete elimination by 1999.

In addition, the Senate added a provision to the income tax bill that would provide an income tax deduction for college tuition. In the first year (1995 tax year), payments to all qualified institutions of higher education would be eligible. In future years only payments to institutions that increased tuition at or below the rate of inflation would qualify. The deduction could not exceed $5,000 or be claimed for more than four years per student. The estimated cost would be $38 million in FY 1995 – 96. Future costs would depend on the rate of tuition increases.

How should one judge this tax cut plan? I believe there are four tests.

  • Do these changes make the tax system fairer?
  • Are revenues adequate to meet future spending needs?
  • Will there be a positive effect on economic growth?
  • Will the stability and growth potential of the tax system be improved?

Income Tax Exemption

The $400 increase in the personal income tax exemption will be worth $17.60 per exemption or $70.40 for a family of four. This will improve the fairness of the tax system as the reduction is a larger share of income for lower income families than for higher income families — 0.24 percent for a family of four earning $30,000, but only 0.07 percent for a family of four earning $100,000. This reduction averages about $117 million over the next five years, or 0.06 percent of Michigan personal income. Because of the small size of the cut it is not likely to have much effect on the economy, even if it is not financed with budget cuts.

The effect on the growth of the income tax is mixed. A rise in the income tax exemption increases the growth potential of the tax, because the tax‐​exempt base increases as a share of the total tax. For example, a family of four earning $30,000 will have taxable income of $20,000 assuming a $2,500 exemption. A 10 percent increase in their income to $33,000 results in taxable income of $23,000, a 15 percent increase. If the exemption were only $2,000, a 10 percent increase in income would increase taxable income from $22,000 to $25,000, or by only 13.6 percent.

Indexing the exemption, however, will slow state revenue growth. If inflation increases 4 percent annually, the exemption will increase $100 (in 1995 dollars), reducing revenue by about $31 million. Indexing preserves the current dollar value of the exemption but makes more sense when tax rates are graduated, in which case indexing keeps taxpayers from being pushed into higher brackets when real incomes are not rising.

The increased personal exemption is the best provision in the governor’s proposal and is a fair method to return excess revenues to the individual taxpayer.

The deduction for college tuition could be beneficial if it encourages universities to moderate tuition costs. However, the deduction’s $38 million cost is about 3 percent of the state higher education appropriation, raising the issue of whether a direct increase in the appropriation would be a better way to limit tuition increases.

The advantage of the tax credit is that it helps subsidize tuition costs for parents of college students. The maximum tax benefit, however, would be $220 each year for four years, not insignificant, but not enough to affect materially the affordability of education.

Single Business Tax

The elimination of payroll taxes from the base of the SBT is a poor choice. The business community views the inclusion of these taxes in the base as a tax on a tax. However, any compensation‐​related cost paid by a firm is part of value added, and the SBT is a value‐​added tax.

The argument that imposing the tax on compensation discourages new hiring is fallacious. If a firm increases its payroll without an offsetting increase in revenue, profits (part of the tax base) will fall by an equal amount, leaving the tax liability unchanged. The only way that the tax liability increases is if revenue increases, which is usually the purpose of hiring new workers.

The data needed to analyze the effect by industry in Michigan are not available. U.S. data are available, however, and are shown in Exhibit 2. The variation across industries is relatively modest. Payroll taxes (legally required benefits) range from 14.1 percent of compensation costs in the construction industry to 7 percent in finance, insurance, and real estate.

These percentages also do not vary much by company size, and in fact are lower for the largest companies. Small companies not subject to the tax due to the $250,000 base exemption or those using the alternate profit calculation (under $10,000,000 in gross receipts), however, will not benefit. In addition, companies using the 50 percent gross receipts limit may not benefit, and firms using the excess compensation deduction will lose some of the benefit as this deduction will decline as a result of the lower compensation tax base.

The stated purpose of the reduction in the SBT is to improve the business climate and job growth. Our view is that the best way to achieve this goal is to lower the tax rate, which is much more visible (and fairer) to firms, particularly for out‐​of‐​state firms, than a reduction in the tax base.

The reduction in the SBT is expected to cost the state about $530 million over five years. For this cost the rate could be reduced from 2.3 percent to 2.18 percent.

Another problem with this proposal is that it will increase the volatility of the tax. The most stable component of the tax is compensation. As compensation is reduced, the share of the tax generated by profits, the most unstable component of the tax, increases. This is particularly important because the changes in the school finance system have already increased the instability of the state tax system.

On all counts this proposed change to the tax system fails badly.

Intangibles Tax

This is the most controversial provision in the governor’s plan because most of the tax relief goes to the very wealthy. As shown in Exhibit 3, two‐​thirds of the tax is paid by taxpayers with incomes in excess of $100,000, and 28 percent of the tax or $25 million is paid by taxpayers with incomes in excess of $1 million. The average liability for these taxpayers is $17,675, a rather large tax break for a group that is doing very well. (About 83 percent of the tax is paid by individuals; the remainder is paid by fiduciaries and financial institutions.)

One of the arguments for eliminating the intangibles tax is that it penalizes savings and investment, and therefore doing away with the tax will stimulate economic growth. To the extent that the tax savings are invested in Michigan this may be true, but the cuts will amount to less than 0.1 percent of personal income when fully implemented, and a significant share of the savings would likely be invested outside Michigan.

Greater economic stimulus would result from tax cuts for low‐ and middle‐​income taxpayers, as most of the tax savings would be spent in Michigan.

The tax could be viewed as imposing double taxation on investment income (which is also subject to the 4.4 percent personal income tax), or as a graduated tax on investment income. Neither is a good justification for its repeal. Double taxation is common in the tax system (income is taxed when it is earned and then when it is spent), and the personal exemption and property tax credit also add graduation (or progressivity) to the income tax.

Our view is that an increase in the current tax credit is warranted, but the tax should not be repealed. The current exemption of $10,000 (tax credit of $350) for a joint return covers investment income of $200,000, assuming a 5 percent rate of return. Doubling the exemption would eliminate about half of the current taxpayers and cost about $25 million. The remaining taxpayers would have average adjusted gross income of more than $200,000. This would alleviate any concern about the burden on middle‐​income senior citizens.

Our preference would be to use these savings to enact a state earned income tax credit to supplement the federal tax credit. This would reward work, help those most in need, and provide greater stimulus to the state economy.

State Budget Impact

A major issue is whether the state can afford permanent tax cuts without cutting important state services. Our analysis indicates that as long as the economy continues to grow at a moderate rate these cuts can be afforded. We know, however, that at some point economic activity will slow significantly, as occurred in the early 1990s, and as could occur again as early as 1996, likely creating a serious budget problem, possibly one that may not be covered by the large balance in the Budget Stabilization Fund (BSF).

As shown in Exhibit 4, a decline in revenue growth to 4 percent in fiscal years 1996 and 1997 will still leave large budget balances. If the economy slips into a recession, however, and there is no revenue growth in these fiscal years, the balance in the BSF will be depleted and budget cuts and other adjustments of about $0.7 billion will be required in FY 1996 – 97. (See Exhibit 5.) These estimates do not take into account the potential federal aid reductions discussed above.


Governor Engler has been blessed with a strong economy that has allowed him to enact tax reductions and still provide a reasonable level of support for state programs. As long as the economy continues to grow, the state fiscal situation should remain stable. If, however, the economy slips into recession as it almost surely will at some point in the next few years, the tax cuts enacted in 1993 and 1994 and those currently proposed for 1995 and future years will create a serious budget problem that cannot be covered even by a BSF with a balance of more than $1 billion.

The most optimistic view would be that downturns are a relic of the past and the “new Michigan economy” will continue to expand into the next century. This would be nice, but it is unlikely and some preparation should be made to deal with a worst‐​case scenario.

We are not opposed to tax cuts, although we do not support key components of the governor’s proposal, as described above. Given the uncertainty about federal aid and the economy and the instability of the new school finance system , we would urge caution in state fiscal matters to avoid rushing headlong over a cliff.

Copyright © 1995