by Robert Kleine, Senior Economist and Vice President

This Advisor comments on the short‐​sightedness of current proposals to cut tax rates.

Emboldened by projections of short‐​term budget surpluses, the legislature appears to be rushing headlong off a fiscal cliff. Shortly after passage of the most far‐​reaching school finance reform plan in decades and a $700‐​million tax cut, the legislature is proposing to cut taxes by at least $155 million, raise spending by $100 million or more, and, if some legislators have their way, repeal the single business tax. This is very foolish for several reasons.

First, the school aid fund will have an annual revenue shortfall of $600 – 800 million that will have to be made up by transfers from the general fund and the Budget Stabilization Fund (BSF). Our projections indicate an overall revenue shortfall of more than $800 million in FY 1996 – 97, assuming the proposed $155‐​million tax cut is approved. In addition, there is much uncertainty about the new school funding plan. It is likely to cost more rather than less than expected. We believe a year or two of experience should precede any additional major tax changes.

Our budget projections for the current and the next four fiscal years are shown in Exhibit 1. The projections assume a current‐​services level of general fund‐​general purpose spending (3 percent) and a slowdown in the economy in 1996 (see discussion below).

Second, the business cycle has not been repealed. There will be another recession in Michigan, resulting in very slow growth or a decline in state revenues such as occurred only three short years ago. As shown in Exhibit 2, the longest recovery in motor vehicle sales (production) since 1961 lasted four years, and this only occurred twice. If vehicle sales increase in 1995 as expected, it will be the fourth straight annual increase. This makes it almost certain that motor vehicle sales will turn down in 1996, slowing economic and revenue growth in Michigan.

Future revenue slowdowns will have even more serious consequences for the budget, as $3.5 billion in local property tax revenues have been replaced by more unstable state tax revenues. General fund revenues will be falling short of estimates at the same time the school aid fund shortfall widens — a one, two knockout punch for the state budget. The sensible, far‐​sighted approach is to save every penny today and build up a BSF balance of about $1 billion. To do otherwise is to set up future legislatures, and perhaps the next one, for tax increases or draconian budget cuts.

Third, any plan to repeal the single business tax (SBT) will only make the fiscal situation much worse. The SBT generates nearly $2 billion annually. The only feasible replacement sources are a gross receipts tax or a business (or corporate) profits tax.

A gross receipts tax, paid whether a company makes money or not, certainly will not console those who complain about the SBT’s similar feature. The result would be to create a new set of winners and losers, with the new group of losers continually lobbying to change or repeal the new tax.

A profits tax (which if adopted should cover business income from all firms, not just corporate profits) has two major drawbacks. First, it would be very unstable, one of the main reasons the SBT replaced the corporate profits tax (and six other taxes) in 1976. In FY 1970 – 71, the corporate income tax fell 44 percent and then increased 89 percent in FY 1971 – 72. If the tax had been in effect in the early 1980s, declines would likely have exceeded 50 percent. A 50‐​percent decline in a $2 billion tax, on top of shortfalls in other revenue sources, would create a nearly unmanageable budget situation. A stable tax, like the SBT, has the advantage of reducing the likelihood of tax increases. The corporate income tax was in place only four years before the rate was increased. The SBT rate has never been increased.

Second, the rate of a profits tax would have to be at least 15 percent to raise $2 billion, giving Michigan the highest rate in the country and creating a major barrier to capital investment in the state. Contrary to the views of the small business community and their supporters in the legislature, a 15‐​percent profits tax would be much more harmful to the Michigan economy than a 2.35-percent SBT.

Even if all the SBT revenues were not replaced, the rate would likely exceed the highest state corporate income tax rate in the nation — 12.25 percent in Pennsylvania. Small businesses, which favor the profits tax, are very important to the state, but the strong economic recovery currently under way is being driven by the motor vehicle industry, which would be hurt by a high profits tax.

One justification for pushing through tax cuts is that state revenues will exceed the constitutional state tax limit in FY 1994 – 95. The Senate Fiscal Agency currently projects that revenues will exceed the amount that requires a refund to taxpayers by about $15 million. This estimate is based on the April 1993 personal income figure, whereas the final calculation will be based on the revised August 1993 figure.

We believe personal income will be revised upward by $1 – 1.5 billion, eliminating the necessity to refund money to taxpayers. Also, we estimate that 1995 – 96 revenues will be about $750 million below the limit, as 1994 personal income will grow much faster than FY 1995 – 96 revenues.

We hope that the legislature and the governor will take the long view. The state has gone through considerable pain to reach a position of fiscal stability, the long simmering school finance dilemma has been addressed, and property taxes (and total taxes, including a $100‐​million reduction in the inheritance tax last year) have been reduced. It is time to consolidate these gains and take actions to insure that the current good times last beyond the next downturn in the economy.

Copyright © 1994