Dynamic Analysis of State Severance Tax Hike

"Dynamic scoring of tax rate changes should be utilized in budgetary projections for the State of Arkansas. It is irresponsible to ignore the behavioral impacts of tax rate changes on consumers and suppliers of labor and capital." (Murphy Commission, Policy Foundation, 1998)

Dynamic analysis can provide legislators with more information when considering fiscal proposals. Legislators, in the case of the severance tax should be provided with a second revenue estimate based on a lower natural gas futures contract price in the $5.50 to $6.50 range. (Policy Foundation, Road Map for Arkansas Prosperity, December 2008)

(September 14, 2009) State revenues from a 2008 severance tax hike are $16.5 million less than the Department of Finance and Administration estimate if based on a natural gas price of $6.21 per cubic foot, not the $8.00 state estimate, according to a dynamic analysis of the tax increase.

A 2008 Univ. of Arkansas Center for Business and Economic Research study cited an average $6.21 price for forecast investments to occur, but natural gas currently trades at a significantly lower price than $8.00. NYMEX Natural gas settled at $2.96 in the most recent trading session.

The Bureau of Legislative Research provided the analysis to state Rep. John Edwards, D-Little Rock, acting in response to a constituent request.¹

Dynamic Analysis

Dynamic analysis is an attempt to measure the full impact of fiscal policy, including tax proposals, on revenue estimates. The concept has evolved from theoretical to practical since the Policy Foundation recommended the idea in 1998. The American Economics Association and National Bureau of Economic Research have published papers on dynamic analysis in the last five years.

Dynamic analysis can also provide legislators with more information when considering fiscal proposals. A common question posed by legislators and the constituents they represent is, 'What is the impact of tax proposals on revenues?' Subjecting fiscal proposals to dynamic analysis would provide them more information.

Policy Implications

Tax Revenues May Diverge Radically From The Original Estimate: Economists do not possess the proverbial crystal ball that allows them to forecast or plan a complex economy with exact precision. F.A. Hayek, the 1974 Nobel Economics Laureate who taught at the Univ. of Arkansas discussed this problem in the profession's flagship publication, The American Economic Review.² Commodity markets may tend to inflation or, in the case of natural gas since last year's severance tax increase—deflation—as a result of unforeseen real world events. The best economists can do is provide policymakers and the constituents they serve with revenue estimate ranges under different economic scenarios.

Policymakers debating the severance tax last year should have been provided with revenue estimates based on natural gas price ranges greater and less than the $8.00 state estimate.

Unintended Economic Consequence: The decline in revenues from the severance tax hike as a result of deflation in the natural gas market is an unintended economic consequence. The problem was summarized in a recent news article:

"Collections were only about half what state officials predicted in fiscal 2009, the first year of the new severance tax on natural gas."³

Legislative, Higher Ed and Private Sector Economists Should Have Greater Roles in the Revenue Estimation Process: An executive branch department should not have sole discretion for official estimates. Other states use a reconciliation process that involves the legislative branch, and university and private sector economists.

Dynamic Analysis Should Be Applied To All Major Tax Proposals: Dynamic analysis should applied to all major tax proposals coming before policymakers. These include, in recent years, proposals to lower the sales tax on groceries and capital gains and income tax rates, and the severance tax increase.

-- Greg Kaza

¹ The author of this research memo initiated the request Aug. 28. Rep. Edwards responded in a timely manner, providing the Bureau's analysis Sept. 10.

² Hayek, Friedrich A. 1945. "The Use of Knowledge in Society." American Economic Review. (September): 519-30.

³ Blomeley, Seth. Arkansas Democrat Gazette. "Gas tax take falls short of forecast: Price drop halves predicted yield." August 2, 2009.