Executive Summary and Exhibits

TAXES AND SAVINGS IN ARKANSAS

by

Dr. S. Keith Berry

Hendrix College


IMPROVING PRODUCTIVITY BY REDUCING TAXES

by

Drs. Ronald John Hy and R. Lawson Veasey

University of Central Arkansas

and

With an introduction by French Hill, Chairman,
Murphy Commission Tax Workgroup

About the Authors

Dr. S. Keith Berry is an Associate Professor of Economics and Business at Hendrix College in Conway, Arkansas. From 1979 to 1989 he was on the Staff of the Arkansas Public Service Commission, a state agency that regulates utilities. He recently received a Wincott Research Fellowship from the University of Buckingham, which allowed him to pursue research activities in the United Kingdom during the fall of 1997. Dr. Berry is the author of numerous articles in economics journals and has presented testimony on more than sixty occasions before various agencies (including the Arkansas Public Service Commission, the Federal Energy Regulatory Commission, and the Securities and Exchange Commission). He received his Ph.D. in Economics from Vanderbilt University and his B.A. in Mathematics from Hendrix College.

Dr. Ronald John Hy is Professor and Chair of the Department of Geography, Political Science and Sociology at the University of Central Arkansas. He recently co-authored a book entitled, State and Local Tax Policies from Greenwood Press and has a forthcoming chapter on "Economic Modeling" in another text entitled The Handbook of Data Analysis. Hy uses various computer models and forecasting techniques to look at both the positive and negative impacts of economic development proposals and policies. His research has appeared in journals, such as: Public Administration Review, Administration & Society, Public Productivity Review, State and Local Government Review, Government Finance Review, Health Policy, and Social Science and Medicine. Hy works with the Arkansas Office of Economic and Tax Policy which conducts economic research for the legislature.

Dr. R. Lawson Veasey is Director of the Public Administration Program and Professor of Political Science at the University of Central Arkansas. His research interests range from issues regarding economic development policy to intergovernmental relations. He has authored articles that have appeared in various journals, such as: Publics: The Journal of Federalism and State and Local Government Review.

The Murphy Commission Tax Workgroup

French Hill, Chairman
Rep. Tom Courtway
Charles Owen
Senator Stanley Russ
Rep. Courtney Sheppard
Ronn Hy, Ph.D.
Johnny Allison
Nathan Evers
Dan Peregrin
John Shelnutt, Ph.D.
Keith Berry, Ph.D.
William Goolsby, Ph.D.

Introduction

by J. French Hill

Arkansas policy--makers remain divided on tax policy issues and struggle to find common ground for reform. Moreover, the Governor and Legislature have been unable to agree on a comprehensive approach to tax reform during the last two sessions of the General Assembly. The outcome of this impasse has not been unexpected: Today, Arkansans face two "citizen -- driven" referenda on the 1998 general election ballot, a repeal of the state sales tax on groceries and a repeal of the property tax replacing it with a 2 cent sales tax increase. While these ballot measures represent the overwhelming belief by Arkansas taxpayers that their state tax burden is too high, they fall short of needed comprehensive reforms that would take into account what is best for long-term economic prosperity and our state's families and businesses.

The two papers that follow provide the reader with more information to better understand complicated Arkansas tax reform issues that loom just ahead. They are also designed to serve as a response to a Winthrop Rockefeller Foundation study, released in January of 1997 and entitled Building a better Arkansas Tax System, Evaluating the Options. The "options", in this case, seem biased toward advocating a continued and greater expansion of Arkansas state government -- this based on the study's analysis that Arkansas spends comparatively less than other states for existing government services. The underlying message is that Arkansas lags behind other states in spending on state services, we therefore need to increase spending in order to close the gap.

Such simplistic thinking fails to take into account a number of key factors -- the effects and implications of an already unprecedented government growth and spending pattern in Arkansas, confusion over the proper role and functions of state government, disturbing cost/benefit indicators that show spending on programs that fail to achieve results, privatization opportunities left unpursued, an absence of efficiency and cost containment practices, and other factors that have led some states to, indeed, reduce government's presence while getting "more for less."

Of course, with more spending comes more taxation and study after study has shown clearly that states undergoing increasing spending and taxation have less economic vitality and growth than those with declining taxes and spending. A recurring theme throughout the Rockefeller study is an increase in the income tax to fuel more government growth. The study also attacks sales and consumption taxes as a poor form of funding government, suggesting that they are regressive -- a position with which the Murphy Commission takes issue.

Several principles underlie the Murphy Commission's tax policy philosophy. They are:

Comprehensive, pro-growth reform. Generally, tax reform that is "comprehensive" reflects the notion that the state should raise only that revenue needed to support core or essential state functions. Other dollars that would have been utilized to support a more expanded role for government are left in the private sector to spur investment, savings, and consumption, thus stimulating economic growth, jobs, and prosperity.

By contrast, government policy on tax increases seems less sophisticated. It's usually takes a form similar to the following: "We need more money, so let's levy a sales tax increase on soft drinks; or our taxes are too high, so let's abolish the sales tax on food or repeal the property tax. The Murphy Commission favors a thorough review of all taxes (thus a comprehensive approach) in order to make an informed determination concerning the right mix of taxes to meet the revenue requirements of core state functions (see Murphy Commission paper by Commission Member Charles Morgan entitled "The Role and Function of State Government in Arkansas").

An additional principle guiding the Murphy Commission is that savings and investment should not be deterred by non-competitive levels of taxation on families attempting to save, to buy a house, start a business or send a child to school. Likewise, businesses should not be penalized. Tax policy should not significantly favor one type of business or professional endeavor over another. Contrary to critics of conservative market-driven tax policies, the term "pro-growth" is not per se a call for a "tax cut." In fact, given two different tax policies--each generating equal amounts of revenue--one might prove to be significantly more growth oriented than the other.

Arkansans are not under-taxed. Proponents of higher taxes and more spending like to point out that Arkansas is, by comparison with other states, a "low tax state" and that Arkansans are thus "under-taxed." They use this argument to advance the case that Arkansas' families and business should pay still higher taxes. An example of this reasoning surfaced last year in a report commissioned and issued in January 1997 by the Winthrop Rockefeller Foundation entitled. Building a Better Arkansas Tax System, Evaluating the Options. The report written by the Washington based Institute on Taxation and Economic Policy' based its findings on the use of average tax burdens which the Murphy Commission also views as flawed reasoning.

According to Zsolt Besci, "average tax rates only measure the size of government collections, and [it is] the marginal tax rates [that] create distortions to individual behavior and the economy as a whole. Distortions occur when households or firms change their work, consumption or investment behavior to minimize tax payments."2 At best, Arkansas ranks in the middle of states when considering tax burdens, not at the bottom. When one considers marginal tax rates, Arkansas ranks 18th nationally and only one of our southeastern states has a higher top marginal rate.' The Tax Foundation, Washington D.C., has also shown that Arkansas ranked 9th out of the 50 states in the its rate of tax growth to personal income growth from 1986-1996. This is yet another study showing how our taxes are growing faster than income.

Clearly a low tax burden is not a reliable or effective measure as to whether or not taxpayer dollars are spent wisely or that government operates frugally. Arkansas could have the lowest tax burden on earth and still be overspending and overtaxing its citizens. It's a measure that is essentially meaningless.

Taxes DO matter when seeking higher economic growth. The Rockefeller Foundation report strongly asserts that "there is little evidence that higher state taxes have significant adverse economic impacts."' While we concur that businesses and families review a host of factors such as "right to work" laws, regulatory environment, cultural and civic factors, skilled work force availability, public and private educational opportunity in determining whether or not to locate in Arkansas or expand in our state, we strongly disagree that there is "little evidence" to suggest that higher taxes do not matter. We want tax rates to be a significantly positive force when deciding to locate or expand in Arkansas. In his paper, Taxes and Savings in Arkansas, Dr. S. Keith Berry, Associate Professor of Economics and Business at Hendrix College, explores the economic evidence tying lower marginal tax rates to faster rates of economic growth.

Consumption taxes are not unfair. The Rockefeller Report echoes a familiar, but misleading "fact" that somehow all taxes on consumption are unfair, regressive, and therefore violate Americans' sense of fair play. The Murphy Commission rejects the notion that consumption taxes are bad. On the contrary, more and more states are moving toward consumption taxes as finance methods. Moreover, a national sales tax has been seriously debated in Congress as an alternative to our federal income tax.

The best way to insure that consumption taxes are broad-based -- and pro-growth --is to carefully legislate the base of goods subject to the tax. Exclusions and exemptions should be carefully crafted so as not to favor one industry over another. We generally support the logic that groceries, prescription drugs, medical services and home purchases should be exempt from sales tax. This is pro-growth and provides tax relief for basic necessities for families, particularly families with lower household incomes.

Keep in mind, however, that when a low-income earner forgoes an opportunity to save or invest in favor of purchasing a four-wheeler for recreational purposes, few would argue that he or she should not pay the sales tax. It is true that a wealthy buyer might feel the purchase less than the low-income buyer, but they both made the choices -and they both pay equally. In their paper, Improving Productivity by Reducing Taxes, Professors Ronald J. Hy and R. Lawson Veasey of the University of Central Arkansas, report that Arkansans, in surveys conducted between 1981 and 1987, consistently rate the sales tax the "most fair." Dr. Berry's paper highlights the academic research that refutes the simplistic argument that sales taxes are regressive and thus are bad.

Savings and investment produce jobs, new business capital and result in higher productivity. These, in turn, produce greater income and wealth. Over the long run, consumption taxes are more pro-growth than income taxes. Our nation's first Treasury Secretary, Alexander Hamilton, described it best in 1782: "The consequence of the principle laid down is that every class of the community bears its share of the duty [tax] in proportion to its consumption ...the chief excellence of this mode of revenue is that it preserves a just measure to abilities of individuals, promotes frugality and taxes extravagance.

Just Say No to Double Taxation. While the Rockefeller study goes on at great length about the regressive nature of consumption taxes, it conveniently overlooks the negative economic effects of high rates of taxation on savings and investment. One of the most onerous of these effects is so called double taxation which comes into play on capital gains, dividends, and interest. Families and businesses routinely suffer the consequences of double taxation which does in fact discourage saving and investing. You will read in Dr. Berry's paper how such forms of double taxation are a deterrent to retirees moving to Arkansas. This is because retirees derive a disproportionate amount of their income from these sources. Thus, while on the one hand state policy makers are keenly interested in making Arkansas more attractive to in-migrating retirees, they ignore this important tax issue.

Another negative impact of double taxation is the "out-migration effect" which drives capital away from our relatively capital poor state to other states who then reap its economic benefits. While difficult to measure, a significant amount of tax revenue is lost each year by Arkansas as corporations and individuals go to great lengths to insure that they are legal residents of another state with lower or zero taxes, such as Florida, Texas, and neighboring Tennessee. "Economic theory, as well as historical experience, also tells us that in the case of state and local taxes, residents and businesses vote with their feet [by moving to new locations] for or against prevailing levels of taxes and spending."

The end result of this capital exodus is devastating for Arkansas entrepreneurs and community needs. These so-called "non-residents" legally limit their profile. They often refuse seats on local business or civic boards of directors, limit their charitable donations, decline opportunities to invest in local businesses and the list goes on. This and the fact that they own property in another state, pay sales tax in another state, may invest in another state is all to their economic benefit and to the detriment of Arkansas which could benefit from their greater involvement, their expertise, and their investment of capital. Higher costs of capital inhibits capital and business formation.

During the 1980's, another small agrarian state, Iowa, developed a high tax regime. One study found that for the thousands of residents who fled the state's high income tax was one of the major factors.' We all remember the "Taxachusetts" of Governor Michael Dukakis. In 1991, Governor William Weld inherited a $1 billion deficit. He slashed $600 million in expenses during his first year and slowed the growth of Medicare and welfare spending resulting in a balance budget. He cut taxes seven times, including eliminating the state tax rate on capital gains further spurring the success of technology innovation and investment in new companies. Today, Massachusetts is stable in its public sector and booming economically in its private sector.

Dr. Berry describes in detail why Arkansas capital gains tax reform is needed. Our marginal rate on capital gains is six percent (6%). Following the recently enacted federal capital gains tax rate cut, the Arkansas rate is an even greater percentage of the federal rate. After the reduction in the federal capital gains tax rate, the marginal tax rate on capital gains in Arkansas is 26% vs 20% for the state with no capital gains tax. That ratio is 1.30, an increase in our competitive disadvantage from 21% to 30%. For taxpayers in the 15% bracket, the post-1997 marginal rate on capital gains in Arkansas is 16% vs. 10% in a state with no capital gains tax. That ratio is 1.6, which implies an even larger competitive disadvantage (60%) than the 21% prior to the 1997 Act.

Dynamic Scoring of Tax Effects.

Professors Hy, Veasey and Berry do a fine job of explaining why the use of "dynamic scoring" of tax policy changes should be important to all academics and policy makers. Common sense and economic modeling both have proven time and time again that when you tax something, you get less of it; likewise, if you raise the price of widgets, at some point consumers of widgets will purchase fewer widgets. However, this common sense responsiveness in relation to tax policy ~'I is rarely considered. Instead, many tax revenue recommendations are reported to the public as "static" models. A "static" model does not take into account any behavioral change on the part of an individual when policy is changed, but at times can serve as starting point for analysis. A comprehensive analysis however requires dynamic scoring.

Good reading.

J. French Hill is a ninth generation Arkansan. He is a banker in Little Rock and serves as chairman of the Murphy Commission's tax workgroup. From September 1991 until January 1993, he was Special Assistant to President George Bush for economic policy. From May 1989 until his joining the White House staff, Mr. Hill was Deputy Assistant Secretary of the U.S. Treasury for Corporate Finance. He was awarded the Treasury's Distinguished Service Award in 1993 by Secretary Nicholas F. Brady. He is a magna cum laude graduate in economics from Vanderbilt University.

Introduction Footnotes

This Institute is an affiliate the Citizens for Tax Justice, a labor union-backed anti-flat tax, anti-consumption tax research group directed by Mr. Robert S. McIntyre.

Besci, Zsolt, "Do State and Local Taxes Affect Relative State Growth?" Economic Review: Federal Reserve Bank of Atlanta, March/April 1996, p. 33. '

Moore, Stephen "Restoring Opportunity to Arkansas," Little Rock: Arkansas Policy Foundation, Spring 1996, page 5.

Moody, Scott, "State Tax Rates and 1996 Collections, " Tax Foundation, Washington D.C., February 1998, p.8

McIntyre, Robert S. et al, "Building a Better Arkansas Tax System Evaluating the Options," Institute on Taxation and Economic Policy, Washington, D.C., January 1997, p. 30. 6

Morris, Richard B, Editor, Alexander Hamilton and the Founding of the Nation. New York: The Dial Press, 1957, pp. 326-327.

Moore, p. 5

Ibid.

TAXES AND SAVINGS IN ARKANSAS

Dr. S. Keith Berry
Hendrix College

Executive Summary

• From 1980 to 1993 Arkansas state and local taxes, as a percentage of personal income, have increased from 9.0% to 9.9%. State tax rates should be structured so as to encourage savings and growth, not deter it. States with lower taxes consistently have been shown to have more capital formation and jobs growth. Unprecedented growth in state government in Arkansas-and in state spending - suggest our state is well-established on a tax and spend binge that, over the long-term, becomes an increasing economic deterrent rather than stimulus.
  
  
• States with lower marginal income tax rates have higher economic growth. Additionally, governmental dependence on revenues from taxpayers in high marginal tax brackets exposes the state government to revenue instability, which makes budgetary forecasting much more difficult. In order for Arkansas to move from a low-wage to a high-wage economy, the state needs to decrease the marginal tax rates on high-income employees, in order to attract those workers to Arkansas.
  
  
• State corporate income taxes are, in many cases, passed along in the form of higher prices to consumers. Good examples of this are regulated utilities, who pass through state corporate income taxes to consumers in the form of higher rates. Many of those rate - payers are low -income Arkansans. In those cases, the utilities simply act as tax collectors for the State.
  
  
• Additionally, state corporate income taxes represent a type of "double taxation", wherein corporate profits are taxed at both the corporate level and the personal income tax level, when dividends are paid.
  
  
• With the reduction in the federal capital gains tax rate to 20%, the Arkansas top capital gains rate of 6% looms even larger than it did before. That makes Arkansas less competitive in attracting capital as compared with states with lower or no capital gains tax rates.
  
  
• State capital gains taxes particularly punish the elderly because of a phenomenon known as "bunching". That occurs when a retired individual makes a once-in-a-lifetime sale of a business held for, say, several decades whose value has grown with inflation. Capital gains taxes then are paid on those phantom inflation gains. This effect is particularly onerous in a state such as Arkansas with a high proportion of elderly and retired citizens.
  
  
• Relative to income taxes, sales taxes encourage savings, which results in greater capital accumulation and greater economic growth. This benefits all Arkansas families, including lower-income families. Furthermore, a sales tax provides for more revenue stability than does an income tax.
  
  
• 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. Dynamic scoring simply recognizes the fundamental economic principle that if you tax something more, you get less of it.
  
  

IMPROVING PRODUCTIVITY BY REDUCING TAXES

by

Drs. Ronald John Hy and R. Lawson Veasey
University of Central Arkansas

Executive Summary

• The central hypothesis of this paper is that it is virtually impossible for any legislative body to cut government spending, especially if that spending reduction is to be based on any meaningful assessment of the efficiency and effectiveness of government programs. Legislatures are more interested in authorizing expenditures than they are with reducing spending. When it comes to fiscal accountability and responsibility issues, most legislative bodies tend to shy away from evaluating the short and long term impact of the programs that they fund. For example, the national government is just now beginning to address debt problems that have been looming large for more than three decades.
  
  
• Arkansas faces a multiple crisis regarding state taxes. First, Arkansas ranks first in the per capita growth of state and local tax burden (1989-1994) at 40.9 percent, well above the national average of 27.3 percent. Second, state and local taxes are growing faster than personal income of Arkansans. Between 1992 and 1995 the real growth rate of Arkansas general revenue was 19.5 percent, while the real growth rate of non-farm personal income was 10.0 percent. Third, that Arkansans, as reflected in public opinion surveys, are cognizant of these facts and are demanding more bang for their tax buck. Finally, one of the major attributes of industrial recruiting in the state is the low rate of taxation relative to other states in the competition for jobs. This presumption of low taxes may be threatened if the above scenario continues.
  
  
• The essence of the proposal in this paper is designed to force the state to become, at least indirectly, more aware of the efficiency and effectiveness of government programs by cutting taxes. Reduced revenues will encourage the state to make difficult choices about where scarce state revenues will be spent. The influence of special interests and the reluctance of legislative bodies to reduce spending appear to make a tax cut a viable alternative to spending cuts and, obviously, would be more popular with the voters. A tax cut, similar to what will occur on the national level during the 1998 tax year, would be more politically palatable with the voters, the members of the General Assembly, and with the Governor.
  
  
• A 10 percent reduction in the Arkansas individual income tax would reduce state revenues by approximately $131.9 million. The state budget surplus along with the normal rate of growth of general revenues would account for about $100 million of this proposed income tax reduction. Consequently, state government operations, including state aid to local governments, are reduced by a modest $31.9 million (expenditures for elementary, secondary, and higher education would not be reduced under this proposal). This $131.9 million reduction would result in a corresponding increase in personal income, returning more disposable income to Arkansans. About 1,634 jobs, primarily in the service and trade sectors, would be created, while about 775 jobs in government and construction would be lost.
  
  
• The ultimate purpose of this proposal is not to reduce government employment or to punish state employees, but is instead a strategy to increase government accountability and responsibility for programs and expenditures. A number of strategies exist to accomplish the state spending reductions from natural attrition schemes to across the board budget cuts (excluding education). Regardless of the way by which government spending is reduced, the real message of this proposal is to increase government productivity by a thorough review of the efficiency and effectiveness of government programs in Arkansas.
  
  

EXHIBIT 1

PERCENT CHANGE IN STATE & LOCAL TAXES

EXHIBIT 2

Percent Real Growth, 1992-1995

EXHIBIT 3

EXHIBIT 4

Ranking of the Forty Most Influential Interests in the Fifty States in the Early 1990s

SOURCES: Compiled from Hrebenar and Thomas 1987, 1992, 1993a, 1993b and the 1994 update of the Hrebenar-Thomas study of interest group power in the states. Gray, Virginia and Herbert Jacob (1996) Politics in the American States, 6th, Washington, D.C., CQ Press. NOTE: This table is based on a ranking of individual interests in the fifty states performed by political scientists during the spring of 1994. Each researcher was asked to rank groups into two categories: a "most effective" and a "second level of effectiveness" category. Rankings were calculated by allocating 2 points for each "most effective" ranking and 1 point for each "second level of effectiveness" placement and adding the totals. Where a tie in total points occurs, where possible, interests are ranked according to the number of "most effective" placements or the overall number of states in which they are effective.

In some cases the totals for an interest add up to more than 50. This is because specific groups within an interest category sometimes appear within both the "most effective" and the "second level of effectiveness" category in a particular state. For example, utilities are ranked in both categories in Colorado. Therefore, they are counted once for each category.

EXHIBIT 5

CLASSIFICATION OF THE FIFTY STATES ACCORDING
TO THE OVERALL IMPACT OF INTEREST GROUPS

Source: Compiled from the 1994 update of the Hrebenar-Thomas study focusing on interest group power in the states. Gray, Virginia and Herbert Jacob, Politics in the American States, 6th ed., Washington, D.C., CQ Press, 1996.

EXHIBIT 6

ARKANSANS' OPINION REGARDING,
WHICH TAX IS THE MOST FAIR 1981, 1982, 1986, 1987

Source: Division of Governmental Studies 1981, 1982, 1986, 1987

EXHIBIT 7




EXHIBIT 8

Source: Office of Economic and Tax Research Bureau of Legislative Research 1997

EXHIBIT 9

*Transportation, Communications, and Public Utilities
**Finance, Insurance, and Real Estate

EXHIBIT 10

Important Strategy Reduction Questions

Source: Levine, 1980: 6-7.

EXHIBIT 11

RESISTING & SMOOTHING TACTICS

Source: Levine, 1980: 21

EXHIBIT 13

MAJOR GENERAL REVENUES, 1996
(In Millions)

Source: Office of Economic & Tax Research Bureau of Legislative Research, 1996.

EXHIBIT 14

ARKANSAS PERSONAL INCOME TAX RATES

(Adjusted for Inflation, 1971-1996)

Source: Office of Economic & Tax Research Bureau of Legislative Research, 1996.

EXHIBIT 15

Source: Office of Economic and Tax Research, Bureau of Legislative Research.