Revenue Shortfalls and Debt Downgrades in Kansas

Kansas policymakers were recently hit with two pieces of bad news: a state bond downgrade by Moody’s investors and lower than expected income tax revenues. Opponents of Kansas tax reform and reform efforts outside the state are hailing this as a “teachable moment” on the problems with tax reform, but their faux-concerns are misplaced. Opponents misunderstand the source of these problems and the virtues of tax reform in putting the state on firming footing.

Lower than expected tax returns are largely the result of slow economy and federal tax policy. First quarter gross domestic product growth in the United States was an anemic 0.1 percent. Slow economic growth generally results in slow revenue growth, particularly for income tax collections. The Tax Foundation has recently pointed out that some of this may be the result of the expiration of bonus expensing, causing a notable fall investment early in 2014. This policy change, combined with a number of other federal tax and regulatory changes has created a difficult environment for economic growth in 2014.

Additionally, Joe Henchman of the Tax Foundation pointed out nearly a year ago that last year’s so-called “surge” in state income tax revenues was likely a one-time jump due to the federal capital gains rate jumping from 15 percent to 23.8 percent as part of the so-called “fiscal cliff” legislative compromises. As such, many investors accelerated their investment sales in order to avoid the increasing capital gains rates. This caused a spike in capital gain revenue last year and a sharp fall in capital gains revenue this year relative to trend. As Will Upton with Americans for Tax Reform has pointed out, the Congressional Budget Office also predicted this all the way back in January of 2013 for the same reasons.

Thus, the state’s recent revenue woes seem to have far more to do with what’s happening in Washington, DC, rather than Topeka, Kansas. Kansas State Department of Revenue has pointed out as much in their press release announcing revenue short-falls, although this has gone on deaf ears among those searching for an opportunity to assail Kansas’ pro-growth tax reform. As the press release and news reports across the country have noted, state tax revenue is down nation-wide, not just in Kansas. The Rockefeller Institute has documented as much in a recent data alert, noting personal income tax returns seem to be down nationally by 0.4 percent in the first quarter and in at least 10 different states. This includes states that didn’t take on any notable tax cuts in recent years. The Washington Post has also covered this dynamic.

Turning to Kansas’ bond rating downgrade, Moody’s cited more than just recent tax cuts as the rationale for a downgrade, despite what opponents of tax reform are touting. Reliance on non-recurring revenues, a lack of spending cuts matching outlays to expected revenues, depletion of the rainy day fund, slow economic growth, and the underfunded state pension system were all noted as budget problems facing the state. That is to say that Kansas can improve their bond rating by addressing spending issues and boosting economic growth, not just raising taxes. Moody’s even makes clear in their analysis of Kansas that they do not view the lack of a state income tax as a source of credit risk. Standard & Poor’s has gone as far as to call low reliance on income taxes a boon to strong credit ratings, stating, “Sales tax-based revenue structure that exhibits sensitivity to economic cycles, but to a lesser degree than those of states that rely primarily on personal and corporate income taxes.”

The fact of the matter is that the Kansas tax cuts are not the source of the state’s woes. Instead, they are reason for deep optimism about the state. States with lower taxes—lower income taxes in particular—see higher economic growth. As we constantly point out, the 9 states with no income tax perform better on job growth, economic growth, migration, and even tax revenue growth. The table below shows the results:

Notable here is that stronger economic performance means more tax revenue growth. When wages grow, the economy grows, and citizens migrate in-state, tax collections are positively affected. Moreover, the primary goal of tax policy should be to fund the necessary functions of government while maximizing economic growth. Kansas is right to push for more sound tax policy that empowers private sector growth while looking to trim government down to right-size. A dollar of tax cuts in Kansas will provide far more benefit to Kansans than a dollar of spending given the state’s current tax and spending picture.

Last, it’s notable that this unexpected drop in tax revenue is the result of reliance on income taxes. Income taxes are by far the most volatile source of tax revenue given their wide fluctuation with economic conditions and to policy changes that entail changing incentives for individuals and firms. The chart below demonstrates this:

Thus, though Kansas has had a rough recent news cycle, tax reform is not to blame. Instead, Kansas’ problems have far more to do with federal policy changes and unaddressed spending side issues in the state. Instead, tax reform in Kansas is a reason for deep optimism for future revenue growth and stability, more jobs in the state, higher income growth, and a stronger shared prosperity in Kansas. Far from a warning to other states considering tax reform, Kansas serves as an example of taking bold steps to shake of the anemic complacency of the status quo and embrace a pro-growth economic policy environment.