eNews Aug. 23, 2018 – Part 1
Thursday, August 23, 2018 - 12:30pm
There is a lot of economic news, and this week VML has taken a closer look at what this news means for the state and for the upcoming session. Be sure to read these stories:
- Too much money has its own set of problems
- The numbers behind the numbers in next year’s debate on state taxes
- Is there an end to the business cycle?
Too much money has its own set of problems
2019 Legislative Session to be dominated by tax and spending issues.
Gov. Ralph Northam strode into the joint meeting of the Senate Finance, House Appropriations and House Finance Committees on August 17 to the sound of enthusiastic applause. The state had closed the books on Fiscal Year 2018 with a reported revenue surplus of $552.6 million ($555.5 million if the $3.0 million in cash transfers is included in the total), and Northam and his Secretary of Finance, Aubrey Layne, were ready to explain the good news.
The bipartisan applause stopped when the governor thanked the General Assembly for passing Medicaid Expansion, which most of the Republicans on the dais opposed. The governor’s proposal to transform the earned-income tax credit to a refundable credit also struck a sour note for several delegates and senators. In interviews with news media later in the day, Republican leadership in the General Assembly championed broad-based rather than targeted tax relief measures.
Secretary Aubrey Layne followed the governor and presented a dizzying number of PowerPoint slides about the general fund surplus, transportation revenues, tax reform, and Internet sales taxes. The information below touches on these items.
General Fund Surplus:
The general fund had increased by 6.3 percent which was 2.8 percent above the 3.4 percent official forecast for fiscal year 2018. The revenue growth was powered by substantial increases in income tax and sales tax collections. Corporate income taxes, recordation taxes and insurance premiums taxes all underperformed, failing to meet their forecasted growth.
Payroll withholding taxes account for almost two-thirds of total general fund revenues — $12.5 billion of the $19.9 billion collected in FY 2018. As employment and wages grow so do withholding collections. Overall employment grew by 0.9 percent, which is less than the 1.3 percent forecasted. Secretary Layne noted, however, that the strength in withholding was broad-based spread among different industry sectors and included strong growth in both large and small businesses.
The story behind income tax collections focuses on individual non-withholding collections which increased $325.6 million ahead of the FY18 forecast. Non-withholding collections grew 15.1 percent compared with the forecasted growth of 4.3 percent. According to the Finance Secretary, 781 high-income taxpayers with more than $1.7 million in taxable income submitted $297.0 million in payments. This contrasts with the average of the previous three fiscal years in which 423 high-income taxpayers submitted $162.0 million. Non-withholding is a volatile revenue source and makes up 15.6 percent of the general fund.
Sales tax collections posted the strongest growth in the last three years. Revenues increased 3.1 percent, ahead of the annual forecast of 3.0 percent growth. Sales taxes make up 17.4 percent of the general fund.
The question for next year’s General Assembly session is the economy’s strength. Can the combination of employment and wage growth plus federal government spending generate a strong showing in revenue collections? Or, will other variables like inflation, trade policy and the national debt shake up the business cycle? No one knows, but we do know that the state’s cash position will be significantly improved over previous years. And, the state will no longer have to rely on withdrawals from the “Rainy Day” Fund to pay for on-going operational costs in the 2018-20 biennium.
Roughly $262.9 million from the FY18 revenue surplus will be deposited to the “Rainy Day” Fund in fiscal year 2020. This deposit plus another $234.4 million to the newly-established Revenue Cash Reserve will rocket unobligated cash to an amount over $1.0 billion by FY20.
Transportation Revenues Stall Out:
Commonwealth Transportation Fund revenues finished $12.3 million below the FY18 official forecast. The percent change from fiscal year 2017 registered a meager 0.1 percent of growth. The official forecast called only for a 0.5 percent revenue increase.
Motor Fuels tax collections were disappointing. A modest 3.3 percent increase in revenues was forecasted, but actual collections declined by 1.7 percent compared with FY17 collections. Rising gasoline prices, higher gas mileage for newer cars and an increasing number of electric and hybrid-engine vehicles have combined to punish this dedicated revenue source.
Given the legislature’s attention to improve traffic safety and reliability in the I-81 Corridor and to support transit operating and capital costs throughout the Commonwealth, there is likely to be a push to use additional sales tax revenue derived from Internet sales collections for transportation purposes.
Tax Conformity Struggle Predicted:
In his address to the three money committees, Secretary Layne said the first item is to bring Virginia’s tax statutes into conformity with federal definitions of income. “The Commonwealth does not currently conform to any Tax Cuts and Jobs Act (TCJA) provisions to the extent they are effective for Taxable Years 2018 and after.”
Layne asserted that the state needs to advance the date of conformity to December 31, 2018 so that the 2019 filing season can begin. Failure to enact timely conformity legislation would hurt individual and business taxpayers, requiring additional forms to make up some 20 to 30 complex modifications on their Taxable Year 2018 returns.
Based on a study commissioned by the Virginia Department of Taxation, about 90.0 percent of all Virginians will see no change in their federal tax liability. Most will experience a reduced tax liability. Almost half of the federal tax relief will go to taxpayers with incomes of $50,000 to $150,000. About 7.0 percent of the federal tax relief will flow to Virginians with annual incomes of $50,000 or less.
Concerning state tax liability, the Secretary of Finance said that almost 26.0 percent of Virginians will experience a higher liability with the highest percentage increases for taxpayers with less than $50,000 in income. According to the Secretary, almost 14.0 percent of the additional state revenues resulting from the TCJA will be paid by those with income of less than $50,000.
Gov. Northam’s proposal is to return about one-half of the TCJA-related revenue windfall to income earners of $50,000 or less by making refundable the Virginia Earned-Income Tax Credit for Low-income Taxpayers. The credit is equal to 20.0 percent of the federal credit. The estimated cost is $250.0 million for the 600,000 eligible taxpayers.
Republicans in the General Assembly have already announced their opposition to the governor’s proposal, promising to contest the tax reform issue. Speaker Kirk Cox called the governor’s proposal a tax increase on the middle class and especially the estimated 640,000 Virginia filers who could no longer itemize on their state tax returns if they choose to stop itemizing on their federal returns.
Internet Sales Taxes is not a Completely Settled Issue:
Secretary Layne brought up several items that the General Assembly will have to consider next year. He shared an article from the Wall Street Journal that urged Congress to pass federal legislation to ensure that the rules, policies and practices of the states with sales tax laws do not place an undue burden on interstate businesses.
Layne gave a qualified estimate of an additional $250.0 million accruing to the state treasury with $44.0 million recognized as belonging to local governments. The “take away” from his comments on Internet sales tax collections is that his estimate depends on actions taken by Congress and the General Assembly in responding to commercial interests. In other words, don’t bank on his estimate.
VML contact: Neal Menkes, nmenkes@vml.org
The numbers behind the numbers in next year’s debate on state taxes
A full week before addressing the General Assembly’s three “money committees,” Gov. Ralph Northam announced his intent to provide tax rebates to low-income Virginians earning less than $50,000 a year through state’s Earned-Income Tax Credit program.
Northam estimated the program’s cost at roughly $250.0 million a year. The governor said that some 600,000 Virginians could qualify for the tax credit each year, but only 200,000 would qualify for the full amount. The Northam proposal would make the state’s earned-income tax credit fully refundable. Under the current program the credit is equal to a taxpayer’s liability. For example, if an eligible individual has an $800 tax bill and qualifies for $1,000 in earned income tax credits, the credit is limited to $800. The governor’s idea is to boost the credit above the taxpayer’s liability to an amount based on earned income and qualifying tax dependents.
Where will the money come from to pay for the credit? Gov. Northam told the House Finance, the House Appropriations, and the Senate Finance Committees last Friday that the dollars will come from the over $500.0 million in additional revenue the state anticipates collecting each year through 2024 as a result of President Trump’s “Tax Cuts and Jobs Act of 2017” (TCJA).
State Republicans cried out that Northam’s proposal would be a tax hike on middle class Virginians, labelling the governor’s scheme as a redistribution of tax benefits to those who did not earn them.
Let’s take a closer look.
Background
In December 2017, the Virginia Department of Taxation (TAX) contracted with Chainbridge Software, LLC to assist the agency in evaluating the revenue impact of the Tax Cuts and Jobs Act (TCJA). The final report was issued July 27, 2018.
Chainbridge and TAX developed microsimulation models using federal and Virginia income tax returns for Taxable Year 2015, then adjusted the federal and state returns to reflect relevant TCJA provisions. As is always the case in modeling, “various assumptions had to be made regarding the choices taxpayers would make in preparing their returns and, to a certain extent, how their behavior may change in reaction to the TCJA.” The evaluators were hampered by the fact that very little federal guidance has been issued regarding TCJA provisions. “It is possible that such guidance, when issued, could affect the assumptions make in developing these estimates.”
General Conclusions
Chainbridge found that TCJA provisions affecting individual taxpayers resulted in an overall federal revenue loss and an overall revenue increase to the Commonwealth. The most important changes in federal law for the individual taxpayer centers on modifications to the standard deduction, loss limitation for noncorporate taxpayers, and changes in itemized deductions. Table 1 shows estimated revenue impact of the TCJA on Virginia revenues.
The Chainbridge report concludes that the overwhelming number of combined federal and Virginia tax returns will show a tax decrease in taxable year 2018. Less than 20.0 percent of the returns will have a combined federal and Virginia tax increase.
When considered together, the average combined federal and Virginia tax decrease will be $2,085 under the TCJA. This is based on 2.3 million tax returns. The combined average tax increase for just over 606,561 returns is $1,937. Table 2 provides more detail based on Virginia adjusted gross income.
The debate in next year’s legislative session will not, however, focus exclusively on combined federal and state returns. Much will be said about the estimated Virginia tax impact. Chainbridge concluded that most returns will experience no change in state tax liability.
Table 3 shows that for the almost six percent of returns having a tax decrease, the average decrease is $164. For the almost 25.7 percent of returns showing a state tax increase, the average increase in liability is $392.
The Northam Administration assumes that taxpayers will want to minimize their combined federal and Virginia tax liability. In Taxable Year 2018, the Chainbridge report estimates that 642,266 returns will switch from itemizing to taking the standard deduction.
Under current Virginia law, if a taxpayer takes the federal standard deduction, then he or she must use the state standard deduction. The law prohibits a taxpayer from using the federal standard deduction and then itemizing deductions on the state tax return. Table 4 is Chainbridge’s analysis of who is most likely to switch from itemizing to taking the standard deduction for both the federal and state returns.
Bottom Line
Before the silly season begins in January, it is important to remember that the federal tax changes for individuals are temporary, unlike the tax breaks for businesses. Unless a future Congress chooses to act in 2024, the state revenue “windfall” will disappear. If a Democrat is elected as president in 2020 and/or Democrats become the majority party in 2018 or 2020, major changes in federal tax policy could occur before 2024.
This means Virginia’s delegates and senators need to act prudently. A headlong rush to permanently change tax rates, the standard deduction, and itemization rules could result in a future budget problem long after the immediate political and monetary benefits fade away.
Does the state need another $950.0 million a year “son of car tax relief program?”
VML contact: Neal Menkes, nmenkes@vml.org
Is there an end to the business cycle?
Next month the Commonwealth will begin its revenue forecasting process, leading to the December submission of amendments to the 2018-2020 budget. The General Assembly will act on the governor’s amendments and work its magic in the 2019 Session.
As part of the process, the Joint Advisory Board of Economists crunches data in October and reviews economic projections for the current and next biennium. The assumptions and recommendations are provided in November to the Governor’s Advisory Council on Revenue Estimates (GACRE). The GACRE group is made up mostly of business leaders and economists, and it is their “real world” recommendations to the governor that are built into the new Budget Bill.
Revenue forecasting is not an easy task. It is tempting to take current conditions and assume that they will continue. And, the current economic conditions in Virginia are good. The unemployment rate of 3.1 percent is at its lowest rate since August 2007. The state labor force continues to expand with its sixth consecutive monthly increase. The labor force is at a record high 4,356,623.
In addition, state revenue collections in FY 2018 exceeded the official forecast by over a half-billion dollars. That’s real proof of a strong state economy.
At the national level, the Congressional Budget Office (CBO) projects the economy to grow by 3.1 percent this year as the federal government turns up the spending spigot and the Trump tax cuts help propel further expansion. In fact, the stock market reached a milestone this week. The Standard and Poor’s 500-stock index has soared more than 320 percent since emerging from the Great Recession, registering more than $18 trillion in wealth.
What can go wrong? Well, here are some facts and figures to ponder:
- The CBO expects economic growth to slow to 2.4 percent in 2019 and to 1.7 percent in 2020, meaning the growth in 2018 should be viewed as temporary.
- The Bureau of Labor Statistics reported that the consumer price index in July was 2.9 percent greater than a year earlier. Rents rose 3.6 percent; hospital prices increased 4.6 percent; gasoline prices were up 25.0 percent; and even taking the family out for dinner cost 2.8 percent more. Inflation is growing at a faster clip than wages.
- As inflation creeps up, it is reasonable to assume that the Federal Reserve Bank will continue to gradually raise interest rates. That’s been the Fed’s practice since late 2015. High inflation and high interest rates are not conducive for long-term economic growth.
- Trade wars lead to higher tariffs (taxes) and higher prices on more and more goods. Trade imbalances between nations result from several variables, some of which are not subject to treaties like the business cycle and energy prices. An extended impasse can shake business confidence and the balance sheets of many different businesses in the manufacturing and retail sectors.
- S. debt is exploding. The debt-to-gross domestic product ratio has doubled in less than 20 years from 33.0 percent in 2000 to almost 80.0 percent today. This ratio tells investors that the country may have problems repaying loans. The federal government is likely to have to pay higher interest on its debt which could crowd out future business borrowing needed for expansion. Fortunately, that scenario is not in the immediate future as many companies have stockpiled cash during this business cycle.
Although economics is not physics, it may be appropriate to apply some Newtonian wisdom regarding the business cycle and its impact on state and local revenues. “What goes up must come down.”
VML contact: Neal Menkes, nmenkes@vml.org
