Budget & Tax

Gradual Income-Tax Phaseout Will Boost Oklahoma

February 1, 2016

Jonathan Small, Wayne Winegarden

We are proposing a tax reform for Oklahoma that would reduce Oklahoma's personal income tax rate by 0.25 percentage points each year over the next 20 years. This proposal would enture adequeate revenues for the state, impose fiscal discipline on spending, and, most importantly, inprove the incentives to work, save, and produce in Oklahoma. These improved incentives will accelerate the state's economic growth rate and help diversify Oklahoma's economy.

Taxes are an important tool for any government. Without taxes, the Oklahoma government could not build the roads, hire the law enforcement officers, or maintain the public schools the citizens of Oklahoma rely upon every day.

However, there is a downside to taxes as well.

Taxes reduce workers’ take-home pay; they lower returns for investors and savers; and, taxes burden businesses with higher costs. These negative consequences reduce an economy’s vibrancy and lower its potential growth rate.

Oklahoma must balance these competing interests. Oklahoma’s tax system must be able to raise sufficient revenues to fund the necessary government services. But in raising the necessary revenues the tax system should minimize its negative economic consequences. Additionally, steeply progressive income tax systems encourage excessive growth in state expenditures. When state expenditures exceed their efficient levels, the value of the government spending to the taxpayers is lower, and the tax burden is higher than necessary, creating unnecessary barriers to economic growth.

Based on the criterion of maximizing Oklahoma’s relative economic growth rate, OCPA is proposing a tax reform for Oklahoma that would reduce Oklahoma’s personal income tax rate by 0.25 percentage points each year over the next 20 years until it is eventually phased out in 2036. This proposal would ensure adequate revenues for the state, impose fiscal discipline on spending, and, most importantly, improve the incentives to work, save, and produce in Oklahoma. These improved incentives will accelerate the state’s economic growth rate and help diversify Oklahoma’s economy beyond the oil and gas and agricultural sectors.

When coupled with the current supermajority requirements to raise taxes, the proposed income tax phaseout sends an important signal to businesses and investors. It says that the after-tax rate of return from operating in Oklahoma will gradually improve over time. The proposal also makes the state tax environment in Oklahoma more predictable for businesses and individuals. For many business decisions, predictability in the tax environment is an important attribute that makes one location more attractive than others.

From a government revenue perspective, due to the gradual phaseout of the income tax, there would not be a year-over-year decline in tax revenues even on a static basis—only a reduction in the growth of state tax revenues.

However, as detailed below, Oklahoma’s government expenditures are around all-time highs relative to the size of the private sector. The phaseout of Oklahoma’s income tax imposes fiscal discipline on the budget process; combining this fiscal discipline with effective budget reform will create a more efficient state government sector that effectively provides needed government services while avoiding those activities that are either unnecessary or better left to the private sector.

Though the proposed tax reform should be coupled with effective budget reform, in a recent study we assessed the economic and fiscal implications from the changed economic incentives created by the tax reform only. Summarizing the findings, if the proposed tax reform is implemented:

The Proposed Income Tax Phaseout

As of January 1, 2016, Oklahoma’s current top marginal personal income tax rate is 5.00 percent. However, even at 5 percent, Oklahoma’s top personal income tax rate does not create a distinguishable comparative advantage compared to other states.

Assuming a 2017 implementation date, the top personal income tax rate schedule that would result from phasing out Oklahoma’s personal income tax by 0.25 percent per year until the personal income tax is completely eliminated in 2036 is illustrated in Figure 1.

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Due to the gradual reduction of Oklahoma’s top personal income tax rate, the near-term consequences on government revenues are lessened compared to a tax reform that eliminated the personal income tax all at once. The large impact on government revenues from eliminating the personal income tax all at once, as well as the destabilizing impacts that such a sudden change can cause, argue for a more gradual implementation schedule.

On a static basis, year-over-year revenues, adjusted for inflation, would continue to grow under the proposed tax reform, albeit less than the baseline revenue growth. (The baseline tax revenues are based on the assumption that without any changes in Oklahoma’s personal income tax, revenues will grow at the average growth rate in tax revenues over the past 10 years.)

When the benefits from increased economic growth are incorporated, the year-over-year revenue growth would be even higher, albeit still below the baseline revenue growth.

The primary reason to gradually eliminate Oklahoma’s personal income tax is the beneficial economic growth impacts such a policy will create. These potentially beneficial impacts are substantiated by the large number
of economic studies that have found a negative impact from increasing taxes (and a positive impact from lowering taxes), particularly personal income taxes, on economic growth.

A review of Oklahoma’s fiscal and economic performance reveals several important trends with respect to the proposed income tax phaseout. When taken together, these trends confirm the findings from the academic and policy studies we reviewed in our study: the proposed phaseout of the personal income tax will benefit Oklahoma’s economy while providing sufficient esources for the state.

Total Expenditures in Oklahoma Are Around All-Time Highs

Figure 2 presents Oklahoma’s total direct expenditures adjusted for inflation and the size of Oklahoma’s population between 1977 and 2012 as measured by the U.S. Census of Governments (the black solid line). Nominal revenues are inflation adjusted using the CPI-U, 1982-84 = 100 data series. The black dotted line presents the average growth in real expenditures over this time period. The data illustrate a consistent upward trend in the real resources the state of Oklahoma is commanding over time, even after population growth is considered.

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Additionally, the data in Figure 2 illustrate a spike in inflation-adjusted expenditures per capita following the 2001 recession. It is noteworthy that the new expenditure level became part of the government’s baseline, illustrating that upward surges in Oklahoma’s spending are never temporary. Instead, temporary spending increases find their way
into Oklahoma’s permanent spending baseline.

Based on the trends illustrated in Figure 2, even if the proposed tax reform froze resources at their current levels, expenditures would remain around their current historic highs. And, including the dynamic impacts of the proposed tax reform, tax revenues will grow after adjusting for inflation and population growth. Therefore, the proposed phaseout of Oklahoma’s personal income tax will allow expenditures to increase from their current levels.

Given the fact that expenditures are currently at historic highs, our proposal, which lowers the growth rate of revenues but still maintains growth rates above inflation and population growth, does not limit the ability of the state government to provide core government services.

If we truly care about empowering the most vulnerable Oklahomans, we must build a strong and diverse economy by creating an environment which is attractive to entrepreneurs and job-creators.

Jonathan Small, C.P.A., serves as OCPA’s president. Previously, he served as a budget analyst for the Oklahoma Office of State Finance, as a fiscal policy analyst and research analyst for the Oklahoma House of Representatives, and as director of government affairs for the Oklahoma Insurance Department. He holds a B.A. in Accounting from the University of Central Oklahoma and is a Certified Public Accountant.

Wayne Winegarden (Ph.D., George Mason University) is a senior fellow in business and economics at the Pacific Research Institute and a contributing editor at EconoSTATS at George Mason University. He has testified before the U.S. Congress and his work has appeared in The Wall Street Journal, the Chicago Tribune, Investor’s Business Daily, and Forbes.com.