The Edmond Sun

February 20, 2012

No free lunch with tax cuts

Mickey Hepner
Special to The Sun

EDMOND — Perhaps one of the most disingenuous arguments being made in support of reducing and/or eliminating the state’s personal income tax is that somehow reducing the state income tax will pay for itself. The evidence, and common sense, tell us otherwise.

In recent months a number of state officials have argued for significant reductions in the state’s personal income tax as a means to stimulate the state economy. Since the personal income tax accounts for 35 percent of the state’s general revenue, those proposals have elicited alarm from many concerned about how the state could weather such a significant loss of revenue and still provide needed government services like education, health care, roads and prisons. In response, some tax cut proponents are arguing that cutting the income tax will not reduce revenues at all even if other taxes aren’t raised.

Their arguments go something like this: With a cut in the income tax, Oklahomans will have more disposable income, leading to higher spending. With higher spending, they reason, there will be higher sales tax collections … offsetting the lost revenue. Voila! Cutting the income tax will pay for itself!

A closer look, though, reveals that this analysis is much too simplistic. Let’s take the best case scenario — a $1,000 tax cut leads to an additional $1,000 of spending on taxable goods and services. Under current law, this additional spending is taxed by the state at a 4.5 percent rate and by the local government at (on average) a 4 percent rate. Thus, this additional $1,000 of spending would generate an additional $85 in sales taxes ($45 to the state and $40 to the local government). In short, state/local governments lose $1,000 of revenue from the tax cut and receive only $85 in additional sales tax collections.

Of course, it’s not very likely that consumers would spend all of their additional disposable income, and certainly not spend it all on taxable goods in Oklahoma. As after-tax incomes rise, consumers generally spend more … but also save more. In this case, one would expect some taxpayers to begin to pay down credit card debt, to pay off loans quicker, and to put more into savings … mitigating the increase in sales tax collections.

Furthermore, the additional spending that does occur when people have higher disposable incomes would not all be on taxable goods in Oklahoma. Any spending that leaks out of state or goes to purchase many services (including doctor’s bills, car repairs, etc.) would not generate tax revenue. This too reduces the amount of sales taxes collected in response to an income tax cut.

Finally, since the income tax cut would reduce revenue, this means that the state must cut government spending too. With less government spending, there is less income to government employees, and lower profits to firms that provide services to the government. This contracting effect further dampens sales tax collections.

One of the most fundamental rules in all of economics is that there is no such thing as a free lunch. In other words, every action, every policy, has a cost. As a result, we must remember that even tax cuts are never free.

MICKEY HEPNER is the dean of the College of Business Administration at the University of Central Oklahoma. Hepner serves on the Executive Committee of the Board of Directors for The Oklahoma Academy.