Iowa Discounted Tax Reform:

Impacts on Iowa Economic Activity and Government Revenues

A Proposal by the Beacon Hill Institute for Public Policy Research

Suffolk University, 8 Ashburton Place, Boston, MA 02108

Phone, 617-573-8750, Fax, 617-720-4272

dtuerck@beaconhill.org, www.beaconhill.org

Kevin McLaughlin of Des Moines, Iowa has proposed legislation that would offer Iowa taxpayers the option of paying income taxes equal to 1% of their earned income.  Taxpayers could, if they wished, continue paying taxes as prescribed by current law, taking advantage of such deductions as were available to them.  Or they could opt for the proposed Discounted Tax Plan if that would reduce their tax liability.

The likely response to the tax reform proposed by Mr. McLaughlin is:  (1) a fall in labor costs as out-of-state residents found Iowa a more attractive place to work and as residents found that, by working, they could keep more of their wages, (2) an increase in the state saving rate as Iowans discovered that the Discounted Tax Plan eliminated state taxes on dividends, capital gains and other forms of unearned income, (3) an expansion in capital spending, by in-state firms and by firms attracted to the state, as labor costs fell and saving rose.

Issues

The two most important issues raised by the Plan are:  (1) how would it affect the state economy?  And (2) how would it affect state and local tax revenues?  The two questions are interrelated.  The Plan is motivated by a wish to make the state more competitive and, in doing so, increase economic growth.  Insofar as the Plan exerts this effect by reducing tax liabilities, however, it can be expected to exert a negative, “static” effect on state tax revenues.  Consideration of this static effect, however, ignores the fact that, by reducing tax liabilities, the Plan would correspondingly encourage an expansion of economic activity and, hence, in the tax base.  Thus there would be a positive “dynamic” effect on tax revenues to weigh against the negative “static” effect.

In order to identify the economic benefits that the Plan could be expected to confer, and to sort out the competing effects on tax revenues, it is necessary to build a model of the state economy. Just as an electrician would not attempt to replace a building’s wiring without a diagram of the existing wiring system, policy makers considering tax reform would not (at least if they were rational) attempt to replace the existing tax code without knowing how that code fits into the state economy.  A proper economic model permits the policy maker to determine how the new tax code would, at a high level of detail, affect the state economy and with what consequences for tax revenues.

Tax reform, when finally implemented, seldom matches exactly the tax reform originally proposed.  Political considerations inevitably (if sadly) need accommodation.  And the original plan might have pitfalls that are not revealed until a model is available.  (The electrician spots a problem not anticipated before viewing the wiring diagram.)  The Discounted Tax Plan is a flat tax that appears not to include a personal exemption.  Whether it does or not, demands for a personal exemption are sure to surface.  Thus architects of the Plan need a model to determine how different-size personal exemptions would affect economic activity.

With a model in hand, policy makers can “fine tune” the original idea, identifying the effects of their doing so.  Hence a model serves a twofold purpose:  (1) showing what effects a particular proposal would have on the economy and on tax revenues and (2) showing how variations on that proposal would affect the economic activities that it is the purpose of its architects to stimulate. 

BHI Proposal

The Beacon Hill Institute (BHI) proposes (1) to build and deliver a computer-based economic model that will permit users to identify the economic and tax-revenue effects of the Discounted Tax Plan and to simulate variations on that Plan and (2) to deliver a report detailing the model’s methodology and the results shown by the model that would follow from implementation of the Plan.

The model to be built by BHI shall be an Iowa version of BHI's State Tax Analysis Modeling Program (STAMP^®).  This Iowa-STAMP will be designed as a Computable General Equilibrium (CGE) model.  Its purpose will be to allow designated users to identify, at a high level of detail, the economic effects of a wide variety of possible tax-policy changes in Iowa.  These effects will include changes in tax revenues, employment, investment and other important indicators of state economic activity for each of a number of sectors into which the state economy is divided.

Iowa-STAMP will provide a capability for projecting the effects of tax changes over time and of comparing tax changes introduced at different times for their effects on the economy. It will also identify the comparative effects of changes in government expenditures on infrastructure and of changes in those expenditures on transfer payments.

SCOPE

BHI shall perform the following tasks:

Data Preparation

Data will be compiled on economic indicators, including data from published sources, and data generated or estimated where published data are not immediately available.  Among the variables incorporated in Iowa-STAMP, for which the model requires data, will be:  household disposable incomes, private consumption expenditures, household savings, various consumer price indexes, labor supply, migration, population, number of working and nonworking households, trade with other states and countries, net capital inflow, investment, capital stock, gross investment by sector of destination, tax collections, government income, government purchases of goods and services, government savings, state personal income and real gross state product.

Determination of Taxpayers Who Take the Discount

In order to estimate taxpayer response to the Discounted Tax Plan, it will be necessary to develop a profile of Iowa taxpayer response to the Plan.  Some taxpayers will take the Discount; others won’t.  In order to determine economic effects, it will be necessary to split the first group from the second, and, having done so, estimate the resulting effects on average tax rates.

CGE Model Construction

Iowa-STAMP will consist of at least 50 sectors, each representing a broad segment of the economy.  Sectors will include household income classes and industrial sectors.  Industrial sectors will consist of agriculture; food; communications; hotels, amusements and motion pictures; various types of manufacturing; transportation; and others.  In addition, the model will distinguish between various types of taxes and categories of government spending.  To complete the model there will be two factor sectors (labor, capital), an investment sector, an Iowa “general fund” sector and a sector that represents the rest of the world. 

Data will be stored in three computer files: a “social accounting matrix” (which details the flows between sectors) a “capital coefficients matrix” (which details investment purchases by sector) and a miscellaneous data file (which has information on employment, tax incidence and transfers).

A CGE model is constructed to provide a snapshot of how a tax change affects the economy (and the various sectors into which it is divided) in a given year.  Unless otherwise directed, BHI will construct this model for fiscal year 2005. Each run of the model will provide fiscal year 2005 values for:

·         gross state product by expenditure component:  consumption, gross investment, government purchases and net exports to rest of the world,

·         aggregate state consumption, saving and net taxes,

·         aggregate state income by type (wages and capital income),

·         tax revenues and government expenditures by type,

·         employment for approximately 25 Virginia sectors,

·         the private capital stock by sector (including government),

·         gross investment by sector,

·         net investment by sector,

·         wages and capital income by sector of origin and

·         intersectoral flows of final and intermediate goods.

DELIVERABLES

BHI will provide the following capabilities and/or deliverables:

1.         A Software Simulation Program.  BHI will provide a desktop version and a web-based version of the model for use in performing policy simulations.  BHI will document how to use the model, and provide initial support in using the model.  Use of STAMP requires Microsoft Excel, and STAMP design is based on a Windows platform. 

2.         A Written Report.  This will include a description of Iowa-STAMP and the results of at least three simulations of alternative versions of the Discounted Tax Plan. BHI shall certify to the accuracy of the model delivered as the result of this project. 

TERMS

The user shall help provide liaison services to the appropriate Iowa government agencies.  This will include making the appropriate introductions and helping BHI gather Iowa-specific data.  BHI will supply a list of the information required.  The user will provide such assistance as possible in gathering information regarding tax policy and tax reform proposals in Iowa.

1.         Completion Date.  The Simulation Software Program and a draft report, including details of the Iowa-STAMP model and sample simulation analyses, will be delivered on April 1, 2004.

2.         Licensing Arrangement.  BHI provides STAMP under license to users. Under this proposal, the user will be entitled to five licenses. Additional licenses will be available, at additional cost, to other users.

3.         Project Team.  The project team will consist of the following BHI staff:

·         Project Director:  David G. Tuerck, Ph.D., Executive Director, Beacon Hill Institute, and Professor and Chairman of Economics, Suffolk University.

·         Project Manager:  John Barrett, MS, Research Economist, Beacon Hill Institute. 

·         Senior Advisor: Jonathan Haughton, Ph.D., Senior Economist, Beacon Hill Institute, and Assistant Professor of Economics. 

·        BHI Staff consisting of research assistants and graduate students in residence.

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