Category Archives: second order effects

8/5/18: Law of Unintended Consequences and Complexity: Tax Cuts and Jobs Act 2017

The law of unintended consequences (or second order effects, as we call in economics) is ironclad: any policy reform has two sides to the coin, the side of forecasted and analyzed changes the reform engenders, and the side of consequences that appear after the reform has been enacted. The derivative proposition to this theorem is that the first side of the coin is what gets promoted by politicos in selling the reform, while the other side of the coin gets ignored until its consequences smack you in the face.

Behold the U.S. Tax Cuts and Jobs Act 2017, aka Trump's Tax Cuts, aka GOP's Gift for the Rich, aka... whatever you want to call it. Fitch Ratings recently released their analysis of the Act's unintended consequences, the impact the new law is likely to have on U.S. States' fiscal positions. And it is a tough read (see full note here:

"Recently enacted federal tax changes (H.R.1) are making budgeting and revenue forecasting more complex for many U.S. state governments," says Fitch. "...provisions including the cap on SALT deductions are a likely trigger behind a spike in state revenue collections for the current fiscal year. In Massachusetts for example, individual income tax collections through January 2018 were up nearly 12% from the prior year, this after the commonwealth recorded just 3% annual growth in January 2017. Many states are seeing robust year-over-year gains in revenue collections, though this will likely amount to little more than a one-time boost with income tax collections set to level off for the rest of the fiscal year."

State tax revenues can increase this year because, for example, of reduced Federal tax liabilities faced by households. As income tax at federal level falls, State tax deductions taken by households on their personal income for Federal tax liabilities will also fall, resulting in an increase in tax revenues to the States. Similarly, as Federal corporate income tax falls, and, assuming, corporate income rises, States will be able to collect increased revenues from the corporate activity domiciled in their jurisdictions. All of this implies higher tax revenues for the States. Offsetting these higher tax revenues, the Federal Government transfers to the individual states will likely decline as deficits balloon and as Pentagon demands an ever-greater share of Federal Budget.

In other words, the tax cuts are working, but do not expect these to continue working into the future. Or put differently, don't spend one-off revenue increases, folks. For high-spending States, like California, it is tempting to throw new money onto old bonfires, increasing allocations to public pensions and state hiring programs. But 2017 Tax Reform is a combination of permanent and temporary measures, with the latter more dominant than the former. Expiration of these measures, as well as complex interaction between various tax measures, suggest that the longer term effect of the Act on States' finances is not predictable and cannot be expected to remain in place indefinitely.

As Fitch noted: "Assessing the long-term implications of H.R. 1 will not be an easy task due to the complicated interrelationships of the law changes and because many of the provisions are scheduled to expire within the next decade. Yet-to-be finalized federal regulations around the tax bill and the possibility of additional federal legislation add more complexity and risk for states."