Takeaways from Independent Fiscal Office Report: Business Tax Cuts Slow PA Revenue Growth Creating Future Budget Gaps

Cross posted at Third and State

Michael Wood

The Pennsylvania Independent Fiscal Office (IFO) released its five-year economic and budget outlook on Thursday, and the picture is not pretty.

Pennsylvania General Fund revenues are expected to grow over time but more slowly than expenditures. The IFO projects a shortfall of $839 million between revenues and expenditures in the 2014-15 budget year, growing to $2.1 billion in 2018-19. This structural deficit, based on current tax law and expenditure trends, is not set in stone but gives us a glimpse at the difficult road ahead.

Although significant, the $839 million estimated shortfall in 2014-15 is less than the $1.3 billion projected gap figure that has been circulating in the Capitol.

Revenue Growth Undone by Shrinking Corporate Tax Receipts

Reflecting Pennsylvania’s gradually improving economy, the IFO projects personal income tax (PIT) growth of about 4.5% per year for the next five years, and sales tax growth of 3% to 4% annually. Not the strongest growth we have seen coming out of some prior recessions but healthy nonetheless.

IFO projections for the third major leg of the General Fund's revenue system — the corporate net income tax (CNIT) — are something to worry about. From 2014-15 through 2016-17, the IFO projects CNIT revenue to grow by less than a percent each year, and then predicts an absolute DECLINE in corporate tax receipts in 2017-18 and 2018-19. This is an effect of the phase out of the capital stock and franchise tax, which is slated to be fully eliminated in December 2015.

All other General Fund revenues are projected to fall in the next couple of fiscal years followed by growth of about 1% per year in the later years.

Altogether, revenue growth looks pretty anemic in the coming five years if circumstances do not change. While the IFO did not say so specifically, the data make clear that 15 years of business tax cuts have contributed significantly to Pennsylvania’s structural deficit.

Expenditures Grow More Quickly

Total General Fund expenditures, based on current trends, are projected to increase from $28.4 billion in 2013-14 to $34.7 billion in 2018-19, an increase of $6.3 billion over the five-year period. This amounts to growth of about 4% per year, again not unusual coming out of a recession.

Much of the projected expenditure growth is driven by required public pension funding increases as the state makes up for a decade of pension system underfunding and historic investment losses. Pension payments from the state are expected to increase from $1.4 billion in 2013-14 to $3.4 billion in 2018-19. That averages to 24% growth per year.

There is no magic bullet to change this outcome. Pension cuts to current employees would run afoul of the state constitution and other suggested changes, like to move to a 401(K)-style defined contribution system, would actually increase short- and long-term costs.

All other education spending (other than pensions) is projected to grow by only 1% per year, $63 million in 2014-15 and rising to $150 million in 2015-16 and beyond, not even enough to keep pace with inflation let alone to restore budget cuts.

Prison costs rise about 4% per year on average, despite a projected decline in the prison population by about 4,000 inmates.

Department of Public Welfare spending increases between 4% and 5% per year, based largely on Medical Assistance enrollment growth of 2% per year, no dramatic changes in federal matching rates, and that the state will not expand Medicaid under the Affordable Care Act.

Demographic Changes Pose More Challenges and Opportunities

Pennsylvania is an aging state. From 2010 to 2020, the number of seniors is expected to increase by more than 500,000 to 2.5 million, the number of working adults is expected to remain at about 7.6 million, and the number of children is projected to decline by 60,000. These changes will have impacts on the state budget — on both the revenue and expenditure side of the ledger. Seniors don’t pay state income taxes on retirement income, and the demand for services, particularly long-term care, is expected to grow.

The largest single driver of overall population growth in the state will be from net international migration — even more than the net difference between births and deaths. This, too, will have a long-term impact on how and what state government does and how we pay for it.

The IFO's report clearly highlights that Pennsylvania has to make careful choices going forward. Tax cuts have not spurred the economy or trickled back in the form of higher revenue collections, as proponents have argued. Going forward, will Pennsylvania embrace a tactic that has not worked, or direct strategic investments in our public education system, higher education, and transportation to help our economy grow?