The PIM interview: State economist Tom Stinson on the origins of Minnesota’s structural deficit (and why it’s getting worse)

By now, anyone with the remotest interest in the state’s budget crisis has heard about the so-called "structural deficit" that’s become a regular part of the state’s biennial juggling act. They also know it’s grown markedly worse since the national economy tanked last fall.

What’s less clear is how we got into this situation. What led Minnesota policymakers and politicos to think the state tax cuts they passed in 1999 and 2000–the largest ones undertaken anywhere in the country at that time–would be sustainable in the long run? And why have tax collection revenues in Minnesota and the vast majority of U.S. states become so much more volatile, so much less predictable?

A recent study by two Federal Reserve Bank of Chicago economists, Leslie McGranahan and Richard Mattoon, suggests that the bubble years of the past decade and a half are responsible. They argue that 1) state tax systems all across the country have grown markedly more sensitive to ups and downs in the business cycle since the late 1990s, and 2) wild fluctuations in capital gains collections during the go-go years in the stock market have played an outsized role in making state revenues less stable. (No transcript seems to be available, but you can find the data slides from their presentation here.)

As it happens, Minnesota state economist Tom Stinson (pictured) has done some pioneering work in that area too. At last fall’s meeting of the Federation of Tax Administrators, he gave a widely discussed talk on the mounting volatility of state revenues. (Powerpoint slides here; see "Tax base volatility.") And under Stinson’s guidance, Minnesota’s economic forecasting team has become one of the first anywhere to look past capital gains as a factor in that volatility. Since September 2001, Stinson and his colleagues have been studying the rise and fall in top-of-the-food-chain bonus income, which has played nearly as large a role as capital gains in making tax collections vulnerable to recessions.

On Wednesday morning, I talked with Stinson about all this. "We think about this stuff a lot," he said. "We’re not good at it, but we think about it a lot, and we’re always experimenting, trying to find a better way to reflect what’s going on.

"And I think we do a good job compared to other states. It’s just become a really hard task trying to sort out all these aspects, like what’s going to happen to the stock market and how people are going to react with their holdings on top of that."

PIM: Back in 1999 and 2000, Minnesota passed some of the largest state tax cuts in the country. Can you take us back to that frame of reference and say why those tax cuts appeared to be sustainable back then?

Tom Stinson: In 1999 and 2000, the economy was growing extraordinarily rapidly. I can’t remember the exact numbers, but real, inflation-adjusted growth rates above 3.5 percent were being projected on out to forever. That was excessive, and it fooled forecasters. Global Insight held out for a long time. They kept saying no, the economy can’t grow that fast. In ‘99 or 2000, they finally changed their outlook [to prolonged high growth].

We were being fooled by technology. What people didn’t realize at the time was that a lot of the demand for technology that was going on wasn’t sustainable. It was being prompted by Y2K types of things. Once the demand for technology and for IT specialist labor fell off following Y2K, the growth rate was substantially less. We’ve been in two recessions, and we’re not through the second recession yet. It’s a situation where what appeared to be affordable at the time turned out not to be affordable.

PIM: There was a lot of faith back then in the permanence of the productivity growth produced by technology, too, right?

Stinson: Yes. The way that you get a real growth rate is–what you’re doing is to count the amount of goods produced and the value of goods produced. And you get more goods in two ways: by more people working more hours, or by people producing more goods per hour of work. The growth of the labor force is pretty well known ahead of time. There can be minor variations in that, but the big variation is in productivity.

Most people from 20 to 65 are working, and at that time we actually had an extremely high participation rate in the labor force. That was a time when, as you probably remember, the fast-food places felt that their billboards or signage was [better used] to advertise for help wanted than for $2.49 hamburgers.

So we knew more or less what was going to happen to hours worked, how that was going to grow over time. And people were of a belief that we were in a technological revolution where everybody was going to be able to make more things rapidly.

PIM: People I’ve talked to at the Department of Revenue say you’ve always been very attentive to the levels of capital gains tax receipts. Perhaps you’ve heard about the recent presentation by a couple of Federal Reserve Bank of Chicago economists claiming that capital gains were a pivotal wild card in destabilizing states’ revenues. Can you explain the role capital gains played during the boom years in distorting the revenue picture?

Stinson: Unlike most other types of income, capitals gains go up and go down both. Wages almost always go up, and if they go down, they go down a very small percentage. A 20 percent increase in capital gains year-over-year is not a shock. That’s within the range that you’d expect.

But when things turn bad, you lose big on [capital gains revenues]. You can lose 40 percent, you can lose 60 percent. I’ve actually written about this. Let me read you a couple of paragraphs:

"During the late 1990s, the incredibly large growth in capital gains realizations (45 percent in tax year 1996, 40 percent in 1997, 25 percent in 1998 and 22 percent in 1999) was largely unanticipated. In Minnesota that growth led to large surpluses, and led policy makers to expect future surpluses. Even though conservative forecasting assumptions were used, when stock market conditions changed, no one was ready for the sudden drop in capital gains revenue that followed. Minnesota’s February 2001 forecast called for no growth in capital gains realizations in 2001. By February 2002, taking advantage of a an additional year’s information and the refitting of the model to just released revisions to the household balance sheet as reported in the Federal Reserve’s Flow of Funds Accounts, net realizations of capital gains were projected in Minnesota to decline by more than 33 percent.

"Legislative leaders greeted the forecast of a decline in capital gains realizations with substantial skepticism. Almost all doubted that capital gains realizations could fall that precipitously. Unfortunately, the forecast turned out to be too optimistic, with capital gains realizations falling by more than 46 percent nationally. The loss in tax base in Minnesota was substantial. Net capital gains realizations by Minnesota resident tax payers fell from $9 billion in tax year 2000 to just over $4 billion in 2001, a decline of more than 55 percent. And, it is important to note that the revenue lost is not just limited to one year. All future changes in projected capital gains realizations come from that lower base. Assuming no changes in future growth rates, that means that all future forecasts would have $5 billion less in capital gains realizations as well. Over the entire forecast cycle from fiscal 2001 through fiscal 2005, the reduction in capital gains realizations would amount to a reduction of more than $20 billion in taxable income."

Another thing you may not have heard as to why capital gains are so volatile on the downside is that capital gains is more than just stocks. It’s also the sale of businesses. When there’s a recession, the sale of businesses pretty much dries up. We go from having something to having zero, or almost zero, in that component of capital gains.

So that’s the nature of the capital gains problem. When it turns down, it turns down huge. That’s one of the arguments for not treating capital gains as ordinary income, or taxing it at the same rate as ordinary income–either by having a special rate, so that you have less of a shock when it turns down and less of a gain when it turns up, or by exempting part of [capital gains income], as Wisconsin does.

PIM: Some of the people I’ve talked to have said, you know, capital gains added volatility to the equation, but that’s not the only factor. There were also breathtaking gains in bonus and stock option income. They’re suggesting, basically, that the whole expansion of income at the top end of the wage scale was a big distorting factor, not just the capital gains piece. Is that correct, in your view?

Stinson: Can I ask who you’re talking to? Are they from around here?

PIM: Yes. People in House Research and the Department of Revenue made the point.

Stinson: I ask because, in Minnesota, we’re probably the only state that has so many competent people working in the public sector on tax issues. People like Joel [Michael of the House Research Department] and Paul [Wilson of the state Department of Revenue] are incredibly competent and well-respected. And the other thing is, we’re probably the only state that recognizes the bonus-and-option revenue as being more volatile than ordinary wages, and has attempted to try and control that.

When we do our forecast–and I discuss this in a book chapter that I wrote–we separate total wages into two components: ordinary wages and performance-based compensation. We create a time series of performance-based compensation by going into the unemployment insurance wage detail file, where we get information on what’s going on by firm. We think we can identify when there are big bonuses or options paid out. We actually incorporate that into the [state revenue] forecast. Not that we have any good way of forecasting what’s going to happen to bonuses and options. But if you can separate that chunk out, away from ordinary wages, then you have some way of controlling what it is you’re assuming about that component as compared to overall wages.

If you just do a regression on overall wages, which includes ordinary wages and performance-based compensation, then you’re implicitly making an assumption about what’s going to happen to performance-based compensation.

So we actually decipher this. We first did it in September of 2001, because we were concerned about performance-based compensation in the aftermath of 9/11. And once we did that, we looked at the result and said, Oh my god–this is a lot bigger piece of the puzzle than we thought. And it didn’t make sense to have an implicit assumption that this piece was going to be growing along with ordinary wage rates when it was clear it wouldn’t.

The November 2001 and February 2002 revenue forecasts both reflected that change, and it put us ahead of the curve in predicting the size of the deficit–but too late to do anything about the deficit. We’ve actually been ahead of the curve with respect to performance-based compensation.

We made some specific assumptions about performance-based compensation in the most recent forecast that now appear to be too optimistic. But it wasn’t that we didn’t think about it; we just didn’t think it was going to be as bad as it is.

That has added to the volatility. A guy named Matt Schoeppner and I have done some stuff about volatility over time, and what you see is that wages have not been particularly volatile until the passage of the bill that disallowed any deduction for compensation of CEOs over the level of $1 million if they were not performance-related. Once that happened, you could see a huge increase in our data at the state level both in performance-based compensation and the year-to-year volatility of overall wages.

So you’re right. It’s made things much tougher, because you’re having to predict what’s going to happen to bonuses. The headache we have now is that we’ve got a large number of stock options out there, many of which are underwater. Does the market come back enough to make these profitable trades? For example, if you’ve got some old Wells Fargo options at $30 or $35 and the stock’s now at $15, what happens when it comes back to a point where you’re a couple of bucks to the good? Do you hold it longer or do you cash out and say, boy, I got out of this thing even if I only made a little bit? It becomes much harder to predict what’s going to happen.

PIM: Help me understand in an overview sense–how does the performance-based compensation compare in scale and volatility to the capital gains picture? Is it a bigger pie, a smaller pie, the same?

Stinson: Capital gains in a normal year is a little larger. In 2007 that was $10 billion versus our estimate of about $7 billion for performance-based compensation. Capital gains are also more volatile. Our 2009 estimate is $3.9 billion for capital gains. Performance based was a little more than $5 billion, although that was probably too optimistic.

PIM: There was an interesting notation in the 2009 tax incidence study saying basically that regressivity in the tax system had grown, although it did not seem traceable to any changes in tax policy. Is that an expression of the shrinkage of those capital gains and performance-based income figures at the top?

Stinson: I don’t think so. Here’s why. If you’re making $1 million in income and you get an extra $10 in wages or an extra $10 in capital gains or an extra $10 because you exercised some options, you’re still going to be taxed at the top marginal rate, no matter where it comes from. Or if you lose $10 in wages, bonus, options, or capital gains, your tax rate is going to fall by the same amount.

PIM: Paul Wilson at the Department of Revenue said he thought the share of Minnesota revenues coming from income taxes has remained pretty steady since about 1980. Is that correct?

Stinson: I’m not sure. I haven’t looked at those numbers. What we know is that looking out to 2010-11, the income tax share goes up, because corporate and sales [tax revenues] go down noticeably, and the income tax remains more or less the same.

PIM: To go back to the question of state fiscal crises all across the country, it sounds like revenues have grown more volatile not strictly because of tax cuts or tax code changes made during the boom years, but because the U.S. economy itself has grown more volatile. Is that a fair statement?

Stinson: That may be a fair statement, but my argument is a little bit more arithmetical. Say you’ve got two parts in a tax system, and 90 percent [of that system] grows at a 2 percent rate and 10 percent grows at a 10 percent rate. And the 2 percent rate [varies by] plus or minus 0.5 percent, while the 10 percent rate varies by plus or minus 5 percent. Over time, that 10 percent piece of the tax base, in this case capital gains, grows compared to the more stable part. Arithmetically, the volatility increases as capital gains and bonus/option income become a larger portion of income. Both those things are more volatile than basic wages. Those things become a bigger part of the tax base because they’re growing faster than the other components, and overall volatility increases.

My argument is that volatility isn’t the most important criterion for evaluating a tax system, but it is something we want to pay attention to. Over time, Minnesota’s tax system has evolved–just by differential growth in different parts of the system–to a point where it’s almost certainly more volatile than we would choose if we were starting from scratch.

PIM: The State Budget Trends Commission looked at the problem of volatility, and you’ve studied it extensively. Is there any clear path to a less volatile system that makes sense policy-wise?

Stinson: There are things that you could do in a revenue-neutral manner to make the tax system less volatile. The question is whether they’re acceptable politically.

Here’s an example. You could exclude half of capital gains from income. Or a quarter, or some other percentage. So that if you had $50,000 in gains, you’d only have to add $25,000 to your wages to come up with adjusted gross income. That would create a revenue hole, and the way you’d solve that hole would be to raise tax rates overall to make it revenue-neutral. Since most of capital gains are at the highest income rate, you might want to raise the highest income [tax] rate to make sure you’d break even. Some people with a lot of capital gains would benefit, and some people with extremely high wages–pro basketball players, for example–would pay more in taxes than they did previously.

Another part of the tax system that’s very volatile is the corporate income tax. One way that you could reduce some of the volatility is to lower the corporate income tax rate by 50 percent or some figure like that. And you could make up the lost revenue by increasing the statewide property tax rate on commercial property. If your business is property-intensive–if it requires a lot of land or a big building, you’re going to pay a little bit more compared to the firm that generates a whole lot of profit from a little tiny office.

There would be distributional changes [in the tax burden], in other words, and those might not be acceptable politically. But it would not change the overall tax burden for everybody in the state.

So there are ways to do it. The question is, is it important enough to the public and to policymakers to reduce this volatility?

PIM: If you assume no substantive changes to the Minnesota tax system, how long under current forecast conditions before we get back to the inflation-adjusted equivalent of pre-recession state revenues?

Stinson: Well, just calculating it crudely, FY2008 had $16.7 billion in revenue. If we use the CPI (consumer price index) [to factor in inflation], it doesn’t happen in ‘10 or ‘11 or ‘12. We don’t quite make it back by the end of 2013. It’s close. We’re about $200 million short [at that point] in real dollars compared to where we were in 2008.

In our February forecast, we project 13 percent growth in income from 2006-2011. A lot of that comes between 2006 and 2007. The numbers are $162 [billion] in 2006, which is the starting point. Then $172 billion in 2007–so it went up $10 billion from 06-07–and $176 billion in 2008, $173 billion in 2009, $175 billion in 2010, and $183 billion in 2011. So half [of the total income growth in that period] came between 2006 and 2007.

These numbers are the projected non-farm tax base, which is roughly comparable to federal adjusted gross income.