What does a state do when faced with a 14 percent decline in income tax collections, much of it due to past tax cuts? Why, it cuts taxes even more—especially when that fall in revenues is lower than expected and—combined with lower spending -- results in a surprising $700 million budget surplus. That seems to be what’s happening in Ohio, where the state legislature took a proposed $100 million tax cut proposed by Governor John Kasich and turned it into a $500 million reduction in 2015, and $100 million every year after that. There is a little something for everyone in the revenue plan. The legislature would cut individual rates by 10 percent across-the-board, raise the personal exemption for low- and moderate-income taxpayers, and double the state earned income tax credit (EITC). At the same time, it would increase an already-generous business tax deduction. In February, Republican Kasich—who was something of a deficit hawk during his years in Congress--presented a revised budget that would reduce tax collections by about $100 million in 2015 and 2016. Kasich would have expanded previously-enacted income tax cuts for businesses and individuals. But because he proposed to partially offset them with a higher commercial activities tax, higher tobacco taxes, and a new, but volatile, horizontal drilling severance tax, his plan would have lost a relatively small amount of revenue. But the deal worked out by the Ohio General Assembly included only income tax cuts without any of Kasich’s proposed offsets. According to the official numbers, it would reduce revenues by about $500 million in 2015 and $100 million after that.  Among the legislature’s changes:

• It would accelerate a previously-enacted phase-in of a 10 percent reduction in all tax rates. The top rate would fall to 5.33 percent this year, down from 5.925 percent in 2012. The rate reductions would cost $100 million in 2015.
• It would raise the personal exemption for households with less than $80,000 in adjusted gross income and double the state’s nonrefundable EITC. These two progressive changes would reduce revenue by about $90 million annually.
• It would further increase the business income deduction – but only temporarily. Last year, the state allowed firms to deduct 50 percent of business income from taxable income. The new bill would increase the deduction for 2014  to as much as 75 percent, depending on the size of the state’s surplus as calculated at the end of July. This fiscal trigger would do little to encourage new investment since it is available only for this year and firms would have only a few months to react once the new deduction is fixed.  It does have a big cost though: the full 75 percent deduction would reduce revenues by as much as $290 million in 2015, when returns are filed.

Even though most of these tax cuts would be dependent on the 2014 surplus and on the books for only one year, they would be on top of  prior year  tax cuts and may lead to future deficits. In 2013, Ohio reduced income taxes--including the rate cuts and the 50 percent business deduction, paying for only part of it with an increase in the sales tax rate. Last year’s package is expected to reduce state revenue by about $800 million this year, and $2.7 billion over three years. Ohio has a biennial budget, and thus in 2013 passed a fiscal plan for 2014 and 2015. That plan restored 2014 spending to pre-recession levels. But excluding the state’s share of Medicaid, 2014 spending still was below 2009 general fund expenditures.  And the 2014-2015 budget was only balanced thanks to a carry-over balance. In the new package, the proposed business deduction is generating the most uncertainty. Business income represents about 7.5 percent of Ohio’s federal adjusted gross income and slashing that revenue source would make it harder to balance future budgets.  While this year’s version is temporary, the federal experience tells us it is not easy to allow a popular business tax preference to expire. Ohio would be better off banking more of the windfall surplus. Kasich seems to have thought so in his recommendation and he was likely right.