B-24/04
October 28, 2004

2004 Annual FTA Revenue Estimating and Tax Research Conference
Summary of Proceedings

To State Tax Administrators:

SUMMARY       The 59th Annual FTA Revenue Estimating and Tax Research Conference was held September 19-22, 2004, in Burlington, Vermont.  Presiding over the conference was Dick Gebhart of the Minnesota Department of Revenue and Chair of the FTA Research Section.  This bulletin summarizes the presentations.  All of the papers are available electronically on the FTA home page at <http://www.taxadmin.org>

The 59th Annual FTA Revenue Estimating and Tax Research Conference was held September 19-22, 2004, in Burlington, Vermont.  Presiding over the conference was Dick Gebhart of the Minnesota Department of Revenue and Chair of the FTA Research Section. Welcoming the participants was the Conference Host, Tom Pelham, Commissioner of the Department of Taxes.

      The program included presentations by the major forecasting firms and industry representatives on their economic forecasts for the next 18 months.  In addition, presentations were made on estimating the size of the Federal tax gap and an update of the states’ fiscal outlook. The entire day Tuesday was dedicated to various concurrent sessions covering issues of interest to state economists such as, income tax forecasting issues, state amnesty programs, single-sales factor apportionment of corporate taxes, tax incentive accountability, tax incidence studies, gambling revenues and managing a research section.

      On Wednesday morning, the participants heard several presentations on topics of broad interest to state economists.  These presentations included a study of tax protesters, dynamic scoring of tax proposals and combating state corporate tax shelters with 482 techniques.

Monday Morning
      Alan Plumley, IRS Office of Research, gave a presentation on the IRS’s methodology and efforts to update the tax gap estimates.  He began by dividing the tax gap into three components—the nonfiling gap, the underreporting gap, and the underpayment gap.  The estimate for the nonfiling gap was developed from a 1988 study of individual nonfilers.  The underreporting gap estimate was made from a 1988 random sample of audits, with updates from data on operational audits and special studies.  Meanwhile, the underpayment estimates are tabulations of actual underpayments.  These components were projected to 2001 using the growth in receipts, essentially assuming the compliance rates remained constant across the different components.

      The 2001 estimates of the tax gap, according to Plumley, was $311 billion, for a noncompliance rate of 14.9 percent.  The largest noncompliance rate was in employment taxes by self-employed individuals at almost 60 percent, followed by corporate income taxes for small corporations at about 40 percent. 

      The IRS is currently working on several projects to update these estimates.  Plumley noted that new compliance data, based on a 2001 sample, will be available by the end of 2004.  This, along with other data, will be used to estimate new underreporting gap measures.  For the nonfiling tax gap, the IRS is developing an estimate bases on the Census Bureau’s exact match study for 2001.  Also, the Service plans to conduct a study of compliance rates on partnerships and S-corporations and utilize operational data to develop more current estimates.  More information on the IRS current studies can be viewed from the IRS Web site http://www.irs.gov/taxstats/article/0,,id=129014,00.html. Presentation is available.

      Donald Boyd, Director of the Center for the Study of the States, noted how state finances are not out the woods yet.  While the economic downturn was mild, Boyd pointed out how state revenues fell by 7.4 percent in 2002, more than twice the decline in previous recessions.  With employment growth slow to recover, state revenues have only recently begun to see growth.  Indeed, they are still below pre-recession levels.

      Boyd noted how states have responded with small increases in taxes/fees and with various spending decreases.  The biggest impact has been felt in higher education, with appropriations down by 4 percent between 2002 and 2004.  States have also made large cuts in state agency employment, more so than in previous recessions.  And, they have cut Medicaid by reducing provider payments, reducing eligibility and setting controls on drug costs.  Yet, Medicaid is still a growing problem for states’ budgets. 

      He concluded by describing several challenges facing state policymakers.  In addition to Medicaid, states need to replenish reserve funds depleted during the recession and replace revenues or spending cuts that were temporary fixes. Also, K-12 education is still increasing pressure on state budgets. Presentation available

   Economic Forecasts
      Global-Insights and Economy.com economists gave presentations on the economic outlook. Cynthia Latta, with Global-Insights, gave a presentation on the overall macroeconomic outlook.  She noted that productivity and corporate profits have been doing well, but business investment in equipment has been slow to increase.  Most of the impetus driving the current economic growth has been from consumer spending, supported by tax cuts and sharp increases in housing equity.  In addition, low interest rates have sparked a building boom as housing starts have reached over 2 million units.  This has left consumer debt at record highs

      Latta noted that the economy is forecasted to grow by 4.3 percent in 2004, decreasing to 3.3 percent in 2005.  However, a number of issues may act to decrease this forecast.  She pointed to sustained high oil prices as a factor that could reduce economic growth.  Indeed, the most recent run-up in oil prices had already reduced the Global-Insights forecast by about half a percentage point.  Other issues include the federal and trade deficits, increasingly skewed income distribution, and a steadily increasing load on Medicare and Medicaid. Presentation available.

      Mark Zandi, with Economy.com, agreed with Ms Latta that the economy is recovering.  However, he noted that this recovery has been disappointing, with 25 percent of the metro areas still seeing negative job growth.  The worst performance has been in the Midwest and Northeast, where payroll employment is 2.9 percent and 2.1 percent below the peak, respectively. 

      Several key economic sectors are going to be important drivers of economic growth, influencing the growth rates for the various regions.  According to Zandi, economies with industries providing materials for national defense, exports to world markets, technology producers and healthcare/education are going to do well.  However, he notes that the potential for higher oil/energy prices would adversely affect recoveries in the Northeast and Great Lakes region.  Also, higher interest rates will hurt auto dependent economies, and some areas have potential housing bubbles.

      The current economy.com forecast shows the mountain states currently at peak employment growth, while some parts of the Northeast and Midwest will not see peak employment growth until 2006.  However, Zandi noted that state tax revenues are returning to normal, with average annual growth for fiscal years 2004–2006 expected to be 4.5 percent. Presentation available.

Wednesday Morning
      On Wednesday morning, participants heard presentations of general interest to state tax analysts. With tax protesters’ bogus claims utilizing a growing level of agency resources, David Boughtwood with New York State conducted a study analyzing the issue.  In his presentation, Mr. Boughtwood noted how he was able to use his database analytical skills to help the agency understand the scope and extent of the problem. This enabled him to identify some potential policy and administrative options.

      In analyzing proceedings from 1987 to 2004, Mr. Boughtwood was able to identify two discernable peaks.  The first peak was in 1990, which was followed by several years when no cases were filed.  Beginning in 2000, many new tax protester cases were filed and the number of cases is currently at its peak.  A number of taxpayers filed multiple cases, and most cases were seeking a refund.

      From this analysis, he was able to identify several potential policy and administrative options, including improved public education, tracking known tax protesters, following tax protester trends, and assessing or increasing penalties. Presentation is available.

      Greg Harkenrider, from the Kentucky Budget Office, discussed his efforts in estimating the dynamic impacts of tax law changes.  While most estimates of tax changes begin with a static baseline revenue forecast, Harkenrider believes that certain changes in tax law may lead to changes in the underlying baseline economic assumptions.  Thus, he suggested that for some tax changes, economists should feed their static estimates into dynamic models to determine the effect on the economic forecast.  This would allow a new baseline forecast with dynamic effects included.

      He then described how he used a REMI model to estimate dynamic effects of the Jobs for Kentucky Tax Plan proposed by the Governor.  He identified several provisions with positive dynamic effects, such as the repeal of the corporate license and intangible property tax, and the reduction of corporate and individual income tax rates, among others.  He also identified some with negative dynamic effects, including AMT changes, LLC’s, raising cigarette/tobacco taxes, and others. 

      Overall, Harkenrider concluded that dynamic analysis is a useful tool for understanding tax changes, when used properly with conservative assumptions.  However, the results are modest compared with expectations. Presentation is available.

      While corporate tax shelters have recently become an important issue for state tax administrators, officials are still searching for tools that can be useful in combating the problem.  With this in mind, Eric Cook with Chairbridge Associates gave a presentation on combating abusive corporate tax shelters using a 482 approach.  While corporate profits increased by 24 percent between 1991 and 2001, Cook noted that state corporate tax collections decreased by a real 7.6 percent.  He attributed this to aggressive tax planning which have cost states an estimated $10 billion annually in lost revenue.  He noted that this problem can be seen in both combined and unitary states.

      He suggests states adopt a system similar to the IRS’s IRC section 482, examining transfer prices between related businesses.  By using microsimulation models, a state can develop a system to monitor corporate tax data and identify unusual transfer prices that effectively move income to non-tax states/regions.  These models provide a valuable tool for auditors and legal teams in the states.  Cook concluded by noting that several states have already adopted this approach and are reporting good results.

Breakout Sessions
      On Monday afternoon, participants were offered two concurrent breakout sessions–the economic outlook for selected industries and managing a research section.

On Tuesday, conference participants were offered several concurrent breakout sessions.  The topics included: income tax forecasting issues, state amnesty programs, single-sales factor apportionment of corporate taxes, tax incentive accountability, tax incidence studies, and gambling revenues.

      Electronic versions of many presentations can be found on the FTA Web site at http://www.taxadmin.org.

Sincerely,
Harley T. Duncan

Executive Director