From left, Governor Phil Scott, Administration Secretary Susanne Young, Senator Jane Kitchel and Representative Janet Ancel. VBM images
by Timothy McQuiston, Vermont Business Magazine This had to be the most jovial Emergency Board meeting since at least before the Great Recession began in 2008. Tax revenues were great last year (fiscal year 2018 ending June 30) and are expected to be great this year (FY19) and likely very good next year (FY2020). The E-Board met Friday afternoon in Governor Phil Scott’s Pavilion conference room.
One-time revenue events, such as changes to the federal tax code and the unknown of the “repatriation” of foreign profits, add wild cards into the forecasting mix. But while they're still scratching their heads about what it all means, the bottom line still looks very strong, according to economists Jeff Carr (on behalf of the Scott Administration) and Tom Kavet (on behalf of the Legislature).
“This was a particularly challenging forecast,” Carr said at the outset. But, he said, “Any way you slice it, this was an upgrade.”
The FY19 General Fund revenues were upgrade by $32.7 million and FY20 by $18 million.
The E-Board is comprised of the chairs of the four legislative money committees and the governor. They are scheduled to meet in January and July of each year to review tax revenue projections. Extra meetings are scheduled as needed, when actual revenues are either running behind (the usual scenario) or ahead of projections.
"It's good to be here and have positive news, for a change," Kavet said.
While most of the increases in revenues started in the second half of the just-completed fiscal year (+$65 million above expectations), the positive forecasts for FY 2019 and FY 2020 were attributed largely to one-time events. But the economy, they said, is also very strong. The US economy is expanding at over 4 percent and the Vermont economy is expanding at over 3 percent.
"The economy continues to cooperate," Carr said.
We are, they said, right at the pinnacle of what certainly will be the longest economic expansion ever recorded in the US. Those records go back to the 1850s. It’s also the strongest employment scene in the US since at the least the 1950s. Vermont’s employment situation is near historic highs as well.
The economists cautioned that the economic growth has come with enormous federal stimulus on the back of a trillion-dollar federal budget deficit and that the inevitable cyclical fall into recession could be steep. But, for the foreseeable future, the economy should remain strong.
The governor, Administration Secretary Susanne Young and legislators were noticably relaxed and friendly before the meeting despite the trials of a bitter legislative session that went into overtime and only concluded last month.
The governor said in a statement after the meeting:
“Through sound management of both the State budget and federal tax changes, the revenues expected in the fiscal year beginning July 1, 2018 were increased by nearly $33 million to the General Fund and $17 million to the Education Fund.
“Unlike the last several years, we did not have to make budget rescissions or corrections because the revenue forecast exceeds the appropriations in the FY 2019 budget.
“To help Vermonters get ahead and keep more of what they earn, I have advocated for responsible fiscal management, ensuring the state budget does not grow faster than the rate of growth in Vermonters’ wages.
“After reviewing expected State revenues and spending, I believe the Vermont Legislature, particularly the House and Senate Committees on Appropriations, House Ways and Means and the Senate Finance Committee – as well as our Departments of Finance & Management, and Taxes – have a lot to be proud of in managing the State budget.”
The members of the E-Board are Governor Scott, Chair; Senator Jane Kitchel; Senator Ann Cummings; Representative Janet Ancel; and Representative Kitty Toll, who was absent from this meeting.
Kavet’s Report (click HERE for full PDF with charts)
Benefiting from a rare confluence of a relatively small number of large revenue events, FY2018 State revenues exceeded expectations in all three major funds. From Federal tax changes that gave rise to Vermont tax revenue from corporate profits parked in foreign jurisdictions, to exceptionally large capital gains liabilities, fewer than 30 revenue events in the past 6 months accounted for most of the $65 million General Fund FY18 windfall. Although many of these events are “one-time” in nature, the massive Federal stimulus from unfunded tax cuts and unprecedented deficit spending will give the economy a near-term boost that is likely to create a more pronounced business cycle over the next five years, with higher revenues expected in FY19 and FY20 and the potential for a steeper recessionary period at some time thereafter.
Due to the many changes in external conditions, including the recent Supreme Court decision allowing state taxation of internet sales and other legislated Federal and State tax changes, revenue comparisons with prior January forecasts are complicated. Revenue changes relative to legislative expectations at the end of the session are summarized in the table on the following page, prepared by JFO. The standard comparison with the prior January forecast is displayed in the below chart, adjusted for new fund allocations mandated in H.911. No matter how measured, however, this forecast represents a significant upgrade to FY19 and FY20 revenues.
The combination of economic stimulus from a ballooning $1 trillion federal budget deficit in FY19 and an economy already approaching its maximum potential will create accelerating near-term growth, more inflation and the likelihood of a more pronounced boom/bust business cycle sometime in the next several years. After 109 months, the current expansion is the second longest in U.S. history and if sustained through July of 2019, as expected, will be the longest ever.
Real GDP is expected to have expanded by as much as 4%-5% in the second quarter of 2018 and job growth is continuing to top 200,000 per month – nearly double the labor force growth, pushing the unemployment rate in both Vermont and the U.S. into near record-low territory.
Despite the record low unemployment rates, ever more frequent complaints by employers of worker shortages, and more widespread labor unrest and job actions, nominal wages have only risen grudgingly to date. As depicted in the below chart, nominal wages are now approaching 3% year-over-year growth, but are doing so just as inflation has also accelerated. The result is real wage growth that has actually been slowing, and in the latest month, June of 2018, turned slightly negative. The distributional problems that have plagued the economy over the past 35 years are clearly not receding in the current expansion, even as a cyclical peak approaches. While wage pressures will mount in the coming year, whether nominal wage raises can keep pace with rising inflation is less certain.
Inflation is likely to accelerate in the coming years, due to higher domestic prices from proposed and recently enacted tariffs on an ever-widening range of goods, and the economy’s response to additional demand while close to full productive capacity. While it is still too early to assess the full economic effects of the tariffs and counter-tariffs initiated by the U.S. and its trading partners to date, fewer U.S. jobs and more inflation are likely outcomes.
As a key metric affecting monetary policy, rising inflation could also act as a trigger for more aggressive Federal Reserve rate hikes and ultimately play a critical role in determining the duration of this expansion.
Initial claims for unemployment insurance in Vermont remained at their lowest level in nearly 30 years through June of this year, indicating continued tight local labor market conditions in the near-future.
Both consumer and business sentiment are climbing to levels not seen in decades – underpinning continued strong domestic consumption and investment. The primary concern limiting this euphoria is concern about the effects of tariffs, which were cited in a decline over the last four months in the University of Michigan Survey of Consumer Sentiment.
Real estate markets continue to improve throughout the country as housing prices increased in virtually every state for the 16th consecutive quarter. As of the first quarter of 2018 (the most recent available), 38 states equaled or exceeded their pre-recession peak levels, including Vermont.
In New England, the only states not to have reached pre-recession home price levels are New Hampshire (-0.8%), Rhode Island (-8.0%) and, now worst in the nation, Connecticut, which is still 15.3% below its previous peak level, reached in the first quarter of 2007.
The strongest real estate markets among neighboring states are in Massachusetts (+7.3% above prior peak levels), New York (+4.3%) and Maine (+3.8%). Vermont home prices are currently 3.0% above their prior peak in the first quarter of 2008. However, as illustrated in the below chart, prices in the Burlington Metro Area are up 11.3%, while prices in the balance of the State are still 3.2% below their last cyclical high.
Colorado has displaced North Dakota (now second) as the hottest real estate market in the country, with Texas and the District of Columbia all posting growth of 40% or more relative to their prior peak levels. The wide divergence in state real estate markets, as well as the regional divergence at the sub-state level within Vermont (and other states), illustrates a key aspect of the real estate industry: it is highly localized, despite credit conditions that can be national or even global. For this reason, if there were to be an economic downturn in the near future, home prices could drop precipitously in some locales, while others would experience no negative price effects whatsoever. The price declines during the last recession were the first time on record that 50 out of 51 states all experienced simultaneous home price declines. Only North Dakota, with its booming energy sector and state bank, avoided price declines during the Great Recession.
The biggest threat to the near-term continuation of economic growth is an escalation of the budding trade wars with China, Canada, Mexico and the European Union. While there are many legitimate trade issues to be negotiated, tit-for-tat tariffs against both allied and other nations is an ill-conceived tool for effecting the desired changes. Recent studies by analysts of all political persuasions show substantial potential economic and job losses that could ensue.
As this economic expansion ages, there are other risks that could also bring it to an end. Although there do not appear to be imbalances in the economy now that would precipitate a near term economic decline (within the 2 year statutory forecast horizon), if the current acceleration in growth continues, such imbalances are likely to develop. Because of this, the consensus macroeconomic forecast that forms the basis of the longer term (non-statutory) revenue forecasts detailed in Appendix A, now calls for a pronounced slowing of growth, though not a recession, in FY2021 and FY2022.
One of the patterns that precedes many recessions is a shift in relative Treasury bond prices known as an inverted “yield curve.” As shown in the chart above, the yield curve, which is the difference between longer term (10 year) and shorter term (2 year) Treasury yields, is usually above zero and therefore upward sloping (the longer the maturity date on the bond, the higher the yield).
About a year in advance of every recent recession, however, this relationship has inverted, with short-term rates exceeding long term rates. This usually happens when the Fed raises interest rates in order to dampen mounting inflationary pressures as the economy approaches a business cycle peak. By raising interest rates, the Fed signals expectations of lower growth and lower inflation. This causes investors to purchase more long term bonds, stabilizing or reducing yields and setting the stage for an inversion if the Fed continues raising rates. As shown on the above chart, the yield curve is closer to zero than it has been at any time since just prior to the last recession. If it were to continue in its present direction, it could invert in about a year, portending a possible recession sometime in FY21.
State Revenues
• Fiscal year 2018 was an exceptionally strong year for total State revenues, with the General Fund ending the year $65M ahead of target (about 4%), on the strength of the volatile Corporate, Estate and Personal Income categories, which benefitted from a small number of large “one-time” revenue events. Accordingly, General Fund revenues in FY19 and FY20 will strengthen as the current cycle peaks, but also be more vulnerable to decline after that. Transportation Fund revenues closed the fiscal year $1.4M above targets, a 0.5% variance, and the E-Fund was up nearly $5M, about 2.5% above expectations.
• Corporate tax revenues ended FY18 about $17M above targets – almost all of which is thought to be associated with repatriation of foreign income as a result of the TCJA (see details associated with this large and uncertain potential revenue flow on the following page). Corporate income receipts are expected to remain relatively robust throughout the forecast horizon, as even partial repatriation payments are expected to generate near-term strength and lower Federal tax rates increase longer term taxable profits. Although highly vulnerable to general recession and pronounced individual firm volatility, the distribution of State Corporate revenues is currently less concentrated than in previous years and should provide a more dependable base of not less than about $60-$70M, with unpredictable individual revenue events adding to – or subtracting from - this in any given year.
• Sales & Use tax revenues continued to benefit in the second half of FY2018 from strong voluntarily paid e-commerce receipts, closing the year about 1.7% above targets ($6.6M in revenue on a “Source” basis). This revenue category, which had been allocated between the General (64%) and Education (36%) Funds in FY2018, will henceforth be allocated in its entirety to the Education Fund.
• The boost from e-commerce Sales & Use receipts to date will be augmented in FY19 and beyond by the recent Supreme Court decision in the so-called Wayfair case (Wayfair v. South Dakota) which opened the door to state ecommerce sales taxation by overturning a 25 year old decision, Quill v. North Dakota. As a result of this, Vermont will now be collecting tax on sales from any e-commerce vendor with $100,000 in Vermont sales or 200 Vermont customers. While it is expected to take months and perhaps years to fully realize potential revenues from this change, it will add $4-$5M in FY19 to the existing e-commerce revenue the State has been collecting and provide an important source of growth that could ultimately represent as much as $15$20M per year to a revenue category that had been lagging due to tax base erosion.
• Sales & Use revenues will also gain in the near-term from accelerating economic growth, upbeat consumer sentiment and related retail spending. The only headwind this category will face in the immediate future will be the regressive price impacts from tariffs imposed on countries whose exports now dominate the shelves of some of the largest retailers – especially China.
• Personal Income revenues experienced exceptional capital gains-related revenue in FY18, leading to a $38M (4.8%) variance against targets. Although an increase in capital gains revenues was expected following the depressed levels of tax year 2016 (which were affected by uncertainty regarding likely GOP tax changes at the time), the 2017 gains exceeded these expectations. Although this same spike is unlikely to be repeated in the next two years, the general improvement in the economy and continued strong equity market gains will support about $15-$20M per year more in FY19 and FY20 PIT revenue than previously projected.
• Meals & Rooms tax receipts finished FY18 about 0.5% ($0.8M) above January forecasts. With the inclusion of Airbnb and other on-line vendor receipts, Meals & Rooms revenue is expected to continue to exhibit above trend growth of about 4% in FY19 and FY20, subject, of course, to the vagaries of winter weather. Skier visitation in FY18 (at 3.97M skier days) was slightly above last year’s total (1.2%) but 4% below the prior 11 year average. Vermont’s share of New England skier visits remained substantial, at 33.7%, and even its share of the U.S. in FY18 was above trend, at 7.5%. Recent ski area acquisitions in Vermont by large western resort operators may be able to expand upon these shares in future years through combined area promotions.
• Cigarette tax revenues lagged targets in FY18, as booming e-cigarette demand displaced traditional cigarette sales and enticed many young users into the vicissitudes and lifetime expenditures associated with nicotine addiction. Historical Vermont cigarette sales volume declines of about 3% per year during periods of relatively stable prices (years without significant tax increases or aggressive industry price hikes) have more than doubled, with an FY18 decline of 8.5%. The recent explosion in vaping is largely attributed to the marketing success of Juul Labs, which now controls almost half of the e-cigarette market, and experienced year-over-year sales growth of nearly 800 percent in 2017 and comparable YTD 2018 growth. Its flagship product, a small, discreet vape pen with higher nicotine levels than its competitors, has been particularly successful with teenagers. A recent study by Dartmouth College’s Norris Cotton Cancer Center said vaping has led more people to start a real smoking habit, rather than avoid tobacco or quit in favor of e-cigarettes, but there may be a lag between the surge in teen vaping and eventual cigarette demand. Until then, State cigarette revenues will be slightly lower than prior forecasts. (Last month, in the New Yorker magazine, the former chair of the American Academy of Pediatrics Tobacco Consortium, Dr. Jonathan Winickoff, described Juul as “bioterrorism” and declared that Juul already represents “a massive public-health disaster.”)
• Source Property Transfer Tax revenues closed FY18 about 1.3% below targets, but will continue to be among the fastest growing revenue sources in FY19 and FY20, as real estate markets continue to recover and investment flows begin to extend more rural areas and second homes. As real estate price gains accelerate, Property Transfer revenues could grow by 6%-10% per year in each of the next two years.
• The Telephone Property tax continues to decline and is now expected to be less than half its FY14 level in FY19, due to aggressive depreciation being taken by some of the largest payers and statutory ambiguity regarding such depreciation and the applicability of the tax to wireless and VoIP providers. Without statutory clarification, this revenue source will likely continue to decline, generating at least $5 million less than FY14 levels for the foreseeable future.
• Transportation Fund revenues finished FY18 extremely close to targets (+0.5%), as slightly higher Motor Vehicle Purchase and Use revenues offset weakness in Fee revenues. Improved external economic conditions will support continued strength in MVP&U revenues in both FY19 and FY20, while higher fuel prices will negatively affect per gallon taxes and positively affect taxes based on price. The net effect of all this will be slightly higher expected revenues in both FY19 (+$2.1M) and FY20 (+$1.5M). • The U.S. and Vermont macroeconomic forecasts upon which the revenue forecasts in this Update are based are summarized in Tables A and B at the end of this report, and represent a consensus JFO and Administration forecast developed using internal JFO and Administration State economic models with input from Moody’s Analytics June 2018 projections and other major forecasting entities, including the Federal Reserve, EIA, CBO, IMF, The Conference Board and other private forecasting firms.
• Due to the reduced availability of forecasts from the New England Economic Partnership (NEEP), State consensus macroeconomic forecasts were developed using a State on-line modeling capability provided by Moody’s Analytics. This forecasting capability allows timely, customized state forecasts with modeling capabilities similar to the prior NEEP capability.
• The standard revenue tables at the end of this report have been changed due to major revenue source reallocations mandated by H.911, enacted in the 2018 legislative session. This change directs 100% of the Sales and Use tax and 25% of the Meals and Rooms tax to the Education Fund, in addition to existing allocations of 100% of the Lottery and one-third of the Motor Vehicle Purchase and Use tax . Accordingly, new current law Available Fund totals are still labelled as Tables 1-3 (General, Transportation and Education Funds, respectively), however, for purposes of comparison, in addition to Tables 1A (General) and 2A (Transportation), which show “source” revenues (from which all allocations are derived), this report includes Tables 1B (General Fund) and 3B (Education), which maintain prior Fund allocation consistent with the prior January 2018 forecast.
• Five-year revenue projections are included in Appendix A, following Tables A and B at the end of this report. Although these are not required by statute, they have been requested by both the JFO and Administration for several years for longer term planning purposes. During the 2015 legislative session, there was considerable misinformation and confusion regarding the role these longer-term projections played in the recent (though not new) discussions of structural budget deficits. As a result of this, these tables are now published on a regular basis, so as to provide clarity with respect to longer term revenue potential and expectations. As illustrated in these tables, and consistent with virtually all past projections, longer term revenue growth from the mix and structure of the taxes in the three funds analyzed herein is unlikely to keep pace with recent levels of expenditure growth, at current law tax rates.
• Forecast versus actual revenue variance data for the most recent twelve years are illustrated in the chart on the following page. The below table summarizes the same data since FY2001. As would be expected, January projections are generally more accurate than July – though not always. Since fiscal year 2001, there have been 36 regular Consensus forecasts (January and July for each year) for each of the three major funds (General Fund, Transportation Fund and Education Fund) for a total of 108 observations. Over this eighteen-year period, there have been 54 variances that were low (under-forecast actuals) and 54 variances that were high (over-forecast actuals). The average absolute value of the variance for these 18 years was about 1.9% for total revenues across all three major funds, with the lowest variance (1.4%) in the Education Fund, due to its reliance on relatively stable consumption taxes, and the highest variance (2.5%) in the General Fund, due to its reliance on more volatile revenue sources such as Personal Income, Corporate and Estate taxes – as exemplified in FY2018.
A Potential Wild Card in the Forecast: Corporate Revenues from Repatriation
One of the most important provisions in the 2017 Federal Tax Cut and Jobs Act (TCJA) also introduces considerable complexity and uncertainty in terms of revenue impacts: repatriation of potentially $3 trillion or more in accumulated U.S. corporate offshore earnings. These profits, sheltered from U.S. taxation in a wide array of global tax havens, have allowed corporations to avoid U.S. and related state income taxes for many years. The Tax Act fundamentally changes the rules of international taxation and provides for repatriation of this accumulated income at a fraction of the prior tax rate (35%), at either 15.5% (for cash) or 8% (for more illiquid holdings), over an eight year period.
It is currently the opinion of both the Vermont Tax Department and Legislative Council that this repatriated income is also subject to state income taxation. Although currently impossible to verify with complete certainty, we estimate that approximately $15 million in FY2018 State Corporate receipts and more than $1 million in FY19 to date have been received in connection with repatriated earnings.
In conjunction with the Tax Department, we have developed a list of 322 corporations with large potential repatriation liabilities based on publicly available information, who collectively have an estimated $2.7 trillion in offshore earnings. We have applied the relevant Vermont apportionment factors to each affected company from Tax filings and estimated potential state Corporate receipts at both the 8% and 15.5% tax rates. Based on this, the State could ultimately receive $100-$200 million, however, the timing and exact liability is still highly uncertain at this time. Some even contest the ability of states to tax this income – and the same legal and accounting firms that set up these and other tax avoidance mechanisms are hard at work to minimize tax payments under the new law. Thus, final receipt of these amounts could be subject to lengthy legal proceedings and even clawback from firms who have already paid.
In recognition of this, we have only included $15-$20 million in expected FY2019 Corporate revenues from repatriation and smaller amounts ($1 to $5 million per year) thereafter. The Tax Department is planning on publishing guidance to Corporate taxpayers on this issue within the next few months, and eventually, forms to specifically identify tax payments connected to repatriated earnings. With this information, and federal tax returns, we will be in a better position to identify payments linked to this liability and establish a more accurate sense of both potential liabilities and tax payment timing.
The Wall Street Journal currently estimates that only about 10% of all corporate repatriation has been effected to date, due to the eight year Federal payment window. At the State level, however, Vermont considers the entire liability to be due with tax year 2017 payments.
We will be tracking this closely in FY2019 and beyond, since it could contribute to enormous revenue variances - up or down - in selected revenue forecast periods.