Tax Reform Can Alleviate State Budget Crises

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The July jobs report, which showed growth in private payrolls more than offset by shrinking public payrolls, has set off new concerns that fiscal tightening will hinder the economic recovery. Governments, still facing anemic revenues despite the growing economy, are running out of stopgap measures like stimulus funds and are laying off employees. How can this be avoided?

I have written in the past about one factor that leads to government layoffs -- unwise contracts and overly stringent labor rules that take other cost-saving options off the table. Governments that are empowered to freeze wages or furlough employees can cut their budgets without driving up unemployment. But another factor is at play here -- because of excessively volatile state tax systems, revenues are off much more than they need to be. Tax reform can improve revenue stability and therefore reduce the severity of budget crises, and the need for layoffs.

The National Association of State Budget Officers reports that state general fund revenues were $608 billion in fiscal year 2010 (which ended on July 1). That's a 10.6% reduction from fiscal year 2008, and it would have been 15.2% if states had not enacted tax increases. But over the same period, nominal GDP actually grew by about 1%. Why did tax revenues fall so much while the (nominal) economy grew slightly?

The problem is in the design of state tax codes, which amplify the effects of economic changes. The three primary taxes that fund most state governments are sales, personal income and corporate income taxes. In general, the bases of these taxes should grow and shrink in proportion to the economy. But structural features can make them much more volatile.

Most state sales taxes are not true "consumption taxes." Instead, they are designed to focus on the taxation of goods, while excluding many or all services. The set of taxable goods is also restricted -- most durable goods (like cars, electronics and furniture) are taxed, while many non-durable goods (such as food and medicine) are excluded.

While total consumption (as measured by the Bureau of Economic Analysis) was up 1% from FY08 to FY10, sales tax receipts did not come close to mapping the overall consumption trend -- in fact, they fell by about 7%. This is because consumption of the kinds of goods that make up sales tax bases sharply lagged overall consumption.

Durable goods consumption was off 8% over the subject period, and the figure was 14% for motor vehicles and parts. Furnishings and durable household equipment were also off 8%. Meanwhile, nondurable goods consumption was flat, including a 4% increase in spending on food -- which is subject to sales tax in only 15 states, and at a reduced rate in 7 of those. "Other nondurable goods" consumption rose 7% -- and a major component of that category is pharmaceuticals, which are mostly exempt from sales tax.

Consumption of services rose 3% between FY08 and FY10. Most services are exempt from tax in most states. Spending on health care services, which are rarely taxable, rose 10% over that period. Consumption of housing and utilities, also mostly non-taxable, rose 5%. The one service category that is widely subject to sales tax -- food services and accommodations -- saw just 1% growth.

This revenue volatility comes partly by design -- state legislators try to exempt "necessity" goods from tax bases so that pinched consumers can avoid sales tax. But a tax base that relies mostly on non-necessity purchases is going to get battered in a recession. And excluding necessities is a highly inefficient way to introduce tax progressivity -- a handful of states take a better approach, taxing groceries and then offering a "grocery tax rebate" only to low-income residents.

States can improve revenue stability by making their sales taxes more like true consumption taxes. That means taxing food, new home construction, and services (yes, even health care). Such a reform can be made revenue-neutral by cutting the tax rate as the base expands -- though it should be noted that a reform that is revenue-neutral for a typical year should raise revenue in a year like 2010, when durable goods consumption is low relative to overall consumption.

Personal income tax receipts have also been far more volatile than GDP -- off by 14% over the last two years. This is partly because of progressivity -- high-income people have incomes that move more with the economy, and they are taxed at a higher rate. And it's also partly because interest, dividends and capital gains -- which are not components of GDP -- have been hit hard in the recession.

While most income tax on labor income is collected through withholding, tax on investment income and self-employment income is largely remitted as quarterly estimated tax payments. For the 2009 tax year, these payments to state governments were off 26.8% from 2008, reflecting extreme weakness in investment income. The bleeding hasn't stopped -- even as the economy grows, April 2010 estimated tax payments were off 10% from April 2009.

In the last two years, the trend has been for states to make their tax codes more progressive by enacting or raising "Millionaire's Taxes." This will only exacerbate the problem of revenue volatility. Instead, states should resist the temptation to increase income tax progressivity or overall reliance on income tax.

Critics on the Left will respond that income taxes are not progressive enough -- that relying on broad-based taxes to pay for state budgets is unfair, especially because low-income people pay a disproportionately high share of their income in sales and excise taxes. But if we need more income tax progressivity, it belongs at the federal level, where the government can address the problem of volatile revenues through borrowing -- and I would note that the federal income tax will already be far more progressive in 2011 than it was in 1999.

Balancing equity and revenue stability (not to mention tax impacts on economic growth) is a challenge. But one reform can improve equity, stability and economic growth all at the same time -- an increased reliance on property taxes. Property tax often gets a bad rap because it's highly visible, and homeowners scream when taxes go up. But property tax is both more progressive and more stable than sales tax -- and it does less economic damage per dollar of revenue than sales or income taxes.

Indeed, the relative stability of property taxes is the reason that local revenues have gone flat in the recession, instead of falling sharply -- property tax is typically the largest component of local taxation. Budget cuts at the local level aren't being driven by weak local tax revenues, but by cuts in local aid made necessary by weak state tax revenues.

To improve stability without increasing regressivity, states can raise property tax while cutting sales and income tax. They could do this by adopting statewide property tax, which is rarely a large component of state revenue systems but is used successfully in New Hampshire. Or they could turn over some state government responsibilities to localities while allowing a one-time step up in property taxes.

This would be an especially good idea in southern and western states with low baseline property taxes -- like California, whose biggest challenge is not high taxes per capita but extremely high income and sales tax rates. If California raised property taxes to a level typical in the northeast, it could repeal its state and local sales taxes entirely without revenue loss, and the state's budget swings would be less severe.

This reform won't work for every state, particularly those that already have outsize reliance on property tax, like New Jersey and New Hampshire. But a combination of sales tax broadening, income and sales tax rate cuts and property tax increases could put most states on better footing to react to the next recession -- without layoffs.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.

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