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State Taxes: Quick Fixes Won't Work Anymore

On Apr. 13 in Virginia's sleepy capital of Richmond, an alarm went off that could wake up a lot of other states. After months of bruising debate, the Republican-dominated legislature took a major step toward reforming the state's archaic tax code by approving the outlines of a plan offered by Democratic Governor Mark R. Warner.

Details are still being hammered out, but the extraordinary bipartisan effort could close loopholes in the state's corporate tax, make the individual income tax more progressive, and modify Virginia's sales tax. And while the reform is driven by a $1 billion short-term deficit, Virginia heralds a lesson that many states may soon learn: Their tax systems are cracking under the pressure of a mobile, service-oriented economy. Even with revenues perking up thanks to the national recovery, "the tax base is not keeping up," says Walter Hellerstein, a professor of tax law at the University of Georgia School of Law. "States have a long-term problem."

The battle in Virginia is just the beginning. GOP governors such as Olene S. Walker of Utah and Ernie Fletcher of Kentucky have put reform at the top of their agendas, too. Walker promises recommendations by August. "Our economy is changing," she says, "We need to modernize our tax system to keep pace."

That isn't easy, especially when powerful antitax groups battle any revenue-raising changes. To prove to voters that new taxes are absolutely necessary, governors must first restrain spending. But even modest progress has buoyed reformers, who in past years saw their efforts crushed in states such as Alabama and Tennessee.

State budgets are under assault from all sides. The recession's revenue losses were compounded by federal tax cuts, because many states piggyback their taxes on the IRS code. Federal aid to states is down, while costs are growing -- especially for Medicaid. The health program for the poor is expanding at double-digit annual rates as seniors' drug and nursing-home costs explode. In response, states enacted more than $7 billion in tax hikes in 2003, according to the National Conference of State Legislatures. Most were modest increases in tobacco taxes, licensing fees, and sales-tax rates.

Closing Corporate Loopholes

But such ad hoc revenue-raisers don't address huge future shortfalls -- or state tax codes' growing disconnect from the modern economy. Sales taxes, for example, are not imposed on fast-growing services, like medical care or legal advice, and are rarely collected by out-of-state catalog or online sellers. State tax experts say that reform should impose a lower sales-tax rate on a broader range of goods and services sold by all retailers -- not just Main Street stores.

States' individual income taxes tend to be highly regressive: Because of near-flat rate structures, low-wage workers pay the same top rate as millionaires. Adjusting rates and dropping special breaks could fix that. Corporate income taxes are in even worse shape: They account for less than 10% of state revenues, which barely justifies the effort to collect them. As a result states face a choice: Either replace corporate income taxes or close loopholes that allow companies to avoid them.

None of these changes come easily. But progress in Richmond -- usually a hotbed of antitax conservatism -- has reformers thinking that the time for big changes in state taxes may be near. Voters in 18 swing states have been subjected to a barrage of TV ads trashing Democrat John Kerry (paid for by the Bush campaign) and attacking the President (mostly underwritten by liberal groups). But how effective has the multimillion-dollar air war been? Not very, according to a new study by the Annenberg Public Policy Center. The National Annenberg Election Survey found that Kerry's negative ratings rose by just one point -- to 29% -- from Mar. 1 to Mar. 31 in the states where he was targeted by the Bush campaign. But the Massachusetts senator's unfavorables jumped five points, to 27%, in the rest of the nation. One possibility: Critical news coverage of Kerry flip-flops has been more damaging than Bush's commercials. Meanwhile, the President's unfavorable ratings were up one point in both targeted states (40%) and ad-free zones (37%). Federal Communications Commission junketeers are at it again, says an Apr. 6 report by the Center for Public Integrity. In the past seven months, agency staffers have accepted $90,000 worth of free trips from the media and tele- communications industries they regulate. FCC Chairman Michael Powell had promised to cut back on such questionable trips after the Center's report last May showed that agency officials had accepted $2.8 million in travel and entertainment from industry over the past eight years. But the Administration wouldn't fund the full $500,000 travel budget, so Powell can only pay for senior staffers' essential trips.

Corrections and Clarifications

"The FCC's free-flier program is back" (Capital Wrapup, Apr. 26) reported that Federal Communications Commission staffers accepted $90,000 worth of trips paid for by FCC-regulated industries. In fact, some of the trips were paid for by universities; others by law firms, banks, and associations that serve the industries but are not FCC-regulated.

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