State Taxes Need New Thinking

With budget gaps across the country widening calamitously, governors will have to be bold. How about pooling their resources?

By Christopher Farrell

The era of federal red ink is back with vengeance. In President Bush's first budget, the Administration forecast a cumulative surplus of some $1.6 trillion in fiscal years 2004 to 2008. Now, driven by large tax cuts and massive increases in defense spending, the Administration predicts a total deficit of more than $1 trillion over the next five years -- and that prognosis doesn't include the cost of war with Iraq.

The feds aren't the only ones drowning in red ink. State budget gaps have increased by 50% over the last two months, to a cumulative deficit of $26 billion from $17.5 billion in November, according to a recent survey of about two-thirds of states by the National Conference of State Legislatures.

The news gets worse. State governments dealt with a $49.1 billion dollar shortfall for fiscal 2003. The gap will be $68.5 billion for 2004, with a third of the states not in the survey. Yet unlike the federal government, states can't run deficits. Their budget shortfalls must be closed.


  The easy remedies have been exhausted. State governments have borrowed, drawn down reserves, and tapped into tobacco-settlement money. Now, from California to Minnesota to New York, governors and legislatures are focusing mostly on slashing spending to balance the books. A handful of states will reluctantly raise revenue by hiking taxes or fees as well.

"All of this suggests that state governments will go from being a significant source of support to their economies, as has been the case throughout the economy's difficulties, to becoming a measurable drag," say economists Mark Zandi and Mark McMullen in a report on state finances for

Adds Alice Rivlin, senior fellow at Brookings Institution and former vice-chair at the Federal Reserve Board: "Large swings in state revenue, especially sharp drops in a weak economy, lead to shortsighted cuts in spending that are especially hard on low-income groups at exactly the wrong time and tend to increase the amplitude of cyclical swings in the economy."


  There has to be a better way. Policymakers are largely looking at the expenditure side of the ledger. States are cutting deep into valuable programs like public infrastructure projects, job training, early childhood education, higher education, and welfare programs because raising taxes to cover the tab is considered politically risky. So take higher taxes off the table for now. Still, the key to better state bookkeeping and more stable finances lies with fundamental tax reform.

America's "laboratories of democracy" are deeply flawed when it comes to taxes. Rivlin has several suggestions for reform. The most intriguing: States adopt one or more common taxes and share the revenues on a formula basis. Among the added benefits of bringing state tax systems into harmony would be reduced state-tax evasion. Consumers or businesses who spend money out of state in search of lower tax rates would lose their incentive. Instead, populous areas, which usually have higher taxes to pay for their social services, would receive a healthy boost.

It would also do away with the widespread practice of preferential taxes to attract specific businesses. Instead, states would compete for business with the quality of their workforce, the adequacy of their infrastructure, and the social amenities of the region.


  The strain on the state fiscal purse will ease once the economy perks up. Yet the underlying problem will persist. The cost of providing labor-intensive state services, such as medical care, social services, public safety, and education, are rising faster than the tax base. For instance, the sales tax has been eroded by exclusions, the exemption of services, and the rise of mostly untaxed electronic commerce. Retail sales over the Internet may be no more than $14 billion currently, but they're bound to grow dramatically in coming years.

Even more important, income tax, states' major source of revenue, is increasingly volatile. Coffers swelled in the 1990s during the bull market, as companies paid employees stock options and bonuses and investors cashed in their gains. But when the stock market tanked, so did taxable realized capital gains and revenue collections. One indication of just how severe the structural deficit is: State finances are in parlous straits despite a relatively low unemployment rate and the mildest recession in recent history.

State budget debates in tough times are inevitably rancorous, as projects get canceled and budgets slashed. Maybe it's time governors and legislators got together and started working toward a fundamental overhaul of the state tax system.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Edited by Beth Belton

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