Perspective: Studies Highlight Tax Policies That Led to Weak Fiscal Conditions

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Drew Douglas and Michael Bologna

Drew Douglas is a BNA correspondent in Tampa, Fla. Michael Bologna is a BNA correspondent in Chicago. BNA editor Dolores W. Gregory contributed to this report.

The news just keeps getting worse for the states, as fiscal conditions continue to deteriorate and budget shortfalls persist.

On Nov. 23, the Nelson A. Rockefeller Institute of Government issued a preliminary summation showing that state tax revenues were down by an average of 10.7 percent nationwide in the third quarter of 2009. Corporate income taxes had taken the greatest hit, falling an average of 19.4 percent over the third quarter of 2008.

Only a handful of states showed growth in any category of tax, but most posted double–digit—and in some cases, triple-digit—declines.

On Nov. 11, the Pew Center on the States released an equally grim report indicating that the fiscal crisis would continue into 2010, triggering new waves of tax increases, layoffs, spending cuts, and service reductions.
The report, Beyond California: States in Fiscal Peril, found that states struggled to bridge an estimated $162 billion budget gap for fiscal year 2010, which began July 1 in most states. By most measures, circumstances have only worsened since those budgets were created. The report noted that state revenue gaps have grown by another $16 billion since then, and unemployment continues to climb—to 10.2 percent in October.

In this climate, the Pew report said, state fiscal problems will likely worsen in the coming year even as a national recovery gains traction.
“States historically have their worst years shortly after a national recession ends, as they cope with higher Medicaid and other safety net expenses at the same time revenues lag because of stubborn unemployment,” the Pew Center reported.

The National Governors Association (NGA) and the National Association of State Budget Officers (NASBO), meanwhile, predicted that states will need a decade to recover from the recession, and the Institute on Taxation & Economic Policy (ITEP) warned that states need to be wary about imposing tax increases to close budget gaps—because their already regressive tax systems unfairly burden poor and middle class taxpayers.

Ten Years to Recovery

In a preliminary biannual report, The Fiscal Survey of States, the NGA and NASBO reported that state revenues declined 4.0 percent in the last quarter of calendar year 2008, and fell another 11.7 percent and 16.6 percent in the first two quarters of 2009. Even though the recession may, in fact, have already ended, the report said, states will take several years to crawl out of the current fiscal hole and return to pre-recession levels of revenue.
“States will continue to struggle over the next decade because of the combination of the length and depth of this economic downturn, the projected slow recovery and the overhang of unmet needs,” NGA Executive Director Raymond C. Scheppach said in written statement.

“The unmet needs are those postponed or deferred during the crisis, including replenishing retiree pension and health care trust funds and financing maintenance, technology, and infrastructure investments. States will also need to rebuild contingency or rainy day funds. The bottom line is that states will not fully recover from this recession until late in the next decade.”

Ten Troubled States

The Pew report focuses on policies that contributed to the fiscal crisis. Many of the same practices that brought California to “the brink of insolvency” are also at play in nine other states—Arizona, Florida, Illinois, Michigan, Nevada, New Jersey, Oregon, Rhode Island, and Wisconsin—the report said.
The Pew report identifies four key trends driving the financial problems:

• overreliance on a particular industry or economic sector, which compounds state financial difficulties when those sectors begin to falter;

• failure to align their revenues with expenditures during the budgeting process;

• adoption of statutes that limit states' ability to respond to financial challenges—in particular, rules requiring super-majority legislative support for any tax increases, and

• a tendency to put off “tough decisions.”

The report points to California, Illinois, and New Jersey as states that have “punted” responsibility for fiscal problems through borrowing schemes and accounting adjustments that simply postpone the need to adopt painful financial solutions.

While it is unclear how these 10 states will choose to manage their financial burdens in the coming year, the report stressed that their responses will have implications for the national economy as well as the residents of those states.
“These states' budget troubles can have dramatic consequences for their residents: higher taxes, layoffs or furloughs of state workers, longer waits for public services, more crowded classrooms, higher college tuition and less support for the poor or unemployed,” the report concluded. “But they also pose challenges for the country as a whole. The 10 states account for more than a third of America's population and economic output. And actions taken by state governments to balance their budgets—such as tax increases and drastic spending cuts—can slow down the nation's economic recovery.”

States With Most Regressive Structures

Meanwhile, ITEP issued a “worst 10”list of its own—identifying states in which middle- and low-income, nonelderly families pay a far greater share of income in state and local taxes than the very well-off.

While just about every state's tax structure is regressive, the report said, 10 in particular—Washington, Florida, Tennessee, South Dakota, Texas, Illinois, Michigan, Pennsylvania, Nevada, and Alabama—were “particularly regressive,” with families in the bottom 20 percent of the income scale paying nearly six times as much of their earnings in taxes as the wealthy.

In Who Pays? A Distributional Analysis of the Tax Systems in All 50 States, ITEP reported that middle-income families in these 10 states pay up to 3.5 times as great a share of their income as the wealthiest families.

“In the coming months, lawmakers across the nation will be forced to make difficult decisions about budget-balancing tax changes—which makes it vital to understand who is hit hardest by state and local taxes right now,” Matthew Gardner, the lead author of the study, said in a written statement.

Nationwide, the average state and local tax rate on the wealthiest 1 percent of families was 6.4 percent before accounting for the tax savings from federal itemized deductions. After the federal offset, the effective tax rate on the wealthiest 1 percent was “a mere” 5.2 percent, the statement said.

Meanwhile, the average tax rate on families in the middle 20 percent of the income spectrum was 9.7 percent before the federal offset and 9.4 percent after, or nearly twice the effective rate that the wealthiest families pay, the report said.

The average tax rate on the poorest 20 percent of families was 10.9 percent, more than double the effective rate on the very wealthy, the report said.
“Fairness is in the eye of the beholder,” Gardner said. “But virtually anyone would agree that this upside-down approach to state and local taxes is astonishingly inequitable.”

Regressive Factors Explained

In the “Terrible Ten” states, the burden on the poor was due to a number of factors, according to the report.

In general, the most regressive states either do not levy an income tax, or levy the tax at a flat rate. They also typically rely heavily on sales and excise taxes and usually do not allow targeted low-income tax credits such as the Earned Income Tax Credit, the report said.

Such tax credits “are especially effective in reducing state tax unfairness,” ITEP said.

The study was conducted using the ITEP “Microsimulation Tax Model,” the statement noted, and included all major state and local taxes, including personal and corporate income taxes, property taxes, and sales and excise taxes.

 

Ten Most Regressive States: Taxes as Percentage of Income for Non-Elderly