The Road to Broadly Shared Prosperity Leads Through the States

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Tax Policy

The 2008 recession brought deep declines in state revenue, but now some of that revenue is starting to return. In this article, Erica Williams of the Center on Budget and Policy Priorities discusses forward-looking steps states can take to improve their economies now and in the future.

Erica Williams

By Erica Williams

Erica Williams is Deputy Director of State Fiscal Research with the Center on Budget and Policy Priorities’ State Fiscal Policy division. Since joining the Center in 2009, her research has focused on tax and spending limits and other anti-tax threats, state EITC developments, poverty, cuts to state services, and immigration.

Decisions made in states every day profoundly affect future economic stability and opportunities in communities across the country. States face a fundamental choice: provide the resources required for public investment in schools, transportation, health care, safe communities, and other building blocks of economic health—or cut taxes while skimping on public investment, which contributes to the concentration of economic gains among the richest households and limits opportunity for the broad majority.

When the recession hit in 2008, record-breaking declines in state revenue brought deep, job-killing cuts to schools, health care, and other key services that people depend on every day. Now, as revenue returns, states have the opportunity to invest in their economies and meet rising needs by eschewing crippling tax cuts and, instead, instituting fiscal policies that can help create jobs now and prime states for long-term, broadly shared prosperity.

California, Minnesota, and Massachusetts stand out as leading examples of states that have recently taken forward-looking steps to improve their economies now and in the future. These states are pursuing measures consistent with the recommendations found in “ A Fiscal Policy Agenda for Stronger State Economies,” a recently released Center on Budget and Policy Priorities report that offers a roadmap for creating and sustaining thriving communities and stronger economies. The agenda lays out five main steps states should begin to take today to build future economic security.

1. Target Public Investment to Boost the Economy, Now and in the Future

States can build a strong foundation for economic growth and promote jobs that enable people to get ahead by investing in areas such as education, public transportation, roads, and water and sewage systems—things that businesses and communities rely on heavily. These investments can create jobs in the short run and improve economic growth and job quality in the long run.

  • Strengthen education:Reinvest in education at every level, from high-quality preschools to college and customized job training, to prepare a workforce that can compete for good-paying 21st century jobs.
  • Invest in infrastructure:Reverse the serious decline in state investment in transportation, water treatment, and other forms of infrastructure (see Figure 1). These investments are key to creating jobs and promoting longer-term economic vitality, as they help businesses get their goods to market and increase productivity. Now is an especially good time to invest, given low interest rates for the borrowing that states can use to finance infrastructure projects.
  • Support entrepreneurs:Help startups and young, fast-growing firms already located in the state to survive and grow instead of cutting taxes and trying to lure businesses from other states with ill-advised tax breaks. The vast majority of jobs are created by businesses that start up or are already present in a state—not by out-of-state firms that relocate or branch into a state.
  • Spend wisely: Make careful, informed decisions by reviewing spending areas that may not be meeting intended goals, such as economic development subsidies; tax credits, deductions, and exemptions; and contracting practices. Such decision-making could free up resources for other priorities.

Figure 1
2. Help Struggling Families Share in Prosperity

State policymakers should help struggling families meet basic needs and avoid cutting supports that ease hardship. They also should reform policies in areas such as immigration and criminal justice that carry unnecessary economic costs, with the goal of helping more people participate more fully in the economy.

  • Enact or strengthen state EITCs: State lawmakers can boost the earnings of families working hard for low pay by enacting or increasing state Earned Income Tax Credits (EITCs). State EITCs build on the success of the federal EITC by keeping working parents on the job and helping families make ends meet. Twenty-six states and the District of Columbia have enacted state EITCs (see Figure 2).
  • Improve state support for families struggling the most: States can protect and better administer supports for those in the greatest economic need. These supports include cash assistance, subsidies for child care and transportation, and free school meals. States also should help families to enroll in SNAP—the federally funded food assistance program that lifts 10 million people out of poverty—as well as protect families with housing vouchers from discrimination and help them move to higher-opportunity neighborhoods.
  • Expand Medicaid: Through health reform, states can extend Medicaid coverage to people with annual incomes up to 138 percent of the federal poverty line—about $17,000 for an individual. This increases the number of people with insurance, protects families against health-related financial shocks, and keeps people healthier and able to work, which helps struggling residents and the state economy.
  • Reform criminal justice policy: States can save millions of dollars without endangering public safety through reforms such as effective addiction treatment instead of incarceration for people convicted of drug-related crimes or using sanctions instead of prison time for violations of technical conditions of parole, such as missing a meeting with a parole officer. These reforms also reduce the rate of people returning to prison and enable marginalized residents to participate more fully in the economy.
  • Improve immigrant policies: State policymakers can bring more immigrants into the mainstream economy, build a more educated and productive workforce, and enable immigrants to contribute to their fullest potential.

Figure 2
3. Avoid Ineffective Strategies and Gimmicks That Can Weaken a State's Economy

Several states have enacted or considered deep income-tax cuts that give the biggest benefits to large, profitable corporations and people with the highest incomes. Others have weighed budget restrictions that would severely limit public investment. Such policies fail to produce promised economic benefits and squander revenue that states could otherwise use to lay a strong foundation for future economic growth through public investment in high-quality schools, infrastructure, and other areas (see Figure 3).They also make it harder for states to save for a rainy day or respond to emergencies.

  • Avoid costly income tax cuts:Proposals such as replacing the state's income tax with a higher, broader sales tax would sharply raise taxes for low- and middle-income households and threaten a state's ability to maintain services necessary for a strong economy. Other proposals would eliminate or deeply cut income taxes for individuals and businesses without replacing the lost revenue, forcing drastic cuts in services such as schools, transportation, and public safety.
  • Avoid costly corporate tax cuts: Large corporate tax breaks typically have a negligible impact on economic growth. Most are zero-sum at best: if a state cuts a tax, it generally has to make an offsetting cut to services to keep its budget balanced; the spending cut likely reduces demand in the economy, which counteracts any stimulative benefits of the tax cut.
  • Reject arbitrary spending limits: Strict formulas to limit revenue and spending, like Colorado's “ Taxpayer Bill of Rights” (TABOR), are gimmicks that hamstring a state's ability to adapt to changing needs. Every state that has considered a TABOR since Colorado adopted it in 1992 has rejected it because it requires massive reductions in support for schools, health care, safe communities, transportation, and environmental protection.
  • Reject supermajority restrictions: Requiring a two-thirds legislative vote to raise revenue, instead of the simple majority required for other legislation, makes it harder for states to protect public investments during recessions. The resulting cuts can cost jobs and weaken economic recovery. They can also cause legislative gridlock when a small minority of lawmakers holds a tax measure hostage to expensive pet projects, making it harder to enact policies that serve the state as a whole.

Figure 3
4. Improve Fiscal Planning to Protect Investments That Promote Long-Term Economic Growth

States can better plan for the future through budget impact analyses that are professional and credible, and instituting mechanisms that trigger mid-year changes when needed to keep the state on course (see Figure 4). Policymakers need accurate information about the cost of spending- and tax-related proposals to make sound decisions. Without it, they may be more likely to adopt proposals that cause serious fiscal problems.

  • Employ best practices in budget planning: States routinely put at risk some of their highest priorities—educating children, maintaining a healthy and trained workforce, and caring for the elderly, for example—by failing to employ proven budget methods. Getting a stronger grasp of likely revenue and the cost of providing core services would help states have the necessary resources. It also can reduce businesses' uncertainty about future funding levels and tax rates.
  • Strengthen “rainy day” funds:Rainy day reserve funds help states offset revenue drops during economic downturns. In hard times, states can tap them to preserve public investment that promotes economic growth and sustain the state's demand for private-sector goods and labor. States without such funds should create them; states with overly tight restrictions on their use should reform those laws.
  • Institute “pay-as-you-go”: In an improving economy, many policymakers are tempted to cut taxes or enact new programs that are not sustainable without significant new revenue. States can protect themselves by adopting a requirement that policymakers fully offset over a five-year period the cost of spending increases or tax cuts.

Figure 4
5. Raise Revenue Needed for Economy-Boosting Investments

Discussions by policymakers about strengthening the economy often center on tax cuts, despite overwhelming evidence of their negligible impact on creating jobs or promoting broad prosperity. States should pursue new revenue when necessary and modernize their revenue systems for the long term.

  • Pursue focused tax increases: For example, policymakers can raise taxes on the highest-income households and profitable corporations (those best able to afford the higher tax and least likely to spend substantially less as a result) by adjusting income tax rates, altering certain tax breaks for these groups, or reinstating taxes on inherited wealth. Experience doesn't support claims that these kinds of tax increases will drive significant numbers of affluent people to other states.
  • Improve tax collections: States can do a better job of collecting taxes due under current law. For example, the failure of catalogue or Internet sellers to collect and remit state and local sales taxes costs states billions of dollars each year. States also can nullify a variety of tax-avoidance strategies employed by large multistate corporations by adopting “ combined reporting,” which treats a parent company and its subsidiaries as one entity for state income tax purposes (see Figure 5).
  • Modernize state revenue systems: States can halt the erosion of their sales taxes and improve their long-term ability to invest in public priorities by updating antiquated tax systems ill-suited to the 21st century economy and broadening the sales tax base to include more services. For example, many states primarily levy sales taxes on tangible goods, even though services such as video streaming—which didn't exist when sales taxes were first enacted—make up a growing share of consumption.

Figure 5
States Paving the Road to Broadly Shared Prosperity

California and Minnesota have pursued a number of policy measures laid out in our fiscal policy agenda to build their economies. The results? Both states have improved their education systems—boosting their future prospects—while maintaining strong economic growth.

Minnesota continues to enjoy strong state finances, California voters will likely vote in November on extending the temporary personal income tax increases they approved four years ago, and another state—Massachusetts—will ask voters to decide the fate of a new measure to raise income taxes to pay for needed investments in transportation and education.

Minnesota raised income tax rates for its wealthiest residents in 2013 to address a gaping budget shortfall and make investments that matter. For example, the increase enabled the state to make a number of promising education investments. These include helping more low-income families afford preschool programs for their children, extending kindergarten to a full day in all public school districts, and offering college scholarships to more low- and middle-income residents. The state also was able to give a boost to working families struggling to get by with an increase in its EITC in 2014.

The sound decision to raise revenue in 2013 continues to pay off. This year, the state registered a $900 million budget surplus. Lawmakers' work this year reflects the choice to make investments that truly matter rather than squander resources on poorly targeted, unaffordable tax cuts. For example, rather than adopt a proposal to cut back the state estate tax, they chose to improve the state's working family and child and dependent care tax credits to buoy those struggling to make ends meet. As part of the package, Minnesota would become the first state and the second jurisdiction (behind Washington, D.C.) to do what Congress has debated for several years to no avail—expand the EITC for workers without dependent children, many of them young and just getting a toehold in the workforce. Altogether, the Working Family Credit would put $49 million back into the pockets of nearly 400,000 working families and individuals. The governor supported these provisions but pocket-vetoed the tax package over an unrelated technical fix. There's still a chance that lawmakers will be brought back for a special session to make that fix and adopt these measures.

California voters in 2012 temporarily raised income tax rates for the wealthiest residents, as well as the state's sales tax, and dedicated the new revenue to education, which the state had cut deeply after the recession hit. Those changes helped California raise annual K-12 funding per student by $ 1,800, as of 2014-15, and better target those dollars to communities with the greatest need, likely improving the state's workforce down the road. As in Minnesota, the brighter revenue picture that has endured since the tax increases allowed California the resources to broaden the economic recovery for deeply struggling workers and their families by creating its first-ever state EITC in 2015.

Because the 2012 tax increases were temporary, voters will likely be called upon this November to extend the income tax rate increases to sustain the progress made. If voters approve the measure, it would extend the tax increase for another 12 years. If they don't, revenue available for education and other essential investments in California's communities would fall by more than $8.5 billion by 2020.

Figure 6

Massachusetts voters will decide in the fall whether to raise individual income taxes on incomes over $1 million, with the additional revenue funding greater investments in education and transportation. As previously noted, these public investments will benefit the state's economy and facilitate more widely shared prosperity.

Massachusetts is one of the country's most unequal states in terms of wealth and income, and the gap has widened in recent decades. Incomes at the top have soared, leaving a larger gap between the state's wealthiest and its middle- and lower-income families. The state's tax system is unfair and exacerbates this problem. The top 1 percent of non-elderly taxpayers in Massachusetts pay much less in state and local taxes as a share of their income than middle- and low-income people. Raising income taxes for people with incomes over $1 million would help address this fundamental unfairness.

Although opponents will likely argue that raising taxes for the highest income earners will cause them to flee the state, harming the state economy, that claim doesn't hold water, as noted above. State after state has found that the revenue generated for schools and other services by such an increase more than offsets any revenue lost if some rich people move out.

Notably, since raising taxes, both Minnesota and California's economies have grown faster than the nation as a whole (see Figure 6.)

As the CBPP has written, state income tax levels have very little to do with state economic growth rates. Focused income tax increases can provide revenue to improve schools and other public services that form a strong foundation for economic growth.

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