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Balancing State Budgets the Smart Way

4 min readBy: Joseph Bishop-Henchman

This commentary originally appeared in The Daily Caller on March 24, 2010.

Few legislators run for office to say no to their constituents. But after years of saying yes to new programs and expansion of old ones, state legislators in 49 states must now cut spending, raise revenue, or both. The panic of the immediate budget crisis and painful recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. should not undermine an opportunity to have a real debate about what state governments need to be doing, and how to pay for it.

It is true that the recession is the immediate cause of the crisis, but it would be dishonest to ignore the fact that when times were good, states used booming taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. revenues to ratchet up spending commitments. Social services were expanded, already generous pensions for government workers were made more generous, state payrolls grew, and subsidies and tax incentives were lavished on politically favored industries.

Enabling this spending free-for-all was overreliance on revenue sources that soared in the boom but plummeted in the bust, like taxes on high-income earners, capital gains, and corporate profits. States became locked into spending growth that they could not sustain. Much of this was sold as a free lunch, as in Maryland where new programs were supposedly to be paid for by slots revenue and a tax on millionaires. (The slots have yet to happen and millionaires have begun vanishing along with their tax dollars.)

Nationwide, after growing at twice the rate of inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. and population growth during the boom, state revenues skidded 12 percent last year leaving budgets awash in red ink. States spent 2009 hitting up smokers for more taxes, holding tax amnesties, or adopting one-time gimmicks. Some started the year engaging in wishful thinking about tax revenues, even though tax collections historically recover only after the general economic recovery. As reality confronts the projections, budget gaps will reopen. Others will engage in accounting trickery or one-time gimmicks like California.

There are other options to put states on sounder legal footing. Here are five ideas for states to help both short-term and long-term fiscal woes:

  • Prioritize appropriations. When the majority-Democratic Arkansas Legislature votes to appropriate money, the money isn’t immediately spent. Instead, each appropriation goes to a legislative committee that ranks them in order of priority. Items are funded only to the extent money is available, forcing debate about how best to allocate limited resources while permitting a wish list if revenue exceeds expectations.
  • Review tax incentive programs. Although many states recognize they have burdensome tax systems, they use targeted incentives for particular industries rather than reducing burdens for everyone. Besides dumping a higher tax burden on everyone else, the jobs created are dependent on the handouts and often vanish when the incentives end. Tax incentive programs also often escape oversight and cost-benefit analysis. Iowa recently recommended elimination of several ineffective tax incentives after a review. Other states should do the same.
  • Broaden sales taxes and use the revenue to lower tax rates. A good sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. applies to all final goods once and only once. Exempting clothing and groceries may seem like a good idea, but doing so causes year-to-year revenue instability and drives up the rate on everything else. Gross receipts taxes and taxes on business inputs cause distortions that harm economic growth. Adopting a sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. of all final products and services would enable both lower rates and more predictable revenue.
  • Reduce reliance on taxes on high-income earners and corporate profits. When deciding in which state to live or locate their business, one of the factors that top earners must weigh is the marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. they will face in each state. While high statutory tax rates on high incomes may bring a revenue increase in the short term, they can harm long-term economic growth as providers of jobs and capital choose to locate in lower-tax states. With these volatile revenue sources at a minimum, it may be perfect timing to minimize them.
  • Establish rainy day funds and spending restraints. To ride out recessions, states need to build a rainy day fund of 12 to 18 percent of their annual spending. Setting aside 2 to 3 percent of each year’s budget in good times can accomplish that, but those structures need to be in place now or else states will be in this mess again.

Good legislators will spend 2010 adopting wise spending and tax policies that recognize and prepare their states for economic realities. With the right policies, states can be positioned to promote economic growth and maintain revenue stability when recovery finally comes.

Joe Henchman is constitutional attorney and tax policy analyst in Washington, D.C.