New TF Report: State Budget Shortfalls Present a Tax Reform Opportunity

February 11, 2009

While many states that have budget shortfalls are seeking federal bailouts, proposing targeted tax increases and calling for hiring freezes, these shortfalls are actually an opportunity for fundamental tax reform, according to a recently completed Tax Foundation study.

In Tax Foundation Special Report No. 164, “State Budget Shortfalls Present a Tax Reform Opportunity,” Tax Foundation Director of State Projects Joseph Henchman reports that forty-five states face budget shortfalls of varying degrees, totaling approximately $132 billion through fiscal year 2010. However, every state but one expects revenues in 2010 to be higher than in 2006, and all but nine states have seen revenues grow faster than inflation from fiscal years 2006 to 2009.

“States hit hardest are those that relied most heavily on growth in unstable revenue sources like taxes on capital gains, high-income earners, and corporate profits,” Henchman finds.

Henchman argues that punitive taxes on unpopular groups, such as smokers, drinkers, or high-income earners, are poor tax policy and a source of instability because they force a small group of people to pay for government services broadly available to all citizens.

Interesting parts of the report include a map of cigarette tax rate changes since 1983, a depiction of the wild fluctuation in volatile tax sources in California, and a table of state operating revenues since 2006.

Some key quotations:

  • A budget squeeze is an opportunity for fundamental tax reform. By broadening tax bases and lowering rates, states can generate extra revenue while bringing the state tax system back to the basic principles of good taxation: simplicity, transparency, and neutrality.
  • In most states, tax revenues are coming in below projections, although that varies by state and by particular tax. Down the most are particularly unstable sources of revenue, such as taxes on capital gains, high-income earners, and corporate profits.
  • The most prominent example of how not to address a state budget is California, which has “balanced” its budget for years with borrowing and accounting tricks. In 2004, California even borrowed $15 billion in long-term bonds to pay for short-term operating expenses.
  • A tax increase that broadens the tax base is preferable to one that piles ever-higher taxes on a narrowly defined, already overtaxed group of taxpayers.
  • Unfortunately many state use their tax codes as a way to pick winners and losers, and not just to raise revenue. Some favored industries and interests are exempted from certain taxes while others are taxed multiple times.
  • Extensive use of targeted tax credits is a warning sign that the state’s tax code is broken. Business should not have to receive special exemptions from the state’s tax system to be willing to invest and create jobs in a state.
  • Taxpayer protections are crucial. Arkansas, California, and Rhode Island require a legislative supermajority to pass the budget, preventing stealth proposals that do not have public consensus.

Read the Special Report. Read the news release. More on state tax policy.

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