Dos and Dont's of Coping With State Budget Crises

The budget news is grim in some states.  Twenty states face a combined budget shortfall of at least $35 billion for 2009, according to analysis by the Center on Budget Policy & Priorities (see CBPP graph below). Another 8 states will likely have budget problems next year or the year after.

The impulse by some state leaders is to slash state spending, but that could be disastrous for the economy if multiple states lay off state workers and cut-off help to those in need just as private spending is falling.

In fact, the right kind of revenue increases may be just what is needed for economic recovery.  As Nobel Prize winning economist Joseph Stiglitz of Columbia University, and Peter Orzag, now the director of the Congressional Budget Office, have emphasized, budget cuts during a recession will usually hurt state economies far more than tax increases, since cuts come dollar-for-dollar out of the economy, while tax increases, especially if targeted at the wealthy, often "reduce saving rather than consumption, lessening its impact on the economy in the short run."

This Dispatch is designed to be a primer on what states can do to ease the burden on working families in distress, while asking wealthier taxpayers and corporations to shoulder their fair share during tough times.

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Have Wealthy Pay Fair Share, Cut Taxes for Working Families

The sad truth is that almost every state tax system requires working families to pay a higher percentage of their income in taxes than their wealthier citizens.  In fact, as the Institute on Taxation & Economic Policy detailed in their 2003 study, Who Pays?: "[O]nly four states require their best-off citizens to pay as much of their incomes in taxes as middle-income families have to pay."  As the graph below from ITEP shows, the average family pays significantly more of their income in state taxes than the wealthy.

States can actually raise revenue, protect social services and actually make the tax system fairer all at the same time.

Strengthen Progressive Income Tax:  Creating higher tax brackets for wealthier taxpayers should be the prime tool for easing budget crises. For example, back in 2004, as New Jersey struggled with both a budget deficit and calls to lower the property tax burden, the state created a new 8.97% tax bracket for those making $500,000 per year or more.  Only 30,000 households saw a tax increase, even as 1.8 million households saw a tax cut.  Similarly, the Minnesota legislature approved a plan last year -- unfortunately vetoed by their governor -- that would have cut taxes for 90% of the populace while raising revenue with a new 9% tax rate for married couples making $400,000 per year or more.  Both of these examples show that a fairer tax system can help middle class families without gutting social spending.

One other tool to help increase fairness in the tax code is creating or increasing State Earned Income Tax Credits to ease the tax burden on lower-income working families.  It is worth remembering that in an economic slowdown, such tax cuts for working families will have the most immediate impact on the economy, since low-wage working families invariably have to spend those tax savings on immediate needs, usually at local retailers or other local services to strengthen local economies.

Circuit Breakers, Not Property Tax Caps:   With the housing market meltdowns, we are seeing more proposals for across-the-board caps on property tax rates-- a bad idea that delivers most of the tax benefits to wealthier property owners who least need the help.  Instead, a better approach are Property Tax Circuit Breakers, which limit property taxes to a percentage of a taxpayer's income, while fully taxing the property of wealthy homeowners.   A new study from Connecticut emphasizes why circuit breakers, along with other reforms, are far better than a tax rate cap proposed by the governor in that state.

Broader-Based Sales Taxes: While sales taxes often contribute to tax inequality, they can be made fairer by broadening the tax base of goods and services covered, especially with an eye to taxing legal and financial services used more heavily by richer consumers.  In dealing with its budget crisis last fall, Michigan approved a new budget that combined an increased income tax with expanding the sales tax to cover more services.  See this New Jersey Policy Perspectives report on the wide range of services that different states tax.

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Cut Corporate Loopholes, Not Social Services


One reason social services face funding crises is that since 1980 state corporate income tax revenues have dropped from 9.7% of all state taxes down to just 5.7% by 2000.   A 2005 study by Citizens for Tax Justice found that 252 of America's largest corporations failed to include two-thirds of their U.S. profits on state tax returns, avoiding an estimated $41.7 billion in state corporate income taxes over three years. (See CTJ chart to right for the low effective tax rate on corporations).

Corporate income taxes are often the main tax that out-of-state corporations and their shareholders pay for the public benefits enjoyed by those companies, so many states are increasingly using a variety of tools to have corporations pay their share.

Combined Reporting:  States are increasingly requiring companies to use combined reporting, listing profit reports for all subsidiary companies together on state tax forms to prevent shell games where companies hide profits through phony transactions among different corporate entitites.  Wal-Mart alone may have avoided $2.3 billion in state taxes between 1999 and 2005 through such gaming of the tax system--- something combined reporting can shut down.

Docoupling:  States can save revenue just by refusing to automatically grant special interest tax breaks handed out by the federal government by "decoupling" their tax code from the feds.  For example, at least 23 states would save $1.7 billion in revenue if they refuse to implement the "bonus depreciation" corporate tax break put into the recent federal stimulus package.  Similarly, some states have already rejected one particular federal loophole, the "Qualified Production Activities Income" (QPAI) deduction, because it threatens to cost states over $1 billion per year as it is phased in.

Oil windfall taxes: A number of groups have advocated state Windfall Profits Taxes to capture the outsized oil company profits.  Such a tax could raise billions for state coffers--  $500 million per year for the State of Washington alone according to the Economic Opportunity Institute, revenues which could be used to offset many of the environmental costs of fossil fuel use.

Tax disclosure:  To highlight exactly which companies are abusing the tax code, states should require all large corporations to disclose whether they are paying their fair share of taxes on profits earned.  In Requiring Corporate Tax Disclosure, the Center on Budget Policy & Priorities has outlined a model plan for how states can design such tax disclosure policy to allow legislators and tax authorities to identify likely corporate abuses more easily.

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Prune Economic Development Subsidies, Protect Social Investments

Too often, state leaders think handing out fat economic development checks to large companies is the route to economic growth. However, as author Robert Lynch outlined in Rethinking Growth Strategies, state and local taxes and development subsidis are too small a part of a typical company's costs to determine plant location, so any cuts in public services needed to pay for them are likely to cost more jobs than any jobs potentially attracted by economic development subsidies. 

The worst thing to do during temporary hard times is to cut back on the investments in education, university research, physical infrastructure, and worker training that DO determine where companies want to do business in the long term.  As CFED's A Progressive Economic Development Agenda for Shared Prosperity argues, low-tax strategies are a "get poor" strategy where the better approach to "local competitiveness needs to focus on meeting the workforce and infrastructure requirements of the New Economy..."

Unfortunately, billions of dollars are offered to large corporations in exchange for only a handful of jobs, instead of using those funds to invest in long-term upgrading of human and physical capital that could payoff in far more job creation. 

The organization Good Jobs First has been the national leader in highlighting the problem of economic development giveaways.  For example, its Illinois affiliate publicized problems in the Illinois subsidy program and then helped pass groundbreaking accountability legislation in 2003.   One result of the new law is the Illinois Corporate Accountability website which tracks reports on every firm receiving different kinds of tax subsidies, the jobs they promised to create or retain, and the results year to year.  Other leading states like Minnesota and Maine have enacted disclosure laws to track individual economic development deals and make the information accessible to the public. (See this study evaluating disclosure in different states.)

Good Jobs First also promotes model subsidy reform legislation with language requiring reporting and disclosure of subsidy information; the creation of quality jobs and a cap on the total subsidy amount; and recapture of subsidies in cases where companies are found noncompliant.  When states enact legislation to review and disclose these deals, they then have the information needed to eliminate or reform overly generous subsidy programs to better serve a variety of community needs.  And if states dump all the bad corporate giveaways, they'll actually have the funds for more effective economic growth programs.

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All of the above are key guidelines for managing shortfalls in revenue without cutting social services or long-term investments in state growth.  As economic slowdowns hit state revenues, cutting off support for those whose family budgets are taking a hit themselves is not the answer.  Instead, the real solution is to ask those who have done especially well during the good times to contribute more when things get tougher-- and gives states a chance to make regressive tax systems just a bit fairer over the long-term.

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