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Chapter 7

State Government Finances

A Review of Current Conditions and the Outlook

Henry A. Coleman

The United States is a federal system of government in which the responsibility for providing and financing public services is shared among three levels of government. The 87,576 units of government in the U.S. federal sys- tem include the federal government, 50 state governments, and more than 87,500 local units of government.1 Each of these jurisdictions provides public services to its citizens and raises revenue to support those services. Economists define fiscal capacity as a jurisdiction’s revenue-raising ability relative to the spending needs that it faces. A jurisdiction’s fiscal capacity is influenced by many factors. The state’s economy and tax system affect its ability to raise revenues. Its income, population, and demographic mix influence public service demand. Where a jurisdiction’s spending needs outstrip its revenue-raising ability, a fiscal crisis looms.

The system of federalism in the United States is both diverse and dynamic. At any point in time, fiscal capacity may differ significantly among units of government. It is dynamic in that considerable changes in fiscal capacity are often evident over time, both within and among units of government.

Within the U.S. federal system, the national government often seems to dominate in regard to the level of spending and taxation, and its ability to influence fiscal activities at other levels of government. Local governments are highly visible due to the sheer number of units and to the widely held view that they are the level of government closest to the people. However, state government finances play an important role in the U.S. federal system, al- though they may be the least visible entities within the federal system. For several reasons, state governments are likely to face an even more expanded role in providing domestic services in the future.

First, in a trend that started during the Reagan administration and was heightened in the aftermath of September 11, the national government is increasingly focused on national defense and homeland security. As such, more traditional domestic service responsibilities will rest with state and local governments.2 However, the future role of local government is itself in doubt, as some scholars hold that local governments need a primary own-source of tax revenue, such as the property tax, to remain viable.3 Other analysts note that the property tax is being undermined as a major revenue source for local governments through tax revolts, tax incentives, tax exemptions, and many school financing controversies around the country.4 So serious concerns have been raised about the extent to which local government can step in to fill the void left by the federal government in providing domestic services. As such, whether through the devolution of responsibilities from the federal government or by default through limitations on local governments, states may be forced to assume more importance within the federal system. This expanded role for state government should not obscure the fact that significant differences in taxing and spending patterns among individual states may exist.

Whether state governments rise to the occasion is a function of their collective willingness and ability to assume an expanded role.5 Throughout much of the current decade, state governments in aggregate have experienced a fiscal crisis, which may greatly affect their ability to assume a larger role within the federal system. The fiscal crisis confronting states has been sustained and significant, with estimates of the deficits totaling nearly $200 billion for fiscal years 2002–2004. Initial state budget projections for fiscal year 2005 showed that $40 billion in shortfalls had to be addressed.6

It has also been argued that the current fiscal crisis (fiscal years 2002–2005) has been both more sustained and more severe than the previous crisis of the early 1990s, which lasted for only three years. Moreover, states have been much more reluctant to raise taxes, and much more inclined to cut services, in responding to the current crisis. Even though state revenues have recently shown signs of renewed growth, they are still well below the level necessary to restore services to the level that prevailed at the start of the 1990s.

The nature of the fiscal crisis facing states varies by cause, severity, and ap- propriate policy responses. For example, the deficit confronting a particular state may be caused by downturns in the overall economy, which is called a cyclical deficit, or by more chronic long-term disparities between revenues and spending, which is referred to as a structural deficit. In other words, a cyclical budget shortfall occurs when, during an economic downturn, state revenues fall while spending pressures increase. Revenues decline because personal income decreases, consumption by individuals and businesses decreases, and business profits decline, thus reducing the revenue yield from the state’s personal income tax, general and selective sales taxes, and corporate income taxes, respectively. Spending increases because poverty and unemployment increase, which leads to increased demand for public assistance, housing assistance, health care assis- tance, and so forth? Because most states are required to spend no more than they raise in revenues—to balance their budget—these cyclical imbalances are a cause for concern. However, cyclical deficits are generally temporary and will likely be reduced or eliminated as the economic recovery occurs.

Structural deficits are said to exist when recurring revenues are not adequate to cover recurring spending needs. These deficits are considered chronic, or long-term, and often indicate that the state’s revenue system is not responsive to the need for more revenues as the costs of providing needed public ser- vices increase. Perhaps more important, structural deficits are believed to result because the tax system for many states has not adapted to reflect evolving economic, demographic, or technological conditions.

Coleman Of course, a state may suffer from any one or combination of these bud- get deficits. Because of their chronic nature, structural deficits are considered to represent the most serious threat to the ability of state government to play an expanded role in the U.S. federal system. A summary of several recent studies suggests that between twenty-seven and forty-four states were experiencing significant structural gaps in their budgets.8

The remaining sections of this chapter present a brief discussion of state budget processes, a review of state government spending and revenue-raising activities, and an examination of the major fiscal policy issues confronting state finances at the beginning of the twenty-first century.

Overview of Budget Processes

Budgets are important because they describe the context in which state spending and revenue decisions are made and any limitations imposed on policymakers in making changes to state tax or spending policies.9 Several aspects of state government budget processes will be discussed, including balanced- budget requirements; limitations on taxes, spending, and indebtedness; and reserves available to help deal with unexpected economic downturns or other emergencies.

Balanced-Budget Requirements

Most states operate on a fiscal year that runs from July 1 to June 30.10 Twenty-nine states operate on an annual budget cycle and twenty-one on a biennial budget cycle.11 Within the prevailing budget cycle, states are required to balance spending and revenues, although the nature of the balanced-budget requirement varies significantly.12 The economists Brian Knight, Andrea Kusko, and Laura Rubin have observed the following:

While all states except Vermont have some form of balanced budget requirement, the manner in which state governments must correct shortfalls in operating budgets depends on the requirements’ details, which vary substantially across states. These rules are either stated explicitly in the state’s constitution or are part of the laws of the state, and some states have multiple provisions that require a balanced budget. Balanced budget requirements can be placed into the following five categories, according to the state’s most stringent provision:

1. Governor must submit a balanced budget—that is, one that contains no projected shortfall (1 state);

2. Legislature must pass a balanced budget (5 states);

3. State must correct any shortfall in the next fiscal year (7 states);

4. No carryover of shortfall into the next biennial budget cycle (7 states); and

5. No carryover of shortfall into the next fiscal year (29 states).13

These authors further note that other factors, such as bond ratings and public expectations, may also contribute to fiscal discipline within a state. For example, bond-rating agencies often take a skeptical view of fiscal “gimmicks”— such as deferring expenditures, accelerating tax payments, selling assets, or one-shot revenues—and respond to such proposals by downgrading the state’s bond rating. This increases the costs of borrowing for the state. Thus, the threat of having its bond rating downgraded helps to instill fiscal discipline. Similarly, the fear that tax and spending policies may be seen as radical and generate an adverse public response—as reflected in opinion polls, unfavorable editorials, or public demonstrations—also prompts adherence to more main- stream policies, which contributes to fiscal discipline.

Tax and Expenditure Limitations

Many states impose some type of restriction on spending or revenue raising. Indeed, thirty states have some type of tax or expenditure limitation, or both. Two-thirds of those states restrict spending growth to some index of inflation. In addition, twelve states require approval by a supermajority (such as two-thirds majority vote margin) in the state legislature for an increase in taxes or fees, and another three states require voter approval.

Debt Limits

In financing many capital activities, states can choose a pay-as-you-go system or the issuance of debt. Two types of debt issues are generally avail- able—revenue bonds or general obligation bonds. With revenue bonds, the re- payment of the principal and interest is contingent on the successful completion of the project. The full taxing authority of the issuing jurisdiction is pledged to the repayment of the principal and interest of general obligation debt, which is also called full faith and credit debt. Several states do not issue general obligation debt, and other states that issue general obligation debt do not limit the amount.14 Each of the remaining states has some type of limitation on the amount of general obligation debt, with the limitation generally based on a formulaic relationship with either the general revenues or appropriations of the state. Alternatively, some debt limits are stated as fixed dollar amounts.

Budget Reserves

The effects of recessions on state budgets were noted earlier. Although the onset of a cyclical downturn is often difficult to predict with any precision, states also have to deal on occasion with unforeseen emergencies due to natural or man-made disasters. To help in dealing with the financial impacts of unexpected emergencies or downturns in the economy, states maintain contingency and stabilization funds. Budget stabilization funds—so-called Rainy Day Funds—allow states to spend during an economic downturn without having to resort to raising existing taxes or introducing new ones.

Some forty-five states (all but Arkansas, Kansas, Montana, Oregon, and Utah) now have such funds. Although these instruments have been helpful in staving off more drastic adjustments during short-term crises, they are seldom capitalized sufficiently to withstand a significant and sustained economic downturn. Among the fifty states all but two (Michigan and Mississippi) have contingency funds—reserves set aside for unexpected emergencies, such as natural disasters.

Again, these budget processes help to provide a context for the adjustments that state governments must make in response to problems brought on by a fiscal crisis. This is an important, but only partial, part of the story. In order to get a more complete picture, information on how states raise and spend money is needed. The following sections shed further light on these aspects of state finances.

How Do States Spend Money?

State governments are major players in the federal system. Total general expenditures for state governments in 2001 were $1.045 trillion, up significantly from the 1990 total of $508 billion. Per capita state general spending grew from $2,048 in 1990 to $3,671 in 2001. Per capita state general expenditures varied significantly among states, with the top states being Alaska ($13,232), Vermont ($5,221), Hawaii ($5,008), Delaware ($4,959), and Wyoming ($4,718). The lowest per capita spending states were Texas ($2,723), Nevada ($2,798), Florida ($2,846), Arizona ($2,926), and Tennessee ($2,981).1

Within the state budget, spending takes place via several funds. Fund ac- counting is used by nonprofit organizations that receive funds whose use is restricted to a specific purpose. The accounting system is organized so that the use of the dedicated funds is separately identified and monitored.16

Although it varies somewhat from state to state, four types of funds are used in state budgeting. The “general fund” is the largest and most flexible fund, and the one generally considered to most closely reflect state preferences and priorities. “Federal funds” are funds received from the federal government, generally in the form of grants-in-aid. “Bond funds” are established with the proceeds from the sale of bonds and used primarily for capital investment purposes. Finally, “other state funds” are used to fund spending from revenues that are restricted by state statute or constitution. For example, casino taxes in New Jersey are dedicated to providing services for the elderly and the disabled. Similarly, the gas tax in many states is earmarked for road construction, maintenance, or improvements. In 2003 general fund spending was almost 44 percent of total state expenditures, followed by federal funds (29 percent), other state funds (24 percent), and bond fund spending (3 percent).

State spending in general is spread among seven functional categories, including elementary and secondary education, higher education, public assistance, Medicaid, corrections, transportation, and all other areas. (See Table 7–1.) Elementary and secondary education is the largest area of total state spending, followed by Medicaid. Medicaid was the fastest growing area of total spending for each of the last two years. The spending pattern for total state expenditures parallels that for the general fund, except for transportation spending. These general patterns mask several significant changes in relative spending over time, and significant differences in relative spending among individual states. For example, higher education was the second largest area of state spending until the late 1980s, when Medicaid emerged as the second largest area. The proportion of total state spending accounted for by elementary and secondary education, Medicaid, and corrections has in- creased significantly over the last decade and a half. Significant differences in spending among states reflect variations in the allocation of service responsibilities between the state and local governments, the costs of providing ser- vices, service preferences, the quality of services provided, and state financial resources.

How Do States Raise Money?

State government general revenue totaled about $1.1 trillion in fiscal 2001, almost double the 1990 level of $517 billion. Per capita general revenue increased from $2,085 in 1990 to $3,685 in 2001. Per capita general revenue varied considerably by state, with the top five states being Alaska ($9,532), Delaware ($5,595), Wyoming ($5,520), Vermont ($5,068), and Hawaii ($4,927). The bottom five states included Florida ($2,699), Nevada ($2,753), Texas ($2,835), Arizona ($2,858), and Tennessee ($2,964).

State revenues are generally categorized as either own-source—reflecting a variety of state-imposed taxes, fees, and charges—or intergovernmental revenue—indicating revenues received from another level of government. State general fund revenues best describe own-source revenues. In 2003 general fund revenues totaled $491 billion. See Table 7–2.

Of this total, personal income taxes represented the largest share, followed by sales taxes and all other taxes and fees, which include cigarette and tobacco taxes, alcoholic beverages taxes, insurance premium taxes, severance taxes, licenses and fees for permits, inheritance taxes, and charges for state- provided services. Forty-one states impose a broad-based personal income tax (all but Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming), and forty-five states (all but Alaska, Delaware, Montana, New Hampshire, and Oregon) impose a broad-based sales tax. All states impose selective excise taxes on items such as alcohol, tobacco, and gasoline.

Major Fiscal Policy Issues Confronting States

State governments are in a truly precarious fiscal position. By devolution or default, they are poised to assume a greater role in providing domestic ser- vices within the U.S. federal system at the same time that they are confronting significant fiscal problems resulting from a fiscal crisis, especially as it relates to the structural deficits being experienced by as many as forty-four states. The issues discussed below are illustrative of the kinds of issues that states must confront and address if they are to deal fairly and effectively with their citizens in adjusting to an expanded role in the federal system

Pressures for Spending Increases

Several factors may accelerate the trend toward increased state spending, including school financing, Medicaid, public employee retirement systems, and limitations on the use of labor-saving technologies in providing public services. The first three of these factors represent large areas of state spending that may continue to experience rapid growth. In addition, political and institutional constraints (such as collective bargaining agreements) may make it difficult to reduce or even control spending in these areas.

Schools

States (and their local school districts) face pressures to increase school funding to deal with a variety of concerns. These include projected enrollment increases, court-ordered requirements to reduce disparities in school funding, public demands for smaller class sizes to address school quality, declining and outmoded quality of school facilities, demands for higher teacher salaries to remain competitive with other occupations, and dealing with federal mandates regarding educational services for pupils with disabilities. Although the extent to which these school-spending pressures will be shared with local school districts will surely vary from state to state, it is safe to assume that much of the additional spending will fall on state budgets. Hawaii, for example, has a statewide school system with no local districts, so all additional costs will accrue to the state.

Medicaid

As noted earlier, Medicaid is already one of the largest areas of state spending, and the fastest growing. Medicaid spending is likely to increase even more because of growing health care costs, which regularly exceed the overall rate of inflation, and the shift in the costs of providing health services for the elderly and disabled from the fully federal-funded Medicare program to the joint federal-state–funded Medicaid program. Iris Lav describes how this shift occurs: Changing medical practices have shortened the length of time that people are hospitalized and have increased the use of prescription drugs and ambulatory care. While these medical advances can reduce overall health care costs and improve quality of care, they have the paradoxical effect of in- creasing Medicaid expenditures while lowering Medicare costs. Further- more, Medicaid covers long-term care, whereas Medicare does not. A majority of the Medicaid expenditures for seniors and people with disabilities are for long-term care services. . . . As a result of these circumstances and trends, Medicaid has been financing a growing share of health insurance costs for the aged and disabled.17 Pensions

Rising state commitments to retired public employees have the potential to dwarf the fiscal concerns related to cyclical and structural deficits, with shortfalls projected to reach several hundred billion dollars.18 There are three sources of funding for state retirement systems—employee contributions, employer contributions, and investment earnings. Employee and employer contributions are about equal to distributions currently paid out by retirement systems. However, investment earnings are well below the level necessary to meet future obligations. This current situation is made even more tenuous in some states because of enhanced benefits still being provided by policymakers, changes in pension fund asset allocations in favor of riskier investments, and significant future payouts as more workers age and become eligible for benefits.

Limitations of the Use of Technology

In an often-cited article written in 1967, the noted Princeton University professor William Baumol described a theory of how inflation could affect the costs of delivering public services.19 The public sector competes with the private sector to attract and retain workers, primarily by offering comparable wage increases. However, because of technological changes that are introduced in the private sector, productivity increases offset the costs of higher wages paid to private sector workers, thereby keeping overall costs under control. Since it is more difficult to introduce labor-saving technology into the service- driven public sector, no offsetting productivity increases take place, with the result that increased wages mean increased costs for the delivery of any given quantity or quality of public services. In short, the more limited ability to in- troduce technological changes into the public sector will contribute to higher costs of services, even with no increase in either the quantity or quality of those services.

Outdated State Revenue Systems

Several researchers have argued that the tax system currently in place in most states is not adequate to address the revenue needs of those states. The tax systems were established when the economy, technology, and demographics were very different from those of today. These tax systems have not been modernized to reflect current circumstances.20

For example, the general sales and use tax is a major source of revenue for state government, representing slightly more than a third of general fund revenues in 2003. The state sales tax, which was first introduced in the 1930s, was established when the U.S. economy (and that of most states) was a goods- based economy, and most sales transactions were conducted face to face. Today’s economy is a services-based economy, with more and more transactions taking place through remote means, such as over the Internet or through mail-order catalogs. State sales and use taxes have not been revised to reflect this new economic reality.

The Institute on Taxation and Economic Policy noted that “in 2003, ser- vices represented almost 60 percent of personal consumption nationally. Few states have successfully adapted to this change in consumption: only Hawaii, New Mexico, and South Dakota [tax] services comprehensively.”21 Similarly, policy analyst Michael Mazerov notes that “ a majority of the states apply their sales tax to less than one-third of 164 potentially taxable services. Eight of the 45 states with sales taxes impose them on fewer than 20 service categories.”22 He goes on to note that “full taxation of ‘readily available’ services could generate sales tax revenue equal to 25 to 35 percent of current sales tax collections in about three-fourths of the forty-five states currently levying a sales tax. The total revenue yield nationally would be approximately $57 billion a year.”

Similarly, remote sales—including sales through the Internet, mail-order catalogs, and direct marketing—have cost states significant amounts of forgone sales tax revenues. Whenever the resident of a state makes a purchase from an out-of-state vendor but the good in question is to be primarily consumed within the state of residence, a “use” tax obligation is incurred. Because of the U.S. Supreme Court decisions in National Bellas Hess vs. Illinois Department of Revenue and Quill Corporation vs. North Dakota, the state of residence cannot force the out-of-state vendor to collect and remit the taxes generated by the transaction.24 Donald Bruce and William Fox estimate that the loss of sales and use tax revenues due to such remote transactions primarily involving the Inter- net could grow from $15 billion in 2003 to somewhere between $22 billion and $34 billion by 2008.25 The Streamlined Sales Tax Project (SSTP) was initiated by several organizations—including the Federation of Tax Administrators, the Multi-State Tax Commission, the National Conference of State Legislatures, and the National Governors Association—to address the concerns raised by the Supreme Court so that states may be able to compel out-of-state vendors to collect sales and use taxes, but Congress has shown little interest or inclination to enact legislation that embodies the work of the SSTP.

Other policies in the state tax system are similarly in need of updating. For example, many states with a personal income tax provide for special treatment of retirement income, without applying any type of means test to the taxpayer.26 When this special treatment was introduced, retirement income was a relatively small component of personal income. As the population ages and more individuals reach retirement age, income from pensions and other retirement accounts has become a more significant portion of total personal income. It now represents a significant personal income tax loss to the states.

The corporate income tax has also declined considerably as a source of revenue for state governments. This has occurred in part because states are at- tempting to reduce business taxes in order to encourage economic development. Policy analyst and State Tax Notes columnist David Brunori holds that corporations have long sought to lower their state tax burdens, and have generally done so using a three-pronged approach: they employ really smart lawyers and accountants to plan around paying taxes; they secure all kinds of tax incentives to do essentially what they would be doing anyway; and . . . they have continued their assault on the traditional way that corporate taxes are levied in the United States.27 Expanding Reliance on Gambling Revenues In addressing their needs for more revenue, many states are looking to nontax revenue sources, such as fees and charges and gambling—including state-sanctioned lotteries, casinos, and racing. A recent report by the Institute on Taxation and Economic Policy finds the following: Some form of government-sanctioned gambling is now allowed in all but two states (Utah and Hawaii). By far the most popular forms of legalized gambling are lotteries and casinos: 37 states and the District of Columbia have state lotteries, and more than half the states have some form of casino gambling. Many states also allow “pari-mutuel” gaming, wagering on live events such as horse racing and greyhound racing. Advocates of state-sponsored gambling typically see it as a painless, voluntary tax—and one that is at least partially paid by residents of other states.28

Although states have shown a greater interest in all forms of nontax revenues, gambling revenues have been especially popular in the last several years. For example, in 2003 total lottery ticket sales increased to $43.5 billion from $2.4 billion in 1980, and net income to states increased to almost $14 billion from $978 million in 1980. See Table 7–3.

Casino tax revenue in 2004 ranged from a high of $887 million in Nevada to a low of $12 million in South Dakota. Note also that the casino industry pays other forms of state and local taxes, such as corporate income taxes, sales taxes, and local property taxes. 29 However, the potential of gambling revenues to help in addressing state fiscal problems should not be over- stated. Although these revenues allow states to increase spending, they will play only a small role in the overall state budget context.30

In many instances, the financial benefits of gaming revenues to the states are overstated. First, it is important to distinguish between gross revenues generated by state-sponsored lotteries and the net revenues available to states to fund services. A significant portion, up to 50 percent, of lottery proceeds must be devoted to administration (including the costs of promoting the lot- tery) and to pay the cash prizes to lottery winners. When these “net” revenues are considered, the fiscal benefits are much more modest. More generally, with the possible exception of revenues in Nevada, gambling revenues amount to a relatively small portion of total state revenues. As the late economist Steven Gold once observed,

Nevada’s gambling and casino entertainment taxes in 1991 produced $348 million, along with another $57 million from licenses for slot machines and other games. These taxes brought in about 24 percent of Nevada’s tax rev- enue. When other business taxes and the tourism it produces are counted, the gambling industry accounts for about half of Nevada’s state tax revenue. But Nevada is unique. It combines a small population with a huge gam- bling industry. Gambling could not have nearly as much impact on state fi- nances in a large state. Consider, for example, New Jersey, where the state’s take in 1991 was $246 million in casino gross revenue taxes, along with an- other $50 million from licenses for casinos and slot machines. New Jersey’s total state tax revenue was $11.6 billion, so these taxes and licenses were only about 2.5 percent of total state tax revenue.3

In addition, the growth in lottery revenues noted above reflects more states adopting lotteries, rather than more revenue from existing lotteries. Lottery revenues have grown very modestly if adjustments are made for revenues from lotteries adopted in additional states.32 Indeed, the success of a state’s lottery depends on attracting nonresidents to play a state’s lottery. As more states introduce their own lottery, fewer out-of-state players are attracted to the lottery outside of their home state. Similarly, playing the lottery (or en- gaging in any form of state-sponsored gambling) is an alternative to partici- pating in other activities that could generate sales or excise revenues. That is, as individuals devote more of their income to playing games of chance, less in- come is available to purchase goods and services that generate sales and excise tax revenues. This may have a significant adverse impact on states that rely more heavily on consumption taxes than on personal income taxes.

It is also fair to say that gambling is not always a voluntary activity, at least for some portion of the population. This means that problems of gam- bling addiction and gambling-related crimes could increase as a result of the introduction of state-sponsored lotteries or state-sanctioned casinos. In deter- mining the true benefits to a state, the costs of dealing with the increased social ills, which may result in increased state spending, should be considered. Finally, low-income individuals constitute a disproportionate share of partici- pants in state-sponsored gambling. Therefore, gambling is said to be regressive in its impacts. In view of this litany of concerns, the Institute on Taxation and Economic Policy concludes that “there is growing evidence that state- sponsored gambling is both inequitable and inadequate as a long-term rev- enue source—and that the associated social costs of encouraging destructive gambling behavior may offset much of the revenue gains enjoyed by states in the short run.

Interstate Competition and Tax Expenditures

Competition among states for economic development has grown significantly, and both targeted and broad-based tax incentives have been provided more frequently by individual states.

All taxes are ultimately paid by individuals, either through reduced compensation to or employment of workers, through higher prices to consumers, or through reduced dividends and other compensation to shareholders. Still, the initial or legal incidence of much of the taxes imposed by states falls on businesses as legal entities. Businesses pay a variety of taxes, including property taxes, sales and use taxes, corporate income taxes, payroll taxes, and gross receipt taxes. 36 It has been estimated that businesses paid 43 percent of all state and local taxes in 2003, approximately $400 billion. It has also been estimated that businesses paid 65 percent of the increased taxes imposed by state and local government between 2002 and 2003.37 Other evidence indicates that businesses pay about 40 percent of sales and use taxes.38 This would suggest that businesses pay a significant and fair share of all state and local taxes.

Still, some analysts argue that taxes paid by businesses over the last several decades have not kept pace with the growth in business revenues, profits, or costs imposed on society. Noted law professor and tax analyst Richard Pomp argues that as a result of reduced federal tax burdens dating from the early to mid-1980s, businesses focused more on reducing their state tax liability.39 Whether through more skillful tax planning, changes in their corporate status, or efforts to induce direct or indirect tax decreases, businesses have seen their corporate income tax liability fall dramatically. For example, there has been a significant increase in the number of businesses organized as pass- through entities—that is, as limited liability corporations, limited liability partnerships, or sub-chapter S corporations. For state tax purposes, this means that these corporations are taxed as individuals according to their state’s personal income tax, rather than corporate income tax, rules.

Similarly, many states allow multistate companies to engage in strategic tax avoidance behavior by deviating from the formula developed for apportioning the income of companies that do business in several states. The Uniform Distribution of Income for Tax Purposes Act (UDIPTA) formula provides for the apportionment of business income of multistate companies among states based on an equal weighting of the relative amounts of payroll, property, and sales in each state. By increasing the weight applied to the so- called sales factor, states attempt to provide an advantage for those companies that create more jobs and invest more in physical facilities within that state. Many states also allow for separate entity accounting, which treats parent companies and their subsidiary companies as unrelated. This policy permits companies to concentrate profits in the state offering the most preferential tax treatment. Companies therefore have an incentive to shop around for the best tax location, even when that location differs from the one indicated by more traditional market factors, such as proximity to the marketplace or quality of the workforce available. Thus, as states engage in destructive competition for jobs and business investment, the result is often a needless loss of tax revenues.

Perhaps the most significant threat to the flow of state tax revenues from businesses is the proliferation of so-called tax expenditures. Tax expenditures are revenues forgone by the state, often as tax incentives—an inducement for a business to locate or expand within a particular state. Tax expenditures have grown significantly as more states engage in interstate competition for economic development. Tax expenditures differ from overall reductions in state business taxes— through rate reductions and other concessions—in that they represent favorable tax treatment provided to a single or limited number of firms.

Thirty-three states now provide some type of tax expenditure reporting, and more states have also introduced greater accountability measures into tax incentive packages provided to businesses. Still, many analysts believe that these tax expenditures represent a significant loss of potential state revenues.40 Estimating the total amount of revenue loss by all states from tax expenditures is difficult, in large part because only about two-thirds of the states engage in some form of tax expenditure reporting, and these reports differ significantly in regard to the (state or local) taxes covered, the frequency of the reporting, and the methodology used to estimate revenue loss.41 However, recent analysis by McIntyre and Nguyen helps to shed some light. These researchers examined 252 Fortune 500 companies over the 2001–2003 periods. They calculated an average statutory state corporate income tax rate of 6.8 percent, which, when applied to the $981 billion in pretax profits realized by this group of firms, should have produced $67 billion in state corporate tax revenue. However, the actual amount of state corporate tax revenue paid by these 252 companies was $25 billion, indicating nearly $42 billion in lost state tax revenues over the three-year period.42

Federal Fiscal Policies

Federal policies have both positive and negative effects on state finances, many of which may be difficult to measure or quantify. Whatever the total impact of federal policies on state governments, available evidence indicates that the negative impacts have increased since about 2000, thereby contributing to the state fiscal crisis. According to Iris Lav, “a conservative estimate suggests that federal policies are costing states and localities about $185 billion over the four-year course of the state fiscal crisis, from state fiscal year 2002 through fiscal year 2005.”43 The primary means of adverse effects on state finances have been through changes in federal tax policies, unfunded federal mandates, shifts in health care coverage from Medicare to Medicaid, reduced federal grants-in- aid to states and localities, and federal limitations on state taxing authority.

Federal Tax Cuts

Federal taxes form the basis for many state-level taxes. For example, the

Federation of Tax Administrators notes that

All states have structured their inheritance/estate taxes to be coordinated with the federal state death tax credit. At the present time, 38 states and the District of Columbia provide that the only state death tax is a “pick-up” or “sponge” tax in which the state death tax is an amount equal to the state death tax credit allowed for federal purposes. . . . Repeal of the federal estate tax will have the effect of repealing the state death tax in those jurisdictions that rely only on the pick-up or sponge tax.4

The Federation of Tax Administrators estimated the state death tax revenues (and therefore the potential loss of revenues facing states) at $7.5 billion in 1999. Moreover, they noted that the “repeal of estate tax may have implications for other taxes as it changes expected taxpayer behavior” regarding the transfer of property, charitable donations, and realization of capital gains.

Similarly, many states link their corporate income tax to the counterpart federal tax. In 2002 the federal government enacted “bonus depreciation,” which had significant adverse revenue implications for states that remained coupled to the federal tax. Under the bonus depreciation provision, federal law

allows a business to claim an immediate tax depreciation of up to 30 per- cent of the cost of new equipment, rather than following the standard ac- counting approach of depreciating the full cost gradually over several years as under previous federal law. The bonus is effective retroactive to September 2001. . . . It expires in September 2004 . . . [and] states stand to lose more than $14 billion in corporate and individual tax revenue over three years.46

Changes in other provisions of the federal tax code, such as Section 179, pro- vided immediate tax relief for small and medium-sized companies that bought equipment, with costs to state coffers that were estimated to total more than $1 billion over fiscal years 2004 and 2005.47

Federal tax cuts may also pose more indirect threats to state finances. For instance, Robert McIntyre contends that “by 2006, Bush’s tax cuts would double the number of taxpayers affected by the AMT [Alternative Minimum Tax] from fewer than 9 million to almost 19 million. . . . Once in the AMT, taxpayers can no longer claim deductions for state and local taxes.”48 This reduces the ability of state and local governments to “export” a portion of their tax burdens and will likely have a limiting effect on the willingness to impose taxes, especially more progressive ones. In addition, the federal government may be inclined to reduce grants-in-aid to states and their localities to help offset the costs of the tax cuts, the war effort, and stepped-up homeland security.

Federal Grants to States and Localities

Even in the absence of the need to finance federal tax cuts, federal grants to states and local governments have been on the decline. Federal grants peaked in 1980 at 40 percent of state and local government expenditures from their own sources and bottomed out in 1990 at 25 percent. Perhaps more important, Medicaid constituted a growing proportion of federal grants, with other grants-in-aid declining precipitously in relative terms.

The conversion of grants that were previously open-ended matching grants to block grants may also produce long-term fiscal difficulties for states. For example, the old public assistance program, Aid to Families with Dependent Children (AFDC), was a joint federal- and state-funded program, with the federal share being an inverse function of the level of personal income in the state. That is, the federal government funded approximately $0.78 of each AFDC grant benefit dollar in a poor state such as Mississippi, but only $0.50 of each dollar expended in a wealthy state like New Jersey. Moreover, the total spending level was not capped. Therefore, as the number of eligible individuals increased, program spending increased. The new program, Temporary Assistance to Needy Families, is administered as a block grant, whereby a fixed sum of money is given to a state to provide the needed assistance. If case- loads—the number of eligible recipients—increase, states must either reduce the level of benefits provided or absorb the costs of providing the expanded benefits in their own budgets; the federal government provides no additional funding.

Federal Mandates

Federal requirements for additional spending in several areas will prove costly to state governments. Iris Lav and Andrew Brecher estimate that the No Child Left Behind Act, which imposes additional testing and other requirements on school pupils, represents an unfunded federal mandate of about $32 billion over the four-year period of the state fiscal crisis.49 The Help America Vote Act, designed to help modernize voting technologies, could cost another $1 billion over that same period. The Individuals with Disabilities Education Act fell short of federal funding commitments by $40 billion over the fiscal crisis period. Finally, state and local spending related to homeland security requirements imposed by the federal government could produce annual costs for states that range between $6.5 billion and $17.5 billion.5

Federal Limits on State Taxing Authority

Limitations on state taxing authority are not new, and they have taken several forms.51 For example, the Internet Tax Freedom Act of 1998 (renewed in 2001) precludes states from taxing Internet access. The cost to states in for- gone revenue over the crisis period is estimated at $4.5 billion.52 The Railroad Revitalization and Regulatory Reform Act of 1976, which places restrictions on state tax treatment on railroad property, has also limited the ability of states to raise revenues.53 Finally, as noted earlier, the failure by Congress to give states the authority to force out-of-state vendors to collect and remit sales taxes has proved very costly to states.

The Distribution of State Revenue Burdens

Another major concern in state and local public finance is the extent to which tax burdens are distributed fairly among taxpayers within the state, based on either a benefits-received or an ability-to-pay principle. The benefits-received principle holds that the distribution of tax burdens should reflect the benefits that taxpayers receive from the services provided, without regard for redistribution among taxpayers at the state (and local) government level. Alternatively, the ability-to-pay principle holds that taxpayers should pay for public services based on some measure of income or wealth, with better-off taxpayers paying a larger share of the costs of public services. Public finance specialists have frequently noted the limitations on sub national units of government in pursuing redistributive tax or spending policies because of the mobility of taxpayers among jurisdictions.54

Because of the incentives for tax avoidance that result when redistribution policies are implemented at the state or local level, the conventional wisdom is that progressive taxes that reflect the ability to pay should be used by higher levels of government. Where tax burdens rise with increases in income or wealth, taxes are said to be progressive. Where a larger portion of the in- come of low-income individuals must be devoted to meeting their tax obligations, the taxes are said to be regressive.

State and local tax systems are generally regarded as regressive, reflecting the relatively large role played by property taxes and various types of general and selective sales taxes.55 Indeed, as noted above, although personal income taxes currently generate more revenue than general sales taxes, more states (forty-five) employ a general sales tax than employ a personal income tax (forty-one), whereas all states employ selective excise taxes. In fact, sales taxes amount to almost 50 percent of total state tax revenues. Moreover, when com- bined with the various nontax revenues, which are also generally regarded as being regressive, state tax systems are likely to be mildly to highly regressive in their total impact.

Andrew Reschovsky notes that states are concerned about the impacts of their major revenue sources:

Most of the 42 states that levy an individual income tax have taken various steps to achieve at least some degree of tax progressivity. The majority of states have a system of graduated rates, with nominal rates rising as income rises. Even states with a flat rate generally build some degree of progressivity into their tax structure through the use of deductions, exemptions, or credits. Of the 45 states that levy a general sales tax, most exempt the purchase of various goods and services with the explicit goal of reducing the burden of the tax on those with limited incomes.5

Several actions taken by state policymakers in the last decade have likely increased the regressivity of state revenue systems. For example, some analysts argue that the failure to include most services in the sales tax base or the in- ability to capture most forms of remotes sales makes the sales tax even more regressive, because low-income taxpayers consume relatively more goods than services and generally have less access to remote means of purchase (such as the Internet). As these components of consumption and remote transactions grow in importance, the sales tax will become more regressive. Moreover, as consumption taxes become a larger component of the overall revenue system for states, the system becomes more regressive.

A disturbing pattern has emerged regarding policy changes in the distribution of state tax burdens. Many states throughout the 1990s made their tax systems less progressive. During periods of economic downturn, when states raised taxes to meet recession-induced budget shortfalls, they predominantly raised those taxes that fall most heavily on low- and moderate-income house- holds. During those periods when stronger economies allowed taxes to be cut, much of the benefit was targeted on higher income families

Personal income taxes accounted for just 32 percent of the net increases enacted in 1990 through 1993 but 74 percent of the net decreases enacted in 1994 through 1997. By contrast, sales and excise taxes accounted for 46 per- cent of the tax increases in the early 1990s but just 0.5 percent of the net tax cuts in the mid-1990s.

Similarly, as more states adopt nontax revenue sources and they contribute a larger portion of the total revenues used to finance public services, low-in- come taxpayers will face an ever-increasing portion of the relative tax burden. As such, one by-product of an expanded role for state government may be relatively heavier fiscal burdens for low- and moderate-income households.

Conclusion

Although the fiscal outlook is improving for many states, the fiscal crisis that extended from fiscal 2002 to 2005 exacted a toll on state finances. States experienced both short-term cyclical fluctuations and more chronic disruptions in their budgets. These tough fiscal times occurred just as more fiscal responsibilities were being loaded onto the states. More fiscal perils lie ahead if current predictions regarding pension finances hold true.

Clearly, states contributed to their own fiscal misery by adopting policies that limit their flexibility to respond to budget crises and through some of the policy choices they made. By failing to modernize their major tax instruments, engaging in destructive interstate competition for economic development, and resorting to gambling revenues that are likely to prove illusory as a long-term solution, states have at least exacerbated their fiscal difficulties.

Federal policies must also share responsibility for the current difficulties of states. Significant problems for the states have resulted from the federal government’s mandating additional state spending, undermining state revenue sources, and imposing significant limitations on the authority of states to tax significant economic activities.

If states are to assume the expanded role in the U.S. federal system, they must be more mindful of the changing economic, demographic, and technological circumstances going on around them and take the necessary policy actions to accommodate the new world in which they are operating. In addition, the states will need more cooperation from the federal government if they are to fulfill their new destiny.

Notes

1. U.S. Bureau of the Census, Statistical Abstract of the United States, 2004–2005 (Wash- ington, D.C.: Government Printing Office, 2005).

2. DaphneA.Kenyon,“TheFederalImpactonStateandLocalGovernmentFinancesat the Beginning of the 21st Century,” State Tax Notes, December 17, 2001, 932.

3. Therese J. McGuire, “Alternatives to Property Taxation for Local Government,” State Tax Notes, May 15, 2000, 1715.

4. David Brunori, “To Preserve Local Government, It’s Time to Save the Property Tax,” State Tax Notes, September 10, 2001, 815.

5. SeeHenryA.ColemanandColinL.Wood,“America’sIntergovernmentalSystem:An Expanded Role for the States,” in Research in Urban Economics: The Changing Economic and Fiscal Structure, ed. Robert D. Ebel, 187–204 (Greenwich, Conn.: JAI Press, 1984).

6. Iris J. Lav and Andrew Brecher, “Passing Down the Deficit: Federal Policies Con- tribute to the Severity of the State Fiscal Crisis” (Washington, D.C.: Center on Bud- get and Policy Priorities, 2004), 1.

7. RobertZahradnik,IrisJ.Lav,andElizabethMcNichol,“FramingtheChoice,”Report by the Center on Budget and Policy Priorities, Washington, D.C., 2005, http://www. cbpp.org.

8. Iris J. Lav, Elizabeth McNichol, and Robert Zahradnik, Faulty Foundations: State Structural Budget Problems and How to Fix Them (Washington, D.C.: Center on Bud- get and Policy Priorities, 2005).

9. This section draws heavily from the National Association of State Budget Officers, Budget Processes in the States (Washington, D.C.: NASBO, 2002).

10. The exceptions are Alabama and Michigan (October 1 to September 30), New York (April 1 to March 31), and Texas (September 1 to August 31).

11. However,inKansas,twentystateagenciesareonabiennial(two-year)budget,andthe remaining agencies are on an annual budget cycle. Similarly, in Missouri, the state has the authority to operate on either an annual or a biennial budget cycle. Since the 1994 fiscal year, the state’s operating budget has been on an annual cycle and its capital bud- get on a biennial cycle. The remaining states operate exclusively on a biennial budget cycle.

12. For states with biennial budgets, revenues and expenditures need not be equal for each year, as long as they are in balance over the course of the budget cycle.

13. BrianKnight,AndreaKusko,andLauraRubin,“ProblemsandProspectsforStateand Local Governments,” State Tax Notes, November 3, 2003, 391.

14. SeeNationalAssociationofStateBudgetOfficers,BudgetProcessesintheStates,24,36.

15. See U.S. Bureau of the Census, Statistical Abstract of the United States, 2004–2005 (Washington, D.C.: GPO, 2005).

16. RobertN.AnthonyandReginaE.Herzlinger,ManagementControlinNonprofitOrga- nizations, rev. ed. (Homewood, Ill.: Richard D. Irwin, 1980), 92.

17. Iris J. Lav, “Piling on Problems: How Federal Policies Affect State Fiscal Conditions,” National Tax Journal 56, no. 3 (September 2003): 545.

18. J. Fred Giertz, “The Impact of Pension Funding on State Government Finances,” in “State Fiscal Crises: Causes, Consequences, Solutions,” ed. Therese J. McGuire and C. Eugene Steuerle, special supplement, State Tax Notes, November 3, 2003, 433–439

19. WilliamJ.Baumol,“MacroeconomicsofUnbalancedGrowth:TheAnatomyofUrban Crisis,” American Economics Review 57 ( June 1967), 415–426.

20. George F. Break, “The New Economy and the Old Tax System,” State Tax Notes, March 6, 2000, 767–771.

21. See Institute on Taxation and Economic Policy, “Should Sales Taxes Apply to Ser- vices?” Policy Brief no. 3, 2004, http://www.ctj.org/itep/.

22. Michael Mazerov, “Expanding Sales Taxation of Services: Options and Issues,” State Tax Notes, July 21, 2003, 183.

23. Ibid.,190.

24. National Bellas Hess v. Illinois Department of Revenue, 386 U.S. 753 (1967); Quill Cor- poration v. North Dakota, 112 S. Ct. 1904 (1992).

25. See Donald Bruce and William F. Fox, “State and Local Sales Tax Revenue Losses from E-Commerce: Estimates as of July 2004,” State Tax Notes, August 16, 2004, 511–518.

26. Lav,McNichol,andZahradnik,FaultyFoundations.

27. DavidBrunori,“CorporateTaxDiscombobulationContinues,”StateTaxNotes,March 26, 2001, 1087.

28. Institute on Taxation and Economic Policy, The ITEP Guide to Fair State and Local Taxes (Washington, D.C.: ITEP, 2005), 44–45, http://www.itepnet.org.

29. RanjanaG.Madhusudhan,“WhatDoWeKnowaboutCasinoTaxationintheUnited States,” Proceedings of the 91st Meetings of the National Tax Association (Washington, D.C.: National Tax Association, 1998), 85.

30. Steven D. Gold, “Gambling Is No Panacea for Ailing State Budgets,” State Tax Notes, October 18, 1993, 909.

31. Ibid.,908.

32. Ibid.

33. Ibid.,908–909.

34. Institute on Taxation and Economic Policy, “Uncertain Benefits, Hidden Costs: The Perils of State-Sponsored Gambling,” Policy Brief no. 19, 2005, http://www. itepnet.org.

35. Robert S. McIntyre and T. D. Coo Nguyen, State Corporate Income Taxes, 2001–2003: A Joint Project of Citizens for Tax Justice and the Institute on Taxation and Economic Policy (Washington, D.C.: CTJ and ITEP, 2005), 5.

36. RobertCline,WilliamFox,TomNeubig,andAndrewPhillips,“TotalStateandLocal Business Taxes: A 50-State Study of the Taxes Paid by Business in Fiscal 2003,” State Tax Notes, March 1, 2004, 737–750.

37. Ibid.

38. Raymond J. Ring Jr., “The Proportion of Consumers’ and Producers’ Goods in the General Sales Tax,” National Tax Journal 42 ( June 1989): 167–180.

39. Richard D. Pomp, “The Future of the State Corporate Income Tax: Reflections (and Confessions) of a Tax Lawyer,” in The Future of State Taxation, ed. David Brunori, 49–71 (Washington, D.C.: Urban Institute Press, 1998).

40. See Good Jobs First at http://www.goodjobsfirst.org/pdf/nmcs.pdf for a sample of rel- evant individual state studies.

41. John L. Mikesell, “Tax Expenditure Budgets, Budget Policy, and Tax Policy: Confu- sion in the States,” Public Budgeting and Finance, Winter 2002, 34–51.

42. McIntyreandNguyen,StateCorporateIncomeTaxes,2001–2003,1.

43. Iris J. Lav, “Federal Policies Contribute to the Severity of the State Fiscal Crisis,” Re- port by the Center on Budget and Policy Priorities, Washington, D.C., October 22, 2003, 1.

44. Federation of Tax Administrators, “Repeal of Federal Estate Tax Would Have Effect on States,” State Tax Notes, March 12, 2000, 903.

45. Ibi

46. Nicholas Johnson, “States Can Avoid Substantial Revenue Loss by Decoupling from New Federal Tax Provision,” State Tax Notes, April 1, 2002, 79.

47. Nicholas Johnson, “Federal Tax Changes Likely to Cost States Billions of Dollars in Coming Years,” State Tax Notes, June 9, 2003, 909.

48. Robert S. McIntyre, “The Effects of the Bush Tax Cuts on State Tax Revenues,” State Tax Notes, May 14, 2001, 1694.

49. Iris J. Lav and Andrew Brecher, “Passing Down the Deficit: Federal Policies Con- tribute to the Severity of the State Fiscal Crisis,” Report by the Center on Budget and Policy Priorities, Washington, D.C., 2004, http://www.cbpp.org.

50. Ibid.,9.

51. See Henry A. Coleman, “External Limits on State Taxation of Business Activities,” in Economic Union in Federal Systems, ed. Anne Mullins and Cheryl Saunders, 193–211 (New South Wales: Federation Press, 1994).

52. Lav and Brecher, “Passing Down the Deficit.”

53. Coleman, “External Limits on State Taxation of Business Activities.”

54. Andrew Reschovsky, “The Progressivity of State Tax Systems,” in The Future of State Taxation, ed. David Brunori (Washington, D.C.: Urban Institute Press, 1998), 161–189.

55. SeeInstituteonTaxationandEconomicPolicy,WhoPays:ADistributionAnalysisofthe Tax System in All Fifty States, 2nd ed. (Washington, D.C.: ITEP, 2003), http://www. itepnet.org.

56. Reschovsky, “Progressivity of State Tax Systems,” 161.

57. Nicholas Johnson and Iris Lav, “Are State Taxes Becoming More Regressive?” Report by the Center on Budget and Policy Priorities, Washington, D.C., 1997, 1, http:// www.cbpp.org.

58. Ibid.,8.

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