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Balancing State Budgets

Rebounding general fund balances led many states to pass unaffordable tax cuts.
After three years of losses, state revenues rebounded strongly. Nonetheless, fiscal directors in many states are concerned that spending needs will outstrip revenue growth over the longer term.1
State taxes are structured so that state expenditures will exceed revenues in the long run.
Overall, states face a long-term structural deficit—a chronic inability of state revenues to grow as quickly as the costs of government. This is because most state tax systems were designed in the 1930s and 1940s for a different kind of economy. Since that time, our nation’s economy has shifted from production to services, far more corporations operate across state and national boundaries, mail order and Internet sales across state borders have exploded, income taxes have become less progressive, and federal policies have increased state budget responsibilities.2
Recent state budget shortfalls were caused by tax cuts, not by overspending.
Adjusted for inflation and population growth, spending of state-raised funds increased by only about two percent annually during the 1990s—substantially less than the increases in state spending over the past five decades.3 Recent budget deficits are primarily the result of states responding to the strong economy of the 1990s with large, permanent cuts in personal and corporate income taxes. In most states, if taxes were restored to pre-1994 levels, budget problems would be solved. Many states have responded to recent increases in revenue by passing tax cuts. But these cuts will cause fiscal strain on future budgets.4
A wide variety of policies are available to increase revenues.
Nobody likes to raise taxes or cut government services, but most legislatures will eventually be forced to do one or both. The following are 25 possible ways to close budget deficits:
  • Tobacco Excise Tax—Increase the tax and cover more tobacco products. One of the quickest and most popular ways for states to raise hundreds of millions of dollars is to increase the tobacco tax. State polls conducted across the country have found that Americans strongly favor tobacco tax increases of 50 or 75 cents per pack.5 Since 2002, 42 states (AL, AK, AZ, AR, CO, CT, DE, GA, HI, ID, IL, IN, KS, KY, LA, ME, MD, MA, MI, MN, MT, NE, NV, NH, NJ, NM, NY, NC, OH, OK, OR, PA, RI, SD, TN, TX, UT, VT, VA, WA, WV, WY) have raised cigarette taxes. Of these, Arizona, Colorado, Montana, Oklahoma, Oregon, South Dakota and Washington increased tobacco taxes by statewide referendum. In 2006, five states (AK, HI, NJ, NC, SD) raised their tobacco taxes, providing nearly half a billion dollars in revenue.6 States have also expanded the tax to cover chewing tobacco and snuff. In addition to the fiscal benefits, higher tobacco taxes save thousands of lives by reducing tobacco use.
  • Alcohol Excise Tax—Increase the tax. All states impose a “sin” tax on alcohol, but most tax alcohol at low rates. The average excise tax on liquor is about four dollars per gallon; several state taxes exceed six dollars per gallon. Most states tax beer and wine at much lower rates than spirits, based on the percentage of alcoholic content. States with the lowest alcohol taxes include AR, CO, IN, KS, KY, LA, MD, MO, NE, NV, ND, SC and TX. A 2004 poll conducted for the American Medical Association found that, by a margin of two-to-one, voters favor a state alcohol tax increase to help cover the ancillary healthcare and law enforcement costs of drinking.7 In 2005, both Kentucky and Washington increased their alcohol excise taxes, resulting in $14.4 and $22 million increases, respectively, in state revenues.8
  • Estate Tax—Decouple from federal estate tax. States have lost billions of dollars in tax revenue because of a change to the federal estate tax enacted in 2001. Most state estate tax formulas are linked to the federal estate tax credit, which is being phased out over the course of three years. As a result, revenues are plummeting. Fourteen states (IL, ME, MD, MA, MN, NE, NJ, NY, NC, OK, RI, VT, WA, WI) have taken action to decouple from the federal estate tax. Three states (CT, KS, WA) have estate taxes that are not tied to the federal tax. Seven other states (IN, IA, KY, OH, OK, PA, TN) were never coupled to the federal estate tax.9 Washington’s new estate tax, which uses a rate structure different from federal law, generated approximately $40 million in 2005.10
  • Personal Income Tax—Raise the rate for the highest incomes. The simplest way to make income tax rates more progressive is to institute a surcharge or a new tax bracket for individuals who earn more than $250,000, $500,000 or $1 million per year. In 2004, New Jersey increased revenues by more than $850 million through a 2.6 percent rate increase for taxpayers who earn more than $500,000. Similarly, a November 2004 California referendum instituted a one percent surtax on taxpayers earning more than $1 million. This kind of increase can be enacted as a permanent or temporary tax. During the last recession, four states increased top rates permanently, while five others enacted temporary increases.
  • Personal Income Tax—Implement a more graduated scale. If taxes must be raised, why not do it fairly? Of the 41 states with a personal income tax on earnings, only 14 have graduated tax brackets that truly differentiate between lower- and upper-income taxpayers. Six states have a flat tax rate—no income brackets at all. In 16 other states, the top tax bracket is $25,000 or less. In other words, about half of the states are ripe for a fundamental reform of income tax brackets.
  • Personal Income Tax—Eliminate or suspend exemptions, credits or deductions. Virtually every state with an income tax has created or expanded income tax exemptions, credits or deductions over the past ten years. Advocates should research tax loopholes—changes designed to benefit special interests or the highest tax-bracket, instead of the average family—and the amount of revenue lost because of each loophole. Legislation can either eliminate the loopholes permanently or suspend them temporarily. In 2005, New Jersey gained $45 million in revenue when it eliminated a pension income tax exclusion for higher-income taxpayers.11
  • Personal Income Tax—Tax non-resident gambling income. State residents’ net winnings from casinos and lottery games are taxed as income. But states can also tax non-residents who have gambling winnings in the state. CA, CO, IL, MD, MA, MN, NJ, ND, PA and WI tax non-resident gambling income. Connecticut and Rhode Island tax non-residents for state lottery winnings. The value of such a tax expansion depends, of course, on the amount of gambling activity in the state.
  • Personal Income Tax—Implement a tax amnesty. Over the past 20 years, 41 states have implemented tax amnesty periods to collect overdue taxes. California, Florida and Indiana offered tax amnesties in 2005. Connecticut’s most recent amnesty collected more than $100 million in back taxes. A 2003 Illinois amnesty collected back taxes from almost 20,000 businesses and individuals. However, by offering amnesties too often, states lower taxpayers’ incentive to pay on time.
  • Corporate Income Tax—Implement a more graduated scale. Thirty-one states use a flat tax for corporate income. That means there is only one tax bracket, with no graduated scale. These states can adopt a graduated system that increases the tax rate for corporate income over certain levels, e.g. $25,000, $100,000, $250,000, $500,000 and $1 million. For example, Iowa, Kentucky and Maine have graduated scales from $25,000 to $250,000, with tax rates ranging from 3.5 percent at the lowest to 12 percent at the highest. If necessary, a graduated scale can be implemented temporarily by imposing a surcharge on corporate profits over a certain level—for example, a five percent surcharge on corporate profits over $250,000. In 2006, New Jersey imposed a corporate surtax expected to raise $121 million.12
  • Corporate Income Tax—Require combined reporting. When filing tax returns, corporations that operate across state lines apportion their income among the states where they do business. In doing so, corporations use many strategies to artificially shift the reporting of their income to low-tax or no-tax states. Combined reporting is the broadest and fairest reform to stop the most common tax avoidance strategies. Because combined reporting requires corporations to add together the profits of related businesses before the combined profit is subject to apportionment, the company gains little or no advantage by shifting profit among its subsidiaries in different states. Combined reporting ensures that a corporation’s state income tax liability remains the same regardless of the corporation’s legal structure. Seventeen states (AK, AZ, CA, CO, HI, ID, IL, KS, ME, MN, MT, NE, NH, ND, OR, UT, VT) use combined reporting.
  • Corporate Income Tax—Close the PIC trademark loophole. Large corporations commonly shift the reporting of income by using a “passive investment company” (PIC), a corporate affiliate that is often no more than a file in a Delaware lawyer’s office. The PIC holds legal ownership to the parent corporation’s patents and trademarks and may charge huge royalties to the parent company, which shields those funds from taxation. This tax dodge was made famous by Toys R Us, which paid its PIC subsidiary for the use of the “Geoffrey” giraffe trademark and other intangible assets. Twenty-six states have closed this loophole, most recently Maryland in 2004. The following states could gain tax revenue by eliminating this income shifting tactic: AR, DE, FL, GA, IN, IA, KY, LA, MO, NM, OK, PA, RI, SC, TN, TX, VT, WV, WI and the District of Columbia. Adoption of combined reporting also blocks the PIC trademark loophole.
  • Corporate Income Tax—Redefine “business income.” The U.S. Supreme Court has limited the types of business income that are subject to apportionment among the states. To comply with Supreme Court rulings, most states define and tax “business income.” But the commonly-used definition allows corporations to avoid taxes by declaring certain transactions to be “irregular” and therefore “non-business income,” a practice which cheats states out of their fair share of corporate tax revenue. States can close the “non-business income” loophole by redefining “business income” to be as broad as the Supreme Court allows—that is, “business income means all income which is apportionable under the United States Constitution.” Only six states (FL, IA, MN, NC, PA, TX) have adopted this definition. All other states with a corporate income tax could increase revenue by adopting this definition as well.
  • Corporate Income Tax—Enact a “throwback” rule for “nowhere income.” A little-known federal law, P.L. 86-272, prohibits states from taxing corporate income if the corporation does not conduct a certain level of activity in the state. As a result, corporations often claim that a substantial portion of their profits come from sales in those states where federal law prohibits taxation. For tax purposes, the income seems to come from “nowhere.” Twenty-six states have a “throwback” rule that directs that if income from a product is not taxed in the state where it is sold, it is taxed in the state where it was made. The throwback rule is simple—it can be accomplished by adding a single sentence to existing corporate tax law. Nineteen states (AR, CT, DE, FL, GA, IA, KY, LA, MD, MA, MN, NE, NY, NC, OH, PA, RI, SC, TN) could gain revenue by enacting a throwback rule.
  • Corporate Income Tax—Tighten rules on “silent partners.” Certain business entities, such as S-corporations, partnerships and limited-liability companies, are not taxed because income flows directly to their partners, who are supposed to pay tax on that income. But many out-of-state partners do not report their earnings to the states where the partnerships earned profits. Often, states do not check to see if these “silent” partners reported any income to the state. Most states’ efforts to check on pass-through reporting are inadequate, and millions of dollars of tax revenue are lost. Ohio, New Jersey and New York have tightened the rules on pass-through entities in recent years.
  • Corporate Income Tax—Eliminate or suspend exemptions, credits and deductions. Over the past 20 years, states have created hundreds of different exemptions, credits and deductions to the corporate income tax. These exemptions, credits and deductions reward different types of businesses or business behavior. Advocates should research each of the corporate tax loopholes created since the early 1980s, and determine the amount of revenue it lost. Legislation can either eliminate the loopholes permanently or suspend them temporarily.
  • Corporate Income Tax—Accelerate sunset dates for tax exemptions. A number of states have created corporate tax exemptions that sunset after a period of years. States can gain additional revenue by accelerating exemption sunset dates.
  • Corporate Income Tax—Decouple from federal bonus depreciation. States lost billions of dollars in tax revenue because of a change in the federal corporate income tax that was enacted in March 2002. A new federal tax deduction, called “bonus depreciation,” allows businesses to claim 50 percent depreciation in the first year for certain business machinery placed in service after September 2001. Thirty states that had previously followed federal depreciation rules have decoupled from the federal tax code, which effectively disallows the new bonus depreciation provision. However, AL, CO, DE, FL, KS, LA, MO, MT, NM, NC, ND, OK, OR, SD, UT, VT and WV stand to lose more than $1.1 billion over the next two years if they do not permanently decouple from the federal depreciation rules.13
  • Corporate Income Tax—Decouple from the federal qualified production activities income depreciation. Twenty-nine states will lose between $850 million to $1.2 billion annually if they don’t act to disallow a new federal tax break known as the “qualified production activities income,” or QPAI. The federal QPAI, enacted in 2004, is the largest new federal tax break for American corporations in years. Eighteen states (AR, CA, GA, HI, IN, ME, MD, MA, MN, MS, NH, NC, ND, OR, SC, TN, TX, WV) and the District of Columbia have disallowed the QPAI tax break. New Jersey has partially decoupled.14
  • Corporate Income Tax—Reform the Alternative Minimum Tax. It is all too common for corporations to use a series of tax loopholes to avoid paying any state tax at all. The federal government has an Alternative Minimum Tax (AMT) for these situations. Currently, 13 states impose a corporate minimum tax that is a fixed amount—ranging from ten dollars in Oregon to $2,000 in New Jersey. Seven states go further and require businesses to pay the higher of a tax calculated as a percentage of profit or a tax calculated on some other basis. In Texas, the alternative basis is the business’ net worth; in New Hampshire, it is “value-added” within the business; and in New Jersey, it is the business’ gross receipts.15
  • Sales Tax—Delete exemptions on some products. Each state has different sales tax exemptions. Some are progressive (e.g. exemptions for food, medicine and back-to-school items), but many states have created sales tax exemptions simply to encourage or reward certain industries, including exemptions for vending machines, technology, warehousing, and chemical sprays. Advocates can create a list of unjustified sales tax exemptions and target some or all of them for suspension or elimination.
  • Sales Tax—Apply to some services. The sales tax—the largest source of revenue for many states—usually applies only to the purchase of tangible personal property (e.g. clothing, housewares, appliances), and in some cases, to the installation or repair of property (e.g. plumbing, auto repair). However, most business, financial and professional services are exempt from the sales tax. States can expand revenue by extending the sales tax to cover specific categories of services, such as advertising, data processing, business consulting, engineering, or architectural services.
  • Luxury Tax—Impose a special sales tax on luxury goods and services. Sales taxes are regressive—they absorb a larger proportion of the income of lower-income taxpayers than of higher-income taxpayers. To counter this, states can single out “luxury” goods or services for a sales tax that is either equal to or greater than the normal sales tax rate. A surtax can apply to goods that are unusually expensive—for example, non-business purchases over $50,000. Or a tax can apply to athletic club, country club, or golf club memberships.
  • Intangible Wealth Tax—Cover stocks, bonds, etc. States can follow Florida’s lead and tax intangible wealth, such as stocks, bonds and money market accounts. For example, a one percent tax on personal and corporate intangible wealth, with a maximum exemption of $3,000 (excluding IRAs and other retirement accounts), would raise nearly $1 billion in the average state. A narrower version has been proposed in New Jersey. In that state, a one quarter of one percent tax on intangible assets worth more than $2 million would affect only the richest one percent of taxpayers.
  • Gasoline Tax—Increase the state tax. Every state levies a gasoline tax in addition to the federal tax of 18.4 cents per gallon. Some states charge a flat rate per gallon, while others tax the price, rather than the quantity, of gas sold. Some states charge as much as 29 to 31 cents per gallon (PA, RI, WI). Nineteen states have gas taxes below 20 cents per gallon (AL, AK, AZ, CA, FL, GA, HI, IN, KY, MI, MS, MO, NH, NJ, NM, OK, SC, VA, WY). Alaska’s and Georgia’s rates are the lowest—less than ten cents per gallon.16 In 2006, New Jersey raised its gasoline tax by referendum.
  • Tax Enforcement—Hire tax investigators to collect more revenue. Most states do a very poor job of enforcing tax law. As a result, hundreds of millions of dollars in revenue go uncollected. It has been estimated, for example, that Illinois could generate $160 million annually by hiring 100 additional tax investigators. A report in Minnesota found that the state was losing $288 million per year in uncollected tax revenue. In 2001, Kansas invested $3 million to create 75 new tax collection positions. While the legislature projected that the additional collection efforts would yield $48 million, the state actually collected nearly $110 million in additional revenue.

The portions of this policy summary dealing with corporate, estate and gasoline taxes rely in large part on information from the Center on Budget and Policy Priorities.

Endnotes
  1. National Conference of State Legislatures, “State Budget & Tax Actions 2006: Preliminary Report,” 2006.
  2. Iris Lav, Elizabeth McNichol and Robert Zahradnik, “Faulty Foundations: State Structural Budget Problems and How to Fix Them,” Center on Budget and Policy Priorities, May 2005.
  3. Elizabeth McNichol, “The State Fiscal Crisis was not Caused By Overspending,” Center on Budget and Policy Priorities, May 2003.
  4. Nicholas Johnson and Sarah Farkas, “Tax Cuts on Layaway: The Short- and Long-Term Fiscal Implications of 2006 State Tax Actions,” Center on Budget and Policy Priorities, October 10, 2006.
  5. Campaign for Tobacco-Free Kids, “Voters Across the Country Support Significant Increases in State Cigarette Taxes,” June 25, 2003.
  6. “State Budget & Tax Actions 2006: Preliminary Report.”
  7. American Medical Association, “Americans overwhelmingly support increase in state alcohol taxes,” U.S. Newswire, May 4, 2004.
  8. National Conference of State Legislatures, “State Budget & Tax Actions 2005: Preliminary Report,” 2005.
  9. Elizabeth McNichol, “State Taxes on Inherited Wealth Remain Common: 24 States Levy an Estate or Inheritance,” September 8, 2006.
  10. “State Budget & Tax Actions 2005: Preliminary Report.”
  11. Ibid.
  12. Ibid.
  13. Nicholas Johnson, “Federal Tax Changes Likely to Cost States Billions of Dollars in Coming Years,” Center on Budget and Policy Priorities, June 2003.
  14. Elizabeth McNichol and Nicholas Johnson, “States Are Decoupling from the Federal ‘Qualified Production Activities Income’ Deduction,” Center on Budget and Policy Priorities, September 14, 2005.
  15. Michael Mazerov, “Many States Could Avoid an Unnecessary Revenue Loss During the Current Fiscal Crisis by Disallowing Business Operating Loss Carrybacks,” Center on Budget and Policy Priorities, May 2003.
  16. Nicholas Johnson, “Should States Suspend Their Gasoline Taxes?” Center on Budget and Policy Priorities, September 8, 2005.
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