Tax reform and budget shortfalls are not peculiar to the State of Maine. Almost 80 percent of the states are now reporting mild to serious budget problems. Sometimes tax reform and budget shortfalls get linked during a budget crisis when tax structures are scrutinized and the flaws and inequities of the tax code surface.
While it is easy for state lawmakers to support tax reform in concept, they often find it difficult to muster the political courage to support specific tax reform proposals. Generally, state legislators shy away from major tax reform because it is easier to “talk the talk” than to “walk the walk”.
Legislative reluctance to deal with meaningful tax reform may be one reason why several citizen-initiated, property tax caps have found their way to statewide referendum ballots in recent years.
Even the state legislators in Michigan, who in 1993 enacted major property tax reform, were reluctant to complete the job and instead sent their tax reform proposal to the citizenry for ratification and direction.
STATE BUDGET PROBLEMS
The September 11th terrorist attacks provided an extra jolt to an already weak national economy. Large segments of the U.S. economy, such as the airline and hospitality industries, were particularly hard hit. Just recently, economists reported that the country’s economy actually fell into recession in March, 2001, and that the events of Sept. 11th exacerbated the situation just as the country appeared to be coming out of the recession.
According to information from the Rockefeller Institute of Government, a public policy research arm of State University of New York, state sales tax growth has slowed in 39 of 45 states with a general sales tax. The Institute says the current rate of growth in this major revenue source for states is the slowest it has been in 10 years. Real sales tax growth (adjusted for inflation) has actually been declining for the past five quarters, according to the Institute. The 2.7 percent drop in real sales tax growth is the first (adjusted) decrease in sales tax revenues since 1992.
In a later report, issued November 7, the Institute added to the already gloomy economic news by revealing that preliminary revenue numbers for the July-September 2001 quarter show the largest year-to-year drop in total state revenues since the Rockefeller Institute of Government began to track state revenues over a decade ago. Total state revenues declined by 3.4 percent. Personal income tax revenues declined even more sharply at 4.2 percent. Corporate income tax revenue plunged by 25 percent.
A survey this fall of the 50 states by Stateline.org, a research organization funded by the Pew Charitable Trust, found that the vast majority of states were experiencing fiscal problems. Forty states reported problems that showed mild to severe budget shortfalls. Ten states reported that revenues were keeping track with estimates. A common denominator among those states (e.g., Texas, Alaska, West Virginia) was their strong oil, gas and mineral industries.
Stateline also reports that at least15 states had made budget cuts or frozen spending, including Maine.
Some positive economic news came from the U.S. Commerce Department in early December when it reported that personal spending rose a record 2.9% in October, offsetting much of what occurred immediately following September 11th. Record auto sales spurred on by special financing packages gave the biggest boost to personal spending. Partially offsetting the good news on consumer spending was the report that personal income actually fell during October.
SUCCESSFUL TAX REFORM
In 1994, the State of Michigan dramatically changed the way it funds K-12 education. The legislature initiated the change and the people of Michigan ratified it and also made the critical choice of what direction tax reform would take.
The legislature approved an education reform package in 1993 that moved away from using property taxes as the predominate revenue source for funding education. Interestingly, the legislature did not decide specifically how the shift away from property taxes would be funded; instead that decision was left up to the voters.
The voters were given an either/or choice on how to fund the reform. They could choose a sales tax increase or an income tax increase. No other choices were given. They chose the sales tax.
Following the referendum, a 2-cent sales tax increase and revenue generated from several smaller sources replaced about two-thirds of the property taxes that were being spent for schools. Michigan’s sales tax was 4-cents prior to the vote. The reform increased the state’s share of education funding from roughly 30 percent to 80 percent.
Another important aspect of the reform was a closing of the gap in per pupil expenditures between the highest and lowest spending school districts. Four years after the reforms had been instituted, the gap in per pupil spending — highest to lowest — had been narrowed from a 3-1 ratio to 2-1.
Education tax reform in Michigan has not been without problems, however.
One problem has been the volatility of the primary funding source for education — the sales tax. Economic downturns adversely affect sales tax revenues more than property tax revenues. Michigan state government has some money set aside in a rainy day fund — the Budget Stablization Fund (BSF). That fund currently has about $600 million in it, which represents about three percent of the state’s General Fund and School Aid Fund (they are kept separate). The annual operating budget (state & local funding) for schools in Michigan is about $13.5 billion. To fix the already approved FY 02 budget, Michigan’s governor is recommending a draw down of $350 million from the BSF.
Before education reform in Michigan, local mill rates could be increased to meet the demands for more education spending. Following the reform, local mill rate increases are capped at 3 mills (assessment are at 50% in Michigan, so this equates to 1.5 mills at full value). Moreover, any tax increase — up to the 3 mills — must get (school) district wide approval. Property assessments are also capped under the reform at the rate of inflation or five percent, whichever is less.
ATTEMPTING TAX REFORM
Michigan is perhaps the only state in recent history to successfully implement major tax reform. While state budget problems have stimulated the debate over tax reform in several state houses, at the end of the day, most state legislators have not had the political courage to actually vote for tax reform.
One state where deficits and tax reform have taken center stage is Tennessee. The Governor of Tennessee, Don Sundquist, has described the state’s financial situation as “The Perfect Storm”, metaphorically comparing it to a movie where the worst conceivable weather conditions simultaneously occurred off the coast of Gloucester, MA, and a fishing boat, caught in the middle of the storm, capsizes and its entire crew drowns.
There’s a lot of other people in Tennessee, besides the governor, who believe the state’s finances have reached the crisis level.
While the Tennessee state legislature has been working on tax reform for several years, it wasn’t until this most recent legislative session that significant tax reform looked like a real possibility.
The financial problems in Tennessee stem from the state’s heavy reliance on a shrinking general sales tax base. In 1979, total taxable sales equaled 59 percent of total personal income in the state; today, the base is 42 percent of personal income.
The economic downturn from the events of September 11th added to Tennessee’s “perfect storm” analogy. Consumer spending which had already been slowed by the national recession dropped sharply in Tennessee. It may have been the straw that broke the camel’s back.
In July, Tennessee lawmakers finalized the state budget with no new revenues, leaving at least a $220 million hole in the FY 02-03 budget. What the legislature did was use its tobacco settlement monies, both recurring and one-time, to balance the state budget. By next June, state budget officials are estimating the deficit will be $274 million. One of the reform-minded state legislators is saying that it will take over $600 million to right the Tennessee state budget ship.
In late June, it looked like significant tax reform was possible. A budget conference committee put out a majority report that would have generated approximately $586 in new revenue through a 3/4 percent increase in the state’s sales tax (currently at 6%), a modest expansion of the sales tax base in four service areas (pest control, private mail centers, car washes and vending machines), a one percent increase in the so-called “sin taxes” and a 1/2 percent increase in the corporate excise tax. The committee also proposed using $160 million from the tobacco settlement and cutting $130 million in spending.
There was no dearth of tax reform ideas. Other reform ideas included a flat income tax of 2.5%, a graduated income tax of 3 to 4% with a substantial personal exemption, repealing local option tax authority and replacing these taxes with a uniform 8.5% sales tax, and a proportional tax increase proposal that would increase all existing state taxes by the same amount, but provide for no new taxes.
None of these proposals was able to survive the state budget process.
SHORTFALLS AND DEFICITS
According to the National Association of State Budget Officers (NASBO), anticipated shortfalls in state budgets for FY 02 are in the $15 billion range. Furthermore, a report from the National Governors Association says that nationwide, state tax revenues are expected to be flat in the current fiscal year. This will be a significant drop from the 6.5 percent growth in revenues during FY 01 and the 8 percent growth during FY 00.
School Funding Cuts
Nationwide, education takes the largest chunk out of state budgets. NASBO says that of the $945 billion that state governments collectively spend, 22.5% goes to K-12 education and 10.9% to higher education.
The State of Florida depends heavily on tourists to fill state coffers. Florida exports much of its state and local taxes, which means that non-residents fund a large portion of the cost of government there.
Florida does not have a state income tax. The state gets most of its revenues through a general sales tax and a variety of charges paid, in large part, by tourists. Property taxes are about 25% of the state and local tax mix and much of that comes from non-residents as well, because Florida has a sizeable homestead exemption that shelters residents from property taxes.
In early December, the Florida legislature voted to cut slightly over a billion dollars from its $20.3 billion operating budget, with over $300 million of the cost cutting being applied to schools. The school cuts were the final sticking point in a compromise worked out by legislative leadership to cope with the state’s $1.3 billion shortfall in its state revenue.
In California, Governor Gray Davis has proposed a $2.25 billion cut to state’s $79 billion FY 02 budget. Over 36 percent of the state’s budget goes to fund K-12 education. Among the proposed cuts is a $843.5 million reduction in programs for K-12 education. These proposed cuts will go before a special session of the California legislature in January.
Easy Way Out
Temporary or politically expedient fixes seem to be the preferred way that state legislatures deal with budget problems.
The tobacco settlement monies (which most people thought were to be spent on health-related programs) have been the magic budget fix for many states. Some states, like Tennessee, have used both the one-time money and the recurring tobacco settlement money to meet state government’s operational costs.
Another easy way out for states is non-tax revenue. Before and during the last recession, a number of states moved into or increased the size of state-run lotteries. Now, many states are looking at video gaming terminals as a non-tax revenue. In October, New York lawmakers came up with a budget agreement that included revenue from the use of slot machines and video gaming terminals.
Video gambling generates millions of dollars a year in revenue for many states and at a time when traditional state lottery proceeds are stagnating or dropping. Five states, and now New York, have added video gaming terminals to their state’s lottery program. Several other states allow the private sector to do video gaming, with some of the proceeds helping to fund state government programs.
After state legislatures have explored all alternatives to increasing taxes, they probably will lean toward “sin taxes” — on tobacco and alcohol — instead of broad-based taxes to help deal with the budget shortfalls. However, it is interesting to note that the National Association of State Budget Officers reports only five states (one of which was Maine) in the last two years have raised cigarette taxes. No state increased taxes on alcohol. That may soon change, given the number of states facing budget shortfalls.