Over the past 25 years, state tax policy has fundamentally changed as restructuring of state economies has forced policymakers to enact more competitive policies and as the tax issue has become potent in political campaigns. This focus has resulted in major shifts in tax policy, and not all of them for the better.
An analysis of 25 years of state tax data finds:
- Tax increases are getting smaller (particularly in recessions).
- Tax cuts during growth periods are becoming more prevalent.
- Revenue sources have shifted away from income taxes to more targeted tax increases such as tobacco and other forms of double taxation on consumption.
State Tax Hikes Declining
The change in policy is timed to the post-1990 recession as governors and state legislators were voted out of office in response to the massive tax increases enacted during the recession. Subsequently, the new governors and legislators began enacting tax cuts as the nation entered a sustained period of growth.
Moreover, migration flows began to accelerate as higher-income taxpayers and an aging population moved to lower-tax jurisdictions. That migration is placing competitive pressures on other states to keep their income, sales, and corporate tax rates at restrained levels.
However, the increases in excise taxes and the multiple layers of taxation on certain products are a cause for concern, as is rapid entitlement spending, which could threaten the gains achieved over the past decade.
Without significant reforms to state spending, those gains will be short-lived.
Broad Base Was Favored
Twenty-five years ago, faced with the deep recession in the early 1980s, states raised expansive taxes such as income, sales, and corporate taxes. By imposing broad-based tax burdens, states were able to generate large amounts of revenue from the entire working population to fund massive spending increases.
Even after the recession, states raised their income taxes (albeit much more slowly than during the recession) throughout the economic expansion of the 1980s. Due to strong economic growth, state government coffers continued to swell; yet, states continued raising taxes in order to fund costly new programs.
Between 1990 and 1994, states raised their income taxes 42 times, generating a cumulative $33 billion in tax revenue.
The voters’ unhappiness over the early 1990s tax increases severely changed the dynamics of state tax policy. Concurrently, the spread between the highest- and lowest-tax states was increasing, which led to an out-migration of higher-income residents to low-tax states.
It was during this recession that Pennsylvania Gov. Robert Casey (D) enacted a $2 billion income tax increase by hiking the rate from 2.1 to 2.8 percent. From 1990 to 1995, net job creation in the state was stagnant.
In New Jersey, Gov. Jim Florio (D) increased the state income, sales, and corporate taxes in 1990. Many consider his failed campaign for reelection in 1993 to be a condemnation of those tax hikes. In New York, one-time presidential favorite and longtime governor Mario Cuomo (D) was defeated by little-known Assemblyman George Pataki (R) in a campaign that focused on the tax increases enacted during this time.
California Gov. Pete Wilson (R) and state legislators hit taxpayers in 1991 with $7.2 billion in tax increases, including a 3/4-cent sales tax increase, expanded to cover snack foods, newspapers, and bottled water; two new personal income tax brackets; and a two-year suspension of corporate net operating loss deductions.
By 1993, more than 30,000 corporations had shut down, and for the first time in California’s history, more people left the state than entered.
Tax Cutting Begins
While states continued to increase spending at rates well above inflation in the boom of the late 1990s and early 2000s (state general fund spending grew 7 percent in 1999, 6.6 percent in 2000, and 8 percent in 2001), the policy decisions differed from the earlier expansion.
In the 1990s, tax cuts were in vogue, and states cut taxes overall an unprecedented seven consecutive years, saving taxpayers more than $37 billion. In an effort to stem the out-migration of residents, state income taxes were cut nine consecutive years.
In 1999 alone, 29 states cut their income tax rates, because more people working and higher capital gains revenue left states flush with tax revenues. From 1995 through 2002, states cut their income taxes 137 times, resulting in nearly $20 billion in savings for taxpayers. Clearly, the tide was shifting as the U.S. entered the 2001 recession.
2001 a Turning Point
Although states were asserting they faced the worst budget deficits since the Great Depression, the 2001 recession marks a transformation of state tax policy. State tax increases were far smaller in the 2001 recession than in the recessions of the 1980s and 1990s.
With tax increases less palatable compared to the 1990 recession, state policymakers were forced to tighten the belt of government operations. In the 1990 recession, states had continued to increase spending by 4 to 5 percent annually. This time around, spending increases were in the range of 1.5 to 3 percent.
Fewer Corporate Tax Increases
A clear decline exists in sales tax increases as well. In a deviation from the late 1980s and the early 1990s, when states hiked their sales tax rates 66 times, sales taxes were increased only 13 times following the 2001 recession. In addition, the sales tax increases following the 2001 recession were 36 percent lower than those of the previous recession.
What the former governors and their successors learned from the early 1990s tax increases is that large, broad-based tax increases are political losers and lead to a loss of businesses, jobs, residents, and economic growth.
However, there is still no appetite among elected officials for spending cuts, so tax increases continue to be enacted, albeit in smaller amounts.
Tobacco a Big Target
Specifically, states found tobacco to be their biggest cash cow in the most recent recession. During the 1990s recession, states raised $5.15 in new income tax revenues for every $1 of increased tobacco tax revenue. In the 2001 recession, states raised just $0.86 of increased income tax revenue for every $1 of increased tobacco tax money.
In other words, states raised more new money from tobacco than they did from the income tax in the recent recession.
Tobacco tax increases represented 30 percent of all dollar increases in state taxes during the last recession, compared to just 5 percent during the 1990 recession. In 2002 alone, 20 states raised their tobacco taxes.
Excise Taxes Attractive
Tobacco is not the only item targeted in states’ shifting tax policies. In 2006, 31 states debated alcohol tax increases, seeking to raise taxes on a product already subject to a sales tax and then hit it with a special tax.
This is also emerging in telecommunications and housing.
Most of these smaller tax increases are occurring in states with already high tax burdens. And although less visible to voters than broad-based taxes, these tax increases compound over time and increase the cost of living.
Taxes matter, and states that are raising taxes are losing population. In 2004 alone, the nine states with no income tax gained an additional 323,579 domestic residents from the 41 states with an income tax.
The residents moving to states with no income tax took with them an additional $10.6 billion of adjusted gross income, according to Internal Revenue Service data.
Furthermore, the states facing the largest fiscal problems from large unfunded liabilities in health care and pensions already have the largest out-migration of residents. Tax increases will only further that out-migration.
The problem will be compounded in 2007 and beyond as states will be required by the Governmental Accounting Standards Board to account for unfunded health care liabilities.
States have not been reporting the expected liabilities for future health care services promised to government workers and qualifying dependents. The GASB requirement is expected to reveal hundreds of billions of dollars in unfunded liabilities collectively owed by state governments. As the nation’s population ages, many state workers will be retiring and ready to collect their generous pensions and health care benefits.
More to Be Done
Despite the progress on state taxes over the past 25 years, more needs to be done to build on this foundation. States continue to spend too much during upturns in the business cycle, leaving taxpayers to pay the bill with additional tax increases during recessions.
- First, a state constitutional limit on state spending to the rate of population plus inflation growth will ensure tax revenue gains during upturns can be used to offset revenue losses during recessions. Such limits prevent large entitlement programs from being created during upturns in the business cycle, thus minimizing risk to taxpayers.
- Second, large-scale reforms of state pension and health care systems are needed to prevent large tax increases in the future. Eight of the past 10 changes to states’ pension systems have come in the form of moving from defined benefit (DB) to defined contribution (DC) plans.
Moving to a DC plan, as the private sector has done, creates better predictability for state taxpayer contributions and will remove the current unfunded liabilities in the system.
Similar changes should be made for health care through the use of health savings accounts (HSAs).
- Finally, states need to curtail their reliance on taxes on volatile revenue sources, such as non-wage income, including capital gains and dividends.
With the run-up in the 1990s stock market, states became flush with temporary capital gains tax revenue and used that to increase spending permanently. When the stock market declined, states lost up to 80 percent of this revenue source but continued spending. That was a major factor driving tax increases thereafter.
By removing capital gains tax revenue from the general budget (or eliminating this growth-inhibiting tax altogether), states will have greater predictability in budgeting and consequently less appetite for tax increases.
Daniel Clifton ([email protected]) is chief economist at Americans for Tax Reform. Elizabeth Karasmeighan ([email protected]) is state government affairs manager at Americans for Tax Reform. This article was excerpted from ATR’s State Tax Policy Research paper published August 14. Used with permission.
For more information …
The Americans for Tax Reform August 2006 report, “State Tax Trends Over Twenty-Five Years: Tax Increases Down, Revenue Sources Shifting,” is available through PolicyBot™, The Heartland Institute’s free online research database. Point your Web browser to http://www.heartland.org, click on the PolicyBot™ button, and search for document 19711.