Accomplishing State Budget Policy and Process Reforms
Abstract and Keywords
This article tackles the issue of comprehensive state budget reform. With structural deficits rampant, reform is needed to maintain the current level of programs that states and localities now provide, but cannot support over time with current revenue policies. Recent “reforms” have mainly focused on cutting both spending and taxes. Nonetheless, it is believed that people want their services and will vote to pay for them, if given that option. The article notes that there have been very few successful state tax reforms in recent years. But modernization of tax systems is needed to alleviate structural deficits. Part of the problem is institutional myopia: improved multiyear budgeting can warn policymakers when proposed actions are likely to create budget problems over the long term.
States and localities pursue a myriad of less-than-optimal tax and budget policies, most of which have been discussed thoroughly over the past two or three decades. Many of these dysfunctions are rooted in policies adopted in the middleof the last century and were never updated as the world around them had changed. They are not the policies one would choose if one were starting a totally new state—from scratch—in the twenty-first century. But starting over is a mere fantasy. And so, unfortunately, is the idea that state budget problems will be solved by radically restructuring state policies.
Despite the hackneyed label for states of being called “laboratories of democracy,” state budget policy—particularly state-tax policy—has been profoundly conservative, in the sense of being resistant to change, for a very long time.1 With a couple of exceptions, such as Connecticut's adoption of an income tax two decades ago, changes enacted by states over the past twenty-five years have largely been quite modest and incremental. Given this history, it is unlikely that current dysfunctions will be remedied by sweeping reform. I would argue that, to be politically viable, solutions to state problems in the foreseeable future have to build on and reform existing policies. Large disruptions to those policies or radical changes in direction have to be kept to a minimum as policies are adjusted, or voters will not accept the changes.
Reform is necessary to allow the maintenance of at least the current level of programs and services states and localities provide, which cannot be supported over (p. 872) time under current revenue policies. There is strong evidence, despite a lot of rhetoric to the contrary, that people want their services and will vote to maintain them when given choices and adequate information to understand the choices. Colorado-like TABOR tax and expenditure limitations have been rejected in every state in which they were proposed between 2006 and 2009, both by more than twenty legislatures in which it was seriously considered and on the ballots of Maine, Nebraska, Oregon, and Washington. Oregon voters approved a large tax increase on the ballot in 2009 rather than experience major service cuts. And polling frequently shows that vague desires to cut government services overall quickly crumble when specific service cuts in education, health, public safety, or other areas are mentioned. People need and value the services that states and localities provide. And while the election season of 2010 suggests that people value their services but don't want to pay for them – the “free lunch” syndrome – it remains to be seen if this is a passing phenomenon or a fundamental change. Because a “free lunch” is not possible, it is likely that people will return to being willing to pay for the services they value.
State and local fiscal problems that urgently need to be addressed to achieve the goal of maintaining services fall into two broad categories: cyclical and structural. Cyclical problems result in a major part from forces outside of the jurisdiction; a recession or natural disaster will cause revenue to decline and service needs to rise, creating deficits that have to be closed under the balanced-budget requirements of most jurisdictions. Structural problems result from the internal policies and practices of the jurisdiction. In particular, most states have revenue systems that grow more slowly than is necessary to maintain their existing level of services—a situation known as a “structural deficit.” Obviously, states have more control over fixing the structural problems to address long-term adequacy, and these problems will be the primary focus of this chapter.2 Both policy changes and budget process changes that could alleviate structural deficits, and to some degree cyclical problems, will be considered.
The policy changes necessary to fix state structural problems are well known in the public finance community. They include extending sales taxes to include services and remote sales, enacting or improving progressive income taxes, and maintaining flexible property taxes. Some of these changes are supported by experts and policymakers over a wide spectrum of political persuasions; others are more controversial. Nevertheless, there is less need to develop new policy approaches than there is to find new ways of achieving the known solutions to the problems. All too often, changes in the tax structure such as an expansion of the sales tax to include more services or changes in income-tax brackets or rates are introduced in the heat of a legislative session focused on closing a deficit. When these proposals are defeated, as they most often are, the defeat is used as evidence that the change cannot be accomplished. Even when the reforms are proposed in a governor's budget released before a legislative session, the opposition often has a chance to get out its negative message before the proponents can muster support for the proposal. It is relatively easy to villainize a proposed change when adequate public preparation has not been conducted. (p. 873)
A better approach is needed if change is to occur. Key elements of a better approach would include designing simple reforms that the public can understand, preparing the ground with affected constituencies before making a public proposal, using modern opinion research and a range of communications techniques to help design proposed reforms and educate the public, and investigating the possibility of coordinated reforms across states in a region.
In addition, the role of the budget process in permitting or preventing the development of structural deficits is often overlooked. There are, of course, those who use the existence of structural deficits or other budget problems as a springboard to propose extreme budget-process changes such as limits on the growth of revenues or expenditures (tax and expenditure limitations, or TELs) such as Colorado's TABOR. Rigid, formulaic restrictions do not solve the problem, however; they just codify existing problems, prevent reforms, and limit a state's flexibility to meet residents' needs. Reforms such as multiyear budgeting based on current services (baselines) could facilitate public understanding and scrutiny of the implications of policymakers' proposals. Light would be shed on phased-in, multiyear tax cuts or program expansions, which can create structural problems. Moreover, the adoption at the state level of a mechanism similar to the federal pay-as-you-go policy known as PAYGO—in which tax reductions or program increases over the baseline would have to be offset by other tax or program changes to create budget neutrality—could help ensure that new structural deficits are not created by policy changes.
I: Structural Problems and Potential Solutions
Most states have one overarching structural problem, sometimes with many manifestations. The basic structural problem is that state revenues do not grow sufficiently from year to year to finance the growth of expenditures, assuming no statutory changes in either revenues or expenditures. Theoretically, this basic problem could be solved either by lowering the rate of growth of expenditures or by increasing the rate of growth of revenues.
In practice, however, states and localities do not have as much control over the rate of growth of their expenditures as they seem to have. The two biggest areas of state expenditures are education and health care. Nearly two-thirds of state general-fund (p. 874) spending (excluding spending from federal funds, restricted funds, or bond proceeds) is for elementary and secondary education (34.5 percent), higher education (11.3 percent) and Medicaid (16.3 percent). States also have other health expenditures for public employee and retiree health insurance, and for prisoners.3 Local governments spend about 35 percent of their own source funds on K−12 education.4
Educating children is by labor-intensive. Most parents don't want their children taught by computers in the classroom; they demand well-qualified teachers and classrooms that allow the teachers to teach effectively. While in a former era highly qualified women and members of minorities became teachers because they had few other career opportunities, attracting qualified teachers now requires paying competitive compensation. For this and a variety of other reasons, the cost of K−12 education for states and localities has grown faster than the economy over the past twenty years, rising from 3.58 percent of GDP in 1988 to 4.02 percent of GDP in 2008.5 As the population ages and the ratio of potential teachers to school-aged children declines, these costs may have to rise still more rather than less rapidly.6 In addition, there is evidence that as half the teachers become eligible for retirement in the next decade, the quality of teachers will decline unless salaries are increased substantially. A McKinsey report estimates that it would cost $30 billion to increase the percentage of new teachers drawn from the top third of their college classes from the current very low 14 percent to 68 percent.7 (The report also projects large economic gains if this were to be done.) Thus, in most states, there is limited potential for lowering the growth rate in education costs (absent declining enrollments) without sacrificing quality.8
Health-care costs are even more problematic. The rate of growth of health-care costs is a national phenomenon, not something that can be controlled to any significant degree by any one state. Health-care cost growth affects the cost of Medicaid, the cost of health insurance for current public-sector workers and retirees, and a variety of other health-related programs that states and localities operate. Current projections by the Government Accountability Office (GAO) show that state and local health-care costs are growing more rapidly than GDP over the foreseeable future.9 While this rate of growth is unsustainable for both federal and state budgets, it is a larger problem for state budgets because annual state revenue growth generally is lower than federal revenue growth. The GAO has projected that state and local revenue growth will lag behind GDP growth, as it characteristically has, while health-care cost growth will exceed GDP growth, meaning that health- related costs will absorb ever larger portions of state and local budgets under current projections. Controlling health-care costs—preventing this scenario from being played out—will require national solutions, but it is highly unlikely that the rate of health-care cost growth will drop below the rate of state revenue growth in the near future.
There may be the potential for states to enact some efficiency measures in education and health, but the effect of such changes on long-term growth trends generally is modest. For example, there is a current focus on ways to reduce the (p. 875) compensation of teachers and other employees through changes in pensions and retiree health insurance coverage. Changes in pensions would primarily affect costs twenty to thirty years from now, given the protections for the pensions of current employees that are embedded in state constitutions and case law. Moreover, many states have underfunded pension plans, and any reductions in benefits is likely to be offset by the need for increased contributions to reach full funding over the next thirty years.10 By contrast, some changes in retiree health benefits, which generally do not have such legal protections, could affect nearer-term costs and cost growth as the baby boomers retire.
There are also other, smaller areas of the budget such as corrections and economic development for which there is the potential to reduce costs and perhaps cost growth. While important to do so, these areas are not a large enough percentage of state budgets to make more than a quite small difference in long-term growth trends.
While it is difficult for states to control the underlying, ongoing growth in costs in some of the largest areas of the budget, states do have control over the way the path of budget growth is changed by legislation. Governors and legislatures have to agree on proposed statutory policy changes that increase expenditures or the rate of growth of expenditures—the expansion of programs or the enactment of new programs. As will be discussed below in the section on the budget process, an important part of preventing structural deficits from developing or worsening is ensuring that sufficient revenue will be available to fund the long-term cost of any newly created expenditure. Or to put it another way, (a) additional revenues need to be available to fund the additional expenditures through the foreseeable future, and (b) the inherent growth rate of the revenues expected to support the additional expenditures should be equal to the inherent growth rate of the expenditures. A classic example of legislation that violates this principle is the expansion of eligibility for a health-care program that is “paid for” by an increase in the cigarette tax. (Cigarette taxes have a slow growth rate or even decline over time because they are levied on a per-pack basis and the rate of smoking is declining. Health-care costs are growing substantially, creating a mismatch of expenditure and revenue growth.) The PAYGO proposal described below is an attempt to suggest a mechanism that could require close consideration of how new programs will be financed over the long term.
Because of the difficulty of controlling some of the major cost drivers of expenditures, it is important to consider ways to raise the rate of growth of state and local revenues and the potential paths to achieving that goal. In any given state and for any particular base level of services that legislators or voters in that state may have chosen, the growth rate of revenue is the key issue. (p. 876)
Some of the best-known problems of state and local revenues are in sales taxes. Two sets of problems are particularly important. First, most states have excessively narrow sales-tax bases. Sales taxes were designed in an era in which the sales of services played little role in the economy, and most states exclude most sales of services from taxation. According to the Federation of Tax Administrators, a majority of states apply their sales taxes to less than one-third of the 168 potentially taxable services that the FTA includes in its survey of state practices.11 Five of the forty-five states with sales taxes impose them on fewer than twenty services. Second, all states with sales taxes are losing large amounts of revenue on purchases their residents make through the Internet and catalogs because of the Supreme Court decisions of 1967 and 199212 that bar states from requiring sellers without “nexus”—traditionally defined as a physical presence in the state—to collect and remit the taxes. These two problems require very different types of solutions.
Expanding the Sales Tax to Services
The problems caused by omitting services from the sales-tax base became widely recognized in the 1980s; ever since that time, various states have tried to address the problem. Two unsuccessful attempts early on in Florida and Massachusetts to expand their sales-tax bases to include most or all services—where legislation was enacted and subsequently repealed before taking effect—arguably poisoned the well and made states shy away from trying to solve the problem in one comprehensive reform effort.
In theory, other states could have learned from the political “mistakes” of Florida and Massachusetts and then moved forward. The Florida legislation, passed in 1986 to take effect in 1987, eliminated (sunset) exemptions for all services including professional, insurance, and personal services. A variety of factors led to the repeal of the expansion, most notably the decision to use a formula to determine what portion of services purchased by multistate companies would be taxed by Florida. This resulted in the taxation of advertising revenue based on the amount of advertising that appeared in Florida media, and this arrangement motivated advertisers to use their resources to encourage popular opposition to the tax. The tax became caught up in demagoguery as well as a political campaign before accurate information about the tax was widely disseminated. James Francis, the director of research in the Florida Department of Revenue at the time, identified three lessons for other states wanting to go down this road:
1. The piecemeal approach to service taxation is not the appropriate method because [if it is done piecemeal] the politically toughest but most important measure will likely never be taken;
2. A method must be found to make the self-serving, antitax posture of the media obvious for what it is. One approach would be to tax advertising sales in a separate bill, after a general-service tax has been implemented (p. 877) and accepted by the public; another would be to tax advertising in a different—yet constitutional—manner, such as by denying the deductibility of advertising and promotional expenses for income-tax purposes; and
3. It must be recognized from the outset that the pro-tax coalition must proceed on a consensus basis both before and after enactment.
In other words, Francis stressed the importance of a full expansion, but he also warned proponents to expect opposition and look for ways to neutralize it. He also stressed the importance of building an effective and cohesive coalition that advocates for the change.13
The Massachusetts experience yields related lessons. In July 1990 Massachusetts enacted an expansion to many different enumerated services, including some but not all categories of professional services. The decision to move ahead with the expansion was made in the late spring, so only a quick set of hearings was held before enactment. Like Florida, Massachusetts sought to apportion services consumed by multistate businesses using formulas that attempted to reflect the share consumed in Massachusetts. Both the definitions of the professional services to be taxed and the apportionment effort came immediately under attack. As in Florida, the expansion became an issue in a political campaign, with the end result that the sales tax on services was repealed two days after it went into effect.14
Despite the potential for following Francis's advice and the lessons of Massachusetts to overcome the obstacles to a full expansion to services, no state enacted such a broad expansion after the Florida and Massachusetts attempts. States did not follow Francis's first point, which most felt was not good advice, but instead they have attempted piecemeal or incremental expansions to services—with mixed results. A few were modestly successful. In 2006, New Jersey added roughly a dozen services to its sales-tax base. At the time the state said this would yield more than $400 million in new revenue each year, a 5 percent increase in sales-tax receipts. Arkansas added about fifteen services in 2004 that boosted sales-tax revenue by about 1 percent. By contrast, a revenue-neutral expansion enacted in 2009 in Maine that would have boosted sales-tax revenue about 4.4 percent in exchange for lower income-tax rates was repealed the subsequent year through a “people's veto” ballot measure. (See the discussion below.) Recent expansions in Maryland and Michigan ran into similar opposition and had to be rolled back. And other efforts have been stopped in their tracks by organized opposition to taxing specific services included in expansion packages, such as bowling alleys and yoga instruction.
The popular opposition to expanding sales taxes to encompass services—especially those services primarily purchased by households—is somewhat surprising. The sales tax is routinely found to be the best-liked of all state and local taxes and sales tax-rate increases typically engender far less opposition than other forms of tax increases. The opposition to taxation of services seems to be a bit outside of rational considerations. Why would, for example, relatively well-off residents of (p. 878) the District of Columbia who for many years have paid sales tax on dry cleaning services vehemently object to paying sales taxes on the cost of their yoga lessons?
The obstacles to expanding the sales-tax base are political rather than substantive, and it is critical to find ways to overcome these obstacles. The sales tax must be modernized to reflect today's economy if it is to survive as one of the two major sources of revenue for states and as an important revenue source for localities in many states. It also has to be modernized to prevent the decline of sales-tax revenue from substantially lagging economic growth. But it has become obvious that an expansion to cover services will not sell itself to the public or businesses. It is not enough to write an expansion into a governor's budget or into a piece of legislation. There are a number of ways that an incremental, yet broad expansion of the sales tax to services—as well as other reforms—could be given a greater chance for success. Using more modern and intense efforts to bring about reform will be discussed below in the section “Modern Methods for Modernization.”
If a straight expansion to encompass more services is not possible, there are some “back-door” methods that in some states could be more appealing, albeit less desirable, than an expansion of the retail sales tax. Services could be taxed at the business level instead of the consumer level through a gross receipts tax or a value-added tax (VAT) that operates as a primary business tax or an alternative corporate income tax. And if the federal government adopts a VAT that ultimately is collected at the retail level, as a variety of experts have suggested will be necessary to sustain federal obligations for the long term (although politically difficult to enact), states would likely have an opportunity to piggyback on the broad base of a federal VAT either in place of or in addition to their own sales taxes.15
Taxing Remote Sales
The other major sales-tax problem is the inability of states to tax most remote sales, that is, sales that are made to state residents through the Internet or from a catalog from sellers that do not have nexus (a physical presence) in the state. The tax on such purchases that legally is due is known as the “use tax”—a tax on purchases from out of state that are brought into the state for use. While use taxes are legally due from state residents who purchase goods in this way, they are extremely hard to collect effectively from individuals. Estimates suggest that states and localities will lose about $23 billion in 2012 from the inability to collect these taxes.16
There are two streams of effort moving to remedy this problem that costs states billions of dollars in lost revenue each year. One is the Simplified Sales Tax Project (SSTP). It was started in 1999 to encourage states to simplify and harmonize their sales taxes, because the two Supreme Court decisions that excused remote sellers from the duty to collect the taxes (made in 1967 and 1992, before the Internet age) cited the complexity of the many rates and bases around the country as the major reason that states could not require remote retailers to collect and remit the tax. By early 2010, twenty states were full members of the project: they have enacted sales-tax revisions that meet the project's criteria, and the committee of states is working (p. 879) through a number of thorny issues that have deterred other states, including large states like California, Florida, New York, and Texas, from joining.17 The premise of the project is that simplification will either encourage remote retailers to voluntarily collect and remit taxes, or it will result in Congress enacting a law that overrides the Supreme Court decision. Legislation to that effect was introduced in Congress in 2010, but prospects for enactment are uncertain.
Another thread is also moving forward on taxing remote sales. A number of states are taking individual action to compel payment of the taxes. In 2008, New York State enacted a law that expands the interpretation of “nexus” to include companies that use in-state businesses—affiliates—to promote sales and thus increase the number of companies required to collect and remit sales taxes.18 Rhode Island and North Carolina enacted similar laws in 2009. In 2010, Colorado enacted a law that requires all remote sellers that do not collect and remit sales taxes to notify their Colorado customers that they may owe sales tax on their purchases, and also to tell the state each year the total dollar value of items purchased by each purchaser—which should result in far greater payment of use taxes owed by residents. The lists provided to Colorado by the online retailers would theoretically allow the state to send bills to their residents for the taxes due.
With efforts moving forward on so many fronts, it is likely that this problem ultimately will be solved. Because the volume of remote sales is likely to continue growing each year for the foreseeable future, the states' ability to collect these taxes is important to maintaining a revenue growth rate that can sustain necessary expenditures.
Personal Income Tax
The personal income tax is important because maintaining a strong income tax is the best way a state can improve the overall growth of its revenues to match the necessary growth of its expenditures. State personal income taxes, no matter what their design, generally grow more rapidly relative to economic growth in good economic times than sales and excise taxes or other types of state revenues. Progressive income taxes, with graduated rates, grow more strongly than flat-rate or nearly flat-rate taxes.
Some theorists and policymakers are concerned because a progressive income tax both grows more rapidly in good economic times and declines more rapidly during recessions (although the rate of decline arguably depends on what types of income are hardest hit in a recession: wages or investment income). While a decline during a recession is an issue, it can be handled outside of the income tax itself by maintaining more adequate rainy-day funds and other measures. Without a strong income tax, most states will continue to experience total revenues that grow more slowly than the economy, be susceptible to developing structural deficits, and will not be able to meet obligations in health care, education, and other areas in the future.
The prospects for incremental reform of the personal income tax are mixed. While there is pressure to improve income taxes in states that have them and adopt (p. 880) them in states that do not, there also is pressure from the political right to eliminate state income taxes and rely entirely on consumption taxes to support what inevitably would have to be a much lower level of services.19 Nevertheless, reform seems likely in some areas.
One potential area for reform of the income tax is curbing tax expenditures. In most states, personal income tax revenue, and potentially revenue growth, is eroded by tax expenditures of varying kinds that rarely are reexamined. Although most states produce tax-expenditure reports or budgets, most also are far from comprehensive and have lacked the information needed by policymakers to make informed judgments about whether tax expenditures are worthwhile. During the Great Recession, states showed renewed interest in examining the value of their tax expenditures. The large federal deficits are also provoking interest in this issue at the federal level; because most states key their personal income-tax provisions to the federal code, reductions of federal tax expenditures could also improve state revenues. One area of state personal income-tax expenditures that merits particular scrutiny is the tendency of states to provide large nonmeans-tested tax breaks to retirees and senior citizens; as the population ages, these will become increasingly unaffordable. Another is the myriad of tax breaks of unexamined and doubtful efficacy that states provide to businesses, some of which are structured as entities that pay personal rather than corporate income tax. Other tax expenditures are peculiar to a small number of states, such as allowing a deduction for federal taxes paid.
States lacking income taxes may or may not consider enacting them within the next decade. There are nine states that lack a broad personal income tax, including the very large states of Florida and Texas as well as Alaska, New Hampshire, Nevada, South Dakota, Tennessee (which has a tax on dividend and interest income only), Washington, and Wyoming. While some of these states are likely never to adopt an income tax, the odds are reasonable that at least New Hampshire and Washington will do so sometime in the next decade. These states are having significant difficulty managing their responsibilities absent an income tax and some important forces within these states are discussing the possibility of adopting an income tax of some sort. In November 2010, citizens in Washington State voted down an initiative that would have created an income tax solely levied on high earners, with rates ranging from 5 percent on residents with incomes exceeding $200,000 for individuals and $400,000 for joint filers to 9 percent on individuals with incomes above $500,000 and joint filers with incomes above $1 million.20 Nevertheless, it is possible, and perhaps likely, that a proposal with more modest rates and the ability to deduct certain items could gain acceptance in the not-too-distant future.
Another potential area is rate reform. There are seven other states that levy their income tax at a flat rate, and several additional states in which the value of the brackets has eroded over so many years that the impact of their tax resembles a flat-rate tax. Improving the rate structure would seem to be an easy way to increase the growth of revenues, but like expanding the sales tax to services it has been difficult to achieve. Such a change would require a constitutional amendment in some flat-rate states such as Illinois and Pennsylvania. The long-standing fiscal (p. 881) problems in Illinois that were exacerbated and became all too obvious during the Great Recession suggest that Illinois may ultimately change its tax structure in this way, despite the difficulty of amending its constitution. Connecticut changed its nearly flat-rate structure to a graduated tax in 2009, suggesting that such a change may be possible in some states—but again this would require the lead time and intense preparation and education activities described below.
Property-tax revenue is less tied to the rate of economic growth than is the sales tax or the personal income tax. In normal economic times, the growth rate of property-tax revenue depends on the rate of growth of the value of existing homes, the rate of growth of new home construction and purchases, and a property-tax rate that is set either locally or statewide. The assessed value of property and/or the tax rate is subject to various constraints in different states, as discussed below. Where flexible, rates applied to assessed values may be set at levels that offset either significant increases or decreases in property valuation, depending on the amounts needed to balance the jurisdiction's budget, thereby controlling the rate of growth in property-tax revenues. In addition, housing values may or may not decline during economic downturns. In the 2001 recession, housing values remained stable or were growing. But housing values dropped precipitously in the 2008–2010 recession, especially in states such as Arizona, Nevada, and Florida, in which a particularly large real estate bubble burst. In other words, the property tax reacts to a different set of variables than economically sensitive taxes such as the sales tax or the income tax.
In theory, property-tax revenues could always grow in tandem with economic growth, assuming that property values are growing with the economy, if tax rates could always be adjusted to allow that to occur. A significant number of states, however, have constitutional or statutory limits on assessment growth, on tax rates, or on annual growth of property-tax revenues. Many if not most of these limits were adopted following periods in which there was rapid growth in property values and rates were not adjusted downward; therefore, property-tax revenues—as well as homeowners' property-tax bills—grew rapidly. Now, however, many limits hold the growth in property-tax revenues below the rate of growth of the economy in normal years, making it very difficult to maintain schools and other local government services that rely on property taxes for support. For example, limits in at least seven states allow for only 3 percent nominal annual growth or less in property-tax revenue, and other states have related limits on assessments or rates that may produce the same result.21
In states that do not already have limits, and in states in which limits allow for property-tax revenue to grow reasonably along with economic growth, it is important to avoid adoption of limits or tightening of existing limits. Arguably, the best way to do that is to provide a property-tax relief regime that prevents homeowners' and renters' property-tax bills from becoming unaffordable; it is particularly important to protect groups that are highly sensitive to property taxes, such as low-income residents and elderly residents on fixed incomes. (p. 882)
States have experimented over time with a lot of different types of property-tax relief schemes. There are homestead exemptions that exempt the first specified amount of a property's value from taxation for owner-occupied homes; since these are first dollar exemptions, they do not address the growth in property taxes. There are also a variety of state-financed property-tax credits. Some of these require homeowners (and sometimes renters) to apply for the credit on a standalone form, while others may be claimed on the state income-tax forms. Each of these methods has a drawback. The participation rate is relatively low if residents are required to submit a special form to claim their credit. For example, a 2006 analysis found that only 41 percent of eligible Maine residents applied for the state's circuit breaker when the state required a special form. Participation tends to be higher for credits claimed as part of the income tax, but residents often do not associate the income-tax credit with their property-tax bills but rather view it as a reduction in their income taxes.22
Vermont is one state that has moved toward solving this conundrum. As a number of states do, Vermont provides “circuit-breaker” property-tax relief, that is, property-tax relief that is related to the income of the homeowner or renter. In its purest form, a circuit breaker prevents property tax from exceeding a specified percentage of a homeowner's or a renter's income; this arguably is the most effective form of property-tax relief.23 In Vermont, homeowners may be eligible for property-tax relief if their income is below $97,000 a year, depending on a home's value. (Renters with incomes below $47,000 may claim rebates.) A special form must be filed to claim the credit, which may be filed either with state income-tax forms or separate from them. What is unique about Vermont's program, however, is that the credit is paid to the town in which the homeowner lives, rather than to the homeowner. The town then directly reduces the homeowner's property-tax bill by the amount of the credit. The intention is to ensure that residents connect the property-tax relief with their property-tax bill, then reliably reap the benefit. Although there has been no formal evaluation, the general sense is that the connection has been strengthened in residents' perceptions. This is a promising direction other states may want to consider.
Experience with Reform: Keep it Simple and Be Prepared
There have been very few successful state-tax reforms in recent years that have addressed the issues of modernization of tax systems and improving revenue growth rates to alleviate structural deficits. Some that have been enacted, such as in Louisiana and Maine, have subsequently been partially or fully repealed. And (p. 883) a number of efforts in other states have failed. Some important lessons may be drawn from these experiences.
Louisiana. In November 2002 Louisiana voters approved the “Stelly Plan” that eliminated sales taxes on necessities (groceries, prescription drugs, utilities) and raised the individual income-tax rates. The plan was designed to be “revenue neutral,” but it was understood that the income tax in Louisiana grows more rapidly than other taxes relative to economic growth, and so long-term improvement in revenue growth was expected. Despite the voter adoption of the Stelly Plan (by a narrow margin) and estimates that it would leave unchanged or reduce the taxes of 87 percent of single filers, 92 percent of heads of households, and 74 percent of joint filers, it remained something of an unpopular “whipping boy” in the state's political process. Because it is difficult for individuals to perceive how much less sales tax they pay in a year but they can see the increase in their income-tax liability, many middle-class taxpayers were convinced (probably erroneously) that their taxes had increased under Stelly. In 2008, the Stelly income-tax increases were repealed.
Maine. In June 2009 the Maine Legislature passed a bill, which the governor signed, that would change the state's income-tax, sales-tax, and property-tax relief program. As in Louisiana, this reform was designed to be revenue neutral. But in something of a mirror image of Louisiana's Stelly, the Maine plan lowered income taxes for what was claimed to be 95.6 percent of Maine households, and the state made up the funds by extending the sales tax to more services such as installation, repair, and maintenance services; transportation and courier services; personal property services; and amusement, entertainment, and recreation services. It also increased the sales tax on prepared food, lodging, and car rentals—an effort to “export” a portion of the increased taxes to tourists. Estimates suggest that the combined result would have been a tax reduction for 87 percent of the state's households.24 Nevertheless, sufficient petition signatures were submitted to put a “People's Veto” of this reform on the June 2010 ballot. The reform was repealed by an approximately 60 percent to 40 percent vote without ever having taken effect. Those who urged repeal argued that it was a tax increase on average-income Mainers and a tax cut for the wealthy—a position not supported by the analysis but which evidently sounded plausible for a tax-reform plan that had several moving pieces.
Other States. The efforts of Florida, Massachusetts, Michigan, and Maryland to expand the sales-tax base to services were mentioned above. In addition, it should be noted that there was a small trend between 2006 and 2008 to “swap” property taxes for sales taxes; Idaho, South Carolina, and Texas increased their state sales taxes in order to eliminate some property taxes that supported schools. Michigan did a similar, more complicated swap in 1993. Far from helping to solve structural deficit problems, however, the state revenues in each case fell short of the amount of property taxes foregone—in part because of the slower growth of sales-tax revenues (and in Michigan's case also cigarette-tax revenues) than the property tax it replaced. Nevertheless, the swaps were acceptable to the voters (who were told future revenues would be adequate). The ability to make such swaps may just reflect the preference of voters for sales taxes over property taxes and not have (p. 884) much bearing on the ability to reform taxes in ways that reduce or eliminate structural deficits.
Modern Methods for Modernization
Just as revenue systems around the country need to be modernized to be viable in the twenty-first century, perhaps so do the methods by which reforms are proposed and supported. The following are five principles that could improve the prospects for reforms to succeed.
First, it is important to keep the reform simple. As much as policy analysts or state officials might understand that it is good policy to trade-off certain types of taxes for others, the electorate is very skeptical of that approach (with the exception of swapping sales taxes for property taxes, of which the public should be more suspicious than they are). As in the examples above, the evidence suggests that people tend to believe that a complicated reform cannot be good for them—no matter what the facts of the situation are.
Second, reform efforts should be better prepared and less ad hoc. It has been all too common for a legislature to slip in a modest expansion of the sales-tax base in the final effort to fill a revenue gap and balance a budget. This usually triggers an immediate attack by the affected industries and thus allows negative publicity to get ahead of clear public explanations of the need for the policy, discussion of alternatives, or negotiations about what is or is not included. This occurred in the District of Columbia in 2010, when a huge outcry by yoga studio patrons—arguably people who could afford an extra dollar per lesson—derailed an end-of-budget negotiations proposal.25 Policymakers should attempt to get buy-in from affected industries, if possible, before introducing related legislation.
Third, reform efforts should be treated more like a campaign. Reform efforts could begin with focus groups and polling to determine, for example, how people perceive expansions to services, what bothers them, what services are “out of bounds” in the minds of the electorate, and how best to discuss such issues. For example, the equity arguments of taxing lawn services as well as lawn mowers seem obvious to policymakers; it is important to know why it often is rejected by a public that generally approves of sales taxes. Similarly, modern, sophisticated opinion research could help policymakers understand why people who often claim on polls to be in favor of more heavily taxing higher-income households balk when it comes to actually changing the state income tax—and what combination of provisions could make a change acceptable. It has not been successful for policy wonks or politicians to sit in a room and design a reform. Care also needs to be taken to ensure that catering to constituencies doesn't undermine the purpose of the reform.
Fourth, once a plan is tested and decided on, the campaign mode needs to continue through the public education and messaging phase. A reform needs to be more than just incorporated into a proposed executive budget or piece of legislation. A prior step would be to communicate the proposal and its justification (p. 885) through all the modern ways people receive information, give feedback, and participate in discussions—including social media.
Campaign tactics are much more likely to be used in states in which the reform is being proposed as a ballot measure. The recent failure of the TABOR proposals in the four states in which they reached the ballot (twice in Maine, and once each in Nebraska, Oregon, and Washington) and the successful tax increase on the ballot in Oregon suggest that using solid campaign tactics can make the difference. But using the campaign mode should not be limited just to ballot measures. It is also important to use these methods if the legislature is going to be considering a reform—something that almost never is done.
It is particularly important to use a campaign to connect the revenues under consideration to the services that people value. Often this is a connection that is difficult for the electorate to grasp, and public education can play an important role in highlighting it. Interestingly, in the successful “people's veto” of Maine's enacted reform (described above), the forces attempting to preserve the reform framed it as a tax cut rather than as a way to maintain or improve public services in the long run.
Fifth, and finally, it may be necessary to have some level of regional coordination. A proposed expansion of the sales tax to services or other reforms often engender fears of revenue leakage over borders or even fears (usually unjustified) of out-migration. A reform effort should be cognizant of what is happening in neighboring states. Ideally, similar or parallel campaigns should be run in several states at once. Nonprofits, advocates, or other organizations outside of the government in neighboring states may be possible partners for encouraging and facilitating this type of coordination.
Preventing Structural Deficits
Structural deficits can develop or deepen when recurring expenditures are increased without adequate revenues that grow in tandem with the expenditures they support. Deficits also can develop or deepen when taxes or other revenues are cut below the level needed to support expenditures, or when the design or mix of taxes is changed in a way that reduces the growth rate of total revenues without also reducing the level or growth rate of expenditures. Improved budget practices could provide a warning to policymakers and the public when proposed actions are likely to create or deepen budget problems over the long term and, thereby, allow independent watchdogs and the media to make that information widely known.
Most of the potential improvements briefly discussed below are used by some states but are by no means universally adopted. Reforming these processes may be a fruitful way for states to begin reforming their budgets and taxes, because the (p. 886) process changes do not necessarily upset specific constituencies to an extent that would engender concerted or organized opposition—as some of the policy changes inevitably do. In addition, a new idea for budget control that is not yet used by any state is suggested.
A change in a spending program, or in the tax code, is sometimes designed in such a way that it has a modest budget impact in the initial year or biennium, but then has a much larger one in subsequent years. Policymakers routinely engage in this type of backloading in order to squeeze their initiatives into annual or biennial balanced-budget requirements, leaving to subsequent governors and legislatures the problem of how to balance future budgets.
If states provide budget data only for the immediate budget period, and/or limit their fiscal-impact estimates to that period, it is difficult to detect these tactics or to gauge whether those future impacts are affordable. Thus, little consideration typically is given to longer-term implications of the policy changes.
According to the National Association of State Budget Officers, about fourteen states provide budget data that extend four years beyond the current budget cycle.26 As described below, however, many of these states fail to base those budgets on meaningful out-year forecasts. At the other extreme, about eighteen states consider only the current budget cycle or one additional year beyond. Ideally, states should include a review of a five-year period in their budgets.
Multiyear budgeting will not accomplish its purpose if projections are not done properly. Expenditures should be projected based on “current services” or a “baseline” analysis.
A current services analysis tells us how much it will cost to continue existing policies and programs—the current level of state services and benefits—in future years. In such an analysis, current-year spending is projected forward, based on expected changes in the number of people requiring those services and benefits, and on expected changes in the per-person cost. Costs typically are adjusted by some measure of price inflation, often with special indices used to project increases in costs, such as in the case of health-care costs. The federal Congressional Budget Office projects future costs in this way.
A current services analysis creates a baseline of what it would cost to continue the government as it is, given existing programs and revenue policies. It does not commit the state to continue all programs and benefits; it just provides an accurate base on which to consider whatever changes are desired. (p. 887)
Only thirteen states and DC use current services budgeting. 27 To the extent that the other states do multiyear projections, they tend to assume nominal expenditures will stay constant. Thus their multiyear projections are not realistic pictures of the future health of the state. Less than a handful of states, including Connecticut and Pennsylvania, prepare detailed multiyear budgets on a current services basis as a regular part of their budgets, although a few others such as Louisiana and Kansas do so at a summary level.
Most states project the revenue side of their budgets based on economic forecasts. States generally have some type of in-house forecasting model—in some cases it is a complex micro-simulation model—either under control of the governor's budget office or the legislative fiscal office. In some states, both the legislative and the executive branches have the capacity to do revenue forecasts, and the dueling forecasts sometimes become a debating point in the political process. This has been fairly common in New York, for example.
Other states have sought to insulate the revenue-forecasting process and have created a council made up of economists and other outsiders that create the revenue forecasts. In states such as Florida that follow this approach, the forecast generally is accepted by all parties to the budget debate. Slightly fewer than half the states use a consensus-forecasting process, in which representatives from the executive and legislative branches—usually aided by testimony and advice from outside economists and advisors—are required to agree on an economic and revenue forecast. Some other states rely on a board of economists to prepare the forecasts.28 Arguably, these are the preferable process by which revenue forecasts should be done, because it reduces the incentive among all parties to “pick-and-choose” to select the most favorable forecast.
Fiscal Notes and Legislative Fiscal Offices
Policymakers and the public need good tools to evaluate proposed changes in budgets and taxation. An important tool is a fiscal note, which is a document that accompanies a piece of legislation and explains how much the legislation will cost or save.
States vary in the degree to which they require fiscal notes, the agency that is responsible for preparing them, and the thoroughness of the information presented. Some states require fiscal notes only for the initial introduction of a bill, while others require revised notes as bills are amended and move through the legislative process. States also differ in the number of years for which the fiscal note estimates budgetary impact; as is the case for proposed budgets, fiscal notes should (p. 888) include projections over the next five years. The best fiscal notes also provide other data, such as who will benefit (or lose) from a proposal and its impacts on local governments.
Fiscal notes may be prepared by the governor's budget office, by a partisan legislative entity (that is, staff employed by the majority part in the legislature), or by a nonpartisan legislative fiscal office. Obviously, only the latter source can generally be depended on to be fully free of political slant. Legislative fiscal offices (either partisan or nonpartisan) also are more accessible to legislators wanting to have an analysis done before proposing legislation.
Legislative fiscal offices also perform other important analytic functions, often looking at the effectiveness and cost of policies in a broader context than at individual pieces of legislation, and typically providing an independent analysis of the executive's proposed budget. Nevertheless, a good legislative fiscal office is only one more voice in the policy process, and by itself it is no guarantee of improved policies. For example, California and Illinois both have good nonpartisan legislative fiscal offices. But California's and Illinois's budget practices are far from exemplary; both states have large, ongoing structural deficits—as does the federal government despite high-quality forecasts by the Congressional Budget Office.
Tax Expenditure Scrutiny
“Tax expenditure” is the term for tax breaks that function more or less similarly to on-budget spending. For example, a state can provide grants or vouchers to low-income working parents to help them afford child care, or it can provide child-care tax credits through its income tax. Many states do both. The goals are roughly similar, but the beneficiaries of the vouchers tend to be low-income residents while the beneficiaries of the tax credit tend to be middle- or upper-income residents. Similarly, many states provide income-tax or sales-tax breaks to businesses that engage in certain types of activities, make investments, or hire workers, as an alternative to on-budget grant programs for which businesses meeting certain criteria can apply.
When these and similar types of subsidies are part of the annual or biennial budget, they tend to receive some level of scrutiny. Especially in periods of fiscal stress when states are searching for ways to cut spending, there is likely to be discussion over whether subsidies in the form of cash outlays are efficient and effective. When the subsidies are provided through the tax code, however, that type of scrutiny rarely takes place; even when deficits develop and budgets are cut “across the board,” tax expenditures are exempted from the cuts. Moreover, unlike direct spending, tax expenditures typically are uncapped; if the cost of a tax expenditure exceeds expectations, there is no automatic mechanism to stop the revenue loss. Structural deficits may deepen if tax expenditures continue to grow rapidly when revenues are growing only slowly or declining in an economic downturn. (p. 889)
Some states do not even know how much they “spend” in terms of foregone revenues through preferences in the tax code. Eight states do not prepare tax-expenditure budgets or reports, and the reports of a number of others contain minimal information.29 Very few states make a serious effort at evaluating the effectiveness of their tax expenditures. And no state, not even one that may produce a tax-expenditure budget at the same time as its regular budget, treats tax expenditures in a manner comparable to on-budget spending. That is, no state decides at budget time whether to “re-appropriate” its tax-expenditure line items as it does for its on-budget spending line items, nor has any state included tax expenditures when it has cut expenditures “across the board.”
States could improve their tax-expenditure reporting by including information about the cost of the tax expenditure, the type of recipients, and evidence about outputs and outcomes similar to those that should be available for on-budget expenditures. States should also have formal mechanisms to review all tax expenditures periodically and to determine whether or not each of them makes sense to continue.
Finally, avoiding structural deficits may require a way to utilize these substantive budget process reforms within the political budget process.
For the last several decades, activists and analysts have sought a budget control mechanism that will prevent irresponsible state budget policies from prevailing—and creating structural deficits—and encourage responsible budget choices. This concern has resulted in the adoption over the years of tax and expenditure limitations (TELs) of varying kinds in some states, the most stringent of which is TABOR in Colorado. Even though many recent attempts in this area have failed, there still is lots of discussion and continuing efforts toward adopting such limits. This desire for tighter budget control also has led a number of states to adopt supermajority requirements, term limits, and similar policies. The tightest constitutional TELs have ratcheted down expenditures and service provision. But they have not resulted in a desirable form of responsible budget policies that prioritize budgetary expenditures, tax expenditures, and revenue policy in a way that best provides for the needs of state residents. And supermajority requirements in California have famously brought the state to a complete and dysfunctional budget impasse.30
A better alternative may be a PAYGO (or pay-as-you-go) system for individual pieces of legislation, similar to that which the federal government successfully used in the 1990s and which has recently been reenacted.31 Under PAYGO, any proposal or legislation that would increase spending or reduce taxes above the current services baseline would have to be offset by a cut in another program or an increase in a revenue source. (p. 890)
• When PAYGO was being seriously adhered to by the federal government in the 1990s, it was very effective in holding down deficits. One important advantage of the federal PAYGO was that it made Congress more likely to scrutinize tax expenditures (the special breaks in the tax code) to come up with “offsets” to help pay for tax cuts or spending increases. So a desired spending increase may be paired with a reduction or elimination of a special-interest tax break. In the absence of PAYGO, such tax-expenditure programs delivered through the tax code rarely receive attention or scrutiny, as discussed above.
• The bigger advantage is that applying PAYGO to each appropriation or tax change does not usurp the authority of the legislature in the way that a formula in a TEL or a supermajority requirement does, and so it does not rob policymakers of the flexibility needed to properly run a state. It also makes the legislative proponent of each expenditure increase or tax cut responsible for the consequences of its actions.
• PAYGO does not prevent program expansions or tax reductions—or the needed restructuring of revenue sources. It just ensures that they are enacted and implemented in a fiscally responsible manner.
No state has tried such a PAYGO-style budget-control mechanism to date. Obviously, this could only be implemented in states that do baseline or current services budgeting, quality revenue forecasts, and multiyear budgets. It is an idea worth trying.
The structural revenue problems of states, exacerbated by cyclical downturns, are likely to lead over time to reduced levels of public services—unless reforms are enacted. But there is no need to say that the future has to be one in which public services cannot be afforded. And the idea that there will be some radical change in the way states finance services is also improbable. Instead, the problems behind structural deficits can be specifically identified and remedied.
While there is strong evidence that the public does not desire fewer or lower-quality public services, it also is becoming common wisdom that the necessary reforms to pay for them are so unpopular as to be impossible to achieve. The common wisdom, however, appears to be based on an incorrect interpretation of the history of fiscal reform efforts. Arguably, it is not a reform per se that is the problem but rather the way it has been undertaken. Just as tax systems are in urgent need of modernization, so too are the methods through which reforms are sought in need of modernization. Keeping reforms simple, conducting adequate preparation and (p. 891) consultations before reforms are introduced, and using modern methods of opinion research and updated modes of communication can all enhance the probability of a proposal's success.
Finally, state budget processes also need to be modernized to prevent structural deficits from developing or deepening. Attempts to simply limit overall spending or revenues through rigid formulas and severe caps can distort the budget-making process and cause a damaging loss of flexibility. Multiyear budgeting techniques that carefully and clearly cost-out programs, and display the effects of changes in tax policy as well as direct spending totals, can help avoid long-term mismatches of revenues and expenditures that deepen structural problems. States should also consider the more novel PAYGO approach of balancing changes in expenditures with changes in revenues within the rubric of an overall balanced operating budget.
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(1) States have been more willing to experiment with social policy, such as welfare reform or health-care reform, than with tax policy.
(2) The concentration of this chapter on structural problems of long-term adequacy is not intended to minimize the importance of other structural issues, such as the equity of revenue systems, that are outside of its scope.
(6) The Census projects that the ratio of adults aged twenty-five to sixty-and to children aged six to seventeen will decline from 1.5 in 2010 to 1.4 in 2030. US Census Bureau, Population Division (2008).
(8) There is a growing debate over whether pensions and retiree health benefits for teachers are too high and could be reduced. Most changes in those areas, particularly in pensions, would have little impact over the next decade or two because pensions for current workers are largely protected by state constitutions and case law. Some savings could be made by changing retiree health benefits, which are not so protected in most states. There is a question, however, about whether states and localities would have to increase current compensation if they decreased deferred compensation in order to attract good teachers.
(12) National Bellas Hess v. Department of Revenue, 386 US (1967): Quill Corp. v. North Dakota, 504 US 298 (1992).
(15) A federal VAT potentially could, however, have some negative effects on state and local revenues. In particular, a federal consumption tax could compete with state and local retail sales taxes, making it difficult to raise sales taxes when necessary. In addition, should a state desire to piggy-back on a federal VAT rather than levy its own retail sales tax, there would be significant complexity involved in coordinating the federal and state VAT, particularly with respect to local government sales taxes.
(16) Recent estimates of the revenue loss were presented at a July 13, 2010, meeting of the Streamlined Sales Tax Governing Board. William Fox, University of Tennessee Professor of Business and one of the leading experts on this issue, found that in 2012 states will lose $11.4 billion in sales tax on purchases made on the Internet. Lorrie Brown, an economist with the Washington State Department of Revenue, estimated that the revenue loss from uncollected taxes on catalog and other non-Internet remote sales to be an additional 11.8 billion in the same year—for a total loss from all remote sales at $23 billion.
(17) Streamlined Sales Tax Governing Board, Inc., http://www.streamlinedsalestax.org/index.php?page=faqs and https://www.sstregister.org/sellers/SellerFAQs.Aspx
(24) Dan Coyne, “Tax Reform Delivers Benefits to Maine Households,” Maine Center for Economic Policy, April 19, 2010.
(30) In November 2010 California voters approved Proposition 25, a ballot initiative that eliminates the supermajority requirement for enacting a budget. At the same time, it approved Proposition 26, which extended the supermajority requirement for raising taxes to include increases in certain fees. It also changed the definition of revenue measures for which a supermajority is required. Previously, a supermajority was required for any legislation that resulted in a net increase in taxes. Under the new law, a supermajority is required to approve any measure that would increase taxes on any single taxpayer in California, even if the tax package as a whole is revenue neutral. The retention and tightening of the supermajority requirement to raise taxes and fees will continue to hamper the ability of the legislature to reach budget solutions and is likely to result in continuing gridlock. See California Budget Project, Proposition 26: Should State and Local Governments Be Required to Meet Higher Voting Thresholds to Raise Revenues? September 2010, http://www.cbp.org/pdfs/2010/100922_Proposition_%2026.pdf.