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States Scramble to Fill the Tax Gap

Revenue is falling short, and states that rely on sales taxes get stung especially hard.

Last year, every taxpayer got a rebate from Uncle Sam. This year, budget-strapped states may take some of it back.

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As the economy has slumped, state tax revenues have shrunk, sending legislators scrambling to bridge the budget gap. "You can argue that it is worse right now than even the peak of the recession in '92" in terms of both the size of state budget shortfalls and the number of states cutting their budgets, says Raymond Scheppach, executive director of the National Governors Association.

To make up the difference, state legislators have been tapping into rainy-day funds and rolling back spending. But that may not be enough for those hit especially hard by the recession. Some will have little choice but to hike sales taxes, or to slap additional levies on cigarettes and alcohol. In a couple of states, unlucky taxpayers face the prospect of paying higher income taxes next year.

The Road to the Poorhouse

The situation is an unhappy turnaround from a couple of years ago, when surpluses were common. State tax revenue grew by an expansive 8% in 2000 and 6.5% in 2001. As their coffers grew fat, state legislators around the nation approved generous tax cuts. For seven years running, states enacted tax reductions amounting to $35 billion, according to the National Conference of State Legislatures.

In 2001 alone, 20 states cut personal income taxes, while 12 reduced taxes on business. "Some legislatures and governors tried to make political capital by giving tax rebates, usually property tax- or sales tax-based," says John Logan, senior tax analyst for CCH, a provider of tax law information and software. "Lots of states, more or less, spent their surpluses."

States Cut Taxes in Fat Years
But now come the lean ones

Then in fiscal 2001 (for most states, that's the year ending June 30, 2001), revenues started to fall in line with the slowing economy. Since then, personal income taxes have dropped as layoffs gained momentum, while the value of taxpayers' stocks and bonds has shrunk, reducing taxable capital gains. Taxes on business have dwindled, too: Corporate profits in the current fiscal year are expected to total $750 billion, compared with nearly $900 billion in 2000.

At the same time, states are now grappling with longer-term problems that were camouflaged by years of heady growth in the '90s. Though economic growth now comes from the service sector, states draw most of their corporate taxes from a dwindling manufacturing base. Plus, they're contending with an expensive surge in Medicaid costs, which jumped 14% in 2001.

And while a few signs suggest the U.S. economy may be picking up, states still wouldn't see any benefits for months to come. Their finances tend to lag the broader economy by a year or more. "Next year will probably be the worst for state budgets," predicts Scheppach.

In short, many states now find themselves in a nasty financial fix. As of November, 43 reported that revenue was coming in below forecasts they made last summer. Since all but one state requires a balanced budget, that means politicians are facing some unpleasant choices.

Closing the Budget Gap

Faced with a shortfall, lawmakers have first turned to reserves to make up the difference. For the current fiscal year (which started in July), 10 states have drawn money from rainy-day funds made up of excess revenue they set aside in years of prosperity. Kentucky plans to use half its rainy-day fund, or $120 million, to balance its budget. Michigan will draw on $155 million from its fund.

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A few states have tapped into tobacco settlement funds to bolster revenue. Still more states have already cut their budgets, while seeking to spare popular areas such as education and health care.

But in light of the crunch, those short-term fixes may not be enough. In a sign of what's to come, a dozen states approved tax or fee hikes for the current budget year. Others are likely to reluctantly pursue more tax increases because the situation is expected to get worse before it gets better.

Already, lawmakers are hewing to a time-honored fiscal canon: Tax the morally dubious first. Nineteen states are mulling proposals to raise taxes on cigarettes. Maine, Rhode Island, West Virginia and Wisconsin have recently slapped new taxes on cigarettes and tobacco, while Arkansas adopted a new tax on beer. Currently, Alaskan legislators are considering a bill to boost the tax on alcohol by 300%, or 10 cents a drink.

Alaska, which has neither an income nor sales tax, is also looking at a plan to impose a temporary sales tax during the tourist season between May and September.

That idea jibes with another well-worn political strategy: Hike taxes where people won't notice them. Because consumers tend to overlook sales taxes, politicians find it easier to approve increases there. For example, North Carolina recently pushed through a half-percent increase in its sales tax. "That isn't going to be very noticeable unless you're buying a large item like a car," says Logan.

In contrast, lawmakers are typically loath to raise income taxes, though some of the worst-hit states are considering such proposals. Last year North Carolina managed to push through an increase in income taxes that was rendered politically acceptable because it applied to only a narrow slice of high-income earners. And in Indiana, the governor has suggested hiking both income and sales taxes. He has said he'd soften the blow by reducing property taxes (paid to local, not state, authorities) at the same time.

Income tax hikes are notoriously hard to sell, though. When Tennessee legislators broached the idea of rolling out an income tax -- the state currently has no personal income tax -- "there was actually a small-scale riot outside the State House," says Logan.

Still, lawmakers there can't jack up the sales tax much more because the combined rate of state and local sales taxes already totals as much as 8.75% in some areas. "It's becoming increasingly apparent that Tennessee has a systemic problem, not only because of the economy but because the state's so reliant on the sales tax, which is so sensitive and so regressive," Logan says.

Tennessee finds itself in a bind shared by a handful of other states without an income tax: Many rely on a sales tax for revenue dollars, and as a result have been hit especially hard by the economic downturn. States without an income tax include Florida, Nevada, South Dakota, Texas, Washington, Wyoming and Alaska.

Not only does Florida lack a personal income tax, but a major revenue source, tourism, was dealt a blow by the travel slowdown after the terrorist attacks. Now the state is considering a proposal to levy taxes on services such as accounting and advertising.

Mustering Political Support for Tax Hikes

As dire as the picture may be in some states, legislators will find it especially tricky to win support for tax increases this year. Governors' races are getting under way for 36 states, with elections taking place in the fall.

Also, because the last recession prompted a wave of tax hikes, some states have enacted hurdles to make it harder to increase taxes, typically requiring a referendum or two-thirds approval by state legislatures.

As desperate as states may be, they'll raise taxes only as a last resort. And don't expect proposals to go anywhere for another five or six months. Legislators will "try to do as much as possible on the cutting side before they look at taxes," Scheppach says.