Making Sense

State Budget Blues

Looking for Funds in All the Wrong Places

By Marianne Hill

This article is from the November/December 2009 issue of Dollars & Sense: Real World Economics available at

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This article is from the November/December 2009 issue of Dollars & Sense magazine.

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California state budget protest

Protesting budget cuts, Sproul Plaza, UCBerkeley, September 2009. Photo credit: Laura Gilbert,

California’s fiscal woes may have grabbed the national headlines, but states across the nation are slashing budgets to close gaps that are averaging a jaw-dropping 24% this year. Even before the economy nose-dived in late 2008, the Government Accountability Office (GAO) was warning states to expect growing revenue shortfalls over the coming decade. The recession and the staggering increase in the federal debt have worsened the GAO’s predictions.


The Economic Crisis in the States, by Gerald Friedman.

The GAO now estimates that, if programs are maintained at current levels, state and local revenues will fall short by an average of 7.6% annually over the coming decade.

To close the yawning gaps in their budgets, states are currently relying on stimulus funds and budget cuts. But fewer federal funds will be there to help as the country begins to pay down the huge national debt. Experts anticipate that federal dollars going to state programs will be scaled back, with funding levels increasing only in targeted areas such as health care and energy. So shortfalls in state budgets will continue for years to come unless states either enact more cuts or update their antiquated tax systems.

In fact, it is past time to overhaul current tax systems. Neither the federal government nor state and local governments are adequately capturing revenue from the high-income, high-growth segments of the economy. At the same time, lower- and middle-income families are unfairly burdened.

Trends in expenditures account for part of the problem. State and local spending on health care for Medicaid, employees, and retirees is projected to significantly outpace revenues. Federal grants-in-aid, which finance about 20% of state and local budget outlays, are dominated by grants to Medicaid. Half of federal grants-in-aid go to Medicaid and this proportion has been increasing with rising enrollment and the growing cost of health care. By 2012, 60% of grants-in-aid will be going to Medicaid, leaving fewer federal dollars for other programs.

Health care reform that succeeds in reducing the cost of medical services while expanding coverage could improve the states’ budgetary outlook, but the outlook for revenue collections would remain problematic. The major factor is the erosion of state tax bases, particularly of the sales tax, which accounts for about a third of state and local revenues.

The fiscal crisis in the states will have a long-term impact on our quality of life since state and local governments, with federal assistance, provide most of the public services we receive. They employ almost seven times as many people as does the federal government, and state and local expenditures on public services are greater than federal expenditures, if Medicare and military spending are excluded.

The growing demands on the states are not taken into account by the GAO study, by the way, which only considers the cost of maintaining current service levels. The future scenario for state budgets, then, is likely to be more dire than the GAO predicts. Even with health care reform and improvements in revenue collection and program efficiency, the states will need new revenue sources, better aligned with their income bases, to carry out their vital role in the economy.

Traditionally, states have turned to the sales tax when seeking additional funds. The sales tax is the largest single revenue source for state and local budgets, accounting for a third of tax receipts. Statewide sales tax rates range from a low of 0% in the five states with no general sales tax to 7.25% in California. Recent expansions of the sales tax include the increased taxation of services and of Internet sales.

This reliance on the sales tax is increasingly a liability, however, since the most rapidly expanding industries are in services that are often not subject to the sales tax, such as health care, education. and financial services (credit cards, loans, etc.). A few states are now taxing gross receipts of all businesses to capture service industries, but economists are generally appalled: firms with high input costs but low profit margins can be crippled by a tax on receipts rather than on income net of costs.

Personal and corporate incomes, other potential revenue sources, offer an expanding tax base, but increases in exemptions and deductions have cut into taxable income. (Personal income taxes accounted for about 24% of state and local tax receipts, corporate income taxes 5%, and property taxes 30%, in 2007.)

How states raise needed revenues can be as critical as how they are spent. Equity—basing taxes on the ability to pay—is a prime concern: equity aids both revenue collections and the economic well-being of families. It is especially urgent given recent income trends.

Since the 1980s, progress in raising living standards has been hindered both in the states and nationally by rising income inequality. Output per employee more than doubled in the United States from 1960 to 2005, but earnings did not. In fact, real hourly earnings in 2005 were lower than in 1967, after adjusting for inflation.

The picture is very different for those at the top of the corporate ladder. The typical S&P 500 CEO had an income about 42 times as high as that of the average worker in 1980, but now this CEO gets 344 times as much, according to the Institute for Policy Studies. The top 5% of families currently have incomes about 20 times as high as the bottom 20% at present, up from 11 times as high in 1979.

These figures help to explain why the poverty rate in 1988, 1998, and 2008 remained stubbornly at 13%, despite rising average incomes.

Taxes can increase inequality. Sales taxes, for example, absorb a greater percentage of the income of low-income families than of high-income families, and so increase inequality. Figures on federal corporate taxation are especially disturbing for this reason: 30% of U.S. corporations with gross receipts of $50 million or more paid no taxes over the 1998-2005 period, according to the GAO. If smaller corporations are included as well, 65% paid no U.S. corporate income tax.

Corporations also avoid state taxes. The Multistate Tax Commission found that large, multi-state corporations avoided about $7 billion in state corporate taxes, due to such tactics as shifting their reported profits from high-tax states to low-tax states.

To combat such problems, 20-plus states have banded together and use combined reporting. This requires a multi-state corporation to add together the profits of all its subsidiaries, regardless of their location, into one report. The report provides each state with information needed to levy the appropriate tax, based on individual state tax provisions.

Combined reporting also makes it more difficult for companies to avoid reporting income altogether: one study of 252 large corporations found that in 2003 those companies on average failed to include two-thirds of their actual U.S. pretax profits on their state tax returns. The study found, for example, that Wal-Mart reported $77 billion in pretax profits to its shareholders but paid state income taxes on about half that sum.

The National Association of State Budget Officers suggests another reform: monitoring tax breaks offered to corporations. It notes that some states impose a surcharge on tax breaks offered under business incentive programs if the return to the state from these tax breaks is not as great as expected.

Other reforms could improve the states’ revenue outlook. Currently, the personal income tax rate paid by those in the top bracket ranges from Vermont’s 9.5% to zero: there are nine states with no personal income tax. An increase in the number of brackets and in rates could boost revenues, while increasing basic exemptions at the same time would protect middle-income families. The tax break on capital gains should be examined.

There are nontraditional means of raising funds as well. For example, penalties and fines for fraud and violations of labor and environmental regulations can be imposed or increased. A carbon emissions tax could be a major revenue source.

Stable, equitable revenue sources are found when taxes are levied in line with the distribution of income and wealth in a state. Taxes like the sales tax that push low-income families further into poverty don’t make sense when alternative revenue sources are available that are both more lucrative and more equitable. It is time to look to these sources to close shortfalls in state and local budgets.

Marianne Hill, Ph.D., has published articles in the Journal of Human Development, Feminist Economics, and other economics journals. She also writes for the American Forum and the Mississippi Forum.

Sources: Center for Budget and Policy Priorities; Citizens for Tax Justice; Economic Policy Institute, Institute on Taxation and Economic Policy, State of Working America 2007; Economic Report of the President 2008; Federation of Tax Administrators; GAO documents GAO-09-210T, GAO-08-957 and GAO-07-1080SP.

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