Revenue Revisions

States and localities should use the current fiscal trauma to adjust and amend the ways they raise money.
January 1, 2009 AT 3:00 AM
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

The deepening recession and its powerful downdraft on state and local economies is causing widespread fiscal misery. Already eroded by the depression in the housing markets that started two years ago, state and local revenues have been on a downward spiral, and the prospects are that that pace will accelerate. Hopes for a recovery anytime soon have faded, as consumer spending is dropping sharply and unemployment is sure to keep rising during the next few quarters.

Efforts are being made to cushion the blow on state and local finances and to prop up their spending in the coming months. But that assistance is short-term relief. The cost of a hugely growing federal deficit cannot be overlooked and that, in itself, soon will limit the power of the federal government to bail out almost anybody other than itself.

This recessionary period and the subsequent efforts to restore some balance and growth in the economy will be painful at all levels of government. The deeper issue is whether fiscal trauma will lead to some long-avoided (and now essential) restructuring of the broader national economy and, specifically, reforms in governmental finance.

Good things can happen if we start applying legendary American "know-how" to the problems of state and local finance. Let us consider the revenue side of the ledger.

First up, the sales tax. Originally, state sales taxes were broad in coverage with low tax rates. Over the years, the tax was butchered by endless exemptions, such as groceries, clothing and medical items. Today, the sales tax continues to exempt most services, where, of course, there is the most growth in the economy. What we need to do is broaden the base of the sales tax by cutting out the exemptions and including personal services. Then, the rates can be sharply lowered.

Likewise, state personal and corporate income taxes have suffered from excessive use of exemptions and credits, as well as over-complexity. In the past, sustaining low rates and broad bases was often sacrificed for a piecemeal accretion of popular preferences. The corporate income tax, in particular, has been ravaged by interstate competition. Progressive income taxation may be desirable, but only as long as the marginal rates are moderate. Bottom line: Redistributive taxation at the state or local level is self-defeating. That is really a federal issue.

The grandfather of energy taxes - the motor fuel tax - continues to be levied at seldom-changed fixed rates that are based on the gallons consumed, regardless of the price of oil, the cost of building and maintaining roads, and the escalating social and environmental costs of oil consumption. Here, the great American myths of cheap mobility and common sense collide, with the latter having lost round after round. We need to change that.

On the broader front of reducing carbon output, many states are trying to coordinate various carbon cap-and-trade systems. I am not a fan of this approach, which deludes many into thinking it is "costless" since nobody pays a tax per se. Planners should be thinking about regional carbon taxes that induce the "real" markets to provide solutions. The unvarnished carbon tax approach is superior, not least because it generates revenues.

The property tax is the mainstay of local government. It is a pretty simple tax to levy, even if it is imperfectly applied. National policy to a large degree undermined the property tax by supporting hyperinflation in housing values. Moreover, some states, such as California, continue to bleed from the exuberant anti-tax populism of the 1970s. They have seen the property tax distorted and weakened as a logical and equitable source of revenue. Every state should review the application of the local property tax and see that it is equitably and efficiently employed. It is meant to supply funds for the sustaining of routine local government spending that relates to the value of properties. Policies that forget this basic economic connection are ill advised.

On the spending side, right now the policy gurus are thinking of ways to spend every dime we can to stimulate the economy. That's a short-term goal. One need not be "anti-government" to see there are many areas where government spending is inefficient, ineffective and out of step with the changing economy. But more of that in my next column.