States Have 20th-Century Revenue Systems

States can no longer rely on federal bailouts or taxes. For the latest on state revenues, click here.
June 2012
Donald F. Kettl
By Donald F. Kettl  |  Columnist
Sid Richardson Professor at the LBJ School of Public Affairs at the University of Texas at Austin

What could be more magical than Snow White winning the lottery? That’s what happened to Natalie Marston, who played the character at Disneyland and won a $5.2 million California prize in 2009, which she said would help make her dream of a romantic wedding to her prince come true.

To cope with their budget problems these days, state governments are making even bigger wishes. One is for more frenzies like the record April Mega Millions $656 million jackpot, which pumped billions into state coffers. The other is discovering that their Magic Kingdom is built atop oil.

Take North Dakota, whose vast reservoir of shale oil helped drive state tax collections up nearly 45 percent in fiscal year 2011. The mega-success of its oil business has produced revenues larger than its state sales tax, individual income tax and corporate income tax combined. Alaska and Wyoming have benefited enormously from oil, too.

For most other states, though, the Great Recession proved much more punishing. The federal government’s American Recovery and Reinvestment Act funds have gone away. Meanwhile, an April study by the Government Accountability Office estimated that state and local governments face decades of growing deficits unless they decide -- today -- to cut spending or increase taxes by 12.7 percent.

What’s at the core of the problem? On the spending side, it starts with health care. Like all employers, states and localities face rising premiums for their own employees. The weak economy has pushed more low-income individuals onto Medicaid. If the Supreme Court upholds the Affordable Care Act, states will have to figure out how to build exchanges and deal with an expansion of Medicaid costs. If the Supreme Court strikes it down, the underlying problems don’t go away and the structure is even less clear. There’s probably not a governor alive who wouldn’t want another bite at the Reagan administration’s apple, the failed plan to swap federal assumption of health care for state assumption of welfare. There’s no fix for the ongoing state and local fiscal crisis without a fix for health care.

Another big part of the crisis stems from the underlying state and local revenue base. The entire system -- based heavily on income, sales and property taxes -- was clobbered by the recession. In most states, revenues are only now recovering to the pre-recession 2007 level. Declining home prices have savaged local property tax receipts -- hit hard by the recession, they rose less than 1 percent in 2011.

The result is a state-local revenue mix in which a handful of states are huge winners, while most are struggling with mid-20th-century revenue systems that don’t match the realities of the 21st-century economy. A 2009 report on California’s tax system identified problems that mirror those in most states: Revenues that lag economic changes produce volatile changes in receipts, discourage growth and investment, and create an uncompetitive economic structure. In the past, the feds could be counted on to be the states’ prince, with a well timed (if sometimes reluctant) kiss of stimulus when the economy slowed. There’s little chance of that anytime again soon.

That, in turn, has led many state and local governments to seek new revenue sources. The states benefited from April’s Mega Millions mania and, in some parts of the country, a veritable gambling arms race has broken out between neighboring states. Many local governments have been turning to expanded user fees, including annual subscriptions for fire protection. In some jurisdictions it’s pay or burn: Two houses in South Fulton, Tenn., were reduced to cinders because their residents hadn’t paid the annual $75 fee. Firefighters on the scene sat by and watched the flames.

All these Great Recession problems have fueled three mega-trends. One is the growing gap between state governments with rich natural resource blessings, and state governments without. This has only reinforced the gap between the old and new state revenue systems.

The second is that the federal government’s role as the great equalizer is evaporating. The federal government used to balance out differences between the states by focusing aid on lower-income individuals. But the feds are backing away from that strategy, and there is no consensus in Washington for dealing with health care, the inescapable economic and social challenge of the next 50 years. Without a solution to health care, there’s no road to state fiscal health, and it’s not a solution that the states can fashion on their own.

Finally, many of the new revenue strategies that state and local governments have cobbled together, from gambling to user fees, are regressive -- they hit the poor more than the rich. It might be impossible to resist them, especially at a time when no one wants higher taxes and further cuts are hard to make, but they only worsen the overall fiscal health of state and local governments.

We don’t need a tax system that ignores state and local needs, discourages economic growth and is increasingly unfair. There’s no fairy tale ending to the long-term budget challenge without tackling these issues in state capitals around the nation.