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States Are Cutting Taxes. Can They Afford It?

Revenues are robust enough to allow for increased spending, and tax cuts on top of it. But current flush conditions might not last long enough to turn permanent cuts into a good idea.

Iowa Gov. Kim Reynolds speaking into a microphone.
Iowa Gov. Kim Reynolds.
(Mario Tama/Getty Images/TNS)
March was a pretty big month for Iowa Gov. Kim Reynolds. She gave the official Republican response to President Biden’s State of the Union address, raising her national profile. What might have more lasting importance, though, is the major tax cut she signed the same day.

Iowa’s new law moves the state toward a flat income tax that will leave it with the fourth-lowest individual income tax rate in the country — down from the sixth highest when Reynolds took office in 2017. All told, the cut is worth $1.9 billion — large by any standards, but huge in a state with an $8 billion annual budget.

Iowa’s tax cut is ambitious but not unique. Across the country, states that are flush with cash are cutting taxes on income, sales and Social Security benefits. Given high gas prices, a number of states are planning to suspend fuel taxes, with Georgia and Maryland taking the lead. For the moment, there’s plenty of revenue of all kinds to cut while leaving money left over for increased spending on many programs. Plus, states are sitting on record reserves.

“This is very much a year with an emphasis on tax cuts, in red and blue states alike,” says Jared Walczak, vice president of state projects at the Tax Foundation. “Revenues are up substantially, and revenue forecasters anticipate future growth.”

But good times never last forever. Some fiscal experts are worried that states are setting themselves up for a fall. To a large extent, states are flush due to influxes of money that won’t be repeated.

“I see this as a temporary increase in revenues that we’re likely going to see dry up in the next year or two,” says Kim Rueben, director of the State and Local Finance Initiative at the Urban-Brookings Tax Policy Center. “If they end up passing permanent income tax rate cuts, they’re digging themselves a pretty serious hole.”

Walczak says that state policymakers are aware that they’re playing with one-time money, at least in part. That’s why there’s a lot of talk about tax rebates. California, for example, is contemplating a $400 gas tax rebate, rather than a suspension of the tax. States including Georgia, Idaho, Minnesota and New Mexico are either offering income tax rebates or are considering doing so.

“A number of the personal income tax proposals are phased in over a number of years, with the cuts in future years based on requirements for future revenue growth,” says Brian Sigritz, director of state fiscal studies at the National Association of State Budget Officers. “States have continued to upwardly revise revenue forecasts and nearly all are exceeding forecasts.”

How States Got So Flush

Total state tax revenues increased by 19.4 percent between April 2021 and January 2022, compared with the same period a year earlier, according to the Tax Policy Center. That’s after adjusting for inflation. Personal income taxes were up 14.5 percent, corporate income taxes were up nearly 60 percent and sales tax collections were up 17 percent.

States are also receiving a windfall from last year’s American Rescue Plan Act (ARPA), which provided them with $175 billion worth of aid. A proposal to claw back some of that money recently failed in Congress.

States not only benefited from direct federal money but from boosts provided indirectly by the federal pandemic response. Individuals had more money to spend, thanks to stimulus checks and enhanced unemployment benefits, and that extra spending led to increased state revenues.

In part, that’s due to the altered nature of spending. During the pandemic, people spent a lot less on services that mostly go untaxed. Instead, they spent freely on taxable goods — lumber for home improvements, outdoor heat lamps, bicycles and kayaks and lots of electronic goodies. “Some of that sales tax revenue will disappear if people go back to more normal spending patterns and shift back to services,” says Rueben.

What’s more, due to the pandemic, income tax collection dates were moved ahead in both 2020 and 2021. In 2020, filing deadlines were pushed back from April until July, moving money into a new fiscal year for most states. And corporate tax collections shot up in part because companies shifted their payments in anticipation of possible tax increases at the federal level.

All this extra money came in after budget forecasts became much more conservative after the sharp recession at the start of the pandemic in 2020. That made it easy to beat expectations in a rising economy. “Last year, nearly all states saw revenues come in above projections, with lower forecasts after the outbreak,” Sigritz says.

Too Many Tax Cuts?

So, states were expecting less money, but suddenly saw a flood of it instead. No wonder they’re feeling flush. Kentucky, Mississippi and West Virginia are thinking about getting rid of their income taxes entirely.

That would likely end up being a mistake because they wouldn’t have enough of a tax base to provide adequate services. Other states started going down this road a decade ago, notably Kansas and Louisiana, and then spent years rebuilding their budgets due to complaints about shoddy schools and roads.

Last week, Michigan Democratic Gov. Gretchen Whitmer vetoed a $2.5 billion tax-cut package passed by the Legislature, saying it would create a “recurring, multibillion-dollar hole in basic state government functions.”

For the most part, lawmakers are being more cautious. “Sixteen states either enacted or implemented income tax cuts last year,” says Walczak, of the Tax Foundation. “Notably, all of them did it wholly or out of fully projected growth. In all 16 of those states, they project larger budgets in real terms in the coming years, even with tax relief.”

Projections are one thing, however. Actual collections are another. Given the hot job market, there’s little sign of recession on the horizon. On the other hand, inflation is at a 40-year high. Although tax cuts are often touted as a way to help citizens cope with inflation, the reality is that tax cuts can make inflation worse by promoting consumption. That might still be a good thing overall, but inflation means states have to pay more themselves for goods such as asphalt and building materials. They also face potentially higher personnel costs, given competition with the private sector for scarce workers.

All this puts aside questions about who benefits from tax cuts. It’s far from a sure thing that gas stations will pass on savings to consumers in tax-holiday states. Last year’s tax cuts mostly went to top earners and failed to address inequality exacerbated by the pandemic.

Lawmakers have not shown much interest in using their surpluses to figure out ways to modernize their tax codes. For decades now, economists have complained that tax systems fail to reflect the economy, given the shift to services. Now, states will have to adapt to a landscape altered by the rise of remote work.

The more immediate question states are facing, however, is how much they can cut taxes now without needing to worry about digging future budget holes. Rueben warns that lawmakers are being too optimistic on that front.

“Everything we know,” she says, “indicates that much of the excess money you have right now is probably going to dry up.”
Alan Greenblatt is the editor of Governing. He can be found on Twitter at @AlanGreenblatt.
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