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With or without income tax, most states mired in money woes

With state government staring at an anticipated $2 billion budget gap, and a special study committee slamming the sales tax as unfair to Washington’s poor, the notion of a state income tax is once again flapping in the political winds.

By Drew DeSilver
Seattle Times business reporter

The tax-study committee concluded that adding an income tax and using the proceeds to reduce sales and property taxes not only would ease the burden on the poor, but also would make state revenues more stable, at least over the long run.

In the short term, however, an income tax is unlikely to solve Washington’s persistent problem in matching spending with revenue — at least, not if the experience of other states is any guide.

Less than halfway into the current fiscal year, 31 states are facing a combined $17.5 billion budget gap, according to a recent survey by the National Conference of State Legislatures.

Twenty-eight of those states have income taxes, and 25 of the 28 have the classic three-legged stool that’s supposed to ensure fiscal stability — property, income and sales taxes.

Across the country, the booming 1990s poured tax dollars into state treasuries. In Washington, lawmakers and voters alike used the windfall to cut taxes and fund new programs, including initiatives to reduce class sizes and raise teacher pay.

When the economy began to tank and tax revenues fell, governments from Seattle to Staten Island were stuck with unsupportable levels of spending and not enough in their rainy-day funds to bail them out. Rising costs for everything from health care to prisons tightened the fiscal squeeze.

"In many cases, people interpret a rainy-day account as a surplus and not as a savings account," said Rep. Jim McIntire, D-Seattle. "The basic pressure the Legislature is under is to do something with that money. Saving it for a difficult day probably comes in third on most people’s hit parade."

From 1990 to 1999, total state tax revenues in Washington rose an average of 5.83 percent a year. As the high-tech economy crashed and new-airplane orders fell, tax revenues slowed to a crawl, then began moving in reverse.

For the first 10 months of 2002, sales- and business-tax collections were down $55 million, or 0.8 percent, from the same period last year.

That might not sound like much of a gap, but it forced lawmakers to scramble to close a $1.6 billion shortfall in the current two-year budget. For the next budget cycle that starts in June 2003, legislators are facing a gap of about $2 billion.

No place to hide

It’s important to note that how high or low revenue swings with the economy is just one measure of a tax system. It can also be judged on fairness, simplicity and ease of administration.

Although the Tax Structure Study Committee, headed by Bill Gates Sr., recommended an income tax for Washington, its main focus was easing the burden on lower-income people, not raising more money for state government.

The panel emphasized that any income tax should be balanced by cuts in sales or property taxes. It noted that sales taxes, while volatile, are less volatile than personal income taxes. And it said the business-and-occupation tax — the state’s second biggest revenue source behind the sales tax — is less volatile than a corporate income tax would be.

Still, it concluded, three legs are better than two.

"Although many of the taxes typically move together over a business cycle, they do not move in lockstep," the report says. "Hence, a combination of tax sources is more stable than either one alone."

Nationwide, 43 states have personal income taxes, 46 have corporate income taxes and 46 have sales taxes. (All states have property taxes of one sort or another.) Thirty-nine of the 50 states use the three-legged stool of income, sales and property taxes.

But public-finance experts warn that simply adding a new tax won’t buttress government budgets against the vagaries of business cycles.

"There really is no place for states to hide," said Donald Boyd, deputy director of the Rockefeller Institute of Government in Albany, N.Y. "The recession is going to hit both the sales taxes and the income taxes."

Added Chang Mook Sohn, Washington’s chief economist: "A lot of people kind of blindly admire the income tax and blame the sales tax for budget shortfalls, but I would not say one tax system is superior to the other."

Oregon hit hard

For proof, just look south.

If Washington has a bad case of the fiscal flu, Oregon — which has no sales tax and relies heavily on its income tax — is battling double pneumonia.

Income-tax collections in Oregon have collapsed in the recession. Individual tax payments are 6.8 percent lower than in the 1999-2001 budget period; corporate income-tax payments have dropped by 42 percent.

The result: Oregon has had to cut its original budget for fiscal 2003 by 16.8 percent, in order to bring spending in line with the shrinking tax revenues.

Carl Hosticka, a former Oregon state lawmaker who now teaches public-policy analysis at the University of Oregon, said capital gains accounted for much of the state’s booming income-tax receipts during the late 1990s, but with the recession and the stock-market slump, that windfall has almost vanished.

The Oregon Legislature, which normally meets every other year, needed five special sessions this year to stanch the flow of red ink. Their solution depends on voters approving a temporary $313 million income-tax surcharge in January; if it fails, lawmakers will have to cut that much from the budget.

Beyond all that, Oregon lawmakers are looking at a $1 billion shortfall for the 2003-05 budget period — the difference between expected revenues and the cost of funding programs at current levels.

Farther south, California has cut its revenue expectations in the current fiscal year by $4.1 billion. Rather than ending 2003 with a $1 billion reserve, the state now expects a $6.1 billion deficit, an 7.8 percent gap. And the gap between revenue and expenses in fiscal 2004 is projected at $15 billion. All this in a state with hefty sales and income taxes.

Nearly every state — with nearly every combination of taxes — has managed to dig itself into a fiscal hole. According to the National Association of State Budget Officers, 45 states faced budget shortfalls during fiscal 2002.

‘States benefited so much’

The states’ experience contradicts economic theory, which holds that personal income taxes should be more stable in the short term than sales taxes — particularly sales taxes, like Washington’s, that exempt necessities such as food and medicine. (Corporate income taxes, in fact and theory, are the least stable of all taxes, while property taxes generally are the most stable.)

Boyd, of the Rockefeller Institute, laid much of the blame for faltering income-tax collections nationwide on the bulge in capital gains from stocks and options in the 1990s. The soaring stock market gave an artificial — and, as it turned out, unsustainable — boost to state and local income taxes. Sales-tax collections also boomed, though not as much, as people spent their bonus checks and stock-market profits.

"What you saw, year over year, was enormous revenue overages," he said. "These states benefited so much it’s hard to fathom."

Where did all that money go? In Washington, much of it went to public schools, colleges and universities; enrolling more people in Medicaid and expanding the state’s own Basic Health Plan for the poor; and housing far more prisoners (the inmate population rose 75 percent between 1991 and 2001).

Surging tax revenues were also used to justify tax cuts. The Legislature repealed most of the business-tax increases it passed in 1993; it also enacted new tax breaks for high-tech research and development, and for manufacturing.

Promoters of initiatives to repeal the car-tab tax and limit property taxes argued that the state could easily afford the tax cuts; after the car-tab measure passed, state money helped backfill local governments that lost revenue.

Now, Boyd said, the states that gained the most in the 1990s boom are hurting the most.

While income-tax revenue has shrunk more than any, sales-tax revenue also has fallen, though not as sharply as theory would predict. The most likely reason, experts say, is the boom in mortgage refinancings and zero-percent car loans.

Income tax less stable

In its report, the tax study committee argued that adding a third major tax would make Washington’s system as a whole more stable, because each tax targets a different aspect of the economy and responds differently to economic change.

The stability of a state’s revenues has much to do with how its taxes are structured, said Russell Sobel, an economics professor at West Virginia University and co-author of "Growth and Variability in State Tax Revenue," the standard work on the subject.

A sales tax that excludes food — like Washington’s — is more sensitive to changes in the economy, Sobel said, because food purchases stay fairly constant through good economic times and bad.

In the first half of 2002, Washington’s taxable retail sales ran 0.9 percent below the same period in 2001. In Idaho, where food is taxed, sales-tax collections have held up through the recession, and in fact are running slightly ahead of projections.

Contrary to the study committee’s findings, Sobel said that in terms of smoothing out revenue bumps, Oregon might gain more by adding a sales tax than Washington would by adopting an income tax.

Rainy-day bailout

For every 1 percent change in the economy, Sobel said, Washington’s base of taxable sales rises or falls by 1.07 percent, slightly less than the national average. Taxable income, on the other hand, would rise or fall 1.5 percent for every 1 percent swing.

"Adopting an income tax might be another source of revenue or shift the burden, but it would probably decrease the stability of your revenue," he said.

Oregon, on the other hand, has the second-most-sensitive income-tax base in the nation: It rises or falls 1.7 percent for every 1 percent change in the economy. A sales tax would probably flatten that boom-or-bust revenue cycle, Sobel said.

But with any tax system, he said, state revenues will drop to a greater or lesser degree when the national economy does. Unfortunately for lawmakers, that’s also when demands on government — for everything from college retraining classes to welfare — grow the most.

To help smooth out the highs and lows, the Washington Tax Study Committee recommended a new, stronger rainy-day fund be embedded in the state Constitution, where it would be protected from legislators and initiative sponsors.

Such a fund should be set up so that tax money is automatically diverted to it in good economic times — similar to 401(k) withholdings — and automatically released when times are bad, the panel said.

"There’s nothing really substantial a state can do," Sobel said, "other than put in place a good rainy-day fund."

Drew DeSilver: 206-464-3145 or [email protected].

Copyright © 2002 The Seattle Times Company

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