Kim Rueben is a Senior Fellow with the Tax Policy Center. Rueben examines issues of state and local public finance focusing on state budget issues, intergovernmental relations, municipal bond markets, capital markets and the economics of education. She is also an adjunct fellow at the Public Policy Institute of California.
Earlier this week, my Tax Policy Center colleague Elaine Maag blogged about proposals by the Center for Law and Social Policy (CLASP) to improve federal assistance for low-income college students, including better targeting of higher education tax credits. But there may be even more effective ways to help these students. One idea: Cut back on tax credits and use the savings to improve Pell grants and loan programs.
As part of the same broad initiative that generated the CLASP plan, I was one member of a group of experts assembled by HCM Strategists to reimagine financial aid. Our aim was the same as CLASP’s, but our proposals took a different tack: Refocus and simplify the whole federal financial aid system including federal grant, loan and tax programs so they work more effectively and cost-effectively.
We started by acknowledging that Congress has greatly expanded federal support for higher education—doubling the amount spent on both Pell grants and tax credits—but there is little evidence that all those extra dollars have similarly expanded the number of college graduates. Almost half of all undergraduates receive a Pell grant but Pell recipients are half as likely to get a Bachelor’s degree within six years as those getting no assistance. And while federal aid has made college more accessible to minority students, it has done little to improve their graduation rates. We concluded there must be a better way and suggested four reforms:
Simplify the aid process. We would replace today’s myriad of programs with one grant program and one loan program and make it possible for students to apply with a simpler application. Grants would be targeted to those who most need aid, and students would be encouraged to take more classes each semester—a step that raises graduation rates. Loans would be consolidated into a single program with common annual and aggregate limits for undergraduates and repayment based on income levels. For all students, the financial aid form would be automatically pre-filled with IRS data, with a small set of students needing to enter more information . By consolidating the application process to rely more on tax return information, the Department of Education could also require better reporting of education costs to the IRS, information that is currently reported on a haphazard basis.
Replace the current tax credits with one tax credit for both college and lifetime learning. Currently we offer numerous tax benefits for higher education including three different credits or deductions for college costs. These credits do little to increase enrollment, largely because students often must pay tuition long before they receive the tax credit (usually in April when they file their return). Students also sometimes choose the wrong credit. Under our proposal loans and grants would provide most support for undergraduate education, but there would also be a tax credit for a broader set of post-secondary options. That credit would recognize that we are moving beyond traditional models of higher education that involve nineteen year olds attending college full time. It would help workers pay for classes that teach new skills, allow students some help in attending school part time, and could be used to pay for an evaluation of on-line learning as programs evolve.
Promote shared responsibility. Students would be encouraged to graduate sooner in part by limiting the amount of time during which they can obtain grants and loans. College applicants would receive both clear financial aid packages and a scorecared that shows how the school performs. This would help students make informed decisions on what schools to attend.
At the same time, institutions would need to do a better job reporting information about both their entire student body and how students do in school. Instead of the current cohort default rates used to determine institutional eligibility for federal financial aid, we propose using a more comprehensive assessment of performance with a new Institutional Effectiveness Index. Comprised of threes measures the index would include the number of Pell recipients attending the school,on-time graduation rates (adjusted for student characteristics if possible) and loan repayment rates. If schools fall in the bottom 10% for two of three measures, they would lose access to federal higher education funding.
Improve the quality of data and create pilot programs. Some of the savings from these proposals would then be used to support pilot projects and collect better information. Pilots could seek more cost-effective ways to prepare students for college before they enroll, ways to award aid based on competencies gained and not hours spent in class, and examine alternate ways of distributing aid.
Of course, streamlining aid and federal assistance requires funding streams that best achieve national goals. In practice reform could run aground against the Congressional committee system with different committees controlling the grant and tax programs. Federal funds can be an important tool to help low-income students get to college and, most important, graduate. But we need to use those dollars in a smarter way.
Higher education is a good investment, even though some new grads currently struggling to get jobs don’t think so. But does it make sense for the federal government to subsidize college with both tax incentives and direct grants? And if it doesn’t, which program should it dump?
There is a strong case that the government should keep and enhance the Pell Grant program, which is the main form of direct assistance for low-income kids. At the same time, it may be time to eliminate or at least consolidate some of the confusing collection of education tax credits.
That, at least was the consensus among witnesses at a recent hearing at the Senate Finance Committee. Experts ranging from Sue Dynarski of the University of Michigan, Scott Hodge of the Tax Foundation and James White of the Government Accountability Office all argued that the credits needed to be reformed.
There are currently 14 tax benefits available for college students and their parents. These include three broad classes – tax benefits for tuition and related expenses , tax benefits for student loans, and tax benefits for education savings plans. Basically benefits for before, during and after college attendance. JCT estimates the cost to the federal government of these tax benefits to be $95.3 billion between 2010 and 2014.
The size of these programs and direct federal grants have rapidly expanded in the last few years. Spending on Pell Grants has doubled – from $18.3 billion in 2008 to $36.5 billion in 2010, reflecting more generous programs and expanded enrollment during the recent recession. Likewise, spending on education tax credits doubled from $9 billion in 2008 to $18 billion in 2009.
Increasing enrollment and encouraging students to complete college, especially for students from low-income families, is one of the best ways to address growing income inequality. According to Dynarski, college attendance rates vary dramatically by income group, with only 9% of children born in the lowest income quartile earning a BA compared to 54% of children born in the top quartile. This gap has increased in the last 20 years.
Does the current panoply of programs, including grants and tax incentives, further the goal of increasing college attendance? While there is some evidence that Pell Grants help, there is little evidence that tax credits do.
The current programs and options are too complicated and families regularly select the wrong tax credit or program or fail to apply at all. The other problem is timing: A student may not see see the benefit of the tax break for up to 18 months after she must pay her tuition. While Dynarski thinks the solution is to simplify the credits and change the timing of delivery, I agree with Hodge that we would be better served by eliminating the tax credits. We could use some of the savings to protect the recent expansion of Pell grants. While we’re at it, we should simplify the Pell application process too.
Unfortunately, we are flying blind in our efforts to reform these subsidies. There are limited data to help evaluate the effects of these programs, including recent expansions. We know little about what the grants and credits mean for students over time. A key question is whether either or both programs result in higher tuition.
One big step forward: The IRS and Department of Education could coordinate their data so we could better understand how these programs work. More importantly, coordination could result in simpler forms for students and their families.
Helping low-income kids get to—and finish–college should be a top priority. But Congress needs to find the most cost-effective way to do that. And the belt-and suspenders approach of grants and tax subsidies may fail the efficiency test.
In testimony before the Senate Committee on Finance this morning, I discussed what federal tax reform would mean for state and local governments and how Congress could help by coordinating tax law across states. Here are my opening remarks. You can find my full testimony here.
With increasing concerns about the federal deficit, fairness, and the complexity and inefficiency of our tax system, the need for fundamental federal tax reform is critical. Often overlooked, however, is the fact that any such reforms will also affect the tax and fiscal policies of state and local governments. Although the country’s economic condition is improving, state and local governments are still struggling to balance their budgets. They also play an important role in our economy, running about half of all domestic public programs and with state and local spending making up about 15% of gdp.
Decisions about changing federal policy should take into account the potential effects on state and local government budgets in both the short and the long run.
I will make 4 points today.
Federal tax policy and reform can help or hurt states. Federal policy affects how attractive specific taxes are for state and local governments and, therefore, how those governments organize their tax and revenue systems. State revenue sources—especially income taxes—often piggyback on federal rules. More specifically, statutory changes in federal law can result in significant increases or decreases in state revenue. For example, state income tax revenue increased after the 1986 tax reform expanded the federal income tax base, and allowed states to also reduce their rates. In contrast, the elimination of the state and local tax deduction could increase the cost to state and local governments of providing services.
Unstable federal tax policy trickles down to the states and uncertainty is especially problematic for state and local governments. State and local governments are required to pass balanced budgets every year. This requires being able to accurately forecast revenues. Problems with state tax systems are exacerbated by uncertainty in federal tax rules. Temporary extensions of credits, deductions, and tax rates complicate state forecasting. Policy changes and uncertainty can directly affect state tax bases through changing definitions of income or indirectly due to changes in taxpayer behavior. Especially problematic has been uncertainty about future federal estate taxes and tax rates on dividends and capital gains, sources of volatile income for states
If fundamental tax reform is undertaken, transition relief might be important for state and local governments. Tax changes can help or hurt states, but understanding the short-run effects will be important and may require slower adoption of policies or some fiscal relief. Understanding the state of the economy and the fiscal health of state and local governments will be important.
Due to our federalist system, Congress has a role in helping to coordinate or protect the existing state and local tax base. State and local governments’ ability to raise revenue can be hobbled by limitations that Congress could remove. Most notably, Congress could enact legislation that could help coordinate action across states and would help enable state and local governments to collect taxes on internet and mail-order sales.
Other panelists explored the costs of current federal tax preferences—the state and local tax deduction and tax-exempt municipal debt—that affect state and local governments as well as how federal legislation could help state and local governments coordinate tax policy in the face of changing technology. The hearing was lively and a good mix of both considering long-term reform and more practical measures that Congress is more likely to act on.
Opening statements from Senators Baucus and Hatch and the other witnesses are here.
With apologies to Charles Dickens, I’d like to tell a Tale of Two States. Earlier this month, on December 5, California Governor Jerry Brown and New York Governor Andrew Cuomo both announced that, even though state revenues in general were rebounding, they were both facing budget shortfalls. This isn’t totally surprising since earlier in the recession both states passed temporary tax increases that had expired or were about to, and both depend heavily on progressive income taxes. Both governors announced a desire to respond to forecast budget deficits with tax changes, including increasing income taxes on high income households. But that is where their tales part ways.
Last year, throughout the budget season, Brown couldn’t get the legislature to extend California’s expiring tax increases He failed both because state revenues were stronger than anticipated last Spring and, more importantly because it took a supermajority of the legislature to pass tax increases. The budget the legislature did pass assumed these strong revenues would continue, even though the source of those extra dollars wasn’t totally understood. Indeed, the budget included an additional $4 billion in unspecified revenues that if not realized would trigger automatic spending cuts.
Well, after a bumpy summer and even bumpier fall, the Legislative Analyst’s Office projected actual revenues will fall $3.7 billion below forecast and help produce a 2012-2013 budget shortfall of $13 billion. That would trigger the large automatic cuts in higher education, social services, and K-12 education. In response Brown announced that he’ll bypass the legislature and ask voters to approve a retroactive tax increase in November 2012.
While some spending reductions will still kick in, late-year revenue increases mean these cuts are smaller than originally expected. However, bigger budget cuts will depend on what voters decide next November, including whether to retroactively raise income taxes and increase the sales tax. However, the presence of numerous other tax proposals might make passage harder. In any event, this year’s budget debate will be interesting, with legislators forced to consider what happens if the ballot measure doesn’t pass.
In contrast, Cuomo proposed comprehensive reform of New York’s tax code. Although he has cut spending and won concessions from labor unions, the state still spends more per capita than nearly all other states and it faces a $350 million shortfall for this year and a projected $3.5 billion deficit next year.
With a temporary surcharge on incomes above $200,000 expiring at the end of this month, Cuomo hoped to make the state income tax more progressive by permanently increasing top marginal tax rates from their pre-surcharge levels (though importantly they’d still fall from what they are today). At the same time, he wanted to lower rates for middle-income taxpayers, streamline other provisions of the code, and restore funding for some government programs. Thus, revenues would go up, Republicans could claim that tax rates will be lower than they are now, and Democrats could take credit for a more progressive tax system and some new spending. Cuomo negotiated his tax reform with just two people – the Republican Senate majority leader (Dean Skelos) and the Democratic Assembly Speaker (Sheldon Silver). The often dysfunctional state legislature approved the whole package within a week.
Cuomo definitely benefited from the timing of the expiration of the temporary tax increases. The recovery looks more uncertain now than it did last year, and by revising rates before the surcharge expired he framed the package as a tax cut. In theory Jerry Brown could also negotiate a deal with a subset of legislators, leadership from both parties in both houses – a gang of five, instead of three. However, in practice often in California, agreement isn’t reached or legislators defect and a deal isn’t kept. Requiring another trip to the ballot box.
Fiscal institutions and rules matter. But as Cuomo proved, good timing and some legislative hardball are just as important when it comes to budget reform.
As a brief respite from our discussions of all the various flat tax plans being proposed (or recycled) – below is a post I did for Metrotrends yesterday on budget antics at the subnational level.
Last month I blogged about how the federal and state governments could learn from cities, which seemed to be making the tough choices and balancing their budgets without politicizing every move. This month, alas, I’m honor bound to report that some cities (and states) aren’t above the political fray.
Exhibit 1 – Harrisburg. The capital of Pennsylvania has been having money troubles for the last few years, and has been on the short list of places most likely to go broke. Earlier this month the shoe dropped, and the city declared bankruptcy. Or at least the city council did – the mayor is against it and so is the state. This has led to a series of announcements from different parties on whether or not Harrisburg is in bankruptcy, who gets to declare bankruptcy, and whether the city council can choose bankruptcy court over accepting a state takeover plan. The council members thought the state takeover would leave the city in worse shape, paying off bondholders while destroying the city’s ability to meet service needs. It also included veiled threats about state officials needing to learn how to put out literal instead of figurative fires, if the sale of assets to pay debtholders led to a lack of firefighters.
The problems in Harrisburg largely stem from an investment project gone wrong – an incinerator upgrade that was supposed to generate revenues through generating power that never materialized. With the current antipathy for Wall Street the council members think they are better off in bankruptcy court which could lead to bondholders taking a loss and possibly lower the cost to taxpayers.
Exhibit 2 – Scranton. While much less extreme an example than Harrisburg, Scranton’s city council and mayor came up with competing proposals to solve its budget deficit that involve either selling the parking meters (to the parking authority) or borrowing against meter revenue to get a one-time payment to balance this year’s budget. Either plan would generate the $6.5 million to plug this year’s deficit. The only problem with this strategy is that next year’s budget deficit is probably going to be even bigger and then what? This strategy either sells off an asset or commits a decade’s worth of revenue to pay for this year’s problem.
So does this mean we are on the brink of a spate of local bankruptcies? No, although the National League of Cities reports cities ending fiscal year 2010 with the largest year-to-year reductions in general fund revenues. However, most cities balanced their budgets by making even larger cuts in spending. And in what might reflect city officials recognizing a “new normal” in city budgeting, a smaller share of them report that they are less able to meet financial needs, even though revenues are down for the fourth year in a row (in real terms)—just 57 percent of cities this year, down from almost 90 percent two years ago. Revenues are going to be tight but in most places, officials are making hard decisions and cutting real programs as well.
Yes, politicians in Harrisburg may be throwing metaphorical cream pies at each other, but most other cities are cutting the mustard.
This year marks the 100th Anniversary of California’s initiative process . In 1911, California famously adopted the direct initiative process and ballot box decision-making has become almost as synonymous with the Golden State as beaches, hi-tech innovation, and Hollywood. While 75% of voters in California still see direct initiatives as a good thing, a similar percentage thinks it could use some tweaking. In honor of the anniversary, Zócalo Public Square garnered commentary on the initiative process. Here’s what I wrote:
What’s the Single Best Thing We Can Do to Improve the Initiative Process?
Make it harder
California’s initiative process gets a lot of attention and blame in discussions of the state’s budget and governing problems. This is in part because it is used either directly or as a bargaining tool to legislate many issues. In 2010, voters considered two initiatives in June and nine more in November. These included rules on the legalization of marijuana, suspending or changing environmental regulations, rules on redistricting, and many fiscal issues. Although ballot initiatives give Californians a loud voice in their government, raising the hurdles for passage would serve everyone better.
So what’s wrong with giving citizens such power? For starters, voters have often approved initiatives that conflict with one other. For example, San Franciscans, when asked whether to rebuild or remove a damaged highway after the 1989 Loma Prieta earthquake, voted yes to both rebuilding it and removing it. (The freeway was removed because that option had more yes votes.) Courts have thrown out initiatives because their language is confusing or vague. California could solve those problems, either by requiring constitutional review before any vote or by making the process less direct by having initiative authors work with legislators to come up with workable proposals. Massachusetts gives that role to the legislature, and many fewer initiatives end up on its ballots.
But I want a procedural reform. Initiatives often pass with a simple majority but mandate that future actions require a super-majority action of voters or legislators. For example, California’s famed Proposition 13 requires a super-majority to enact any new special taxes. Proposition 218 did the same thing for some fees. Shouldn’t any law with super-majority requirements be required to have a super-majority vote to pass?
California should also raise the bar for constitutional changes (as opposed to statutory changes). Right now, the only additional requirement for changing the constitution is that a slightly higher number of signatures be collected: 8 percent of the number of votes cast for Governor in the last election rather than the 5 percent needed for statutory changes. With the advent of paid signature gatherers, the bar should be raised for constitutional changes. And passage should require more than a simple majority vote.
If the process were a tad more cumbersome and fewer initiatives made it to the ballot, discussions of the initiatives could be more thoughtful, elected officials would need to take more responsibility, and possibly California would be slightly more governable.
Legislative leaders in California, big box stores, and Amazon have reached an agreement to delay internet tax collection until September 2012. There is no word on whether Governor Jerry Brown will support the plan and no mention of whether the 7,000 distribution center jobs Amazon previously offered the state is part of the package. Amazon did agree to stop supporting a repeal referendum and will join other retailers in pushing Congress to enact an internet sales tax law applying to all 50 states and the District of Columbia.
In a landmark 1992 ruling governing collection of sales taxes by remote sellers (they were mail-order firms then), the U.S. Supreme practically begged Congress to resolve the mess by enacting national standards. But Congress never acted, and given how quickly legislation gets through Congress these days, that’s not likely to happen any time soon.
Nonetheless, Amazon promises to start collecting the tax in September 2012 if Congress fails to act. It will be interesting to see whether that really happens.
After threats and tough talk for most of the summer, Amazon seems to be changing tactics in its battle against collecting sales tax on purchases by Californians. For months, the firm has been bankrolling a ballot initiative to reverse a new state law requiring online retailers to collect the levy. Wednesday, Godfather-like, Amazon made Governor Jerry Brown an offer it thought he couldn’t refuse: Amazon would open new distribution centers in California in exchange for a two-year delay in the law. Yesterday, the governor said he thinks not. He hasn’t made a final decision but he’s signaling no. I’m sure that Amazon and its supporters will now blame Brown for costing the state 7,000 new jobs.
Here’s the back story: In June, Brown mandated collection of the tax. Sales tax collections by out-of-state sellers are governed by a legal principle called “nexus.” In effect, if a business has a physical presence in a state, it must collect taxes. Amazon promptly cut ties with 10,000 California business affiliates to erase any physical presence. It refused to collect the tax and funded the campaign to repeal the law through the ballot box. This isn’t a new fight. We blogged about it last March, when states started proposing laws to collect internet sales tax, and back in 2009, when New York first raised the issue of Amazon paying taxes due to the presence of affiliates within the state.
Amazon offered to bring 7,000 distribution center jobs to California to avoid a ballot-box fight in exchange for a two-year moratorium on the tax. Want to guess how long the jobs stay once the freeze ends? Are 7,000 jobs worth the $200 million-a-year in sales taxes the state figures it will collect (plus another $100 million for local governments)? And would they ask for another delay or blame Brown for sacrificing these jobs? Of course, offering to set up distribution sites has already worked for Amazon in South Carolina and Tennessee.
Meanwhile, the repeal effort rolls on. Amazon has donated over $5 million to collect signatures, and many of the paid signature gatherers were set up in front of its big box store competitors. The referendum, which would repeal the law, requires 505,000 signatures of registered voters to make it onto the ballot. Given California’s record on tax votes, chances are the repeal will go through.
Amazon is bound and determined to avoid collecting sales tax to keep a price advantage over its competitors, even though in doing so it is effectively encouraging its buyers to break the law. Other e-tailers seem to have no problem calculating and collecting the tax.
What does this mean for California’s budget? It obviously doesn’t help. State revenues already appear to be coming in below projected levels, which means more budget cuts later this fall. But that might be a blog for another day.
Meanwhile, Amazon’s move may signal the end of my love affair with my Kindle. As convenient as shopping at Amazon is, I’m going to buy things from sites that charge their customers sales tax. While I did pay use taxes in California (where you report it on your income tax return) I haven’t figured out how to do the same in DC (my current residence). Amazon’s refusal to collect taxes encourages customers to avoid the taxes they owe. I’ll stop feeding my Kindle because, in the end, I think a customer boycott may be the only way to get Amazon to behave.
Below is a post I did for Metrotrends on Friday.
Financial markets have been on a pretty turbulent roller-coaster following the last minute bargain Congress struck to forestall a debt crisis, S&P’s downgrade of US Treasuries, and economic uncertainty in Europe. Most discussion has focused on national issues but it’s important to ask what this all means for state and local governments. State and local budgets are still pretty tight, with revenues well below 2008 levels (adjusted for inflation). But the current federal drama doesn’t seem to be compounding subnational government woes.
Most state and local officials knew that they were unlikely to get more federal aid after the stimulus funds dried up, but the actual deal struck by Congress is better than many states expected. The agreement cuts federal discretionary spending a lot but largely protects entitlements, including Medicaid (and Social Security and Medicare). New limits take the form of spending caps on discretionary spending using the Congressional Budget Office’s “current law baseline,” which adjusts for inflation. Baselines are often political creations but they sometimes matter a lot—Standard and Poor’s really blew it by assuming the wrong one—and that’s clearly the case for the cuts in discretionary spending.
The money that state and local governments get from the feds is part of “other domestic discretionary programs.” Working off of an inflation-adjusted baseline means these cuts start from a higher level and thus aren’t as bad as they could be. (In the short term—i.e., fiscal 2012—the caps on discretionary spending will slice about $2 billion from non-security programs). The debt agreement may not really solve the federal debt problem but, thanks to the magic of baselines, it doesn’t do much short-term damage to state and local programs.
As Stateline pointed out, the caps actually allow for $24 billion more in spending than the budget resolution the U.S. House of Representatives approved earlier this year. That bill, which died in the Senate, proposed cutting some state grant programs by as much as 20%.
State and local government aren’t off the hook yet. No one yet knows how Congress will allocate these cuts across domestic programs. The Super Committee has broad flexibility to cut both discretionary and entitlement programs—and even raise taxes. But the chances of the panel reaching consensus are very small. If Congress can’t agree on $1.2 trillion in automatic spending cuts by the end of this year, the debt limit deal requires automatic spending reductions starting in 2012. But these exempt most of the mandatory spending that makes up the social safety net, including Medicaid, CHIP (children’s health program), TANF (welfare) and SNAP (food stamps). A few programs that affect state and local governments, such as education funding, early childhood assistance and affordable housing aren’t protected. But in the short term at least, the debt agreement is unlikely to do much new damage to state and local budgets.
So what about the Treasury downgrade? Despite getting the math wrong, S&P stood by its downgrade and even said that other issuance downgrades would follow. It has already cut its rating on some other government bonds, but those are largely housing development funds and bonds pre-funded by treasuries. S&P seems to think that any investment backed by treasuries is more at risk. Meanwhile, the other ratings agencies have largely left things alone.
The markets seem to disagree with S&P’s assessment. In the wild ride of the past couple of weeks, Treasury yields have fallen to half century lows, and thanks to this rush to safety, many muni yields have followed them down. Remember that many tax-exempts are still rated AAA. Thus, the rates that state and local governments must pay on new bonds are at all-time or multi-decade lows, saving issuers money. It might be odd that a subnational government can have a higher bond rating than its parent government. But when ratings are cut to reprimand Congress and the risk of default is still perceived to be close to zero, well, normal bond pricing rules might not apply.
So what will affect state and local governments’ bottom lines? The stock market tumble and economic conditions. While the current uncertainty might be good for muni-issuances, it has pushed down the return on state and local investments and will possibly cut their income tax revenues too. Specifically, public pension fund assets have lost value in the market fall, and state revenues look less rosy as capital gains turn to losses. And that will hurt states’ financial ratings. Indeed, despite recent efforts by New Jersey to cut spending, Fitch just dropped the state’s rating from AA to AA- because of outstanding levels of debt and benefit obligations.
Federal action can definitely affect how well or poorly subnational governments fare, but the current drama doesn’t seem to have had much of a direct effect—other than that caused by sending the economy and financial markets into a dizzying tailspin.
As I noted a couple of weeks ago, California’s April income tax revenues were well above forecast levels. Many other states, especially those reliant on somewhat progressive income taxes have also reported higher than expected revenues. Goldman Sachs reports first quarter state revenues were up 9 percent year over year with April alone up 12 percent. Last week, Governor Brown’s May Revise (the update to his January budget) anticipated an additional $3.5 billion in revenues for the current fiscal year, and a combined two-year gain of $6.6 billion. Coupled with budget actions adopted in March (about $13 billion) this brings California’s budget closer to balance from an estimated $25 billion in the red to a $9.6 billion budget gap. So what’s happening here?
Before we pop the champagne, let’s look at both where the money is coming from and what that source means to the budget process. Federal and state personal income tax revenues are up nationwide even though in some places corporate taxes are down. The revenue gain may reflect stronger ongoing economic activity, but it could also represent a one-time revenue boost due to taxpayer actions. I already blogged about potential revenue gains from IRA conversions. Conversations with others over the last week have suggested other possible explanations. Although the two-year extension of the Bush tax cuts kept capital gains tax rates low, that didn’t happen until mid-December. I’m guessing at least some high-wealth households decided to realize some capital gains to lock in the 2010 rates and avoid the uncertainty of potentially higher future rates. After all, it was pretty clear that tax rates on long term capital gains wouldn’t go down come 2011 and investment advisors seemed to think that realizing gains was worth considering. In 1986 when taxpayers knew for certain that tax rates were increasing in the following year, realizations spiked to 7 percent of GDP before falling back down in 1987. Thus, uncertainty in federal tax policy may have led to a boom in this year’s revenues that might not last.
Why does this matter? For starters, states still need to deal with ongoing structural deficits. If states think the higher revenues will be permanent, they may postpone hard decisions. As Billy Hamilton (a former deputy state controller in Texas) said in a recent Pew Center for the States and the Rockefeller Institute report, “One of the rules of revenue estimating is ‘It’s the turns that kill you’”.
California’s Department of Finance estimates that while the state’s economic growth will be weaker than the nation as a whole in 2010 and 2011, it will then outpace the rest of the country in 2012 and 2013—the May Revise predicts a 5.9 percent average year-over-year growth rate for state revenues through 2015.
This medium-term forecast reflects an assumption that much of the gain in personal income tax revenues has come mainly from wage growth for higher-income residents in 2010. In contrast, the Legislative Analyst’s Office(LAO) forecasts almost identical revenues for 2010-2011 and 2011-2012, but assumes that a much higher share of personal income growth this year came from capital gains ($65 billion vs. $46 billion) and thus predicts lower revenue growth in future years. For example, the difference in forecast assumptions translates into 2014-2015 major taxes ( personal income tax, sales and use tax and corporate tax) being $3 billion higher in the governor’s estimate than the legislature’s ($107 vs. $104 billion). While $3 billion dollars may seem like rounding error for California’s huge budget – even “small” numbers accumulate over time.
The difference in assumptions also illustrates a fundamental flaw in California’s revenue system–its volatility. As the governor and others think about possible tax reforms to bring to voters, they might want to think about ways to tame the roller coaster of California revenues. I suggest they consider setting up a special fund for capital gains and dividend revenues (or those from all schedule D income) and remit the money into the general fund based on their 3-year or 5-year averages. California (and other states) will benefit from the current windfall, but future revenues and expenditures would then be more immune to the next boom and bust cycle.
For now, I hope states will view the April revenue surprise as another temporary benefit from federal policy and not an indication that revenue growth rates have returned to pre-recession levels. With stimulus funds ending this year, the boost in income tax revenues is most welcome, though the added money doesn’t end the need for longer term reform.