Norton Francis is a Senior Research Associate at the Urban Institute. Francis examines state and local finance issues including tax policy, revenue estimating, and budget issues.
House Ways and Means Chair Dave Camp’s recent tax reform plan would raise the cost of doing business for many state and local governments.
Camp would repeal the deductibility of state and local taxes, including both property taxes and income taxes. He’d abolish tax-exempt private activity bonds. And he’d impose a 10 percent surtax on municipal bond interest for high-income households, a step likely to raise the cost of issuing state and local debt.
But Camp’s plan also includes some less obvious changes that could increase state income tax revenues, especially for states that piggyback on the federal income tax. By limiting deductions—and thus boosting taxable income—Camp’s plan could also increase state income tax revenue, just as the Tax Reform Act of 1986 did.
Here is a brief summary of the state and local provisions in Camp’s plan:
Repeal of the state and local tax deductions. In 2011, itemizers deducted $470 billion of state and local taxes they paid. Camp would repeal the deduction for state and local income taxes, and for real property taxes. Only the personal property tax, usually related to business equipment, would remain deductible in most cases.
For states with income taxes, the deduction is a federal subsidy. The state gets the revenue, but the filer may deduct state income tax against his federal obligation. The real property tax deduction reduces the cost of home ownership for mostly high-income households who are more likely to itemize and subsidizes local governments that rely on property tax revenue.
Tax municipal bonds. In 2011, state and local governments issued $171 billion of debt and 4 million filers reported $62 billion of tax-exempt interest. Camp would deny the deduction of muni bond interest against the 10 percent surtax on high-income taxpayers. That would limit the value of the preference to 25 percent, close to the 28 percent limit President Obama has repeatedly proposed in his budgets. The Tax Policy Center estimates about 80 percent of the explicit benefit of the current exemption goes to these households. Limit the tax subsidy and state and local governments might face higher interest rates to sell as many tax-exempt bonds as they do today.
Tax private activity bonds and advanced refunding bonds. PABs are used by state and local governments to finance privately owned projects that have an ostensible public use, such as nursing homes and some real estate projects. Today, each state may issue a limited number of these bonds based on the size of its population. In 2011, state and local governments issued $87 billion of these bonds.
Advanced refunding bonds, which constituted 40 percent of long-term municipal bond issues in 2011, allow government entities to refinance their non-callable high interest debt and thus lower their overall borrowing costs. States won’t be able to reduce debt service costs by reissuing lower rate debt.
If Camp’s plan were enacted, bond-financed private projects would likely be shelved and because most states have caps on their total debt service, more public projects would be shelved as well.
Changes in taxable income. The Federation of Tax Administrators reports 36 states and the District of Columbia start with the federal definition of adjusted gross income (AGI) or taxable income to calculate state taxable income, generally referring to a specific line on the federal 1040 in their instructions. In Camp’s plan, changes to the sources of income and the repeal of many income adjustments, such as education deductions and moving expenses, increase AGI. The substantial increase in the standard deduction is offset by the repeal of many itemized deductions at the federal level but since more states have their own standard deductions and adopt the federal itemized deductions, taxable income will increase.
Reduction of the Earned Income Tax Credit. 24 states and the District of Columbia have a state EITC calculated as a percentage of the federal credit. Camp’s EITC would be less generous, lowering the value of the state credit, saving the states money but at the expense of low income families.
The net impact of Camp’s plan on state governments is far from clear. By reducing federal subsidies, it will likely boost overall costs to state and local governments. But increasing taxable income will increase income tax revenue, offsetting some of those costs, at least for the income tax states.
Government employment is down again. But while cuts in state and local jobs drove the decline in 2011 and 2012, the federal government is the culprit now. The federal workforce has decreased about 3 percent, or 75,000 positions, from last year. That’s in sharp contrast to the slightly positive growth (0.3 percent) for the state and local sector.
Overall, government employment has not grown for five years when you take out temporary workers hired to take the census in 2010. After this adjustment, there are 730,000 fewer government jobs since the peak in January 2009, with about 10 percent of the decline coming from federal employment and 90 percent from the state and local workforce.
Interestingly, many of the states taking the hardest hit from the loss of federal jobs were not in the DC area. By Census region, the biggest declines came in the south and west where federal employment makes up about 2 percent of total jobs. From December 2011 to December 2013, the federal workforce was cut by 37,300 in the South (chart). Many of the losses were in civilian defense jobs.
A great table in our last State Economic Monitor shows that only six states had no net loss of federal jobs: Idaho, New Hampshire, North Dakota, Utah, Vermont, and Wyoming.
Not surprisingly, California and Texas, the largest states, had the biggest decline in federal jobs in absolute terms.
But in terms of percent change, Alaska had the largest contraction, losing almost 8 percent of its federal workforce in December 2013 compared to a year ago. Others taking a big hit, declining by more than 4 percent: Arkansas, Kansas, Montana, New Jersey, and Washington.
None of the states in the Washington DC metro area are even in the top ten measured in terms of percentage losses: DC is 15th, Virginia 28th and Maryland 43rd. However, because the federal government makes up 28 percent of the workforce in D.C., a proportionately small decline in federal jobs translates to over 6,000 jobs.
Alaska is similar: Federal employment represented fully one-fourth of the total workforce, so the 1,200 jobs lost in December disproportionately affected the economy. The federal jobs also tended to be higher paying and more stable than other Alaskan work.
Although overall state and local employment increased in 2013, twenty-two states reported a decline from the prior year. This loss of human capital has already begun to affect government services, most alarmingly education, which accounted for 60 percent of the local government decline in employment from 2009 to 2013.
Thus while our economic monitor shows some cautious improvement in other employment indicators, declining public sector employment, particularly in the federal government, continue to drag down the recovery.
Last Tuesday, voters in several states approved modest tax hikes. Increasingly, states are using ballot measures to determine whether to support new taxes. Some of these referenda are binding, others just advisory. But in 2013, voters in several states seem to be hungering for more revenue—though sometimes from unusual sources and decidedly not by raising income taxes—at least in one state.
Here is a rundown of the results:
- Colorado: Voters approved a 25 percent state-wide tax on marijuana, on top of some additional county dope taxes. But they soundly rejected adding a new top rate to their income tax. While some of the new state marijuana tax revenue is designated for school construction, the public education system missed out on $1 billion in new aid when voters rejected the income tax hike.
- New York: Let the games begin. New York State voters expanded gaming to allow seven new casinos including three in New York City after seven years. Until now, legal betting has been restricted to “racinos” (horse racing tracks with slot machines and video gaming), charitable gambling such as bingo, and state approved lotteries. The recession stopped the growth nationally in state gaming revenue, but several states have expanded their gaming venues to try and keep some of this money at home.
- Texas: Lone Star State voters decided to tap the state’s rainy day fund for…water. Texas managed to keep a sizable reserve fund through most of the recession. This measure authorizes the transfer of $2 billion from the Economic Stabilization Fund, which has a balance of about $8 billion, to two funds that will be used for water infrastructure projects. Under the heading “Tax Law That Probably Didn’t Need a Citizen Referendum,” Texas voters also increased the number of days that property imported for the manufacture of airplanes could remain in the state as exempt personal property. Since the exemption is in the Texas constitution, amending it had to go to the voters. Texas, according to Ballotpedia.org, has the longest constitution and every other year there are about 16 more amendments to vote on.
- Washington State: Voters in the Evergreen State get to pass judgment on laws that have already been enacted. On August 1, 2013, the state imposed the same levy on landline phones faced by wireless users. On November 5, voters called in their response: They didn’t like it. Voters barely endorsed an increase in the estate tax and a switch from a personal property tax on commuter airlines to an airplane excise tax–both of which have also been enacted already. All these votes were purely advisory, however, and the legislature is not bound by the results.
Even when they are non-binding, these ballot measures are a useful look at voter moods, especially in off-year elections. They are one of the few opportunities for the voters to be heard on specific issues. Coloradans are ok with a new tax on pot but like their flat income tax just as it is and Texans are willing to spend a little of their savings when it is as important as water.
The latest edition of the Tax Policy Center’s State and Local Finance Initiative’s State Economic Monitor finds that revenue growth is accelerating in most states but many jurisdictions faced strong economic headwinds going into the recent partial government shutdown and potential default. In several states, a decline in public sector jobs was boosting unemployment even before the partial shutdown.
The State Economic Monitor shows state-by-state economic and finance trends and our new page on the website includes interactive maps and charts.
Between August 2012 and August 2013, the public sector shed 94,000 jobs, mostly federal positions. Forty-six states lost federal government jobs. Total government jobs (including state and local positions) increased in 18 states but every state except West Virginia remains below its peak level of government employment, seasonally adjusted.
The trends in unemployment rates vary widely. Thirty-six states have lower unemployment rates than a year ago while twelve states have higher rates.
In Louisiana, for example, the unemployment rate rose from 6.4 percent in August 2012 to 7.0 percent in August 2013, but remained below the 7.3 percent national average. The number of unemployed in the state increased by almost 13,500.
California, Florida, and Nevada had better news: the unemployment rate in each state fell by 1.5 percentage points or more from a year ago. This is particularly welcome in California and Nevada, where unemployment rates remain substantially above the national average.
Unemployment rates can be difficult to interpret, however, since they depend on how many people enter or drop out of the labor force as well as the sheer number of jobless. For example, Massachusetts, Missouri, and Nebraska added jobs but their unemployment rates rose because more people were looking for work. In Delaware, the number of unemployed was unchanged from a year ago but its unemployment rate increased because 4,000 residents dropped out of the labor force.
Our update does not reflect the partial government shutdown that began on October 1. However, states with high concentrations of federal employees and contractors began to feel the effects almost immediately. The Washington, DC, metro area will be particularly hard hit. In 2012, federal wages made up about 35 percent of wages in the District of Columbia, 10 percent in Maryland, and 8 percent in Virginia. Tourism in the D.C. area has also likely been more affected than most localities by the shutdown of museums, monuments, and parks.
Along with the Monitor, we’ve updated the State and Local Finance-Data Query System, a tool to download and customize annual state and local revenue and expenditure data. The system is particularly helpful now while these numbers aren’t available on an inactive Census of Governments website. Give it a try.
Kansas Governor Sam Brownback (R) and the GOP-controlled legislature are struggling to accomplish two goals: They want to repeal the state income tax but need to balance a budget that, despite substantial spending cuts, faces a $700 million shortfall.
It is no easy trick. Their solution: new net short-term revenue increases accompanied by a promise to phase out the state’s income tax. This year’s final budget agreement includes both spending cuts and about $300 million in new sales and income tax revenue that promise to balance the fiscal year 2014 books. But over the next five years, those new revenues will be overwhelmed by a proposed 20 percent cut in individual income tax rates, setting the stage for annual budget crises.
It isn’t easy to keep track of whether Kansas is cutting taxes or raising them. The agreement backtracks on income and sales tax cuts scheduled to happen this year. Much like the congressional tax debate of 2012, it is all about what baseline you prefer.
Let’s start with the new revenue, which the state projects will boost its coffers by about $365 million in 2014. About $195 million will come from setting the state sales tax rate at 6.15 percent, lower than the current temporary rate of 6.3 percent but above the 5.7 percent scheduled to take effect in July.
The remaining $170 million will come from changes to individual deductions. Itemized deductions, other than charitable contributions, will be trimmed by 30 percent in tax year 2013 and the haircut will gradually increase to 50 percent by 2017. At the same time, lawmakers scaled back a scheduled rise in the standard deduction, further increasing the tax base.
However, the revenue from these base-broadeners, which grow to about $480 million in 2018, will gradually be eaten up by phased-in cuts in the individual income tax rate and a partial restoration of the food sales tax credit (Kansas is one of the few states that taxes groceries).
In 2014, these tax cuts will reduce revenues by about $55 million (for a net tax hike of about $300 million). But by 2018, the revenue gain will disappear: The top income tax rate will drop from 4.9 percent to 3.9 percent, draining $465 million from the state budget while the food tax credit will siphon off another $20 million, leaving a net tax cut of about $5 million.
While the state is cutting taxes over the next five years, it also projects spending growth will slow sharply, averaging just 2.6 percent per year between 2014 and 2018. Even if these forecasts are realized, Kansas’ year-end fund balance will fall below the statutorily required 7.5 percent in fiscal year 2015 and balances will be exhausted by 2018.
The uncertainty will grow after 2018. These rate reductions are just the first step in a planned repeal of both individual and corporate income taxes. After 2018, individual income tax rates are scheduled to be reduced to zero (the pace is tied to a formula based on state revenue growth). Once the individual tax disappears, the state will begin to phase out its corporate income tax.
But even in 2018, the income tax will generate more than one-third of state tax revenues and the current plan does not explain how that revenue will be made up. Gov. Brownback and the state legislature may expect that their rate cuts will boost the economy and, in turn, revenues will be much higher than projected. But there is no credible evidence that tax cuts pay for themselves. And with the bulk of the state’s budget going to education and health care, spending will very likely exceed projections.
The result: Kansas is setting itself up for a period of ongoing budget crises and uncertainty that seems likely to undermine the attractive environment for business lawmakers are trying to create.
Senate Majority Leader Harry Reid (D-NV) plans to bring the Marketplace Fairness Act of 2013 to the floor today for a preliminary vote. The measure would give states authority to require on-line sellers to collect sales tax on the products they sell to consumers within their jurisdictions.
This is big news. Two years ago, Senate Finance Committee Chairman Max Baucus (D-MT) refused to send the bill to the Senate floor.
So this year, Reid is bypassing the committee. The idea has growing bipartisan support among the nation’s governors–many of whom are strapped for tax revenues. A few weeks ago, 75 senators voted to include it in the non-binding Senate budget resolution, and an identical version in the House appears to have support. That sounds promising.
This year’s bill doesn’t differ much from the 2011 version, but it does increase the threshold for covered businesses to firms with sales over $1 million, making it easier for small business groups to stomach. And if it really does bring in the millions of dollars promised, it might make up for the sequester’s cuts in just about every program that helps states.
Let’s see what the Senate does and, if the Senate OKs the bill, what happens in the House. As I said in February, this might be the year the decades old impasse over taxing remote sales is finally resolved.
How many tax bills introduced have bipartisan support in today’s hyper-partisan Congress? Not very many but last week identical bills were introduced in the House and Senate that enjoyed rare bipartisan support. Twenty senators and 37 members of the House from both parties signed on to the Marketplace Fairness Act of 2013 (MFA)—legislation that would allow states to collect taxes on what consumers buy over the Internet.
The measure would finally resolve a decades-old dispute over whether states can collect sales taxes on mail-order and online purchases. Currently, states are barred from requiring out-of-state sellers to collect sales taxes, unless the retailers have a physical presence (or nexus) in their jurisdiction. The MFA would allow states to require sellers to collect these levies no matter where the firms are located.
The MFA is similar to bills that died in 2012 and which my TPC colleagues discussed here and here. Under the new measure, states would be permitted to require online sellers to collect tax, though the decision would be left to each state. Today, online buyers owe tax on their purchases (through use taxes) whether sellers collect the levy or not, though few taxpayers bother to comply.
Increasingly, Democratic and Republican governors have had their eye on online sales taxes. The issue has taken on increasing importance with several GOP governors proposing to repeal their state income taxes, a step that would force them to rely even more on sales levies.
MFA would allow states that establish certain simplified procedures, such as a single point of contact for returns and audits, and limitation of seller’s liability for certain errors, to require out-of-state vendors to collect the tax on items purchased by in-state residents for in-state use. Out-of-state vendors with sales under $1 million would be exempt from collecting sales taxes.
The 24 states that are full members of the Streamlined Sales Tax Agreement (SSUTA) would be automatically eligible to collect the tax. Other states would have to enact legislation that 1) identifies the goods and services in their tax base, 2) establishes a single entity for administration, returns processing, and audits, 3) creates a single form for all taxing jurisdictions in the state, and 4) provides appropriate tax software free of charge to vendors. The SSUTA includes these requirements but also addresses more issues like uniform definitions of taxable items and vendor compensation.
The Commerce Department reports that online sales accounted for 4.4 percent of retail sales in 2010 but grew 16 percent from 2009 compared to 6 percent for all retail sales. However, according to a 2009 study, state and local governments only collect about 75 percent of the tax owed on e-commerce sales.
With so many advocates and with the $1 million exclusion—double the exclusion proposed in Senator Michael Enzi’s 2012 bill—the MFA has a good chance of passing this time around. So, as a resident of Washington, D.C., which should be eligible with its single taxing jurisdiction, I’d no longer have to worry about paying use tax on that waffle maker I bought at a President’s Day sale on Amazon. I’d still have to keep the receipt from the tiny sugar shack in Massachusetts where I got my artisan syrup. But, it is long past time online sellers have the same obligation to collect sales taxes as their bricks-and-mortar competitors.
The fiscal cliff deal is done and the question on everyone’s mind: What about the states? Okay, so only a handful of us are actually asking this question. But there are some important provisions that will matter to states still woozy from the Great Recession.
The good news for states is that American Tax Relief Act of 2012 will end much of the uncertainty that has plagued the income tax code in recent years. No longer will states have to guess what will happen to many provisions of the federal revenue code that were set to expire. The bad news is some states will lose revenue they were counting on from scheduled changes in the federal estate tax that won’t happen.
The federal credit for state estate and inheritance taxes is gone for good. The 25 dormant states that had an estate tax only when the federal credit existed will continue to not collect estate taxes. (My brief on state estate taxes and the fiscal cliff has more details but ATRA is the nail in the coffin on the state death tax credit.) Twenty states and the District of Columbia, because they either have an inheritance tax or an estate tax independent of the current federal law, will continue to collect the tax that can still be deducted on the federal return. Five states completely repealed the estate tax. Those states with zombie estate taxes still on their books, knowing the credit is not coming back, may choose one of these options. Or some may just wait to see if Congress changes its mind again.
By engaging in a bit of wishful thinking that the credit would be revived, a few states included revenues from a resurrected estate tax in their latest budget forecasts. Now, with the credit gone for good, those states will have to hope for additional revenue from other taxes to avoid having to revise their projections downward. California used a projected—and now gone—$45 million in new estate tax revenue to help balance its 2012-2013 budget. Wisconsin’s executive budget office included it in its November 2012 forecast. The Colorado Legislative Council Staff was more prescient, revising its revenue forecast in December, eliminating estate tax revenue that had been previously included.
The deal also makes several changes to the individual income tax that will affect states.
The restoration of the top 39.6 percent rate on ordinary income and the new 23.8 percent rate (which includes the surtax for healthcare) on capital gains for high-income households won’t affect the tax structures in most states.
However, states may see a short-term, and entirely misleading, run-up in revenues from taxes on capital gains realized at the end of 2012. This will be driven in large part by investors taking gains in November and December in anticipation of higher taxes on investment income in 2013. States have been fooled in the past by investors accelerating gains to avoid a tax increase. One can only hope they’ll recognize this timing change is likely to be offset by lower capital gains taxes in the first part of 2013.
A handful of states will lose some revenue from higher federal taxes. Six (Alabama, Iowa, Louisiana, Missouri, Montana and Oregon) allow taxpayers to deduct federal income taxes from state taxable income. Thus, to the degree taxpayers pay more to Uncle Sam, they’ll owe less to their states.
The reinstatement of the limitation on itemized deductions known as Pease will reduce deductions, raising taxable income in states that allow the option of federal itemized deductions. The reinstatement of the personal exemption phaseout (PEP) will have a similar effect for the five states that use federal taxable income as a state tax starting point: Colorado, Minnesota, North Dakota, South Carolina, and Vermont.
The permanent alternative minimum tax patch will mean that nearly 30 million middle- and upper- income taxpayers who would have been hit by the AMT are now protected. As a result, they’ll continue to benefit from deducting state and local income taxes on their federal returns, which is effectively a state and local subsidy.
Other changes include the five-year continuation of the earned income credit provisions, which affects 23 states and the District of Columbia that link directly to the federal credit, and the extension of the federal deduction for state sales taxes through 2013, benefitting taxpayers who itemize and primarily reside in states with no income tax.
Now, at least with regard to taxes, all the states need to worry about is what happens if Congress actually undertakes tax reform—when everything is likely to change yet again.
As Congress and President Obama continue to spar over how to avoid the looming fiscal cliff, most public attention has been focused on what tumbling over the edge would mean for the federal budget and the national economy. But the tremendous uncertainty over the threat of tax increases and cuts in federal spending could cause big problems for state budgets as well.
Two new studies, one by The Pew Center on the States and another by the Tax Policy Center, show what falling over the cliff would mean for states. There is a sliver of good news: If all of the last decade’s tax cuts are allowed to expire, states might see a short-term boost in revenues. They might, that is, if the economy isn’t thrown back into recession.
The Pew report, The Impact of the Fiscal Cliff on the States, takes a comprehensive look at how the states will be affected by gridlock. State revenue is dependent on the feds, with $1 in every $3 coming from federal grants in 2010. While Medicaid, one big source of federal dollars, is exempt from the automatic across-the-board spending reduction due to take effect in January, eighteen percent of federal grants to states will be subject to those cuts in FY 2013.
On the tax side, the picture is murkier. Because many states link their tax codes to the federal law, if all of the tax cuts expire and revert to pre-2001 law, states could benefit when some elements are restored. For instance, the old limitation on itemized deductions for high-income taxpayers would increase taxable income and some states could enjoy new income tax revenue.
For example, take the estate tax. I looked at what would happen to that levy in a new TPC paper called Back from the Dead: State Estate Taxes after the Fiscal Cliff.
In 2001, in what Congress hoped would be the first steps on the road to full repeal of the estate tax, lawmakers temporarily phased out a credit for state estate and inheritance taxes, In 2005, the credit was replaced with a less-generous deduction. Some states responded to these changes by simply repealing their estate taxes. Others decoupled from the federal law, either establishing a stand-alone tax or explicitly linking their taxes to the old 2001 law. But many states did nothing, which left their estate tax tied to the repealed federal credit.
Now, if Congress goes over the cliff and the estate tax reverts to the 2001 law, 30 states will once again benefit from the resurrected credit, and their revenues will rise by about $3 billion.
That’s potentially good news, of course, for states still struggling to recover from the recession. But the promise of higher estate tax revenues could easily be swamped by those across-the-board cuts in federal spending or, worse, another recession. On the other hand, if Congress kicks the proverbial can down the road and delays efforts to address its fiscal challenges until next year, states (like businesses) must try to budget in a period of ongoing uncertainty. Both of these new reports highlight the links between states and the federal government and underline the need for clarity and permanence in federal fiscal policy.
On Friday, the Bureau of Economic Analysis released its first look at Gross Domestic Product and its components for the second quarter of the year plus revisions going back to 2009. Those data confirmed that weak government spending continues to hamper the economy. In the second quarter, government spending declines subtracted more than a quarter point from GDP growth, almost exclusively from the state and local government sector.
State and local spending cuts also dragged the economy down in 2010 and 2011. In 2011, the state and local sector contracted 3.4 percent, the largest decline since World War II.
In 2009, real GDP fell 3.1 percent, the largest contraction since 1946, and would have contracted even more without government spending. That decline is smaller than previously reported because of an upward revision in state and local spending. Most of the revision was to the final quarters of 2009 which was the same time as the American Reinvestment and Recovery Act (ARRA) began distributing funds.
The level of state and local spending in 2010 was revised up by a similar amount, so the rate of decline from 2009 to 2010 remained the same at 1.8 percent. The pace of decline in 2011, however, increased by over one percentage point. Instead of state and local government spending contracting by 2.2 percent it turns out the contraction was 3.4 percent. By late 2010 and 2011, the ARRA money was mostly spent, revenues were still well below the peak and states began cutting expenditures in earnest. Many of the cuts in spending were not done as part of the normal budget process. The National Association of State Budget Officers reported in its Spring 2012 Fiscal Survey of States that in fiscal year 2010, 39 states made mid-year budget cuts and 19 made mid-year cuts in FY 2011. Given the urgent nature of the changes required over the last four years, it is likely that the accounting for the crisis is not yet complete.