Commentary—

Busting The State Tax Revenue Boom

By Chris Edwards

The nation’s strong economic growth is creating a tax revenue boom for the states. State tax revenues jumped 8.7 percent in 2004 and about 8.0 percent in 2005. About three-quarters of state governments had tax revenue growth of six percent or more in 2005.

What will the states do with their overflowing coffers? During the revenue boom of the 1990s, states allowed their budgets to bloat as they expanded programs such as Medicaid to unsustainable levels. When the recession hit in 2001 and revenues stagnated, state officials moaned that they were innocent victims of a fiscal crisis. Their strategy for recovery amounted to hiking taxes and clamoring for more aid from Washington.

Only a few years into the current boom, some states are already making the same mistake of overspending. In California, Governor Arnold Schwarzenegger has proposed a budget increase for fiscal 2007 of 8.4 percent, which follows a 9.7 percent increase in 2006. This is the same governor who, in 2003, said, “If you spend, spend, spend, then you have tax, tax, tax, but all of a sudden you say, ‘Where are the jobs?’ Gone, gone, gone.”

While seeking reelection this year, Mr Schwarzenegger has found a new interest in “spend, spend, spend.” The governor of Maryland is taking the same approach as he seeks reelection. Robert Ehrlich has proposed a huge budget increase for fiscal 2007 of 11.4 percent, which follows a 7.6 percent increase in 2006.

Otherwise sensible policymakers — such as these governors — apparently think that there is no harm in allowing spending to rise rapidly during booms, as long as tax rates aren’t increased. That is not correct: Every dollar used for budget expansion is a dollar sucked out of the private economy and not available for investment and job creation. The cost to California and Maryland of using rising revenues for added spending is that crucially needed reforms to improve the states’ tax competitiveness are not being made.

Some governors are using current budget surpluses to cut taxes. Unfortunately, most cuts this year are gimmicks such as rebates and narrow credits, rather than reductions to tax rates. State policymakers seem to have forgotten that the purpose of tax cuts is to promote economic growth, not to buy off various special interest constituencies. Governor Jon Huntsman of Utah is an exception — he is calling for a cut to the state’s top income tax rate to “send a signal about our commitment to long-term competitiveness.”

Competitiveness means responding to the rising pressures from mobile capital, mobile workers, and mobile retirees. Mobile capital, for example, is increasingly avoiding jurisdictions that impose high corporate income taxes. Thus, a good use of budget surpluses would be to cut or abolish these damaging taxes, which have huge compliance costs but collect relatively little revenue.

A few smart states, including Nevada and Washington, do not have corporate income taxes. Smart because that policy maximizes state investment by local and incoming businesses. For footloose industries, why invest in California with its 9.3 percent corporate tax or New York City with its exorbitant state/city corporate tax of 17.6 percent, when you have the option of paying zero elsewhere?

The same calculus applies to high-paid — and thus high-skilled — labor. Some states do their best to repel this valuable resource by imposing steeply graduated individual income taxes. New York City’s top individual income tax of 12 percent is very uninviting compared to the nonexistent income tax in Texas and Florida.

Another aspect of state tax competition is the retirement market. By one estimate, one-fifth of the 79 million baby boomers will move to another state when they retire. Clearly sunshine and lifestyle are key motivators, but most retirees are on fixed incomes and likely to be cost conscious in making retirement location choices.

Kiplinger’s Personal Finance magazine has found that state and local differences in sales taxes, property taxes, and the tax treatment of pension and retirement income can create after-tax differences of thousands of dollars for typical retirees. For wealthy retirees, state death taxes are also important.

In sum, if states continue using today’s surpluses to expand budgets they will set themselves up for a California-style budget crisis when the economy slows. If, instead, states use surpluses to reduce tax rates, they will increase competitiveness, spur growth, and keep their budgets in the black when the next slowdown hits.

(Chris Edwards is tax director at the Cato Institute and author of Downsizing the Federal Government.)