State Tax Reform and State Fiscal Crises State Tax Reform and State Fiscal Crises

MGMT 932

Local Public Economics and Business Strategy

Session 4: April 6, 2006

Professor Therese McGuire

These slides are for exclusive use in MGMT 932 at the Kellogg School of Management, Northwestern University.No other use is allowed without permission of Professor Therese McGuire.

2

Road MapRoad Map

The “big three” state and local taxes. General sales tax. Individual income tax. Property tax.

State tax reform – what are the issues around the country? Education finance reform. Other spending pressures – Medicaid. Avoiding the “T” word.

State budget deficit/surplus dynamics. The fiscal crisis of 2001 and beyond. Can the ride be smoothed?

Rainy day funds.

3

How do the big three state and local taxes stack up?How do the big three state and local taxes stack up?

General sales tax 45 states and numerous local governments rely on this tax.

In Chicago, at least four taxing jurisdictions: state, county, city, RTA.

Consumption taxes broadly defined are generally preferred on efficiency grounds. Why?

But most general sales taxes are not broadly defined.

Generally, a regressive tax. Food often exempt for this reason. Is this good tax policy?

Generally tend to be more stable and less responsive than income taxes. Big issue: the lack of taxation of personal services.

An example of inertia in policy in the face of changed realities.

Illinois institutional details. 6.25 statewide (1.25 back to counties and cities). Home-rule jurisdictions can add in increments of .25 (aggregate rate in Chicago: 8.75). Food and services generally exempt (1.00 on food collected for local governments). Fairly high rate compared to other states; fairly typical narrow base.

4

How do the big three state and local taxes stack up?How do the big three state and local taxes stack up?(continued)(continued)

Personal (individual) income tax 41 states and a few local governments rely on this tax. Generally viewed as an engine of progressivity because of graduated rate

structures and zero-tax amounts (ZTA). How far can a state push progressivity before inducing out-migration of high-income

people?

Many states rely on federal definition of income, simplifying compliance. But some glaring exceptions: retirement income, capital gains.

Illinois institutional details. Enacted in 1969 (state constitutional convention) at rate of 2.5% and $1,000 personal

exemption. Constitutional prohibition on having a graduated rate structure. Since 1989 3.0% flat rate on income above the personal exemption. Personal exemption raised to $2,000 a few years ago. Retirement income is exempt. Very low top rate and quite low ZTA compared to other states.

• Low ZTA a philosophical decision.

5

How do the big three state and local taxes stack up?How do the big three state and local taxes stack up?(continued)(continued)

Property tax Rationale 1: benefit tax. Rationale 2: wealth tax. Primary source of own-source revenues for most local governments. State governments define and restrict this local tax. Consistently comes out as the least loved of all taxes. Why? Debate over the incidence of the tax. Big issue: the unequal distribution of the tax base across jurisdictions.

This drives most challenges to education funding systems.

Illinois institutional details. Relatively heavy reliance compared to other states. State aid to school districts to combat disparities is low relative to other states. Most local governments in the country (over 6,800). Why? 1991 passed a tax cap initially on the collar counties. Since, it has spread to non-

home-rule jurisdictions in Cook County and more than 30 downstate counties. Classification of property in Cook County only.

6

Sidebar: Corporate Income TaxSidebar: Corporate Income Tax

40-45 states rely on this tax for small amounts of revenue. Average of 6.2% of tax revenues when aggregated across all states.

A very unstable tax. Uncertain how it scores on equity and efficiency.

Incidence of the tax difficult to determine. Distortions to economic behavior debatable.

Question of how to determine a given state’s share of a multi-state corporation’s income. Formula apportionment (weighting factors) v. separate accounting (transfer prices).

Trend toward sales factor only as an economic development tool.

Illinois institutional details. Enacted in 1969 at a rate constitutionally restricted to 8/5 of individual income tax rate. Add on Personal Property Replacement Tax brings total rate to 7.3%.

Another example of inertia in policy in the face of changed realities.

Recently went to single (sales) factor formula.

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Why state tax reform is needed and why it is not likely Why state tax reform is needed and why it is not likely to happen in our lifetime.to happen in our lifetime.

Antiquated tax systems. Lack of taxation of services under the sales tax. State corporate income taxes.

Spending pressures. Education finance reform. Medicaid. Pensions.

Recurring fiscal crises. Piecemeal responses rather than fundamental change.

Political paralysis – avoiding the “T” word.

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What’s Behind the State Fiscal Crisis of 2001 and What’s Behind the State Fiscal Crisis of 2001 and Beyond?Beyond?

9

10

MysteryMystery

The 2001 recession was relatively mild, but states experienced one of the The 2001 recession was relatively mild, but states experienced one of the worst fiscal crises in memory. Why?worst fiscal crises in memory. Why?

11

From: Knight, Kusko, and Rubin; State Tax Notes, 2003.

12

Total

165170175180185190195

1978

q3

1979

q1

1979

q3

1980

q1

1980

q3

1981

q1

1981

q3

1982

q1

1982

q3

1983

q1

1983

q3

1984

q1

Quarter

General Sales and Gross Receipts

52

54

56

58

60

62

1978

q3

1979

q1

1979

q3

1980

q1

1980

q3

1981

q1

1981

q3

1982

q1

1982

q3

1983

q1

1983

q3

1984

q1

Quarter

Individual Income

4547495153555759

1978

q3

1979

q1

1979

q3

1980

q1

1980

q3

1981

q1

1981

q3

1982

q1

1982

q3

1983

q1

1983

q3

1984

q1

Quarter

General Sales and Gross Receipts

76777778787979

1989

q3

1989

q4

1990

q1

1990

q2

1990

q3

1990

q4

1991

q1

1991

q2

1991

q3

1991

q4

1992

q1

1992

q2

Quarter

Individual Income

73747475757676

1989

q3

1989

q4

1990

q1

1990

q2

1990

q3

1990

q4

1991

q1

1991

q2

1991

q3

1991

q4

1992

q1

1992

q2

Quarter

Total

294299304309314319324

1999

q3

1999

q4

2000

q1

2000

q2

2000

q3

2000

q4

2001

q1

2001

q2

2001

q3

2001

q4

2002

q1

2002

q2

2002

q3

2002

q4

2003

q1

2003

q2

Quarter

General Sales and Gross Receipts

9899

100101102103104

1999

q3

1999

q4

2000

q1

2000

q2

2000

q3

2000

q4

2001

q1

2001

q2

2001

q3

2001

q4

2002

q1

2002

q2

2002

q3

2002

q4

2003

q1

2003

q2Quarter

Individual Income

95

100

105

110

115

120

1999

q3

1999

q4

2000

q1

2000

q2

2000

q3

2000

q4

2001

q1

2001

q2

2001

q3

2001

q4

2002

q1

2002

q2

2002

q3

2002

q4

2003

q1

2003

q2

Quarter

Shaded areas represent recession periods.

Figure 6State tax revenue immediately before, during and immediately after

recent U.S. recessions (Billions of real 1983 dollars)

Recession timing: Recession 1 was a double dip January 1980 to July 1980 and July 1981 to November 1982 Recession 2 was July 1990 to March 1991 Recession 3 was March 2001 to November 2001

Total

229

231

233

235

237

239

1989

q3

1989

q4

1990

q1

1990

q2

1990

q3

1990

q4

1991

q1

1991

q2

1991

q3

1991

q4

1992

q1

1992

q2

Quarter

13

Figure 7Figure 7State Expenditures Immediately Before, During and Immediately After Recent U.S. Recessions (Real 1983 State Expenditures Immediately Before, During and Immediately After Recent U.S. Recessions (Real 1983

Dollars per Capita)Dollars per Capita)

Medical Vendor payments (Medicaid)

80

90

100

110

120

130

1979 1980 1981 1982 1983 1984

Fiscal Year

Medical Vendor payments (Medicaid)

100

150

200

250

300

1990 1991 1992

Fiscal Year

Medical Vendor payments (Medicaid)

220

270

320

370

420

2000 2001 2002 2003

Fiscal Year

Cash Assistance

34

36

38

40

42

1979 1980 1981 1982 1983 1984

Fiscal Year

Cash Assistance

34

36

38

40

42

44

1990 1991 1992

Fiscal Year

Cash Assistance

19

20

21

22

23

24

2000 2001 2002 2003

Fiscal Year

Recessions: The first was a double-dip recession from January 1980 to July 1980 and from July 1981 to November 1982.The second recession occurred from July 1990 to March 1991.The third recession occurred from March 2001 to November 2001.

Education

680

700

720

740

760

780

2000 2001 2002 2003

Fiscal Year

Education

455

460

465

470

475

480

1979 1980 1981 1982 1983 1984

Fiscal Year

Education

560

570

580

590

600

1990 1991 1992

Fiscal Year

14

Illinois General Fund RevenuesEstimated FY2006

Millions of Dollars

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

Individual Income Tax Sales Tax Gambling Corporate Public Utility

Source

15

Illinois General Fund AppropriationsRecommended FY2006

Millions of Dollars

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

16

Illinois General Funds RevenuesMillions of Dollars

21000

22000

23000

24000

25000

26000

27000

28000

2004 2005 (Estimated) 2006 (Estimated)

Year

Total Receipts

Total Receipts Less Transfers-In and PensionObligation Bonds

17

Mystery Solved Mystery Solved (sort of)(sort of)

Unprecedented (in modern history) swing from surplus to deficit..

Very little of this swing is attributable to the macroeconomy implying that we cannot grow our way out of the problem.

In large part, and in contrast to previous downturns, the problem was brought on by the inability of policymakers to increase taxes or cut spending.

During the most recent recession, state spending grew or was maintained while revenues plummeted and stayed down; ergo, state fiscal crisis.

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The California “Debacle”The California “Debacle”Based on case packet reading by Steven SheffrinBased on case packet reading by Steven Sheffrin

A budget surplus of $7 billion at the beginning of FY 2000-2001 was turned into a budget deficit of $38 billion at the beginning of FY 2003-2004. How? Rapid increases in revenue in the late 1990s fueled rapid increases in spending. When revenues began to collapse in 2001-2002, policymakers failed to adjust

spending. Revenues from capital gains and stock options peaked in FY 2000-2001 at 38

percent of personal income tax revenues. Once the stock market bubble burst, the drop in tax collections became

permanent and the earlier increase in spending became unsustainable. The state relied on borrowing and one-time solutions rather than permanent cuts

in spending or increases in recurring revenues.

California’s budget woes are not over.

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Rainy Day FundsRainy Day Funds

A Rainy Day Fund is a special reserve of revenues set aside in good economic times to be drawn upon in bad economic times.

Between 2001 and (early in) 2005, states used about $30 billion in reserve funds to close cumulative deficits of over $250 billion. In the early part of the fiscal crisis, reserve funds closed about one-quarter of the deficits that had developed through FY 2003. In FY 2006 about half the states still face deficits of an aggregate of over $30 billion.

How big do Rainy Day Funds need to be? Before the fiscal crisis began (end of FY 2000), states held 10.4 percent of spending in

reserves. By the end of FY 2005, this figure was at 3.3 percent. Center on Budget Priorities and the Government Finance Officers Association each suggest

that reserves much greater than 5 percent are needed.

Why do not all states have well-designed/well-funded Rainy Day Funds?

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Preview of Topics for Week 3Preview of Topics for Week 3

Are taxes a significant factor in business location decisions? Inter-regional decisions. Intra-regional decisions.

Can tax incentives be justified from society’s perspective? A close look at the relocation of Boeing’s corporate headquarters.

Location-specific inducements to economic activity. Enterprise zones. Tax increment financing (TIF).