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February 21, 2003


Prelude to a Crisis – The State Tax Cuts of 1994-2001

Nearly every state is facing enormous revenue problems now and in the foreseeable future. Total state revenue in fiscal year 2002 was some $38 billion lower than it was in the previous year after adjusting for inflation. Some 45 states lost revenue. Official state forecasts released to date suggest that state revenues at best will hold steady after adjusting for inflation in fiscal year 2003, meaning that none of that $38 billion is likely to be recouped this fiscal year. Indeed, the revenue hole could get even significantly deeper.

These revenue problems are taking a significant toll on the services provided by state governments, with mental health budgets being a prime target. Many states are reducing health insurance coverage and benefits for lower-income families, or increasing the amount that poor and near-poor families must pay to obtain health insurance. Furthermore, such cuts are likely to occur as states exhaust their rainy day funds and other one-time procedures for fixing their budgets.

How did the states get into their current revenue shortfall predicament?

  • In the mid- to late-1990s and into 2000 and 2001, revenue collections grew significantly as a result of unusually high – as it turned out, unsustainably high – levels of economic activity, particularly personal consumption and capital gains realizations. These revenue windfalls turned out to be temporary, as capital gains have declined substantially, and the growth in personal consumption as a share of income is unlikely to be sustainable.
  • Several states used those temporary levels of revenue growth to finance largely permanent tax cuts. Based on revenue forecasts that assumed revenue growth would continue at or near the levels of the late 1990s, some 43 states enacted large tax cuts in 1994 through 2001. These tax cuts, net of a few tax increases enacted in those years, reduced revenue by some 8.2 percent of state tax revenue in the U.S. The ongoing loss of state tax revenue resulting from the net tax cuts enacted from 1994 to 2001 is more than $40 billion per year.
  • Not surprisingly, states that enacted very large tax cuts in the 1990s are in the biggest financial and budget trouble now. For instance, the ten states with the largest tax cuts in the 1990s faced a median budget gap in 2002 equal to nine percent of state spending, and a 13 percent gap in 2003. By contrast, the ten states that cut taxes the least in the 1990s had a median budget gap in 2002 equal to five percent of state spending and a one percent gap in 2003.

Moreover, widely acknowledged structural problems with state budgets are likely to preclude significant growth in state tax bases even when the economy enters a full recovery, whenever that might be. For instance, state sales taxes are gradually eroding as the economy moves from (taxed) goods to (untaxed) services. Most states are suffering from increasing activity by corporations to exploit loopholes in state corporate income tax systems.

Raising Taxes to Alleviate the States’ Budget Crises

State legislators and other state policymakers will cast the budget debate this session as a spending problem and lay the blame on rising Medicaid costs. Health care costs are rising dramatically in the public and private sector. But the impact of the economic downturn in the states has been exacerbated by the large tax cuts implemented by states between 1994 and 2001.

NAMI advocates must make the link between tax and revenue decisions and spending decisions, and develop credible and principled revenue solutions that are fair, broad-based, and sustainable.

The Center on Budget and Policy Priorities has advanced a range of state revenue enhancement strategies, including:

  • Raising "sin taxes" on tobacco, alcohol, and some luxury items;
  • Broadening the state sales tax base to tax more services and to assert jurisdiction over remote sales (catalog and e-mail sales);
  • Boosting income taxes for higher income families;
  • Raising business registration fees;
  • De-linking state estate tax rules from the new federal rules that benefit only the wealthiest 2 percent in most states; and
  • De-linking state bonus depreciation tax rules from the new federal rule that allows corporations to deduct 30 percent of their equipment right away, rather than depreciate them gradually.

States need to reconsider tax cuts made in the 1990s and in many cases ending them or enacting equivalent tax increases.

For further information, please contact Mike Fitzpatrick at (207) 353-9311 or Joel Miller at (703) 524-7600.