December 19, 2006
TAX CUTS AND CONTINUED CONSEQUENCES:
States That Cut Taxes the Most During the 1990s Still Lag Behind
By Nicholas Johnson and Brian Filipowich
With some states contemplating tax cuts in 2007, this is a useful time to examine the effects of the last major round of state tax cuts, during the 1990s. Some 44 states enacted tax cuts in the middle and late 1990s. Many states were restrained in their tax-cutting, but a few were not.
During that period, six states reduced their annual revenue by more than 10 percent: Colorado, Connecticut, Delaware, Massachusetts, New Jersey, and New York. Another ten states reduced revenue by 7 percent to 10 percent: Arizona, California, Georgia, Iowa, Maine, Maryland, Michigan, Minnesota, Pennsylvania, and Washington. In dollar terms, those 16 states together accounted for most of the nation’s state tax cuts during the 1990s.
Contrary to the promises of tax-cut proponents, the tax cuts failed to improve those states’ fiscal and economic health, particularly after the U.S. economy ran into trouble in 2001. In fact, the big tax-cutting states generally faced larger fiscal problems, and have had worse economic performance, than other states that were more cautious about tax cuts.
A comparison of the states that cut taxes the most during the 1990s with other states shows that:
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Large tax cuts led to larger budget shortfalls when the economy weakened. In the 16 states that cut taxes by at least 7 percent during the economic expansion, fiscal year 2004 budget deficits averaged 14.9 percent of spending. This compares to budget deficits of “only” 8.9 percent of spending for the other 34 states. Despite strong revenue growth after 2004, 10 of the 16 largest tax-cutting states still face documented budget problems, compared to only 14 of the remaining 34 states.
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Large tax cuts were often followed by credit rating downgrades. Eight of the 16 top tax-cutting states received general obligation bond downgrades from the three major rating agencies in 2001, 2002, or 2003, compared with only seven of the other 34 states. Those downgraded credit ratings have not yet been restored.
In addition to experiencing larger fiscal problems, the biggest tax-cutting states also fared worse economically during the period of increasing unemployment that began with the 2001 recession. Even as the economy has slowly recovered, the top tax-cutting states of the 1990s still lag behind the more fiscally responsible states.
Between 2001 and 2006, the states that had cut taxes most:
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Created fewer jobs. Total payroll employment in the 16 states with the largest tax cuts grew by just 0.4 percent per year, less than half as much as in the 34 other states. The six states that cut taxes by over 10 percent fared even worse, adding less than 0.1 percent more jobs per year.
Policymakers who supported large tax cuts during the 1990s relied on two major arguments: that the tax cuts were affordable, and that they would improve the state’s economic performance. (The latter argument ignored a body of literature showing that taxes have only modest, if any, impacts on business activity and economic growth; see the box on page 4.) The findings of this report suggest that both justifications were questionable at best.
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It is now clear that the tax cuts of the 1990s seemed affordable at the time only because of the unusual, overheated economy. Capital gains, stock options, and other forms of executive compensation grew to inflated — and unsustainable — levels. Consumption peaked because paper stock-market gains led people to feel wealthier and because consumer debt soared.
Most states based their tax cuts on the assumption that the revenue from the bloated income and consumption levels would continue into the future. It did not; the level of revenues experienced in the late 1990s was a “bubble.” When the stock market declined and the economy went into recession, state revenue also declined sharply. The states that cut taxes deeply found they had overshot the mark of affordability by a significant margin.
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It is impossible to know how states’ economies (and budgets) would have performed had policymakers made different decisions regarding tax cuts. However, the fact that the biggest tax-cutting states had worse economic and fiscal performances than other states during the economic slowdown and beyond suggests that the tax cuts did not achieve their desired results.
Tax Cuts: Rhetoric vs. Reality
Many claims by leading tax-cut advocates in the 1990s proved incorrect. For example: |
State |
Claim |
Outcome |
New York cut taxes by 24 percent. |
“We've proven over and over again that tax cuts create the financial freedom that creates new jobs and new opportunities for New Yorkers.”
Governor George Pataki |
New York lost 0.2 percent of its jobs over the last five years, compared to an average national gain of 0.7 percent. |
New Jersey cut taxes by 17 percent |
“Together we will unshackle that economic engine from the restraining chains of high taxes.” Governor Christine Todd Whitman |
Personal income in New Jersey has risen 1.1 percent per year since 2001, less than half the rate of inflation and lower than the national average. |
Michigan cut taxes by 10 percent. |
“Long term, state budget needs are dramatically lessened when we improve the family budget by raising incomes and cutting taxes.” Governor John Engler |
In Michigan, despite yearly real per-capita spending cuts averaging 3.5 percent for four years, the state still faces a projected budget deficit for FY 2008. |
To be sure, some of the big tax-cutting states enjoyed strong economies during the late 1990s, but not because of their tax cuts. For example, New Jersey, which cut taxes by over 10 percent between 1994 and 1996, created roughly 350,000 new jobs between 1996 and 2000. Tax-cut advocates, including Governor Christine Todd Whitman, were quick to credit the tax cuts (see box). But researchers from the University of Oklahoma found that region-wide economic growth, not tax cuts, spurred New Jersey’s employment gains.[1]
Moreover, the economic gain by tax-cutting states during good times to a great degree was wiped out by the deep economic distress these states experienced during the downturn (in terms of low employment and income growth). For example, Massachusetts cut taxes by over 10 percent of revenue between 1996 and 1998. At the end of the 1990s the state’s economy, like the nation’s as a whole, performed well; Massachusetts gained about 145,000 jobs between 1998 and 2000. However, between 2001 and 2003 Massachusetts lost 143,000 jobs, virtually wiping out the job gains of the late 1990s. Since 2003, only about 10,000 of the jobs lost have been recovered.[2]
Today, states are in danger of making the same mistake that many states made during the 1990s. In some states, the run-up in real-estate prices of the last few years produced a capital-gains boom that led to budget surpluses and a sense that tax cuts were easily affordable. Indeed, nine states in 2006 enacted substantial tax cuts with delayed — and quite possibly unaffordable — fiscal impacts.[3] But the past year’s cooling of the real-estate market, and the potential softening of the economy heading into 2007 and 2008, suggest that continued strong state revenue growth is far from certain.
Substantial Body of Academic Literature Questions Role of State Taxes in Economic Development
A large body of academic literature has found that state and local taxes have, at best, a modest impact on economic development. In a recent study, economist Robert G. Lynch analyzes the existing research on the impact of state and local taxes on economic development.a Lynch’s study confirms that the costs of taxes are much less important to businesses than other location specific costs such as qualified workers, proximity to customers and quality public services. Some other key findings of the study include:
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There is little evidence that state and local tax cuts — when paid for by reducing public services — stimulate economic activity or create jobs. There is evidence, however, that increases in taxes, when used to expand the quantity and quality of public services, may promote economic development and employment growth.
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A review of the hundreds of survey, econometric, and representative firm studies that have evaluated the effects of state and local tax cuts and incentives makes clear that these strategies are unlikely to stimulate economic activity and create jobs in a cost-effective manner.
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Even with optimistic assumptions, for each private-sector job created by state and local tax cuts, governments may lose between $39,000 and $78,000 or more in tax revenue annually. This substantial revenue loss can force governments to lay off public employees in numbers that probably exceed the number of jobs created in the private sector.
a Robert Lynch, Rethinking Growth Strategies: How State and Local Taxes and Services Affect Economic Development, Economic Policy Institute, 2004. |
Unlike the federal government, which can run large operating deficits when necessary, states have few palatable options when their fiscal and economic circumstances turn down. These results suggest a need for more prudent state fiscal policies. When contemplating tax reductions, states should carefully consider their multi-year revenue projections, as well as the potential risks of revenue shortfalls. In addition, states should assure that their rainy-day funds are adequate before embarking on significant tax cuts.
The Tax Cuts of 1994-2001
As the economy emerged from the recession of the early 1990s and entered the remarkable boom period of the middle and late 1990s, many states enacted dramatic tax cuts. Beginning in 1994 and continuing all the way into 2001, states in aggregate enacted net tax cuts that by the end of the period were costing them roughly $33 billion, or about 7.6 percent of their revenue. Although some 44 states enacted tax cuts, the bulk of the tax cuts occurred in 16 states in which tax cuts exceeded 7 percent of tax revenue. The deepest tax cuts occurred in the six states — Colorado, Connecticut, Delaware, Massachusetts, New Jersey, and New York — that reduced state taxes by more than 10 percent of revenue. See Table 1.
The tax cuts were premised on the unusual level of revenues states were collecting in the boom years of the economy, and on the assumption that those revenue levels would continue indefinitely into the future. This turned out not to be the case. For example, taxable capital gains realizations rose from 2.4 percent of GDP in 1995 to 6.6 percent of GDP in 2000. But this increase was unsustainable; when the stock market declined, these realizations plunged to 2.2 percent in 2002.[4] This decline, coupled with rising joblessness, declining wage and salary income, and flagging consumption growth combined to cause state fiscal and economic troubles. State revenues declined in inflation-adjusted terms for nine consecutive quarters.[5]
Table 1: Cumulative Tax Cuts as a Percent of Prior Years’ Revenue, 1994 - 2001 |
New York
New Jersey
Massachusetts
Delaware
Connecticut
Colorado
Iowa
Michigan |
24%
17%
17%
14%
13%
12%
10%
10% |
Pennsylvania
Arizona
Georgia
California
Washington
Minnesota
Maryland
Maine |
9%
9%
8%
8%
8%
8%
8%
7% |
Average of all other states with tax cuts: 3.5% |
Source: Center on Budget and Policy Priorities analysis of data collected by the National Conference of State Legislatures, State Tax Actions, various years, supplemented with data from state fiscal offices.
See also The State Tax Cuts of the 1990s, the Current Revenue Crisis, and Implications for State Services, November 2002, at https://www.cbpp.org/11-14-02sfp.htm. |
As states now rebound from the 2001 recession, policy-makers should be wary of calls for more unaffordable tax cuts. Two factors that prompted the tax cuts of the 1990s, rising capital gains realizations and surging state revenues, may once again give the appearance that there is room for large tax cuts. Capital gains realizations once again are at historically unusual levels — 4.2 percent of GDP in 2006 compared to the 30-year average of 3.4. In addition, inflation-adjusted state tax revenues have increased for 11 straight quarters. These signs could tempt policy-makers to enact another round of excessive tax cuts. This paper gives evidence that, even in seemingly prosperous economic times, large tax cuts can be damaging economically and fiscally.
Tax-Cutting States after the Recession
This report considers all of the tax cuts enacted between 1994 and 2001. It finds that the states that enacted the biggest tax cuts in the 1990s suffered worse fiscal outcomes between 2001 and 2003 (the time period during which state revenues were in the worst shape) and worse economic outcomes throughout the recession and recovery. Adjusting for tax changes and inflation, state revenues increased for the first time in over two years during the fourth quarter of 2003. Tax increases and the strengthened economy then ushered in a multi-year period of sustained state revenue growth which allowed states to get back in control of their fiscal situation.[6] Economically, however, the states with the largest tax cuts were not able to undo the damage. These states still lag behind in income growth, job growth, and unemployment, compared to the more fiscally responsible states.
Table 2: Economic Performance of Tax-Cutting States |
Indicator |
Sixteen states with tax cuts greater than 7% of revenue in the 1990s |
Other 34 states |
Jobs gained: Percent change in average annual payroll employment, 2001 to 2006 |
0.4% |
0.9% |
Unemployment: Change in annual unemployment rate, 2001 to 2006 |
0.9 percentage points |
0.3 pct. points |
Personal Income: Average annual change in total state personal income, 2001 to 2006 |
1.5% |
1.9% |
|
Six states with tax cuts greater than 10% of revenue in the 1990s |
Other 44 states |
Jobs gained: Percent change in average annual payroll employment, 2001 to 2006 |
<0.1% |
0.8% |
Unemployment: Change in annual unemployment rate, 2001 to 2006 |
1.3 percentage points |
0.4 pct points |
Personal Income: Average annual change in total state personal income, 2001 to 2006 |
1.3% |
1.9% |
Sources: Center on Budget and Policy Priorities calculations of data from Bureau of Labor Statistics and Bureau of Economic Analysis. The unemployment rate data and the payroll employment data are based on state fiscal years. The personal income data is based on calendar years. |
Economic Performance
Table 2 compares the economic performance of the 16 states that cut taxes substantially between 1994 and 2001 — those that cut taxes by 7 percent of revenue or more — to the 34 states that enacted smaller tax cuts or none at all. It also compares the economic performance of the six states that cut taxes by 10 percent of revenue or more between 1994 and 2001 to the 44 states that enacted smaller tax cuts or none at all. The 16 tax cutting states represent about 85 percent of the net tax cuts for the 1994 to 2001 period; the top six tax cutting states represent almost half of the net tax cuts. (For detailed data on the 16 states, see Appendix Tables A & B). Since 2001:
Table 3: Fiscal Performance of Tax-Cutting States |
Indicator |
Sixteen states with tax cuts greater than 7% of revenue in the 1990s |
Other 34 states |
Reserves when the boom ended: Total ending balance as a percent of expenditures, FY 2001. |
9.5% |
11.5% |
Budget deficits in the downturn: Highest projected FY 2004 budget deficit as a percent of spending. |
14.9% |
8.9% |
Tax Changes: Net tax changes as a percent of collections, 2001 to 2003 |
3.4% |
2.7% |
Bond Downgrade: Downgraded by at least one rating agency in 2001, 2002 or 2003 |
8 downgrades |
7 downgrades |
Continuing deficits: Had to close a budget deficit for 2007 or face projected deficits in future fiscal years |
10 deficits |
14 deficits |
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Six states with tax cuts greater than 10% of revenue in the 1990s |
Other 44 states |
Reserves when the boom ended: Total ending balance as a percent of expenditures, FY 2001. |
9.3% |
11.1% |
Budget deficits in the downturn : Highest projected FY 2004 budget deficit as a percent of spending. |
14.3% |
10.5% |
Tax Changes: Net tax changes as a percent of collections, 2001 to 2003. |
6.3% |
2.4% |
Bond Downgrade: Downgraded by at least one rating agency in 2001, 2002 or 2003 |
4 downgrades |
11 downgrades |
Continuing deficits: Had to close a budget deficit for 2007 or face projected deficits in future fiscal years |
4 deficits |
20 deficits |
Sources: Center on Budget and Policy Priorities calculations of data from National Conference of State Legislatures, National Association of State Budget Officers, Moody's, Fitch, Standard and Poor's.
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Fiscal Performance
By cutting taxes in the 1990s, the large tax-cutting states reduced the ability of their revenue system to generate sufficient revenue during the economic downturn. In some cases, they also were unable to save as much as they needed in reserve funds. As a result, states that cut taxes the most during the 1990s had lower reserve levels at the start of the fiscal crisis, faced larger deficits during the fiscal crisis and had to raise taxes more to close deficits. Table 3 compares the fiscal performance of the 16 states that enacted tax cuts in the 1990s exceeding seven percent of annual state tax revenue to the 34 states that enacted smaller tax cuts or none at all. It also compares the fiscal performance of the six states that enacted tax cuts exceeding 10 percent of revenue to the other 44 states. The data show that:
Budget deficits in the top 16 tax-cutting states in fiscal year 2004 averaged 14.9 percent of spending, compared to “only” 8.9 percent of spending for the other 34 states.
California is one of the top 16 tax-cutting states and its deficit was dramatically larger than any other state at 36.7 percent of spending. However, even when California is removed from the analysis, the remaining 15 large tax-cutting states had average deficits of 13.4 percent compared to 8.9 percent for the other 34 states. Four out of the six largest tax-cutting states had larger deficits than the national average state deficit.
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Even now, the tax-cutting states of the 1990s still appear to face larger fiscal problems than other states. The National Conference of State Legislatures reports that 10 of the 16 tax-cutting states had to close a deficit in the current fiscal year (2007) or are facing potential deficits in future fiscal years, compared with 14 of the other 34.
The Six States with the Most Tax Cuts
The results for the six states with the very largest tax cuts in the 1990s, exceeding 10 percent of annual revenue, tell a similar story. The top six tax-cutting states had larger deficits and smaller reserves at the start of the crisis and larger tax increases than the other 44 states. Four of the six top tax-cutting states (67 percent of the states in the category) received bond downgrades, compared to 11 bond downgrades among the other 44 states (25 percent of states). Each of the large tax-cutting states has experienced varying degrees of fiscal and economic hardship over the last few years, and a majority (four of six) are facing continued budgetary challenges.
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Colorado made large personal income tax cuts during the 1990s, and also cut the state sales tax rate and provided substantial tax rebates. During the fiscal crisis, Colorado cut spending by more than twice the national average and saw its credit rating downgraded in 2002.[8] Despite a number of natural economic advantages, such as its location in the fast-growing Rocky Mountain region, between 2001 and 2003 Colorado experienced the largest unemployment rate increase in the nation.
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Delaware also cut its personal income tax significantly during the 1990s, a time in which the state’s economy performed slightly better than average. During the economic downturn, Delaware’s job losses exceeded the U.S. average.
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Massachusetts, which cut its personal income tax rate during 1990s, had a budget deficit equal to 13 percent of spending during the fiscal crisis and cut real per capita spending by 4.8 percent, more than double the US average (it also enacted a substantial package of temporary tax increases that have expired or will expire over the next several years). Massachusetts lost over 140,000 jobs between 2001 and 2003, a 4.3 percent decline — the largest proportional decline in the nation. Between state fiscal year 2001 and 2003, personal income in Massachusetts grew at a rate that was less than one-third the rate of growth of inflation.
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New Jersey cut personal income tax rates and other taxes during the 1990s. New Jersey’s budget situation during the fiscal crisis was one of the worst in the nation, with a 2004 deficit equal to nearly 20 percent of the budget. In 2002, New Jersey’s bond rating was downgraded. Between 2001 and 2003, New Jersey experienced above average growth in unemployment and below average growth in personal income.
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New York was the largest tax-cutting state in the 1990s, with tax cuts exceeding 20 percent of revenues. New York faced deficits in excess of 20 percent of the budget during the fiscal crisis, had above average tax increases, and received a bond rating downgrade. New York’s personal income growth from 2001 to 2003 was less than one-third of the national average.
Why Is This Relevant Today?
This analysis serves as a caution to state policymakers who may be tempted to begin another round of tax cuts now that tax revenues are growing more rapidly. Booming capital gains realizations and sustained state revenue increases - two signs that prompted the damaging tax cuts of the 1990s - could give the false appearance that there is room for large tax cuts. States would do well to assess carefully their long-term revenue projections and the assumptions behind those projections. Claims that tax cuts might boost jobs and wages should be scrutinized with a great deal of skepticism. An alternative to tax cuts, in light of this analysis, would be for states to increase their “savings” by increasing the size of their rainy day funds, reducing pension-fund and other shortfalls, and otherwise preparing for the next economic slowdown. |