Tax Cuts on Layaway
October 10, 2006
Key Findings
States that cut taxes significantly in 2006 typically did so in ways that hide the true cost and will make it harder to balance budgets in the future. Of the 10 states enacting tax cuts in 2006, nine “backloaded” the tax cuts, meaning that the bulk of the cost will occur in future years for which budgets have not yet been written. Those future revenue losses will exceed $5.1 billion per year, more than five times what states have budgeted for. This level of revenue loss could reduce states’ ability to meet existing or emerging needs in areas like education, health care, and transportation.
State governments face major fiscal challenges in the next few years. They will need adequate revenue bases to tackle those challenges. But a number of states in 2006 cut taxes deeply without identifying how the tax cuts will be financed.
They could do this, despite balanced budget requirements, because they postponed the bulk of the fiscal impacts to years beyond the states’ current budget windows. This failure to plan ahead will make it even harder for those states (and any states that follow their lead) to address upcoming budgetary needs.
The tax actions that states took in 2006 appear on their surface to be modest in their fiscal impacts. Of the 22 states that cut taxes at all, only five states’ tax cuts are having a “significant” impact on tax collections in the current budget year (FY 2007), meaning that they cost more than 1 percent of state tax collections. From an entirely short-term perspective, the combined cost of the tax cuts in those five states and in five other states with important tax cuts adds up to only $942 million in lost revenue in 2007 – 0.7 percent of those ten states’ tax collections. (The ten states are Arizona, Iowa, Michigan, Nebraska, New York, North Carolina, Oklahoma, Rhode Island, Utah and Wyoming).
Viewed over a longer period of time, however, the tax cuts in those ten states have a far larger annual cost, and there is substantial reason to believe they are unaffordable.
- In fiscal year 2008, which in most states begins next July, the estimated cost of those ten states’ tax cuts more than quadruples from the level identified in 2007 budgets. This is a problem because almost none of those ten states have written budgets for 2008, and therefore there is no mechanism for making sure that those tax cuts can be funded. Nor will there likely be any further consideration of priorities between the tax cuts — which will be included in future revenue estimates — and other actions that likely will be necessary to balance the state budget in light of the tax cuts, such as forgoing necessary public services, raising other taxes, or raiding reserve funds.
- Four of those ten states — Michigan, Oklahoma, Rhode Island and Iowa — enacted tax cuts that will be even costlier in 2009 and into the next decade than they are in either 2007 or 2008. Adding those future fiscal impacts to the total brings the annual cost across all ten states to $5.1 billion, or about 4.0 percent of those ten states’ tax revenues. (See Figure 1)
- Other states also have taken tax actions in 2006 that may have significant negative consequences in future years. For example, Idaho, South Carolina, and Texas all enacted large cuts to local property taxes that are financed by smaller tax increases at the state level, resulting in net fiscal costs to the state.
It is well documented that states already face a host of fiscal problems in the next few years, including long-term erosion in the sales tax and the corporate income tax, increasing demographic pressures, and cuts in federal aid, among others. These tax cuts will further diminish the stability and sustainability of state finances. They will reduce the amount of revenue that is available in future years to pay for public services such as education, health, transportation and public safety, and they will reduce the resources available to set aside in rainy day funds or other reserves. They will also diminish those states’ ability to pay for other forms of tax relief since states generally must balance their budgets.
But in states enacting tax cuts, these tradeoffs between services, reserves, and other forms of tax relief will not be considered explicitly in future years as part of the budget process. Rather, the rapidly rising costs of the already enacted tax cuts will be completely hidden because they are implicitly incorporated into revenue estimates that are prepared in most states at the beginning of the budget process. Costly as they may be, these tax cuts — and the resulting revenue loss — may never receive reconsideration in the course of future budget discussions.
The Large Tax Cuts of 2006 Include Several That Are Highly Backloaded
This analysis focuses on ten states that in 2006 each enacted significant state-level tax cuts that, when fully phased in, will cost at least 1 percent of each state’s 2005 tax revenue. The states are listed in Table 1.[1] This analysis finds that nearly all of them are structuring those tax cuts in ways that pose fiscal problems in the not-too-distant future. The reason is that several of the largest tax cuts are “back-loaded” — that is, their full revenue loss and resulting budget pressure will not be felt for several years.
According to official projections by state agencies, the cuts will reduce state revenues in FY 2007, which in most states began on July 1, 2006 and ends on June 30, 2007, by $942 million, or 0.7 percent of those ten states’ total tax collections. This relatively small fiscal impact, combined with short-term revenue growth projected in many states, means that many of the tax-cutting states were able to accommodate the tax cuts into their FY 2007 budgets.
But in fiscal year 2008, the total cost of these ten states’ tax cuts will more than quadruple from the 2007 cost, rising to $4.0 billion, or 3.2 percent of the ten states’ tax revenues. A substantial portion of the projected increase results from a very large tax cut in Michigan that takes effect January 1, 2008. Other states where the fiscal impact will double or triple include Arizona, Iowa, Nebraska, New York, North Carolina, Oklahoma, and Rhode Island. Only Wyoming shows the full impact of the tax cut in its 2007 budget (See Table 1).
These rising out-year increases are potentially problematic because nine of these ten states have not yet formulated their FY 2008 budgets. This is because they budget either on an annual basis, or on a biennial basis that extends only through 2007. As a result, in those nine states, the full cost of the tax cuts has not yet been taken into account. The exception is Wyoming, whose two-year budget extends through 2008 and whose temporary tax cut expires at the end of that fiscal year. The other states will have to figure out how to accommodate those tax cuts into the FY 2008 budget when they begin budget deliberations sometime in early 2007.
Several states will not face the full hit of the 2006 tax cuts until even later than FY 2008. Major tax cuts in Michigan, Oklahoma, Rhode Island and Iowa will not reach their full fiscal impact until fiscal years 2009, 2011, 2012 and 2015 respectively (See Figure 2, 3, and 4). By that time, it is likely that many of the legislators and governors who enacted the tax cuts will no longer be in their current positions and therefore will not have to face the fiscal consequences of the tax cuts. Taking into account the final, full-year fiscal impacts, the total annual effect of the ten largest 2006 tax cuts equals $5.1 billion, or about 4.0 percent of those ten states’ tax revenues.
Table 1:
2006 State Tax Cuts with Final Fiscal Impacts Exceeding One Percent of State Tax Collections
