State Tax Changes in Response to the Recession

March 9, 2010

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Nicholas Johnson, Catherine Collins, and Ashali Singham

The national recession has had such a devastating effect on state finances that states took in $87 billion less in tax revenue from October 2008 through September 2009 than they collected in the previous 12 months. This 11 percent decline, the steepest on record, resulted from the impact on tax collections of lost jobs, reduced wages, and lowered economic activity.

At the same time, the recession has driven up the number of people needing various state services. This, along with the requirement that states have balanced budgets, has increased the pressure on states to deal with the unprecedented revenue shortfalls in a variety of ways. Nearly all states have cut spending. In addition, most have opted for a balanced approach that includes revenue.

To recoup lost revenue, states have taken such actions as eliminating tax exemptions, broadening tax bases, and in some cases increasing rates as well as raising a number of fees. Doing so is part of an established pattern; states historically have turned to revenue increases as part of the response to recessions. They have found that raising new revenue provides more short-term economic benefit than relying only on spending cuts and does not have an adverse impact on longer-term economic performance.

This report analyzes tax changes enacted in 2008 and 2009. It finds those tax changes to be substantial and widespread.

In 33 states, tax changes are increasing annual revenues, relative to what the state otherwise would have collected, by $31.7 billion. Even after accounting for a few states that lowered taxes, net tax changes for 2008-2009 total $29.7 billion in expected revenues, or 3.8 percent of total state revenues. The difference between the fall-off in revenues and the limited impact of the tax actions enacted is shown in Figure 1.

In 20 states, tax changes are providing a significant boost to revenues — that is, they are producing additional revenue of more than 1 percent of the prior year’s total revenues. Ten of those states have raised taxes by more than 5 percent of the prior year’s collections: California, Delaware, Florida, Indiana, Massachusetts, Nevada, New Hampshire, New York, North Carolina, and Oregon.

Personal income taxes and sales taxes, the two largest sources of state tax revenue, experienced the greatest changes.

Overall, 13 states raised new revenue from personal income taxes, 17 enacted sales tax increases, 22 increased excise taxes on tobacco, alcohol, or motor fuel, 17 increased business taxes, and 24 increased fees or other taxes.

In dollar terms, sales and excise tax changes account for 37 percent of the net increase, or $11.0 billion. Nearly one-third of the expected new revenues — $9.8 billion — came from personal income tax changes. The remaining nearly $9.0 billion — close to one third of the total — is made up of corporate taxes, miscellaneous taxes, and fees.

Corporate tax changes account for 11 percent of the revenue increase, or $3.1 billion, equal to slightly less than 0.5 percent of state revenues.

State tax actions are likely to continue to occur in legislatures over the next two years. There usually is a lag between the time a national recession ends and the recovery of state and local government budgets. This is because unemployment tends to be the last economic indicator to improve, and employment levels are crucial to revenues returning to pre-recession levels. In the past two recessions, state budget shortfalls continued for several years after the recession officially ended. The current recession, with state revenues having suffered an unprecedented drop, could have an even longer recovery period. Additional tax measures would help states address budget gaps that are projected to reach $180 billion in fiscal year 2011 and another $120 billion in 2012.^[1]

It is common and reasonable for states to enact tax changes following the onset of a recession, when declining revenues and increased costs create large budget gaps. The size of the current recession and resulting record budget gaps create a particularly strong case for revenue raisers.

In the wake of the recession of 1990-91, states enacted tax changes that raised revenue by 8.9 percent compared to what they otherwise would have collected. Following the somewhat less severe 2001 recession, states enacted tax measures to raise revenue by 3.5 percent. With the current recession having such a profound impact, and state budget gaps being larger as a result, state tax actions over the past two years have already exceeded those taken in the 2001 recession. It is possible that states will have to raise additional taxes by at least as much as they have already done since the start of this recession, as revenue and economic projections indicate large shortfalls are likely to continue.

Because this recession is both depressing revenue and increasing public need for assistance by so much, tax measures are the only way to avoid a cuts-only solution to current state budget crises. Avoiding sole reliance on spending cuts and embracing instead a balanced approach that includes revenues is important for the health of state economies. When states and localities cut spending, they reduce employee wages and payments to private-sector vendors and individuals — actions that, in turn, reduce the amount that those firms and individuals spend. This creates a ripple effect that can jeopardize recovery. Tax increases can avert some of the reduction in economic activity, particularly when levied on higher-income households and profitable corporations.^[2]

Even the states that have already enacted substantial tax increases will likely revisit the issue soon, in part because many of the 2008 and 2009 tax increases were enacted as temporary measures and are scheduled to expire after two or three years. Of the $30 billion in new taxes, as much as $20 billion will expire by December 2011 — some even sooner. State economies will not have fully recovered by that time, meaning those expirations likely will not be affordable. If states do not extend those tax increases, the revenue could prove hard to replace.

The Tax Actions of 2008 and 2009

The national economy started to decline in late 2007. Gross Domestic Product fell throughout 2008 and much of 2009, costing states considerable revenue. Receipts from income taxes, sales taxes, and corporate taxes all dropped because workers and investors were making less money, families and businesses were spending less, and corporate profits were down. The reduction in tax revenues has so far cost states $87 billion, or 11 percent of their revenues. This is the steepest decline since the U.S. Census Bureau began tracking state revenues collections in 1960.

As a result, when state policymakers began work in early 2008 on budgets for the 2009 fiscal year, they faced large gaps between expected revenues and anticipated spending on public needs. When they met in 2009 to work on budgets for the 2010 fiscal year they faced even larger gaps. Additional gaps have been announced since then as revenues continued to decline. The combined gaps for fiscal years 2009 and 2010 have reached $300 billion.

Required by their laws to balance their budgets, states responded to the unprecedented shortfalls in a combination of ways other than taxes.

They have drawn down reserve funds and used other sources of one-time funds; states’ reserves, at an all-time high going into to the recession, are now largely gone.
They have reduced outlays: state general-fund spending declined 4 percent in fiscal year 2009 (which in most states was July 1, 2008 to June 30, 2009) and another 4.8 percent for 2010, even as the need for public services has grown.
And they have utilized federal assistance, largely through the American Recovery and Reinvestment Act enacted in February 2009, which is filling about one-third of state budget gaps for 2009 and 2010.

But those actions proved in many states to be insufficient to make up for all of the revenue lost through the impact of the recession. Budgets still could not be balanced. In response to the crisis, most states also enacted measures to increase revenue. These principally involved increases in tax rates, measures to subject more items or purchases to existing taxes, and eliminating various tax credits, deductions, and exemptions.

This analysis examines tax actions states have taken since the recession began — those enacted in 2008 and 2009. It includes both newly enacted tax actions and newly implemented installments of previously enacted tax actions. Increases in certain fees, such as motor vehicle registration, are also included. And it measures the size of these actions in terms of their full-year impact on state revenues, to allow for meaningful comparisons with previous years’ actions. Other actions that maintain existing policies, such as extending a tax that was to expire or delaying a scheduled tax cut, are not captured, although these actions also clearly have a revenue impact.

Overall, 33 states raised new revenues, relative to what otherwise would have been collected during 2008 and 2009, of $31.7 billion a year. There also was a counter-trend during this period. In a contradiction to their urgent need for more revenue, a number of states cut taxes. By far, most of the tax cuts occurred in 2008 — before the full extent of the recession was well known — and most were relatively small. The largest tax cuts to take effect during this period were installments of measures that were enacted prior to the recession and scheduled to phase in gradually. They affected revenues after the recession began. In any event, the total dollar impact of the tax cuts in states with overall tax cuts in 2008 and 2009 — $2.1 billion — has been far smaller than the tax increase.

Nationwide, tax changes enacted in all states during 2008 and 2009 totaled a net increase of $29.7 billion in states’ expected revenues, an amount equal to 3.8 percent of prior year revenue. While some states enacted tax increases that raised relatively small amounts of new revenue, 20 states’ actions are expected to increase revenues significantly (i.e., by more than 1 percent of the prior year’s revenues):

Ten states raised revenues by at least 5 percent: California, Delaware, Florida, Indiana, Massachusetts, Nevada, New Hampshire, New York, North Carolina, and Oregon.

Another ten raised revenues by between 1 and 5 percent: Arkansas, Colorado, Connecticut, Hawaii, Kentucky, Minnesota, Mississippi, New Jersey, Rhode Island, and Wisconsin.

Significant tax increases have occurred in all regions of the country. States have enacted increases in all of the major taxes they levy — personal income taxes, general sales taxes, business taxes, and excise taxes. Personal income taxes and sales taxes, the largest sources of state tax revenue, have experienced the greatest increases.^[3]

Personal Income Taxes

Eleven of the states that enacted significant revenue-raisers in 2008 and 2009 did so, at least in part, through their personal income tax. As a result, personal income tax revenues are estimated to increase by $11.4 billion relative to what otherwise would have been collected— about one-third of all tax increases nationwide. The largest increases, as a share of total tax revenues, were in California, Connecticut, Delaware, New Jersey, New York,^[4] Oregon, and Wisconsin. Figure 3 highlights major changes that states enacted in their personal income tax.

Eight of the 11 states increased taxes primarily on high-income taxpayers, with new brackets and/or higher rates at upper income levels. Maryland enacted a similar increase, although the changes amounted to less than 1 percent of total tax revenue. Only one state, California, raised rates on all levels of income.

Nine of the 11 states increased revenue from their income tax by reducing certain exclusions, such as preferential treatment of capital gains, or limiting the amount of deductions that taxpayers can claim.

A large share of the revenue from these tax increases for the 11 states that enacted significant increases is scheduled to expire by December 30, 2011. Temporary tax increases account for $10 billion out of the $11.4 billion raised by these states. For example, New Jersey’s high-income brackets were in place for just one tax year, while the increases in California and North Carolina were enacted for two years, expiring in January 2011. Oregon’s measure raising the top rates will lower them beginning in tax year 2012, though not all the way to the 2008 level. The high-income brackets in Connecticut and Wisconsin are not scheduled to expire.

Several of these states provided some targeted income tax reductions as part of a larger tax increase. New Jersey continued phasing in an increase of the earned income tax credit that began in 2007. Wisconsin created a deduction for high health insurance premiums, excluded retirement income from taxable income, and expanded the state’s property tax credit.

States that reduced their income taxes in 2008 and 2009 include Georgia, Louisiana, Michigan, Missouri, and New Mexico. Some of the changes that were enacted, such as expanding the earned income tax credit in Michigan, reduced the taxes on lower-income taxpayers. In Ohio, the final installment of a phased-in income tax cut had been scheduled to take effect this year. However, in late December, the governor and legislature agreed to postpone it for two years.

Sales Taxes

Nationally, states are raising an additional $8.0 billion from changes to their general sales taxes in 2008 and 2009. Seventeen states raised their sales tax rates, increasing revenues by $8.2 billion. Some states enacted reductions to their sales taxes in the form of mostly small cuts that total less than $250 million a year. Figure 4 highlights major tax changes that states enacted to increase revenues from their sales tax.

Among the states that had significant increases, the largest increases as a share of tax revenue were in California, Indiana, Massachusetts, Nevada, and North Carolina. Each of these states, except Nevada, raised the general sales tax rate by one cent or more. Nevada increased the rate by about one-third of a cent (0.35 percentage points). As with the personal income tax increases, these sales tax increases are mostly temporary. They are scheduled to expire in June 2011 in California, Nevada, and North Carolina; they are permanent only in Indiana and Massachusetts.^[5]

States also broadened their sales tax bases. Three states did so by extending the tax to items previously subject only to an excise tax: alcoholic beverages in Kentucky and Massachusetts, and tobacco products in Colorado. Other states, including North Carolina and Wisconsin, extended the tax to cover digital downloads from the Internet, such as music and movies. Of these measures, only Colorado’s expansion is temporary.

Other states extended sales tax to transactions that, although already legally taxable, often go untaxed. New York, North Carolina, and Rhode Island, for example, extended the obligation to collect sales tax to include certain out-of-state online retailers. ^[6]

While most of the sales tax increases of the past two years occurred in 2009, most of the reductions were quite small and occurred in 2008. They were aimed mostly at exempting certain goods and services used in manufacturing, with the largest such reduction enacted in Louisiana. Two states, Arkansas and West Virginia, reduced sales taxes on groceries.

A concern about sales tax increases is that they are regressive, meaning that low- and moderate-income families pay more as a share of their income than higher-income families. Two states that raised sales tax rates, Indiana and North Carolina, mitigated the regressive impact by increasing the earned income tax credit for low-income families.

Business Taxes

Business tax increases raised a net of $3.1 billion, or about 10 percent of the total tax increases. Seventeen states raised their business taxes, increasing revenues by $4.0 billion. During the period 17 states, including some states that had overall tax increases, took the opposite course and reduced these taxes by around $950 million. Figure 5 highlights major tax changes that states enacted to increase business tax revenues.

States that increased taxes significantly (i.e., by more than 1 percent of the prior year’s revenues) increased business taxes by $4 billion. New York accounted for $1.9 billion of that amount, including $1.5 billion from a new tax on business payrolls to support public transportation in the New York City metropolitan area. (New York also reformed some tax credits and extended various business taxes to some additional firms.)

Business tax rates were increased in Nevada (which raised the rate on its business payroll tax on larger companies while lowering it on smaller ones), Delaware, and Oregon. The increase expires in Delaware after 2013 and in Nevada midway through 2011; the increase in Oregon is partially rolled back after 2012.

Connecticut imposed a surcharge on larger firms, which will expire in 2011. North Carolina likewise imposed a surcharge on its corporate taxpayers, but the state also expanded business tax credits, which more than offset the revenue increase.

Massachusetts and Wisconsin adopted combined reporting, which in effect treats a parent corporation and its subsidiaries as a single entity for state income tax purposes.^[7] In Massachusetts,

combined reporting more than offset the revenue loss from a reduction in the corporate income tax rate in the initial years.

Other states revised various business tax subsidy programs. Hawaii and Wisconsin anticipate additional business revenues from adjustments they made in their subsidy or tax credit programs. California generated revenues by restricting businesses’ ability to offset income with prior-year losses and by limiting businesses’ use of tax credits, but since these limitations were in place only for 2008 and 2009, they increased revenues only modestly. ^[8]

Many of the 17 states that reduced business taxes instituted new credits or expanded existing credits. Michigan initiated one of the larger new programs, with the purpose of encouraging development of new technologies to benefit hybrid car production. Along with Georgia and Utah, Michigan also put in place credits to encourage the making of movies and television shows in-state.

Excise Taxes

In 22 states, excise taxes on tobacco, motor fuel, or alcohol were raised in 2008 or 2009. The total new revenue from excise tax changes is $3.0 billion — over 9 percent of newly enacted taxes. Only one state made minor reductions in these taxes.

Almost three-quarters of the total revenue increase from excise taxes occurred in 2009. More than 80 percent ($2.5 billion) came from increases in tobacco taxes in 20 states. In all but two of these states, excise taxes were part of broader packages to increase taxes.

Other Taxes and Fees

In addition to the taxes discussed above, states impose numerous other, smaller taxes, such as excise taxes on restaurant meals and hotel rooms and tax-like fees, especially on motor vehicle registration

and licensing. During 2008 and 2009, 24 states increased a number of these types of taxes and fees. Net increases in these 24 states (minus net reductions in three other states) raised $6.1 billion, or 20 percent of the net revenues generated by all state measures.

Three states raised particularly large amounts of new revenues from such “other” taxes and fees — Colorado, Florida, and Nevada. These include transportation-related fees in Colorado, a variety of license fees on businesses and motor vehicles in Florida, and hotel taxes and other items in Nevada.

What Tax Actions Will States Take in 2010 and Beyond?

State Tax Actions Have Not Yet Been as Great as in Some Past Recessions

For states to raise taxes to recover revenue losses due to a national recession is consistent with past actions. In response to the 1990-91 recession, 44 states raised revenues significantly (by 1 percent or more); revenue increases were large in the initial years following the onset of the recession but then lessened as the recovery began to take hold. Overall revenue increases totaled 8.9 percent of revenue over the four years after the recession began.

Similarly, in response to the 2001 recession, more than 30 states enacted significant revenue increases, with 15 increasing revenues by 5 percent or more. The tax increases occurred over three years and raised overall state revenues by 3.5 percent.

During each of these periods, states increased a range of taxes — personal income, corporate income and other business taxes, sales and excise taxes, as well as fees and other miscellaneous taxes.

The current recession has led to greater tax increases than occurred in response to the 2001 recession, but has not yet led to tax increases as great as those in response to the recession of the early 1990s. In 2008 and 2009, as noted above, 20 states have already raised their revenues significantly, with overall increases in revenues totaling 3.8 percent. Experience suggests that states are likely to continue raising revenues for several years after the recession has technically ended.

Though the last recession ended in 2001, states continued to experience budget shortfalls through 2005. A comparison of the pattern of tax increases during recessions is shown in Figure 6.

The tax increases of 2008 and 2009 include more revenue from personal income taxes, and less from consumption taxes, than those enacted in response to the 2001 recession. (See Figure 7.) However, as noted above, many of these personal income tax measures are slated to expire soon — while sales and excise tax increases are more likely to be permanent. A lasting impact of this recession, therefore, could be increased state reliance on consumption taxes.

Without Additional Tax Actions, States May Resort To Excessive, Economically Harmful Cuts to Services

The impact on state budgets of the current recession has been much greater than in previous downturns. States are facing the steepest decline in tax receipts on record, and state budget shortfalls in the first years of this downturn have been far larger than those caused by the 2001 recession. Moreover, in two-thirds (35) of the states, new budget gaps have developed for the current fiscal year since they adopted their budgets. ^[9] Nationally, projected shortfalls for 2010 and 2011 are even larger than the shortfalls states faced in 2008 and 2009, and are not likely to ease much even in 2012. To make matters worse, the recession has also increased the need for public services that states provide, as residents lose jobs, income, and health insurance.

Every state except Vermont is required to balance its operating budget each year or biennium (for states that operate under a two-year budget period). Unlike the federal government, states cannot maintain services during an economic downturn by running a deficit. Their options to balance their budgets are limited. After drawing down reserves, states face choices that involve reducing spending and increasing revenues.

States that increased revenue in this recession also reduced spending, suggesting that they saw the need for a balanced approach rather than confining themselves to one budget-balancing tool. While 20 states have increased their taxes by more than 1 percent of their revenues during this recession, many more — at least 42 — have enacted program cuts. These cuts reduce services in all major areas, including health care, assistance to the elderly, K-12 education, and higher education. States have also reduced their government workforces through layoffs and unpaid leave. The cuts not only

harm vulnerable residents but also worsen the recession by reducing overall economic activity. When states cut spending, they lay off employees, cancel contracts with vendors, reduce payments to businesses and nonprofits that provide services, and cut benefit payments to individuals. All of these steps remove demand from the economy, which is particularly harmful during a recession when the private sector is faltering.

States were able to avoid even larger spending cuts (particularly in health care and education) and tax increases by using federal recovery funds. The federal assistance to states provided in the American Recovery and Reinvestment Act is closing an estimated 30 to 40 percent of state budget gaps. But this state fiscal relief — primarily for Medicaid — is scheduled to expire by December 2010, and funds for fiscal stabilization will be mostly drawn down by then as well. However, large budget shortfalls will remain.

Table 1: Annual Economic Growth by Various Indicators 2004-2007
Indicator	States That Increased Taxes Significantly	States Without Significant Tax Increases
Personal Income	6.0%	6.2%
Employment	1.6%	1.8%
Median Wage	3.1%	3.1%
Source: Bureau of Labor Statistics, Bureau of Economic Analysis, and CBPP calculations of data from the NCSL and state revenue departments. Note: States were grouped according to the amount of gross tax increases between 2002 and 2004, excluding Colorado. States that increased taxes significantly are those that enacted cumulative increases of at least 1 percent of the previous year’s tax revenues.

The Economic Consequences of Raising Taxes

For states short of revenue to meet public needs, tax increases — particularly on higher-income households — can lessen reliance on spending cuts of a magnitude that would harm vulnerable residents and threaten economic performance. Like spending cuts, tax increases remove some demand from the economy by reducing the amount of money people have to spend. But as Nobel prize-winning MIT economist Joseph Stiglitz and Peter Orszag (then a Brookings Institution economist and now the director of the Office of Management and Budget) explained in a 2001 analysis, tax increases can be less detrimental to state economies than budget cuts because some of the additional tax payments will be made from savings rather than from money that would otherwise be spent. Since higher-income families tend to save more of their income than less-affluent families, tax increases on them are the least damaging approach. ^[10]

It is sometimes argued that raising taxes will slow the rate of states’ economic recovery. Available data do not appear to support this argument. Tax measures that states used to help balance budgets during the 2002-04 period appear to have had no adverse effect on states’ economies. When compared on major measures of economic progress, states that raised taxes performed at roughly the same level as states that did not. Table 1 compares the 29 states that raised taxes during the 2002-04 period with those that did not. It shows that during the subsequent period of economic recovery — from 2004 through 2007 — the states that raised taxes fared about as well as those that didn’t. In short, neither economic theory, nor recent history, support allowing a fear of weakened economic growth to affect the decision of whether or not to raise taxes.

Some states that have raised taxes during the current recession still face large projected shortfalls, in part because their tax increases were only temporary. For those states whose tax increases are to expire before the states fully recover, extending the temporary measures would provide much-needed revenue. Several other states are now facing increased budgetary pressures in part because they reduced taxes during the past two years. For states scheduled to carry out previously enacted tax reductions, such as New Mexico, postponing those reductions would likely be less detrimental to the state’s economy — and to vulnerable residents — than the deeper spending cuts that would occur if revenues were not retained.

Conclusion

Since the beginning of the most severe national recession since the Great Depression, states have experienced an unprecedented decline in revenues while having to address increased public needs stemming from rising unemployment. The budget gaps states have faced the past two years have been greater than the shortfalls reported during all four years of the prior recession.

To close the budget gaps created by this recession, at least 42 states cut spending the past two years; 33 raised revenues. For 20 of these states, the revenue increases were significant, equivalent to at least 1 percent of their total revenues. All types of taxes — personal income, sales, business, and excise taxes and a wide variety of fees — were increased.

Budget shortfalls are likely to continue at least over the next two years and could be as large as the gaps in the past two. Two-thirds of the states are facing midyear deficits for fiscal 2010 and 38 already have addressed or are facing budget gaps in 2011. As revenue forecasts continue to be bleak, additional shortfalls may develop.

The availability of federal recovery assistance over the past two years lessened the need for states to make cuts or raise taxes. However, as matters stand, federal aid is not likely to be available after December 2010, at least not in the manner provided under the American Recovery and Reinvestment Act. States will then have to address these large budget shortfalls with measures that include deeper spending cuts and more increases in taxes.

The tax actions that states have taken during the past two years may provide the basis for further measures. Tax increases adopted as temporary can be extended. Tax reductions already adopted can be postponed or rolled back. Expanding the sales tax to more services and to Internet sales would add to revenues not only during this period of recovery but also as states’ economies continue to grow.

This recession has had such a profound impact on state budgets that the solution cannot be just to make more spending cuts. The effects of doing so on people in need and on states’ economies would jeopardize recovery. Rather, a balanced approach that includes revenues is the prudent course for states to take.