Using Income Taxes to Address State Budget Shortfalls

PDF of this report (11pp.)

By Elizabeth McNichol and Andrew Nicholas

February 21, 2008

Key Findings:

  • States facing deficits due to the current economic downturn should avoid spending cuts that can further weaken their economies.
  • Raising taxes, especially on wealthy households, is less economically damaging than cutting many types of services.
  • To fill budget gaps, states should consider enacting temporary income tax surcharges.
  • Nationwide, over $13 billion could be raised if every state with a personal income tax enacted a 1 percent rate increase for high-income taxpayers. An across-the-board surcharge equal to 5 percent of taxes owed could raise a similar amount.
  • If enacted quickly, revenues from a surcharge could help states close gaps in their current year budgets.

Introduction

States are on the brink of their worst fiscal problems since the 2001 recession. At least half the states are anticipating budget shortfalls for next year (fiscal year 2009).  For those states that have estimated the size of the gap, estimated deficits range from $34 billion to $38 billion in total. Among affected states, these deficits represent between 8 percent and 9 percent of total state expenditures.

These shortfalls result in large part from the downturn of the economy. The bursting of the housing bubble has reduced state sales tax revenue collections.  Property tax revenues have also been affected and local governments will be looking to the states to address the squeeze on local and education budgets.

Furthermore, many economists expect that a recession will follow the recent housing crash. This would result in larger shortfalls, more affected states and a state fiscal crisis that lasts well beyond the next fiscal year. Virtually all states have balanced budget requirements, so they will have to take actions to close these deficits.

While many states may be able to draw down rainy day funds in the short-term, most do not have reserves large enough to weather a protracted recession. Thus, states will soon be forced to use some combination of cuts in programs and revenue increases to close most of these gaps.

If — as is increasingly likely — the state fiscal crisis deepens, state actions are highly likely to cut basic services such as health care and education.  Indeed, many such cuts have already been proposed in states facing the largest shortfalls.  The depth of the cuts necessary, however, can be reduced if states include revenue increases as a part of their budget balancing packages.

The personal income tax, which is a major revenue source for all except nine states, is a particularly promising source of new revenues because it can yield a significant amount of new revenues to help plug the large budget gaps.[1] One way to tap this revenue source is to adopt an income tax surcharge.

An income tax surcharge refers to an increase in an existing income tax that is calculated as an add-on to the amount of taxes that would be owed under existing tax law.  The amount of this additional tax is generally determined in one of two ways:

  • A high-income surcharge - an additional rate (or rates) are added to the top of the existing rate structure;
  • An across-the-board surcharge - an additional amount of tax is levied on all taxpayers that is equal to a percentage of the taxes that would be owed under existing law.

States have often used income tax surcharges and the creation of additional tax brackets to fill budget gaps in past recessions.  There are a number of reasons why states should consider enacting surcharges during the current fiscal crisis.

  • States can raise a substantial amount of revenue from an income tax surcharge with a relatively small increase in current tax rates.  For example, if every state with an income tax added a tax bracket for taxpayers with incomes exceeding $200,000 and applied a tax rate that is one percent higher than its current top rate to those high-income taxpayers, the total additional revenue raised in all states would be $13 billion.  Alternatively, a surcharge equal to 5 percent of taxes owed for all state income taxpayers — regardless of income — would raise over $13.5 billion.
  • An income tax surcharge could be used to address both the shortfalls that have developed in fiscal year 2008 budgets and the looming gaps in fiscal year 2009 budgets.  A surcharge effective for the current tax year (2008) would bring in revenue during fiscal year 2008 if it were enacted prior to the end of the current fiscal year (July 1 for most states) and withholding tables were adjusted.
  • Because it is based on the existing personal income tax system, an income tax surcharge would be relatively easy for states to administer.
  • In addition, an income tax surcharge is one of the least painful options available to states to raise significant amounts of revenue.  This is because it can be targeted by income, because part of its cost would be borne by the federal government and because it would have less effect on economic growth than other budget balancing options.

End Notes:

[1] The nine states that do not levy a broad-based income tax are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

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