A Guide to State Fiscal Policies for a Stronger Economy
June 24, 2014
Building stronger state economies that create jobs and expand opportunity will require sensible, forward-looking state fiscal policies. States need to invest adequately in education, health care, transportation, and workforce development. To do that, they need to make decisions about how to raise and spend revenues with an eye toward the future.
This paper is a guide to fiscal policies that can create jobs now and prime states for long-term prosperity. Each section contains links to CBPP analyses that describe these best practices in more detail. As this paper explains, policymakers should:
- Target investments to boost the economy, now and in the future;
- Improve fiscal planning to protect services and investments that promote long-term economic growth;
- Help struggling families meet basic needs and participate more fully in the economy, by reducing poverty, hardship, and income inequality; and
- Avoid ineffective strategies and gimmicks that can weaken the state’s economy.
Target Economy-Boosting Investments
States and localities educate the nation’s children and build and repair its roads, bridges, airports, and public transit systems. They provide public safety, fund health care, help vulnerable families, protect the environment, provide job training, and much more.
Many of these services are essential to economic growth. For example, spending on education, transportation, and health has been shown to stimulate growth in the short run and is an important determinant of economic growth and job quality in the lon run. Research also shows that expanding and improving upon these investments through well-targeted tax increases (in other words, finding new money to pay for better services) stimulates income and job growth.
States face major challenges in paying for such investments in the aftermath of a recession that brought record-breaking revenue declines and deep cuts in education, health, human services, and other key services. These cuts directly cost jobs in both the private and public sectors and indirectly cost additional jobs by reducing consumer buying power, making the recession deeper and longer than it otherwise would have been.
More than six years after the recession hit, state revenues have just barely surpassed pre-recession levels and have not kept pace with growing needs. For example, states have nearly 500,000 more K-12 students and nearly 800,000 more public college students than before the recession. State policymakers continue to face difficult decisions about how much to reinvest in core services like schools and roads and whether to pursue new opportunities, like cost-effective investments in early education, job training, and new business incubation.
Maintaining and improving schools, transportation networks, and other public services will require resources, both now and in the future. States will need to scrutinize spending to identify priorities, pursue new revenue where necessary, and modernize their revenue systems for the long term.
- Invest in the state’s priorities. States should use the rebound in revenues to reinvest in key areas like K-12 and higher education and health and to sustain (and, where possible, expand) investments to strengthen the economy. For example, research clearly shows that specific types of education and training have high “bang for the buck.” Preschool not only improves children’s academic performance but, over time, increases the quality of a state’s workforce and its jobs. Likewise, customized job training that assists people with the basic skills sought by local employers have been shown to produce substantial payoff.
- Make careful decisions on other forms of spending. States can free up funds for priorities by reviewing other areas of spending in search of better ways to reach the intended goals. While the savings from finding efficiencies are usually modest, some areas of state spending hold particular promise. A number of states, for example, have implemented corrections reforms that save money without compromising public safety. States can also better monitor and evaluate economic development subsidies and eliminate subsidies that are ineffective.
More broadly, states should scrutinize the billions of dollars they spend each year through the tax code instead of the appropriations process, through tax credits, deductions, and exemptions. For the most part, policymakers don’t regularly examine these “tax expenditures” for effectiveness as they do on-budget expenditures. They also can evaluate their contracting practices, potentially saving money by lessening their reliance on consultants.
- Pursue focused tax increases. While state revenues have rebounded to pre-recession levels, they remain inadequate in many states. Tax increases on high-income individuals and profitable corporations, which are best able to afford the increase and least likely to spend substantially less as a result, are preferable to spending cuts. This is especially true when the cuts in question could weaken the underpinnings of a sound economy — a high-quality education system, access to college, and modern transportation networks, for example.
Policymakers can raise taxes on high-income households and profitable corporations through the state income tax or by reinstating taxes on inherited wealth. Evidence doesn’t support the frequent claim that these kinds of tax increases will drive large numbers of affluent people to other states.
- Improve tax collections. States experiencing a slow recovery should try to do a better job of collecting taxes already due rather than cut or underfund services. For example, the failure of catalogue or Internet sellers to collect and remit state and local sales taxes costs states billions of dollars each year. Similarly, many states forgo revenues by failing to ensure that online travel companies like Expedia, Orbitz, and Priceline collect and remit the appropriate tax on hotel room bookings. States also can nullify a variety of tax-avoidance strategies employed by large multistate corporations by adopting “combined reporting,” which treats a parent company and its subsidiaries as one corporation for state income tax purposes.
- Modernize state revenue systems. Strong revenue growth would help states restore school funding, rebuild budget reserves, and invest in the future, but states’ antiquated tax systems are ill-suited to raising adequate revenue in a 21st century economy. For instance, many states primarily levy sales taxes on tangible goods, even though services — many of which, such as video streaming services, didn’t exist when sales taxes were first enacted — make up a growing share of consumption. States can halt the erosion of their sales tax systems, thereby improving their long-term ability to invest in state priorities, by broadening the sales tax base to include more services.
Improve Fiscal Planning
Strong fiscal planning can help states gauge the resources they will need to sustain investments critical to economic growth beyond a particular budget year.
- Employ prudent fiscal planning tools. State budget decisions have important implications for key services — like education and health — not just during the budget period but for many years to come. They should be informed by the best available information about the state’s changing needs and circumstances, such as projections of tax revenue and the cost of maintaining services. Policymakers can better plan for the future by laying out a clear roadmap, by ensuring that budget impact analyses are professional and credible, and by instituting mechanisms that trigger needed mid-year changes when needed to keep the state on course.
- Strengthen “rainy day” funds. Reserve funds to help states offset revenue declines during recessions — also known as “rainy day” funds — are a crucial part of prudent fiscal management. In hard times, policymakers can tap these funds to both protect state investments that promote economic growth and sustain state demand for private-sector goods and labor. States that lack such funds should create them; states with arbitrary or onerous restrictions on the funds’ use should reform them.
- Institute “pay-as-you-go.”With an improving economy, many state policymakers are tempted to cut taxes in ways that will damage their state’s ability to maintain investments over the long term. States also may be tempted to enact new programs that are not sustainable without significant new revenue. States can protect themselves against these possibilities by adopting “pay-as-you-go” (PAYGO), a system that requires policymakers to fully offset over a five-year period the cost of proposed and enacted spending increases or revenue reductions. PAYGO would help policymakers and the public understand the consequences of budget decisions and tax cuts so they can properly weigh the long-term impact of competing proposals.
Help Struggling Families
Millions of families continue to struggle in the wake of the recession. Unemployment and poverty remain high, and the income gaps between the top households and low- and middle-income households are wide and growing in most states. Weak purchasing power among poor and middle-class families, who spend all or most of what they earn, holds back state economies.
Poverty (especially among children) and severe inequality are costly over the long run, too. Children in poor families not only perform less well in school than their better-off counterparts, but also likely earn less as adults. Forgone earnings and other side effects of child poverty create a substantial drag on the economy over the long run. Likewise, unevenly shared prosperity has restricted economic opportunity for the majority of households and children, even as households at the top enjoy disproportionate gains. And research suggests that income inequality and lack of economic mobility can harm an economy.
State policymakers should therefore redouble efforts to help struggling families remain out of poverty and should avoid cutting supports that ease hardship. Policymakers also should reform policies in areas such as immigration and criminal justice that carry unnecessary economic costs. Helping people participate more fully in the economy would allow states to harness more of the earning potential and purchasing power of groups currently on the sidelines.
- Protect and expand state EITCs. Many states tax income below the poverty line. State earned income tax credits (EITCs), other low-income tax credits, and “no-tax floors” can help low-earning families keep more of what they earn to meet basic needs. Such policies can also shield these families from the unintended consequences of broad-based tax increases or improvements, like expanding the sales tax base to services.
State EITCs are based on the federal EITC, which has a documented track record of reducing poverty and improving life outcomes for children. EITCs play a particularly important role in the current economic climate, as many families have seen their wages or hours cut back or have lost a wage earner due to the recession.
State EITCs in conjunction with the federal credit are considered the most effective tool for combating child poverty. And, by helping make work pay, they give low-earning families the “bootstrap” they need to move up the economic ladder. EITCs also allow low-wage working families to keep more of what they earn, which they tend to spend in their communities, giving local businesses a boost. Policymakers should look to create or expand these credits as the economy improves.
- Protect supports for the neediest. Families turn to welfare when they lose a job, face a crisis such as fleeing an abusive situation, or need to care for a sick child. Many also face serious mental or physical health problems. States should maintain support for cash assistance and other supports like child care and transportation subsidies, provided through Temporary Assistance to Needy Families (with both federal and state dollars), that help these families meet basic needs and find and keep jobs.
- Help struggling residents — and the state — by adopting health reform’s Medicaid expansion.States have the option of extending Medicaid coverage to people with incomes up to 138 percent of the poverty line, thereby reducing the ranks of the uninsured, protecting families against health-related financial shocks, and keeping families healthier and able to work — as well as bringing substantial federal funds to the state. The federal government will pay the full cost of the expansion through 2016 and nearly all costs thereafter. For states that have been using their own funds to provide health coverage and services to people ineligible for Medicaid, this option is particularly attractive because it enables states to use federal money to help cover existing costs, freeing up state funds for other priorities.
- Reform corrections and immigration policies.State policy reforms can produce significant savings and allow marginalized members of society to participate more fully in their economies. For example, some states have chosen effective addiction treatment instead of incarceration for people convicted of drug-related crimes; others have chosen sanctions rather than prison time for people who violate the technical conditions of their parole, like missing a meeting with their parole officer. These reforms have saved states millions of dollars without endangering public safety. They also have reduced recidivism and given many people a better chance to become productive members of society.
States also can avoid the unnecessary social, economic, and fiscal costs of detaining undocumented immigrants who have committed minor infractions and traffic violations by leaving immigration enforcement to federal agencies. And they can help build a more educated and productive workforce through policies such as in-state tuition and financial aid for young undocumented immigrants.
Avoid Ineffective Strategies and Gimmicks
Several states have enacted or considered deep income tax cuts that promise the largest benefits for profitable corporations and high-income people; others have weighed budget restrictions that would severely limit state investments both now and in the future. Such proposals would impair a state’s ability to make key investments, save for a rainy day, or respond to changing circumstances. They not only would fail to produce the promised economic benefits but also would hinder policy options that do create jobs over the short and long run. 
- Avoid costly income tax cuts. Some leading policymakers have proposed extreme tax changes, such as replacing the state’s income tax with a higher, broader sales tax. That would threaten a state’s ability to maintain many of the services necessary for a strong economy. It also would sharply increase the other taxes that low- and middle-income households pay. Other proposals would eliminate or deeply cut income taxes for individuals and businesses without replacing those revenues, resulting in drastic reductions in services like schools, transportation, and public safety.
Many states have enacted less extreme but still deep income tax cuts that benefit individuals at the top of the income spectrum and profitable businesses, while doing little to nothing for low- and middle-income households and damaging states’ ability to maintain the foundations of a strong state economy.
- Avoid costly corporate tax cuts.Costly corporate tax breaks typically do little, if anything, to spur economic growth; most are a zero-sum game at best because they require a dollar-for-dollar cut in other areas of spending and are no guarantee of job creation. State film tax credits are one example. Film companies receive generous tax benefits in many states for creating largely temporary and part-time jobs that they might have created anyway, while people who rely on other forms of state spending take the hit.
- Reject artificial spending limits.Strict, arbitrary formulas to limit revenues and spending, like Colorado’s “Taxpayer Bill of Rights” or TABOR, are gimmicks that can sound appealing but hamstring a state’s ability to adapt to changing needs and voter demands. Since its 1992 enactment in Colorado, TABOR has been rejected in every other state that has considered it because it does more than limit state spending. It requires massive reductions in vital services that residents want and need — education, health care, public safety, transportation, environmental protection, and others — and that lay the foundations for a strong economy.
- Reject supermajority restrictions. Requiring a legislative supermajority or voter approval for bills that raise revenue makes it harder for states to protect priority investments during recessions. The resulting cuts can cost jobs and weaken an economic recovery. These restrictions typically reduce a state’s ability to repeal costly and wasteful tax loopholes, as well. They can also damage a state’s bond rating and cause legislative gridlock: because a small minority of lawmakers can block a tax measure, they can hold it hostage to narrow concerns, making it harder to enact policies that serve the state as a whole.
 Timothy Bartik, “State Economic Development Policies: What Works?,” presented at the 19th Annual State Fiscal Policy Conference, Center on Budget and Policy Priorities, Washington, DC, November 30, 2011, http://research.upjohn.org/presentations/27/; Peter S. Fisher, “Corporate Taxes and State Economic Growth,” Iowa Fiscal Partnership, revised February 2012, http://www.iowafiscal.org/2011docs/110209-IFP-corptaxes.pdf.
 Robert G. Lynch, “Rethinking Growth Strategies: How State and Local Taxes and Services Affect Economic Development,” Economic Policy Institute, 2004, http://epi.3cdn.net/f82246f98a3e3421fd_o4m6iiklp.pdf.
 Elizabeth McNichol, “Out of Balance: Cuts in Services Have Been States’ Primary Response to Budget Gaps, Harming the Nation’s Economy,” Center on Budget and Policy Priorities, April 18, 2012, http://www.cbpp.org/cms/?fa=view&id=3747.
 When states cut services, they end contracts with private-sector businesses and reduce spending on private-sector goods, leading to layoffs or lower wages among private-sector workers. These cuts can also mean layoffs for teachers, firefighters, police officers, and other public-sector workers; states and localities have shed 456,000 jobs since December 2007. In turn, private- and public-sector workers who are laid off or see their pay reduced buy less, which reduces economic activity further.
 Bartik, op cit.
 Greg J. Duncan and Katherine Magnuson, “The Long Reach of Early Childhood Poverty,” Pathways (Winter 2011), http://www.stanford.edu/group/scspi/_media/pdf/pathways/winter_2011/PathwaysWinter11_Duncan.pdf. Job loss during the recession exacerbated poverty and hardship for children, which means even greater future costs to individuals, families, and state economies.
 Harry Holzer et al., “The Economic Costs of Poverty in the United States; Subsequent Effects of Children Growing Up Poor,” Center for American Progress, 2007, http://cdn.americanprogress.org/wp-content/uploads/issues/2007/01/pdf/poverty_report.pdf.
 Elizabeth McNichol et al., “Pulling Apart: A State-by-State Analysis of Income Trends,” Center on Budget and Policy Priorities and Economic Policy Institute, November 15, 2012, http://www.cbpp.org/files/11-15-12sfp.pdf .
 See, for instance, Andrew G. Berg and Jonathan D. Ostry, “Equality and Efficiency,” Finance & Development, vol. 48, no. 3, September 2011, http://www.imf.org/external/pubs/ft/fandd/2011/09/pdf/berg.pdf and Jonathan D. Ostry, Andrew Berg, Charalambos G. Tsangarides, “Redistribution, Inequality, and Growth,” International Monetary Fund, February 2014, http://www.imf.org/external/pubs/ft/sdn/2014/sdn1402.pdf.
 Phil Oliff, Chris Mai, and Nicholas Johnson, “The Impact of State Income Taxes on Low-Income Families in 2011,”Center on Budget and Policy Priorities, revised April 17, 2012, http://www.cbpp.org/cms/index.cfm?fa=view&id=3740.
 Michael Mazerov, “Academic Research Lacks Consensus on the Impact of State Tax Cuts on Economic Growth,” Center on Budget and Policy Priorities, June 17, 2013, http://www.cbpp.org/cms/index.cfm?fa=view&id=3975; Erica Williams and Nicholas Johnson, “ALEC Tax and Budget Proposals Would Slash Public Services and Jeopardize Economic Growth,” Center on Budget and Policy Priorities, February 12, 2013, http://www.cbpp.org/cms/index.cfm?fa=view&id=3901; Peter Fisher, Greg Leroy, and Phillip Mattera, “Selling Snake Oil to the States,” Good Jobs First and Iowa Policy Project, November 2012, http://www.iowafiscal.org/2012docs/121128-snakeoiltothestates.pdf.