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States Should Protect or Raise Revenue as Uncertainty Looms

In many states policymakers are starting 2023 legislative sessions with calls to layer more tax cuts on top of wasteful ones already enacted over the past two years. But with state revenues slowing and a potential recession looming, such a path could pose serious harm for workers, families, and communities nationwide.

States should instead be taking the opposite approach: avoiding additional short-sighted tax cuts, reversing or at least trimming recently enacted ones, and enacting policies to raise revenues where possible. That way, their revenue systems and the vital public services they support will be better prepared for a rocky economic road that could lie ahead.

State revenue collections are facing significant uncertainty that demands caution, even if the direst scenarios don’t materialize. Revenue collections have been strong over the last two years, fueled by the economy healing from the pandemic and supported by major federal relief efforts that both strengthened the recovery and directly bolstered state revenues. But revenue growth slowed significantly over the latter half of 2022 due to factors including high gas prices, supply chain shocks caused by geopolitical disruption, and a weak stock market. National and many state forecasters expect revenue growth could continue to slow over the course of 2023.

The most serious headwind facing state revenues is a potential economic downturn. While economic growth has proven more resilient than some gloomier forecasts had predicted, it has generally weakened over the course of the past year. And repeated interest rate hikes by the Federal Reserve could dampen economic activity further, by making it more expensive to get a car loan, buy a house, carry a balance on a credit card, or borrow for business investment. A full-fledged recession, whose probability economists pegged at 61 percent in the next 12 months in a survey last week, is not guaranteed but is certainly possible.

Recessions are especially harmful to states because state leaders, unlike their federal counterparts, must balance their budgets each year, even when revenues are down. And unless they offset these revenue drops with targeted tax hikes or by using other fiscal planning tools such as rainy day funds, they must make sizable cuts in essential services that could prompt teacher layoffs and growth in class sizes, less access to affordable health care or child care, deferred maintenance on roads and other vital infrastructure, and cutbacks to libraries, senior centers, and other local services.

After the Great Recession, for example, states enacted enormous cuts to K-12 education, which in many states were never fully reversed and, nationwide, led to significant harm to children’s learning. Cuts to economic supports, meanwhile, slowed the recovery, increased hardship, and worsened long-standing structural inequities that hold back Black, brown, and Indigenous people as well as women and low-paid workers.

In addition to the threat of a recession, states will also have to contend with the effects of major federal relief measures winding down in the next few years. For one, states must fully allocate the flexible COVID-19 recovery funds they received under the American Rescue Plan by the end of 2024, adding another risk factor to dwindling revenue surpluses and potentially spurring a need for new revenues to fund ongoing investments states made using the recovery funds. Many of these investments, such as housing assistance and workforce development, were key to helping residents hit hardest by the pandemic recession and will remain crucial for households struggling to afford the basics or seeking new opportunities to get ahead, whether in good economic times or bad.

The pending expiration in 2025 of large parts of the federal Tax Cuts and Jobs Act, enacted in 2017, also adds some uncertainty to state budgets, due to deep and intricate linkages between state and federal income tax codes. At the same time, state budgets could see some indirect gains from the infrastructure legislation and the Inflation Reduction Act enacted last year, since their sizable climate and infrastructure investments may help foster stronger economic growth.

Unfortunately, state tax policy choices made in the past two years already put many states in an unnecessarily precarious position. In several statehouses, policymakers used the temporary surge in revenues from the COVID-19 recovery to justify permanent cuts to their state revenue systems. Twenty-one states cut their personal or corporate income tax rates in 2021 and 2022, with Arizona, Iowa, Kentucky, and Mississippi (to name a few) enacting especially costly cuts. Kentucky’s tax cut package, for example, could cost as much as $1.2 billion annually once fully phased in by 2025 — more than that state’s entire budget for its colleges and universities. And Iowa’s could cost nearly $2 billion a year by 2028, compared to what’s now an $8.2 billion budget for the entire state.

Some policymakers have also shown a desire to continue the tax-cutting spree when state legislatures return in January. Mississippi’s governor, for example, is renewing his two-plus-year push to eliminate the state’s personal income tax, using many of the same arguments that fueled failed tax cut experiments in Kansas and other states. This reckless idea could also see serious consideration in Arkansas and Louisiana this year.

In other cases, lawmakers could move to accelerate the phase-in of previously passed cuts or slash rates further. And a broad swath of other states appear likely to consider either new rate cuts or more modest, but still costly and (often) poorly targeted, one-time rebate packages. Such rebates would deliver scant benefits to most workers and families — while losing sizable revenues that would be better used to strengthen services crucial to helping support families and communities, particularly in times of recession.

Given the uncertainty and potential economic headwinds ahead, states should resist the tax-cut temptation. They should instead learn from the mistakes of the Great Recession by prioritizing revenue and shoring up their tax systems to protect jobs, vital state services, and the families and communities these services help support. Options available to states include exploring targeted revenue increases, especially on high-income households and profitable corporations, which are relatively resilient to economic swings; pausing or rolling back recently enacted tax cuts; and looking to economy-boosting, targeted tax credits as a responsible alternative to costly rate cuts. States can also continue building on some commendable efforts to strengthen their rainy day funds (which are in better position today than before the Great Recession) by pursuing additional policies — such as stronger unemployment programs and access to health care — that can help strengthen state budgets and economies in preparation for a downturn.