State Tax Impact of Widening State Budget Gaps

With the economy in one of the worst downturns in history, state governments have begun to face the stark realities of the recession.

Most states have seen unprecedented unemployment and unemployment claims draining the system. While the funding for these claims is supplemented by the federal government, the states have seen total revenues drop to an extent they have never experienced.

California has been the hardest hit to this point. California implemented numerous program cuts and revenue enhancers in order to balance their budget, but to no avail. Yet, California is not the only state in this situation. According to the Pew Center on States, more than ten states are showing the same symptoms that led to California’s crisis. Illinois and New Jersey have specifically been singled out as states that have “punted” responsibility for their fiscal problems. They have used borrowing schemes and accounting adjustments to delay the inevitable pain of enacting actual revenue raising provisions to balance their budgets.

Unlike the federal government, states must find a way to raise revenue or cut expenses anytime a budget gap arises (all states, except Vermont, have balanced-budget statutes in place). Many states have cut funding for all non-essential programs already. States are now focusing more than ever on ways to raise revenue, as there is very little “fat” left to cut from their budgets. Revenues continue to drop and spending continues, opening additional gaps in the current budget and in next year’s budgets. With the fiscal year 2011 budget process beginning soon, states need to continue to find money to close their budget gaps.

The most prevalent way for a state to balance its budget is to raise taxes. The District of Columbia recently raised its sales tax rate by .25%. They also raised excise taxes on cigarettes and gasoline. Personal income and corporate income tax rates are also being raised. North Carolina just placed a 3% surtax on top of its corporate income tax to raise additional revenue. Connecticut imposed a surtax on high-income households.

Another way some states have been able to raise money quickly is through the creation of an amnesty program, where taxpayers with unpaid liabilities can file back tax returns with the state and make good on the unpaid liabilities. In exchange, the state will generally abate any penalties accrued by the taxpayer and in some cases abate a portion of the interest. These programs have been very successful in states where implemented, and the revenue received has in many cases exceeded expectations, making this the perfect opportunity for other states to implement.

States are also expected to substantially step up audits while simultaneously slowing the issuance of refunds. While states are trying to work with taxpayers by offering amnesty programs, states will be more aggressive in going after taxpayers with unpaid liabilities who do not participate in such a program. It is expected that new amnesty program legislation will drop the hammer on non-participating taxpayers with ever-increasing post-amnesty penalties.

Types of Tax Law Changes

The states use many methods to raise taxes. The most obvious method is a tax rate increase. Yet, other legislative possibilities exist. For business entities, combined reporting seems to be a trend. Already we have seen the District of Columbia pass a combined reporting statute as part of their 2010 budget. Maryland required groups to file a combined informational report for the 2006 through 2011 tax years, and based on the information collected so far, the state would have collected over $100 million of additional revenue for the 2006 tax year (the report projected that 70% of companies with incomes over $25 million would have paid additional tax to the state if combined reporting had been in effect for 2006).

The domestic production activity deduction (DPAD) is another taxpayer beneficial provision that could come under fire by the states. DPAD was created by the federal government in 2004, and as most states conform to the federal tax code, the benefit was enjoyed by taxpayers on the state level as well. Originally, the federal DPAD was computed at 3% of qualifying income. However, in 2007, the percentage allowed was raised to 6%, and is increasing to 9% for the 2010 tax year. Currently, twenty-one states and the District of Columbia do not conform to DPAD. In 2009, Connecticut and Wisconsin decoupled from this provision. According to the Center on Budget and Policy Priorities, twenty-five states will lose revenue due to this provision in 2011, totaling an estimated $505 million. Illinois, Florida, Pennsylvania and Virginia are expected to be the four biggest losers from this provision.

The current economic climate also gives states the opportunity to completely revamp their tax systems in order to provide for a more stable income stream in the future. Both Michigan and Texas are recent examples of this phenomenon. California enlisted a Commission to offer tax recommendations for a steadier income stream. The Commission’s proposal was essentially a complete overhaul of the state’s current tax structure. The proposal included dropping the current sales tax and corporate income tax. The Commission instead proposed a tax on the net receipts of businesses.

What will happen down the road remains to be seen. Some of the budget measures put in place by states now will have a direct impact on future revenues. According to the Rockefeller Institute of Government, the long-term outlook is even worse, with estimated gaps two to four times larger than they are now.

Now is the time for states to begin looking at serious tax reform. While we don’t know what changes are forthcoming, we do know with certainty the states will attempt to make many changes this budget season. Further, while tax increases may not be passed this year, rest assured the states will try again, as raising revenue seems to be a necessary part of the budgetary process as the states attempt to balance their budgets.