RYAN: Recession could prompt tax reform

Earl Ryan
January 2, 2010
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Although the Great Recession appears to have bottomed out, state and local officials around the country are looking ahead with trepidation.

A new study by the National Conference of State Legislatures shows that states have narrowed a collective budget gap by $145.9 billion in the fiscal year that began July 1, only to be faced with another $28.2 billion gap for the remainder of the fiscal year. And fiscal 2011 and 2012 are equally bleak, with gaps between revenue and expenditures forecast at $54.2 billion and $68.8 billion, respectively.

In Indiana, a new forecast for the current biennium projects tax revenue to be $1.8 billion lower than expected when the budget was adopted in June.

The governor has taken steps to contain expenditures, recently announcing $300 million in cuts in K-12 education spending and reducing support for higher education by $150 million for the remainder of the biennium. The administration estimates that previous actions taken in November will save the state an additional $300 million to $400 million. Even these reductions, however, will not relieve the state of the necessity of tapping $1.3 billion in reserves that had been guarded until now.

Choices even harder than those already made are on the horizon.

Further budget cuts are always an option. But a point is reached at which functions of state government are compromised to such a degree that it makes fiscal sense to find new sources of revenue to prevent long-term damage to state programs and facilities, as well as its financial condition. Several states have chosen to do this, and the National Association of State Budget Officers estimates that, nationally, enacted state revenue increases for fiscal year 2010 will total $23.9 billion, by far the greatest increase in at least 30 years.

With each round of budget cutting, the pressure to find new revenue increases and, as the experience in other states indicates, the options are limited. Most of the significant recent increases have been either 1) increases in the rate of the sales tax or 2) increases in the top brackets of the personal income tax in states with graduated income tax rates. Corporate taxes have been increased in only a few states, while actually being reduced overall, as states are reluctant to jeopardize their ability to compete for business.

Despite the growth in the services sector, few states have chosen to broaden the base of the tax to include a large number of services, opting instead to increase the rate on the existing base. Those states that have tried to broaden the base in the last few years have had to brave fierce political headwinds to the point at which most recently enacted service taxes have been rescinded. Nevertheless, as a study by the Indiana Fiscal Policy Institute concluded, expansion of the sales tax base to cover a broader array of services could permit a reduction in the rate of the tax to 6 percent, while at the same time helping to better align the Indiana tax system with the economy.

Another option available is that of a graduated income tax, in which rates increase as taxable income goes up. Indiana is one of only four states (of the 43 that levy personal income taxes) that have flat-rate income taxes. Graduated taxes tend to grow faster than flat-rate taxes over time and are viewed by many as a fairer way of distributing the tax burden, particularly in an era of increasing income disparities.

There will be no popular choices available in the months ahead, but if it is determined that new revenue is needed, policymakers would do well to consider not only the amount of revenue needed, but also whether this economic crisis might be used to improve the equity and responsiveness of the Indiana tax system.•


Ryan was the founding president of the Indiana Fiscal Policy Institute and recently retired as president of the Citizen Research Council in Michigan. His report about the effect of extending the Indiana sales tax to services is at www.indianafiscal.org.


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