Raising State Revenue: The Year of the Punt

To see the way many cash-strapped states ginned up revenue for the coming fiscal year, Colorado is a good place to look.

Like virtually all states, Colorado was in survival mode this year. It wasn’t in as dire shape as Arizona, which famously sold its Capitol buildings and raised its sales tax rate to close a $3 billion gap. Nor was it in the same league as chronically indebted California, where the governor unsuccessfully pleaded for an $8 billion bailout from the federal government and is now calling for steep cuts to plug a $19 billion hole. Nor did Colorado borrow billions of dollars, as Illinois and New York are considering doing to dig themselves out of massive deficits.

Instead, Colorado erased its billion-dollar shortfall by piecing together a budget that, for now, is balanced. It found a few new items to tax, curtailed spending and relied heavily on federal stimulus dollars. So did many other states, which collectively had to erase more than $100 billion in funding gaps for the new fiscal year that begins July 1 almost everywhere in the country.

The good news for states is that they seem to have hit bottom after two years of steep declines in revenue that created historic budget shortfalls. Tax collections are beginning to tick up, albeit anemically. The bad news is that state revenues are far below what they were before the recession began. Meanwhile, demands are growing as more people turn to states for Medicaid and unemployment help. All the while, states know the flow of federal stimulus dollars is drying up.

“States are still suffering significantly,” says Scott Pattison, executive director of the National Association of State Budget Officers, whose latest report puts general fund spending nationwide at $52 billion below the 2008 figures. “It’s going to take until 2013 or 2014 for states to go back to their pre-recession levels.”

Lifting sales tax exemptions

Like many other states, Colorado didn’t raise its sales tax rate this year – so far only Kansas and Arizona have done that – but instead dropped exemptions on a host of items that previously were not taxed. Some are more obscure than others. “To-go containers” from restaurants, printed materials employed in direct-mail advertising and compounds used in agriculture all are taxed now. Garnering more attention, however, was Colorado’s decision to apply the sales tax to candy and soda, something Washington State also did this year. The governors of Massachusetts and New York have proposed to do the same.

Coke and Hershey bars were easy targets, but groceries were not. Colorado Governor Bill Ritter ruled out lifting the sales tax exemption on food. So did New Mexico Governor Bill Richardson, who vetoed a measure that would have brought $68 million in new tax money.

States still covet the millions of dollars their treasuries could receive from taxing online purchases that are largely untaxed now. Colorado this year enacted the so called “Amazon” tax, essentially applying the state sales tax law to Internet purchases by requiring Amazon.com and other Internet retailers to mail notices to customers reminding them of their tax liabilities. Oklahoma went a similar route this year and a measure is pending in California. But online companies have battled the few states that passed these laws, including New York and North Carolina. Already in Colorado, Amazon has shut down its affiliate program in the state, crippling thousands of small businesses that were marketing Amazon’s products over the Web.

New scrutiny for tax credits

Tax credits that states felt they could no longer afford also were on the table. Colorado dropped a property tax break for seniors and scaled back a tax credit for alternative-fuel vehicles. Iowa eliminated $115 million worth of job tax credits it didn’t think created jobs. Oklahoma suspended tax credits for restoring historic buildings and for generating wind power. This is “a more palatable action than imposing new taxes or raising rates,” says Corina Eckl, director of fiscal affairs at the National Conference of State Legislatures.

Increasing taxes wasn’t a popular option in Colorado, or anywhere else in this election year. After raising taxes by $24 billion last year – a record – states have been far more cautious in 2010. The increases that have become law have for the most part been modest and narrowly targeted. Wyoming, for example, became the first state to tax wind energy. And smokers are still an easy mark. Cigarette taxes went up in Hawaii, New Mexico, Utah, South Carolina and Washington this year, on top of the more than a dozen states that raised tobacco taxes last year. Still, tallied together, the tax increases for this year in all 50 states combined aren’t expected to total $3 billion.

States likewise shied away from going after the rich, a tactic that a record eight states used last year, including Oregon, where voters in January approved a $727 million tax hike on the wealthy and corporations. Connecticut would have became the first state in the country to levy a tax on bonuses of more than $500,000 given to executives whose firms received federal bailout funding, but Governor M. Jodi Rell vetoed it. Likewise, Governor Tim Pawlenty vetoed a tax on the richest Minnesotans. And in New Jersey, Governor Chris Christie vetoed a measure that would have restoreda tax on the wealthy as part of his controversial plan to fix a $10.7 billion budget deficit exclusively with cuts.

“There is a sense that people have maxed out on tax increases,” says Raymond C. Scheppach, executive director of the National Governors Association. “Most of the rest will come out in the spending side.”

That means everything is on the chopping block. Education, usually sacrosanct, was cut in 30 states, including Colorado, which reduced K-12 funding by $260 million and higher ed by nearly $62 million.

Dipping into reserves

Faced with extraordinary revenue drops, states tapped their rainy day funds heavily. Colorado dipped into its reserves, although not to the same extent as 13 other states that essentially emptied theirs. Most budget experts and bond rating agencies recommend that states hold at least 5 percent of their treasury in rainy day funds. While NASBO figures show that states set aside 6.2 percent of expenditures in rainy day funds at the end of fiscal 2010, that number is skewed because Texas and Alaska have so much in their reserves. Without those two states, the national number goes down to 2.2 percent for 2010 and 2.9 percent for 2011. “Anything below 3 percent is exceptionally low,” Pattison says.

Colorado’s budget also banks on Congress giving states money to help with Medicaid health insurance expenses, a move President Obama recently urged in a letter to Capitol Hill. Thirty states have crafted 2011 budgets assuming that Congress will extend the extra Medicaid assistance that was part of the federal stimulus package and is set to expire at the end of December. Colorado faces a $212 million gap if Capitol Hill doesn’t come through.

Shaming tax cheats

Colorado went after the tax money that was owed but not collected by posting online the names of businesses and individuals who were delinquent on their taxes. So did a number of other states. California hoped to bring in $6.5 billion from a list of delinquents that included, among others, actress Pamela Anderson and singer Dionne Warwick. On New York’s list was the convicted Ponzi schemer Bernard Madoff. Other states offered amnesty to tax scofflaws willing to come forward and pay up. Tax amnesty programs added millions of dollars to coffers in Illinois, Oregon, New York and Pennsylvania.

While nibbling around the edges gave states just enough money to balance the budget for the year, few states figured out what they will do when the stimulus money ends or debated how to fix broken systems that produce ongoing structural deficits.

Only Rhode Island made a fundamental change to its tax structure this year, aimed at making revenues more predictable and the state more attractive to business. Maine voters this month rejected a plan that would have done something similar, decreasing income taxes while extending the sales taxes to more goods and services. Sweeping proposals to tax services offered by the governors of Michigan and Pennsylvania went nowhere. Georgia created a tax reform council charged with coming up with recommendations for the 2011 legislative session.

Sujit CanagaRetna, a senior fiscal analyst at the Council of State Governments , likens the fiscal predicament states face to that of a homeowner with a leaky roof during a thunderstorm. The homeowner runs from leak to leak with a pan to catch the water because there is no money to fix the roof. States “are scurrying around now,” he says, “but eventually they will have to deal with the underlying problem.”