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Understanding State-Local Revenue: A Taxing Exercise

Posted on Jan. 11, 2021
Ronald C. Fisher
Ronald C. Fisher

Ronald C. Fisher is a professor of economics at Michigan State University.

In this installment of State Fiscal Affairs, Fisher examines various approaches to increasing tax revenue that state and local governments may take in response to the COVID-19 pandemic.

Copyright 2021. Ronald C. Fisher. All rights reserved.

The combination of an economic recession caused by the pandemic, a national election, and now the prospect of the administration of President-elect Joe Biden has fueled substantial speculation and debate about the implications for state and local government taxes. Certainly, states and localities are facing revenues less than anticipated and additional expenditures to deal with the public health crisis. The magnitude of the resulting budget deficits remains uncertain, although some fiscal adjustments certainly will be required. But one thing does seem apparent — a clearer understanding of the structure and magnitude of revenues for state and local governments would enlighten the discussion.

The most commonly cited expectations — many offered in Tax Notes State articles — include expansion of the sales tax base to various types of services or other currently exempt purchases. Expanding the sales tax base might especially include taxation of various digital, streaming, and delivery services.1 Liz Farmer even suggests that grocery sales might be taxed more extensively, reflecting the decline in food consumption away from home.2 Annette Nellen goes further, making the classic public finance case for a pure consumption sales tax that includes all individual purchases and no business-to-business sales.3 In that she joins the views of John L. Mikesell and many other public finance economists.4 Karl A. Frieden and Douglas L. Lindholm similarly argue for converting sales taxes to some form of broad-based consumption tax.5

Other analysts suggest the possibility of increased business taxes, higher property taxes, and even adoption of a VAT. William G. Gale has argued for a national VAT, which could be implemented in a progressive fashion and presumably generate federal revenue, some of which could be used to support state and local governments.6

Table 1. Major State-Local Governments Revenues, 2018

 

State Governments

Local Governments

All Taxes

39%

37%

Intergovernmental Grants

26%

30%

Insurance Trust Revenue

19%

5%

Charges and Fees

9%

16%

Utilities

1%

8%

State and Local Revenue Facts

An all-funds perspective of state-local finances, based on Census Bureau data, provides the context for all policy discussion. It includes revenues for all public entities responsible to states, including counties, cities, townships, school districts, other special districts and authorities, public hospitals, and public colleges and universities, in addition to the official state government budget. The most recent complete data are for fiscal 2018 (released October 1, 2020). The data are summarized in Table 1 and in greater detail in figures 1 and 2. Here are some key observations.

  • Taxes are a substantial but minority player in the big picture of state-local finances. Taxes of all types taken together provide about 39 percent of state government revenue and 37 percent of local government revenue. Of course, this means that any individual tax is even less important fiscally. Which taxes are relatively more important varies by government. The largest single tax overall is the property tax.

  • Intergovernmental reliance is fundamental for state and local revenue. Federal grants (largely for Medicaid, but also for transportation and other services) represent the largest single source of state government revenue, and state grants (mostly for K-12 public education and school districts) the largest single source of local government revenue. Thus, it is simply not possible or reasonable to talk about revenue and balancing budgets for either state or local governments without considering the fiscal and policy status of the higher-level government in our federal system.

  • For state governments, on average, individual income taxes and general sales taxes are the largest tax sources (15 percent and 12 percent respectively) and taken together provide about the same share of revenue as federal grants. Thus the federal tax structure (independent of base conformity issues) and federal revenue are just as important to state governments as their own income and sales tax structures.

  • For the all-encompassing set of local governments, state government grants and property taxes are about equal in fiscal importance, together accounting for more than half of local revenue. One might be concerned that the picture for all local governments together is deceiving because the bulk of state grants go to school districts to fund K-12 education.

  • For comparison, the data for municipalities are shown in Figure 3. Property taxes are the largest single source of revenue, followed closely by charges and fees and revenue from city-owned utilities (such as water, sewer, electricity). State government grants are about two-thirds as significant as property taxes. Income and general sales taxes are important only in some municipalities in those states where they are authorized.

  • Select sales taxes — excise taxes on motor fuel, tobacco, alcohol, utility services, and more recently legalized drugs and gambling, among others — account for just 6 percent of state revenue. Among these, revenue from taxing sales of motor fuel is far and away the largest. For local governments, select sales taxes are even less important, representing only 2 percent of revenue.

  • The select sales tax category includes what are often called sin taxes (those on tobacco, alcohol, drugs, gambling), because the objective of the tax may be to affect demand as much as generate revenue. Indeed, these are small revenue generators; the largest (on tobacco) provides less than 1 percent of state revenue. One has to love David Brunori’s comment reflecting on budget deficits that “anyone who thinks they’re going to balance using marijuana taxes is high.”7 Potential revenue from taxes on legalized marijuana and gambling on sports events is not just pennies — it is a fraction of a penny.

  • Charges and fees represent prices charged by governmental entities for a variety of goods and services and are substantial revenue sources for both state and local governments.8 For states, revenue generated by public colleges and public hospitals is the largest component of general charges. Although prices represent only 10 percent of revenue for states, they are more substantial than select excise taxes.

  • For local governments, revenue generated by public hospitals, sewer systems, and airports is the largest component of general charges. Combining these with utility revenue (fees for water, public transit, and public electric or gas), prices for services amount to nearly one-quarter of local government revenue, almost as important as the property tax.

  • The category of “insurance trust revenue” requires explanation. In the census definition, this includes two separate components. One is revenue from employee retirement systems, which includes both employee contributions and investment earnings. Therefore, in a year when investment value grows substantially, this revenue source is large. For comparison, in 2018 when the stock market was rising, insurance trust revenue was more than $500 billion; in 2008 during the Great Recession, less than $50 billion. The other component of insurance trust revenue includes the premium payments from employers for unemployment and workers compensation insurance systems. These are much more stable from year to year than retirement systems revenue.

Figure 1. Figure 2. Figure 3.

Messages

The fundamental message from this review and the implication for state-local fiscal adjustment in the current environment is, simply put, magnitudes matter.

  • State fiscal health depends on support from the federal government more than any other single factor. And local governments similarly depend on support from state governments. This is one obvious reason why the possibility for a follow-up to the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) receives and deserves so much attention. State and local governments rely on federal support and are crucial in a macroeconomic sense.9

  • Raising charges and fees does not seem a viable solution to current deficits. At the state level the bulk of charges comes from public universities and public hospitals. Universities are largely in online mode with reduced revenue, and hospitals are fiscally stressed both by the loss of regular business and the cost of treating COVID-19. At the local level, transit and airport use has plummeted.

  • Most tax revenue collected through businesses is part of broad general taxes, both property taxes on business property and sales tax collected on business-to-business sales. Scott Roberti and coauthors suggest that states might increase taxes collected from businesses, “often invoking the mantra that business does not pay a ‘fair share’ of taxes . . . even though research has shown business tax revenue reliably constitutes a substantial portion of overall state and local tax revenue — 43.5 percent in fiscal 2018.”10 If this ratio is accurate, businesses taxes of all types are about 17 percent of total revenue (because taxes are 39 percent). Interestingly, California voters rejected a proposal to raise business taxes by treating business property differently.

  • Direct taxation of business income is a minor revenue source. Carolina Vargas reported that Helen Hecht from the Multistate Tax Commission said, “Some of the major tax changes states could make include increasing taxes such as individual, sales, and corporate taxes, all of which are major revenue raisers for states.”11 Well, not corporate income taxes, as they provide only 2 percent of state government revenue. The focus on state corporate taxation by practitioners, while important to taxpayer-clients, often seems disproportionate to its fiscal importance.

  • Expanding the sales tax to digital, streaming, and delivery services would be expected to generate a very low amount of revenue, not nearly sufficient to deal with the expected current budget deficits. General sales taxes provide 12 percent of state revenue. Michael Mazerov has estimated that adding a broad set of services purchased by households to the sales tax could increase sales tax revenue by 20 percent, which would be about 2 percent of total state revenue.12 Digital and delivery services are a very small fraction of all household service purchases, so the effect on total revenue would be miniscule.

  • In the past, increases in selective excise taxes have been common. However, in total they provide just 6 percent of state revenue, with motor fuel taxes the largest. Even with current low fuel prices, motor fuel consumption is down some 15 percent, so potential revenue is also down.

Policy Implications

In fiscal 2010, responding to the effects of the Great Recession, 29 states increased taxes or charges in response to falling revenue and impending deficits. The net estimated magnitude was only about $24 billion, which is obviously small relative to the current estimated deficits.13 The most common change was an increase in charges, which we have seen does not seem an option now. Net personal income tax increases were enacted by 12 states, and sales tax increases also were enacted in 12.

Two opposing forces have affected sales tax collections. With the increase in online ordering during the pandemic, states are fortunate that most online remote sales are now taxed (as a result of both corporate decisions and Wayfair14). On the other hand, the shift from restaurant sales (taxed) to grocery purchases for at-home consumption (mostly not taxed) has reduced tax revenue. The idea to reform sales taxes to be a broad consumption tax, as has been proposed, does make sense. But such a change, even if possible, would take some time and thus not be a solution to the immediate situation.

It is hard to be optimistic about such a substantial change anyway, as even small moves in that direction have been unsuccessful largely. The Hawaii General Excise Tax and the Washington Business and Occupation Tax approach this standard from a different direction, but have been in place for many years. The Michigan Single Business Tax, a modified VAT that covered all types of sales (consumption), was unpopular both politically and with taxpayers and was replaced with a corporate income tax.

Discussing the possible addition of services to the sales tax base, Michael J. Bernard and George L. Salis argue that tax and business executives should be alert and proactive, arguing: “Tax executives can and should do more than monitor state and local tax policy changes. Influencing that thinking and shaping tax changes increasingly qualify as parts of a tax executive’s fundamental responsibilities.”15 I’m not sure what “shaping” means in this context, but surely business should not oppose all tax changes that might increase their liability.

That leaves personal income taxes (PITs). PIT revenue has been supported during the pandemic recession directly by payments through the Paycheck Protection Program and the time extension, supplemental amount, and addition of self-employed for unemployment insurance (UI) benefits. Also, the “stimulus checks,” although not taxed directly, have helped maintain jobs and income by supporting consumer spending. All of these have or were soon scheduled to end. As of this writing, however, congressional leaders just announced that agreement has been reached for an additional federal “stimulus package.” If adopted, this would provide some continuation of PPP and enhanced UI benefits and new direct payments to individuals. The goal is that this will support economic activity and lessen the depth of the recession, again supporting the PIT for states.

Still facing potential deficits, a natural tendency might be to increase PIT taxes temporarily, effectively asking workers who are surviving the pandemic-induced recession to pay more. This has been a common response in the past. However, in this instance some workers who are still employed have experienced furloughs or pay cuts. And income tax increases of any type are seldom popular. Indeed, Illinois voters rejected a proposal to replace its flat rate tax with a progressive rate tax, which would have increased taxes for high-income individuals.

Thus, options are limited, so what to do? For most states fiscal 2021 ends in June, so it seems the best hope for this fiscal year is for continuation of extended and enhanced unemployment insurance benefits (which will support both income tax and sales tax revenue) coupled with new direct federal aid to states. This could permit the fiscal status quo to be maintained, with the idea that the vaccines will have been widely used by July, when the new fiscal year begins. Of course the “fiscal status quo” has required substantial budget cuts. State-local employment in November 2020 was 1.3 million less than in December 2019, with half of those cuts being workers for local schools.

In the best-case scenario, economic activity might begin to increase in the third and fourth quarters of 2021, which is the start of fiscal 2022 for most states. Planning for fiscal 2022 is happening now, as governors typically announce proposed budgets in December and January. Those plans, both for revenue and spending, depend on the economic forecasts that each state uses, which in turn depend on expectations about the pandemic. Each is uncertain. Also, most states have used available rainy day funds.

A reasonable guess, therefore, is that a number of governors will propose temporary adjustments intended to increase revenue, anticipating that the fiscal effects of the pandemic-induced recession will spill over into fiscal 2022. Based on experience, the revenue adjustments are likely to include both income and sales taxes and both tax rates and bases. Unlike the past, using selective excise taxes and fees and charges seems less likely. Any property tax adjustments, which mostly affect local governments, are likely to come later because the assessed value effects arise with a lag. With the existing substantial differences among state revenue systems, I expect a wide variety of proposed revenue adjustments rather than a single pattern.

Therefore, analysts, tax professionals, and taxpayers should watch for states’ proposed budgets that will be announced in the next month or so, and respond accordingly. Whether short-term changes in behavior brought about by the pandemic — including both increased working from home and online purchasing — continue obviously will influence subsequent state fiscal decisions. It may be that longer-term trends already underway — including in energy and transportation — may have greater implications.

Whatever the direction, it seems in no one’s interest for state and local fiscal problems to persist given the importance of their key public services (education, health, infrastructure) and their magnitude as employers. A combination of state revenue enhancements and federal government support will permit state and local governments to return to the sound financial position most enjoyed before this pandemic-induced recession.

FOOTNOTES

1 Jeff Cook, Harley Duncan, and Allen Storm, “Going With the Current: State and Local Taxation of Streaming Services,” Tax Notes State, Aug. 17, 2020, p. 689; and Tram Le, “The Digital Era: States to Expand Tax to Digital Goods and Services,” Tax Notes State, Aug. 31, 2020, p. 875.

2 Farmer, “3 Tax Hikes That Could Come to Your State in the COVID-19 Era,” Forbes, July 22, 2020.

3 Nellen, “Now Is a Good Time to Start Fixing the Sales Tax Base,” Tax Notes State, Sept. 7, 2020, p. 987.

4 Mikesell, “Reversing 85 Years of Bad State Retail Sales Tax Policy,” Tax Notes State, Dec. 23, 2019, p. 1147; and Mikesell, “State Retail Sales Taxes in 2018,” Tax Notes State, July 22, 2019, p. 313.

5 Frieden and Lindholm, “U.S. State Sales Tax Systems: Inefficient, Ineffective, and Obsolete,” Tax Notes State, Nov. 30, 2020, p. 895.

6 Gale, “How a VAT Could Tax the Rich and Pay for Universal Basic Income,” Brookings Institution, Jan. 30, 2020.

7 Carolina Vargas, “States Will Look to Increase Taxes to Recover From Pandemic,” Tax Notes State, Nov. 2, 2020, p. 541.

8 In the census accounting method, “general charges” are reported separately from revenue from public utilities, but each is similar economically. Both are prices charged for goods or services.

9 Ronald C. Fisher, “How State and Local Governments Are Crucial to the Economy,” Governing, Sept. 28, 2020.

10 Roberti, Rebecca Bertothy, and David Sawyer, “How the 2020 Elections Could Affect State and Local Tax Policy,” Tax Notes State, Nov. 2, 2020, p. 453.

11 Vargas, supra note 7 (emphasis added).

12 Mazerov, “Expanding Sales Taxation of Services: Options and Issues,” Center on Budget and Policy Priorities (July 2009).

13 National Association of State Budget Officers, “The Fiscal Survey of States” (Dec. 2009).

14 South Dakota v. Wayfair Inc., 585 U.S. ___ (2018).

15 Bernard and Salis, “Rethinking the State Taxation of Services After COVID-19,” Tax Notes State, Aug. 24, 2020, p. 797.

END FOOTNOTES

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