Governing magazine: State and local government news for America's leaders

State Tax Codes in Need of Repair

by | March 2011

State revenue systems are antiquated relics. The bases used for state taxes no longer reflect the economic activity that takes place within them. How revenues are raised has little relationship to either the benefit received or costs incurred in providing state services. With reduced resources to meet needs, the battle over the shrinking pie promises to become increasingly intense, as the slices become thinner.

Hope springs eternal, however. These harsh economic times will, by necessity, lead to a reconsideration of how state revenue systems are designed and should perform. Topping the list of reforms should be a simplification of state tax codes. They are filled with a legion of special treatments that could very well lead to a state’s fiscal destruction. I am not a voice in the wilderness. Economists of all ideological stripes agree that simple tax systems that have broad bases and can use low rates to raise revenues are the least disruptive to markets, foster economic growth and are the most efficient way to raise revenues.

The most egregious difficulty in having state tax systems attuned to the realities of the 21st century has been the widespread use of tax “preferences.” Those are the deductions, credits and reduced tax rates that provide more favorable treatment to privileged forms of income, behavior and types of taxpayers. Be it to encourage fuel-efficient cars, new plant locations, movie production, spaceport construction or to help the lame and meek, even the tightest state budget seems to have room to squeeze in yet another tax preference loophole.

The consequence of such a bounty of tax expenditures is to produce de facto public spending that takes place outside of the budget. In other words, unlike expenditures that undergo the appropriation process, the costs of such tax breaks never show up in the state budget. One can read a state’s budget cover-to-cover and see nary a mention of the revenue forgone to accomplish the objectives of the tax break. As a result, the favored activities, and those firms and individuals that benefit, fall below the budgetary radar screen. Once enacted in the tax code, the tax expenditures’ veiled life goes on forever, typically unmolested and unaccountable for whatever public purpose they are meant to achieve.

This is not to say all tax preferences are bad. Many are sound in logic and practice. For example, some make the state and federal tax codes consistent and help avoid double taxation. But using the tax expenditure device can be addictive and is unusually tempting to tax-cutting legislators. How else can they simultaneously say they are cutting taxes and yet “financing” the preferred activities? What is left out of this calculus is that real money is being transferred from public coffers to pay for selected activities and their beneficiaries. In the wake of this ill-begotten largess is left a complicated, Swiss-cheese tax code, where special interests are served and the general welfare is largely ignored.

Several states have taken steps to get a handle on their tax expenditures. But in most states, information about them is sparse and scattered; substantive analysis of their impact is insufficient or missing. Regularly publishing a comprehensive tax expenditure report that is incorporated into the overall state budget process is needed. That report should specify the intended public purpose of each tax break, describe who benefits and by how much, and give an estimate of total cost in terms of forgone revenues that would be collected were the preference not to exist. Most important, the tax preferences should be subject to limits on their duration and examinations of their effectiveness before any re-enactment.

Hard times bring hard choices. When potential tax dollars are spent on giving tax breaks that reduce revenues, the taxpayers need to know about it. That’s my pie you’re slicing thinner.

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