The Folly of State-Level Tax Cuts

The national jobless rate has reached its lowest level in eight years. Home sales have reached their strongest level since 2006. Even the U.S. budget deficit is narrowing, to a respectable $439 billion.

Overall, the state of the nation’s economy is is fairly healthy. But for individual states? Not so much.

A few examples: Louisiana is laying off 30,000 state employees and cutting social programs. Illinois is stuck in the middle of partisan battles over how to close a $5 billion budget deficit that’s caused the state to stop paying social-service providers, which have in turn slashed services. Governor Sam Brownback of Kansas is cutting spending on state universities even as courts say he slashed K-12 funding to unacceptable levels, leaving schools in poor and minority areas underfunded. North Dakota—one of the few states that saw a budget surplus during the Great Recession—is cutting agency budgets and dipping into its rainy-day fund. In December, Oklahoma declared a “revenue failure,” which means the state failed to bring in as much money as it had planned for and thus had to cut spending. And Alaska—one of the most conservative states in the union—is thinking about implementing an income tax for the first time in 35 years to help close its $3.6-billion budget deficit.

Why are these states having so many problems at a time when the country’s economy as a whole finally seems to be on more stable footing?

The oil market definitely plays a role. As the price of oil and gas has continued to fall, drilling has slowed and the revenues states can collect from oil and gas royalties shrink. Some of the states with the biggest budget problems, including Alaska, Louisiana, and Oklahoma, depend on taxes from oil and gas extraction (around 85 percent of Alaska’s general-fund revenues are supported by oil). But other states that make a lot of money from oil—like Texas—are doing fine, and states like Illinois and Kansas are plagued by budget problems, but aren’t dependent on oil at all.

“Energy prices are not the only factor that put these state budgets into disarray,” Carl Davis, the research director of the Institute on Taxation and Economic Policy (ITEP), told me. “There are conscious policy decisions being made here as well.”  What’s happening across the country is that state legislatures have made decisions about taxation that don’t jive with the 21st-century economy. They’ve tried the supply-side model pushed by Reagan economist Arthur Laffer, who said cutting taxes could help spur job growth and spending to such a degree that revenue would not be significantly affected. They’ve found that this theory has not played out, and that although the recession is over, they’re still cash-flow negative.

For example, in an era of rising income inequality as the rich get richer, many states retain flat tax rates and can’t reap more money from those at the top of the economic ladder. Illinois, for instance, is one of eight states with a flat income-tax rate. (The state’s income-tax rate was 5 percent, but was lowered to 3.75 in 2015. That means someone making $500,000 a year in Illinois would pay just 3.75 percent in taxes, and someone making $50,000 would pay 3.75 percent as well. Minnesota, by contrast, taxes its lowest income bracket 5.35 percent, and taxes people making more than $258,261 at a rate of 9.85 percent.

Other states have cut taxes on the wealthy, creating their own budget deficits. Oklahoma slashed its top tax rate from 6.65 percent in 2003 to 5.5 percent in 2009 to 5 percent currently. Davis says this series of cuts reduced the state’s revenues by $1 billion. Kansas instituted massive income-tax cuts in 2013 that favored the wealthy, and the state has flailed since. North Dakota, buoyed by a booming economy and a seemingly endless (at the time) supply of oil and gas, cut both personal income taxes and corporate income taxes.

But it’s not just income taxes either. Motivated perhaps by Tea Party vigor, states have rolled back other forms of taxation as well. West Virginia has phased out both the grocery tax on food and its business-franchise tax, and has lowered the corporate-net income-tax rate, Davis said. Louisiana has offered big tax breaks to businesses who relocate there, as it rolled back tax rates for high earners.

What’s more, Davis says, state tax codes have not kept up with the changing nature of the economy. Many states still depend heavily on sales taxes, but people are buying fewer goods in brick-and-mortar stores. They’re buying fewer things in general, and instead spending more on services such as gym memberships, lawn services, and haircuts. Yet services are generally not taxed.

States that have tried to add taxes on services have not had much success. When Governor Martin O’Malley tried to expand sales tax to health-club memberships and tanning salons, he was met with fierce opposition. When D.C. put a tax on health clubs, the so-called “yoga tax,” confusion was widespread (in part because no one was sure whether yoga studios really counted as fitness centers).

But without additional taxes, services are lagging behind pre-recession levels. Many states have cut school funding to levels lower than they were in 2008, according to the Center on Budget and Policy Priorities. Oklahoma, for instance, spends 24 percent less per student than it did in 2008. In fact, five of the states with the deepest K-12 cuts have also cut income tax rates since 2008: Oklahoma, Alabama, Arizona, Wisconsin, and Idaho, according to CBPP.

Of course, there are states that are doing just fine, that have changed their tax codes so they can actually increase spending on government programs to improve their schools and prepare their populations for a 21st-century economy. Hawaii, New Mexico, and South Dakota have applied taxes to all purchases, which can be a more effective way of collecting revenue from all the transactions in a state, Davis said.

Perhaps states can learn a lesson from everybody’s favorite utopia, Minnesota.

That state had tried cutting personal income taxes, as other states are doing now, in 1999 and 2000, and the state struggled, Governor Mark Dayton said in his 2016 State of the State address. State funding for higher education and K-12 funding dropped and the state had to cut funding for elderly care and mental-health services.

But it has since reversed course. In 2013, the state passed a budget that called for $2 billion in new taxes, increasing income taxes on high earners and adding a $1.60 per pack cigarette tax. The state is now increasing funding for learning scholarships for early-childhood education and in 2014 rolled out full-day kindergarten. Despite those investments, the state has a $1.9 billion budget surplus.

Minnesota learned its lesson.

“Why on earth would we want to go back and try that again?” Dayton said, in the speech. “We haven’t made such progress during the past five years by having state government do less or fund less.”