Taxes on the Horizon? History Suggests States Often Turn to Tax Increases in Painful Post-Recession Periods

By Snell, Ron | State Legislatures, April 2011 | Go to article overview

Taxes on the Horizon? History Suggests States Often Turn to Tax Increases in Painful Post-Recession Periods


Snell, Ron, State Legislatures


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Will states raise taxes in 2011?

Many governors have sworn they won't, and it's unlikely legislatures would even consider tax increases with the threat of a veto hanging over them. Anti-tax sentiment, partisan politics and the pain tax increases can inflict all argue against hikes.

But not so fast. A new study by the National Conference of State Legislatures shows a close link between recessions and tax increases, particularly in the years after recessions have ended. The effects of recessions linger and that's when states increase taxes.

So tax increases, however reluctantly approved, remain a distinct possibility during this post-recessionary year.

TAX DELAY

Although state tax increases usually closely follow recessions, legislators try to delay them as long as possible for several good reasons.

* Tax increases can have a damaging effect on consumers and businesses already experiencing falling incomes.

* Raising taxes can make policymakers appear to be insensitive to their constituents' economic distress.

* Policymakers don't want to act prematurely. If they increase taxes in a downturn that proves to be short and shallow, this pre-emptive action could be interpreted as an overreaction.

Lawmakers prefer to respond to falling revenues by reducing or postponing expenditures, tapping into reserves and finding ways to postpone tax increases.

BALANCING ACT

As legislators know very well, state fiscal conditions do not respond immediately to the end of a recession.

About 70 percent of state tax collections are from taxes that respond quickly to the economic cycle--the general sales, personal income and corporate income taxes.

When consumer and business spending slows, for example, states feel the pain pretty quickly. Similarly, personal income tax withholding on wages and salaries also is a sensitive indicator.

The other portions of the personal income tax base and the corporate income tax respond more slowly to changing economic conditions. Every April, when the previous year's tax obligations are resolved, the final numbers indicate current economic trends.

State tax responsiveness to economic conditions can extend the damage to state finances after a recession ends. Even with a recovery underway, persistently high unemployment can drag down growth in personal income, consumption and corporate profits, and thus slow growth in state tax collections.

After the recession of 1990-1991, the national unemployment rate stayed above the 1990 level of 5.6 percent until 1995. After the 2001 recession, employment did not return to the level of 2000 until 2006. The end of the 2007-2009 recession similarly has been followed by a very slow recovery, with employment remaining well below pre-recession levels. Earnings, personal consumption and construction--three sources of tax growth in good times--only have begun to affect state revenue collections.

In addition to economic conditions, the other driver of post-recession tax increases is state governments' commitments to balance their budgets, whether an annual or biennial cycle. States go to heroic lengths to avoid borrowing for operating expenses, even if they do not always succeed.

States usually balance their responses to budget gaps with a combination of budget cuts and revenue increases, but when budget cuts go deeper than the public will tolerate, raising taxes becomes a viable response. …

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