The State Tax Wars

In July, Oregon's Democratic governor, Ted Kulongoski, and the state's Democratic legislature soaked the rich. They agreed on a budget that includes an income tax hike for married couples earning more than $250,000 a year and individuals making over $125,000. Corporations netting more than $250,000 annually also will pay higher taxes. At the same time, the Oregon legislature largely avoided the kind of draconian cuts to public services California approved at the insistence of its Republican governor, Arnold Schwarzenegger, even though Oregon has the second highest unemployment rate in the country and faced a huge budget gap of its own.

The day after the legislature adjourned, Kulongoski said, "In a time when many states I know have gone backward, Oregon has the courage to look to the future. I will be the first to tell you I do not think Oregon is California." Still, the tax hikes could be challenged in a January statewide vote if 55,000 signatures are gathered by Sept. 25. If Oregon's voters were to reject the increases, as they have in the past for across-the-board income-tax surcharges, Kulongoski said, "I think there's a risk we're going to be like California."

Joining Oregon this year in passing budgets with higher marginal tax rates on upper-income residents were New York, New Jersey, Wisconsin, North Carolina, Delaware, and Hawaii. Maryland led the way with progressive income-tax increases that took effect in 2008. The governments of all those states are entirely under Democratic control, except Hawaii, which has a Republican governor but an overwhelmingly Democratic legislature. Overall, 31 states raised taxes this year, primarily in ways that disproportionately hit low- and middle-income residents. While comparable numbers of states imposed tax increases during past recessions, the magnitude of the hikes is significantly higher during this severe downturn. The main positive development has been the greater reliance in some states on targeting upper-income residents, which is the least economically damaging way for states to balance their budgets.

Democratic leaders like Kulongoski who pursued the most progressive approaches to managing their budget crises largely sold their responses to the public by projecting a sense of optimism about rebuilding their states for the future. At the same time, they conceded the pain involved while arguing that their choices were the least worst of the options available. Gov. Jim Doyle of Wisconsin, for example, said after signing his budget, "I knew we could avoid irreparable harm to our services -- and our people -- by making sure we made responsible cuts that took the path of least destruction." To a large extent, their rhetoric and policies echoed President Barack Obama's upbeat pragmatism and emphasis on fairness.

All 50 states except Vermont operate under balanced-budget constraints -- either constitutional or statutory prohibitions against running operating deficits. Because tax receipts plummeted in all but a handful of relatively sparsely populated states due to the recession, governors and legislators negotiating their fiscal 2010 budgets -- which began July 1 -- faced unusually painful decisions. The federal stimulus bill helped to narrow the budgetary gaps, but most states still needed to significantly cut services and raise taxes. A survey by the National Conference of State Legislatures found that stimulus money closed fiscal 2010 budget gaps by more than 50 percent in only nine of 25 states that provided information.

Given the choice between cutting state spending and raising taxes during a recession, mainstream economists argue that hiking levies least harms state economies. Every dollar that state governments spend on goods and services directly contributes to economic activity through public-sector jobs, the work of local contractors, and the provision of benefits to low-income residents who typically spend all of their income out of necessity. In contrast, some portion of any tax increase will merely reduce household savings, which do not immediately contribute to economic activity. Because upper-income individuals are more likely to save each additional dollar they earn, taxing them hurts the economy less than taxing lower-income people who are more apt to spend all of their money.

Beyond that near-term economic rationale, asking upper-income households that prospered to a much greater extent than everyone else during the Bush years to pay more during the recession, as Obama has argued, is more equitable than any of the alternatives. Moreover, state tax systems are collectively much more regressive than the federal tax code, because they rely on a combination of sales and excise taxes along with flatter levies on income across the earnings spectrum. Adding a degree of progressivity to state tax systems during this crisis would help to establish a fairer and more robust system for financing state governments whenever the economy turns around.

Nonetheless, most of the state-level tax or fee increases enacted since the beginning of the year have been regressive. For example, tobacco and alcohol tax hikes were approved in at least 15 states, sales taxes were raised in 13 states, and motor vehicle taxes and fees were increased in 12 states, according to the Center on Budget and Policy Priorities. That even solid red, anti-tax states like Arkansas, Kentucky, and Mississippi approved significant tobacco tax increases shows how widespread anti-smoking sentiment has become.

Three Democratic governors who have emphasized an optimistic message about the need to minimize damage to state services have had mixed success in selling broad across-the-board tax increases that disproportionately affect low- and middle-income residents. In Massachusetts, the Democratic governor, Deval Patrick, and the Democratic legislature raised its sales tax for the first time in a generation, from 5 percent to 6.25 percent. Democratic governors Pat Quinn of Illinois and Ed Rendell of Pennsylvania both pushed plans to increase the rate of their states' flat income tax but so far have been rebuffed by their legislatures.

The Democratic governors advocating across-the-board increases in flat income tax rates might want to heed polling that indicates that more progressive hikes focused mainly on higher earners would be more popular, albeit less lucrative. A February Quinnipiac University poll of voters in New York state, which later implemented a progressive income-tax increase, found that raising income taxes on those earning more than $250,000 a year was favored by 56 percent. Support was somewhat higher for increasing sin taxes. But given a choice between a broad sales tax or income tax hike, 64 percent preferred raising sales taxes. The New Yorkers polled also favored cutting services over raising taxes by a 51 percent to 34 percent margin, which only underscores why it's so difficult for state officials to do what would be best for their local economies.

Of course, the political fallout from all of these painful and acrimonious budget battles remains to be seen. The popularity of governors who raised taxes, whether progressively or not, is mostly well below 50 percent. But many governors who did not raise taxes have sub-50 percent approval ratings as well. The public mood is sour because of the economy, and none of the actions states have been forced to take to balance their budgets are popular. Still, with signs mounting that the federal stimulus legislation has succeeded in halting the economic freefall, and at least some Democratic state officials implementing policies that are most likely to deliver on their optimistic message, progressivism just might be sprouting a few green shoots of its own.