Special Report
Budget & Finance

Elusive Answers

The rising demands on public schools, a fluctuating economy, and successful lawsuits are forcing states to search for new ways to make their tax systems fairer and more reliable.
By David J. Hoff — January 04, 2005 | Corrected: February 22, 2019 14 min read
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Corrected: The print edition of this story misspelled the name of Nicholas W. Jenny. The error has been corrected in the online version.

Last year was a good year for most states. All but a few of them escaped without trimming their fiscal 2004 budgets. Income-tax revenues grew substantially in April for the first time in four years, and sales-tax collections also looked healthier than at any time since the eight-month recession in 2001. In many regions, especially along the coasts, escalating home prices yielded additional dollars from property taxes—the main source of local revenue for schools. By the end of the year, many states were predicting surpluses for fiscal 2005, which ends June 30 of this year for most.

State officials must feel flush with cash, at least compared with the revenue crunch that hit them in 2000 and didn’t let up until last year.

Now, those officials are asking: Will the current climate be enough to return states to their 1990s heyday? The answer from most experts: No.

Overall, fiscal 2004 revenues for states grew by an estimated 5.4 percent, according to the National Conference of State Legislatures. The Denver-based group expects revenues to grow by 3.7 percent this fiscal year.

But even with the recent improvement, many states still aren’t collecting enough money to keep up with the current levels of services. This is what economists call a structural deficit.

“What they have to spend [to keep services at current levels] is more than the revenue they are going to get, unless they change the amount of revenue they’re collecting,” says Thomas A. Downes, an associate professor of economics at Tufts University in Medford, Mass.

Other economists predict that states’ revenues may keep up with most of their needs, but only if policymakers resist the temptation to lower tax rates ad extend new tax exemptions now that revenues are rebounding.

“The sky is not falling” for state revenues, says William F. Fox, a professor of economics at the University of Tennessee. “But it’s true that if states continue to legislate the narrowing of their [tax] bases, they’re going to have difficult times going forward. There are some reasons to fear that states may indeed create some serious fiscal problems for themselves in the next decade.”

Feeling the Heat

In the future, the amount of state revenues and the sources of that income will be increasingly important in determining how much is available for schools.

Although local budgets—bolstered largely by property taxes—have historically been the primary source of school funding, states are playing a more prominent role in paying for schools.

In the 1999-2000 school year, states paid 49.5 percent of K-12 costs, up by 2.4 percentage points from 10 years earlier, according to the National Center for Education Statistics, citing the most recent data available. Over the decade, the share of local funding for schools dropped from 46.8 percent to 43.2 percent.

The trend is likely to continue for at least two reasons. First, state courts are increasingly ordering states to ensure that their schools are adequately financed. Second, as states claim a bigger part in setting academic goals for public schools, they want more say in spending decisions.

‘The sales tax is relatively outmoded. There’s a fear there’s going to be a long-term decline.’

Texas is just one of several states embroiled in legal and legislative battles over school aid. More than 300 Texas school districts have joined a lawsuit challenging the current school aid system. They argue that the system imposes an illegal statewide property tax, and that it fails to provide adequate money to finance their schools. A lower-court judge ruled in their favor last year.

Policymakers there responded with promises to raise the state’s share of total K-12 spending to 60 percent—up from less than 40 percent now. But their attempt to fulfill that promise in last spring’s special session derailed when the legislature couldn’t agree on how to raise revenues. Even though the state is appealing the September ruling, legislative leaders are promising to address the decision in the legislature’s session this winter.

“The revenue question is a tough one,” says Pascal D. Forgione Jr., the superintendent of the Austin Independent School District, one of the plaintiffs in the suit. “That’s why you have policymakers … to solve it.”

At the same time, legislatures are under intense pressure to keep taxes where they are, or to lower them even further.

In February 2004, Oregon voters repealed a tax measure that would have provided an additional $284.6 million for education and another $258 million for other social services in the biennial budget for fiscal years 2004 and 2005.

In Kansas’ legislative session last year, lawmakers rejected Gov. Kathleen Sebelius’ proposed three-year, $300 million package of tax increases to respond to a state judge’s order to raise state spending in schools. While the Democratic governor’s plan would have raised property-tax rates, it would have left those rates significantly lower than they were at the beginning of the 1990s.

The Republican-led legislature rejected the plan, opting instead to wait for a decision from the state supreme court.

The revenue problems also have led to gridlock in some states.

Kentucky’s legislature, for example, adjourned last year without producing its biennial budget for the 2005 and 2006 fiscal years. Proposals to overhaul the tax system were the sticking point in talks between the Democratic-led House and the Republican majority in the Senate.

Overall, fiscal 2004 revenues for states grew by an estimated 5.4 percent, according to the National Conference of State Legislatures.

But Kentucky and other states wouldn’t be in such trouble if they hadn’t reduced tax rates during the revenue-rich 1990s, some experts note.

When Fox, the University of Tennessee economist, studied Kentucky’s revenue system for the state legislature in 2002, it appeared at first blush to be adequate, he says. As he looked more closely, he found that the state had made changes to its tax code in the 1990s that reduced its tax receipts.

For example, when Kentucky was faced with a court order to exempt state pension income from taxation, the legislature chose to give that same break to retirees from private companies as well.

“A good deal of [Kentucky’s] problem wasn’t that they had a structure that failed to perform,” Fox says. “It was that a combination of legislative actions and judicial actions had significantly eroded their tax base.”

States continue to make such decisions even though their tax receipts haven’t fully recovered from the economic downturn, Fox adds. Last year, for example, just as sales-tax revenues were recuperating, at least a dozen states offered tax-free shopping in the back-to-school season. “That’s just an erosion of the tax base,” Fox says.

Changing Times

Still, state officials across the country are trying to overhaul their tax codes to capture a larger share of state economies, though few have been successful. The one notable exception is Virginia.

Last year, Democratic Gov. Mark Warner persuaded the Republican-led legislature to adopt sweeping changes to the tax code, including raising income- and sales-tax rates.

Warner says state leaders dramatically cut away Virginia’s tax base during the ’90s. The state loses $1 billion annually from a reduction of tax rates on cars and other personal property that the legislature passed under his predecessor. The state enacted other tax cuts that cost an additional $500 million a year, Warner says.

“In the long term, it couldn’t be sustained,” he says. “You could make the case that ultimately we were going to break the bank.”

The governor says he succeeded in changing the tax code because a coalition of interest groups—including precollegiate and university educators, health-care advocates, and business leaders—collaborated to ensure the state collected enough money for each of their interests.

Over the past century, however, the share of state and local government funding that comes from property-tax revenue has declined dramatically.

Warner also worked to make the tax code more progressive. The final bill raised the sales tax by half a percentage point, but also reduced the tax on groceries by 2 percentage points. On the income tax, the state eliminated for the wealthiest senior citizens the $12,000-a-year personal exemption. Both changes made the tax burdens more progressive, Warner says.

In the final tally, more than half of taxpayers ended up paying lower taxes as a result of the changes, he says. “That threw the opposition,” he says. “They didn’t know how to respond to that.”

Things were a lot different in the 1990s, when most states were so flush with cash that they were able to lower tax rates and still raise enough revenue to keep services growing. At the end of the decade, state income-tax collections were growing by 10 percent annually.

But the bottom fell out shortly after 2000. The stock market slide, which was followed quickly by a recession, hit states with a double whammy.

Investors went from augmenting their incomes with capital gains to declaring capital losses, in turn driving down taxable income—and income-tax receipts.

A slump in consumer spending further depressed the proceeds from sales taxes.

As a result, real state aid for elementary and secondary education—defined as per-pupil spending adjusted for inflation—fell by 3.6 percent from fiscal 2002 to fiscal 2004, according to Andrew Reschovsky, a professor of public affairs and applied economics at the University of Wisconsin-Madison.

In 35 states, Reschovsky’s research shows, real K-12 spending fell over that period. Those states enroll 75 percent of the country’s students.

Experts worry, however, that even as the economy picks up, state revenue systems won’t be able to fulfill schools’ needs at the same time states must meet the rising costs of health care, corrections, and other high priorities.

Without changes to how states collect money, they will always struggle to find the cash they need for schools and other services that they are required to provide, analysts warn.

The issue is especially important for schools because their needs are projected to grow along with enrollment, particularly of children who are poor, lack fluency in English, or are otherwise among the hardest and costliest to educate.

“Those kids cost more to educate than the typical kid at the suburban school,” says Warner, the Virginia governor.

Though school budgets have historically been tied to property taxes collected at the local level, they have gradually come to rely more on money from states.

Under pressure to respond to lawsuits, states are centralizing how they pay for schools. Fifteen states now collect property taxes at the state level, according to the NCSL.

Over the past century, however, the share of state and local government funding that comes from property-tax revenue has declined dramatically, the NCSL said in a report released last year.

In 1902, property taxes made up 82 percent of the revenue raised by states and municipalities. By the 1940s, less than half of their revenues came from property levies. That proportion declined to 29 percent in 2002.

That trend shows that states are relying on other revenues to finance their schools. The most common choices are sales and income taxes—the two revenue sources that states traditionally have relied on to pay for services.

In 2001, sales and income taxes produced almost 70 percent of state tax dollars, according to the NCSL’s analysis of U.S. Census Bureau data. That year, states collected $201 billion from income taxes and another $178 billion in sales levies, the NCSL says.

Experts worry that even as the economy picks up, state revenue systems won’t be able to fulfill schools’ needs at the same time states must meet the rising costs of health care and other high priorities.

But, observers say, sales-tax systems have been struggling to keep up with the areas of the economy that are growing the fastest. Forty-five states and the District of Columbia collect broad-based sales taxes on retail transactions. Many states exempt groceries, clothing, and other daily necessities from the sales tax, which range from rates of 2 percent to 7.25 percent.

When states started collecting sales taxes in the 1930s, revenue collectors considered private services such as lawyers’ fees and doctors’ bills “too difficult to tax,” according to Robert Tannenwald, an economist at the Federal Reserve Bank of Boston.

But in recent decades, such services have become a larger share of economic activity.

In 1960, so-called goods producers—those in manufacturing, construction, and mining—produced 42 percent of U.S. wages. By the turn of the 21st century, that share had fallen to 24 percent, according to data Tannenwald cited in a 2001 article in the New England Economic Review.

Over the same span, income earned by providing services rose from 15 percent to 37 percent of the U.S. total. Likewise, the share of income that Americans spent on services rose from 41 percent to 58 percent over those 40 years.

While the shift from goods to services has cut into the ability of the sales tax to generate more revenue from the fastest-growing segments of the economy, the problem goes further than that, Tannenwald argues.

Most goods are taxed at several points. For example, a mining company pays a tax when it extracts iron from ore, then a manufacturing company pays inventory levies when it uses that iron in producing steel, and finally the consumer pays a sales tax when buying the finished product.

But even if a sales tax captures services, it is usually for one-time transactions, such as a lawyer’s fee for writing a will or an accountant’s charge for completing a tax return.

Examining Exemptions

The expansion of mail-order sales and Internet retailing also has eroded sales-tax collections. Although consumers are obligated to pay sales taxes on anything they purchase from a catalog or via the Internet, they rarely do, either because they are unaware of their legal obligations or they know the taxes on such small transactions are easy to evade and difficult for states to enforce.

Under federal law, states are prohibited from demanding that retailers collect sales tax on purchases in states where they don’t have headquarters or other major operations.

In 2003, state and local governments lost at least $15 billion in sales-tax revenue from Internet transactions, according to estimates published by Fox and Donald Bruce, also of the University of Tennessee. By next year, they estimate, the losses could reach $26 billion nationwide.

“The sales tax is relatively outmoded,” says Nicholas W. Jenny, a senior policy analyst at the Nelson A. Rockefeller Institute of Government in Albany, N.Y. “There’s a fear there’s going to be a long-term decline.”

Even with the many shortcomings of the sales tax, states often look to it as a way to solve their revenue dilemmas.

As states work to solve their school funding dilemmas, many will be examining the sales-tax exemptions they give.

“Those conversations will continue as [Texas] scours about for other revenue sources,” says Robert L. Bland, a professor of public administration at the University of North Texas in Denton.

Even with the many shortcomings of the sales tax, states often look to it as a way to solve their revenue dilemmas.

When Michigan lawmakers wanted to reduce local property taxes for schools in 1994, they raised the sales tax from 4 percent to 6 percent to finance the reduction.

Last year, faced with a court order to raise school aid, the Arkansas legislature raised the state’s sales levy from 5.125 percent to 6percent.

Politicians often turn to the sales tax because it raises money in little bits—some believing that voters don’t notice a few pennies at the cash register as much as tax increases that lower their paychecks or provide an unwanted April surprise.

But states that rely on the sales tax will struggle financially, Fox says.

“You don’t have a tax source that will be able to keep pace” with economic activity because the areas of fastest growth aren’t subject to taxes, he argues. “They’re in for a lot more trouble,” Fox says, than states with income and other taxes.

For example, Michigan school districts receive less revenue under the current system than they would have if the state had remained heavily dependent on property taxes, according to a 2004 analysis by the state Senate Fiscal Agency.

Income: The Elastic Tax

The 41 states and the District of Columbia that collect income taxes have better odds of staying afloat in the coming years, Fox says.

Income taxes are what economists call elastic, meaning they grow at about the same rate the economy does.

Most states will have income growth that will produce enough revenue to keep up with their needs, Fox says. While income taxes go through cycles along with the job market, their revenues tend to rebound along with the economy; sales-tax collections don’t grow as quickly as the economy does.

Texas is among the minority of states without an income tax, and it is unlikely to enact one soon, says Bland of the University of North Texas.

“We’re very proud of the fact that we don’t have a state income tax,” he says. “That has almost become a cause célèbre for Texans. I don’t know if it’s possible to … have even a civil discussion of a state income tax.”

Instead, Texas depends on the 6.25 percent sales tax for about half of the revenue the state collects. Taxes related to oil and gas exploration were once major sources of state money, but now they are only 1 percent of general revenue.

The problem with Texas’ approach, says Downes, is that it doesn’t provide balance to the revenue streams.

“If you depend on a single tax, it’s like not having a blended portfolio” of investments, says the Tufts University economist. “If you have a more balanced system, then if one of the taxes is not doing well, another one may be more effective.”

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