'April Surprise' Turns Into July Fright As States Begin New Budget Year

Last Monday, July 1, marked the start of a new fiscal year for most states, many of which had to resolve large deficits after years of "April Surprises" -- the affectionate name given to the larger-than-expected influx of state income tax revenue each April 15.

Last Monday, July 1, marked the start of a new fiscal year for most states, many of which had to resolve large deficits after years of "April Surprises" -- the affectionate name given to the larger-than-expected influx of state income tax revenue each April 15.

According to a recent report issued by the National Governors Association, state treasuries have enjoyed this annual "surprise" every April for the last 6 years as revenue from individual income tax returns increased each year, on average, by 9%. But now, all but a handful of states, like the federal government, have been hit with a cumulative deficit of more than $40 billion. In addition to income tax decreases, states have also lost money from the drop in corporate profits, which had been providing 8% of state budgets and now make up only 5%. Also like the federal government, these states are now reeling from the aftermath of tax cuts that seemed so politically reasonable at a time of rising corporate profits and individual incomes -- and whose elimination now seems, in a year of reelection campaigns, politically impossible.

The Rockefeller Institute of Government reports that during the "boom" of the late 1990's, states cut taxes each year -- a total of $30 billion during the period 1995-2001. Because of the surplus revenue that arrived each year as the "April Surprise," however, states were also able to increase spending a total of 28% over the last 10 years. (Medicaid spending increased an amazing 79%; spending on K-12 education increased 31%; higher education spending increased 18%, and spending on all other state-funded activities increased about 20%.) Only spending for "cash assistance" programs declined during this period, a drop the report attributes to "widespread and steep caseload declines … due to the strong economy and state policy changes."

Unfortunately for the states, however, the federal government also took advantage of predictions of surpluses as far as the eye could see. Last June, the President signed a $1.35 trillion 10-year tax cut, which has placed a huge burden on states, many of which base their tax collection directly on federal taxes.

Economic Policy Institute economist Max Sawicky explained in a February 2002 EPI Issue Brief that because "state income taxes on individuals and corporations often 'piggy-back' off the federal system" by using federal definitions of taxable income, when the "federal government narrows the tax base by enacting new deductions, revenues to state and local governments may fall." So, when the June 2001 tax law cut your federal tax bill, it also likely cut the amount you paid to your state government.

When combined with the downturn in the economy, the accompanying dramatic drop in corporate profits, and state-level tax cuts, these federally enacted tax cuts added up to huge losses for state coffers. This indirect loss, however, has been exacerbated by federally legislated reductions in state tax revenues, such as the phase-out of the estate tax included in last year’s tax cut.

To help pay for the phase-out of the estate tax, which only reaches the richest 2% of estates, Congress had to expedite the phase-out of the state-level "pick-up" or "piggy-back" estate tax. This accounting trick could cost states a total of $23 billion over the next 5 years, according to reports from the Center on Budget and Policy Priorities (CBPP). Similarly, the accelerated "bonus depreciation" offered corporations as part of last March’s "economic stimulus" legislation impacts states by excluding large amounts of corporate income from federal taxes -- income on which states base their own corporate income taxes. CBPP estimates that states could lose more than $14 billion through September 2004 unless they "decouple" from this federal calculation of corporate income taxes.

Unlike the federal government, however, every state but Vermont has a constitution that requires it to begin each fiscal year with a balanced budget. In at least 30 states, this balanced budget requirement translated into budget cuts for even the most popular programs such as K-12 education earlier this calendar year.

In many states, such as New Jersey and Connecticut, the start of FY 2003 brought late-night legislative sessions and last-minute short-term fixes to prevent government shut downs. In California and Tennessee, July 1 came and went without any new budget as California continued to look for nearly $4 billion needed to get out of its deficit and Tennessee was forced to shut down all state government programs except for those providing essential emergency services. (For a state-by-state analyis of what these budget crises mean and for another look at the federal role in these crunches, see this report from the National Priorities Project.)

While few states have been willing to raise taxes to help patch up their budget holes, and no state has begun raising income taxes, many states have turned to increasing so-called "sin taxes," or "excise taxes" on cigarettes. CBPP reports that 14 states have already increased their state cigarette taxes and estimates that by the end of this year, one-third of all states will have taken similar steps. (For an analysis of some important considerations for states choosing to increase cigarette taxes to bridge budget gaps, including the potential for only a short-lived increase in the state’s revenue, see this CBPP analysis.)

Tennessee is one such state that has used cigarette tax increases to help improve its budget outlook. Legislators finally resolved the state’s budget dilemma on July 3 by increasing the tax on cigarettes by 7 cents per pack, increasing its state sales tax by one cent (Tennessee, one of only 9 states without a state income tax, now has one of the highest sales taxes in the nation) and using the remaining $560 million in its share of the states’ tobacco settlement money.

Many other states are attempting to limit the damage from the federal estate tax phase-out and economic stimulus legislation by "decoupling" from the federal tax. CBPP reports that 26 states and the District of Columbia have decoupled their collection of corporate income taxes from the federal structure, and 15 states and DC have taken steps to preserve state revenue from the federal estate tax phase-out.

As the reports from the National Governors Association and the National Association of State Budget Officers explain, rising Medicaid costs, the 15% drop in state income tax receipts from 2001 and historical trends that suggest that states’ economic recoveries will lag behind national recoveries by about a year and a half suggest that, "the outlook is for continuing fiscal distress over the next year."

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