By Catherine Hubbard, CCH Washington Staff Writer

States governments are in the worst fiscal situation since World War II, caused in part by outdated tax systems, according to National Governors Association (NGA) Executive Director Raymond C. Scheppach.

States "continue to have tax systems built for a manufacturing economy in the 1950s, not for the high-tech, international economy of the 21st century," he said at a late November, 2002, press briefing in Washington, D.C. to announce the release of The Fiscal Survey of States.

Scheppach said the explosion of health care costs also has led to overextended budgets. Making matters worse, he said, is a "collapse of capital gains tax revenues." Many states "rode up these revenues during the stock option period," he said adding that "this is a revenue that virtually collapsed." Even with economic recovery, structural problems in the tax system "will make states struggle for several years to come," he predicted.

The biannual survey, conducted by NGA and the National Association of State Budget Officers, showed that in fiscal 2002 sales tax collections were 3.2 percent lower than originally budgeted, personal income tax collections missed states' targets by 12.8 percent and corporate income taxes were 21.5 percent lower than projected. Forty-one states collected less revenue in fiscal 2002 than they had planned for in their budgets, the associations said.

NGA said it has supported past proposals that would have provided fiscal relief to states through a combination of social services block grants and increased federal Medicaid funds. "The fiscal relief package is an effective means of minimizing Medicaid cuts and would help offset the negative impacts of state budget cuts on the overall economy," Scheppach noted.

Revenues are failing to meet projected levels in two-thirds of the states, according to another survey released in late November by the National Conference of State Legislatures (NCSL). More than half the states surveyed reported that they face gaps in their fiscal 2003 budgets. Thirty-three states report that revenue collections were below forecasted levels through October. "State revenue collections continue to be anemic," said the conference. In addition, 29 states said they have revised their revenue estimates for fiscal 2003. In 26 states, the revenue forecast was lowered, according to the report, State Budget Update: November 2002.

"The revenue outlook for the remainder of the fiscal year does not reflect confidence for strong revenue recovery," said NCSL. Twenty-nine states are concerned about revenue performance and nine are pessimistic. Meanwhile, eight states reported a stable outlook, and two said they are optimistic. The report, based on information collected from legislative fiscal directors in mid-November, covers the revenue and expenditure situation through the early months of fiscal 2003. Forty-six states began their fiscal year on July 1. The four exceptions are New York (April 1), Texas (September 1) and Alabama and Michigan (October 1).

Are Internet Sales Taxes an Answer?

Future state sales tax revenues are not expected to improve without major reform because more and more transactions are being made on the Internet--where purchases are generally sales tax free. State governments have recognized this eventuality for some time, and are taking steps toward reform.

Roughly 15 states will adopt the guidelines of the Streamlined Sales Tax Project during their next legislative session, predicted Diann Smith, general counsel to the Council On State Taxation, Washington, D.C. on December 3. Smith said 37 states governments are participating in the project to develop a uniform sales tax law across the states, allowing for ease of collection and administration. Notably absent are New York and California, she said during a teleconference sponsored by the American Bar Association's Tax Section and center for Continuing Legal Education.

The Supreme Court's Quill case "is driving the issue in this area," Smith said, noting that the High Court ruled that the vendor must have a physical presence in the state before a state can require sales and use tax collection responsibility under the Commerce Clause of the Constitution. Nevertheless, she said, 46 states and about 7,500 jurisdictions impose a sales and use tax, each with their own filing requirements. This results in "too great of a burden for vendors to collect the tax," she said, adding that the simplified system "would be so easy that vendors would want to comply."

Under the project's agreement, each state would be able to determine what items to include in the tax base, but there would be uniform sourcing and filing rules, Smith said. "Everyone can benefit from a uniform, simplified sales tax system," she added.

States that adopt the agreement could show Congress they have simplified sales tax enough that the federal government should impose a nationwide collection responsibility on all vendors, Smith said. In addition, she said, the states could argue that sales and use taxes on remote vendors are no longer a burden on interstate commerce--as Quill held--and "start the litigation process all over again."

Smith noted that the agreement would create a uniform tax base definition for items such as "clothing," "food," "delivery and installation," and "downloaded software." When states decide to tax certain items, the definition of those items would be standard, she explained. States would be responsible for developing and publishing a matrix that shows what is taxed and what is not, she said. If the matrix is wrong, she noted, the vendors would not be held responsible.

The project would eliminate the good faith and the paper requirements of exemption certificates, said Smith. "Keeping track of exemption certificates is a nightmare," she said, adding that eliminating the requirement "is a great byproduct of this proposal." It also would provide one-stop vendor registration, she said. Still unresolved, is how the project will be governed, Smith said. "That's something that's still being worked on." Also, she said, a threat to the project's efforts is that state agencies and courts could "come up with their own interpretation."

The simplified system also would reduce the number of sales tax rates and incorporate new technology to modernize many administrative procedures. A pilot project to test the collection mechanisms of the new system has been in operation for about one year, according to a November press release.

The agreement does not become binding and take effect until 10 states comprising at least 20 percent of the total population of states with a sales tax have approved the agreement. "We believe it is important to demonstrate that a significant number of states will participate in the agreement before throwing the switch and putting it into action," said Angela Monson, co-chair of the Streamlined Sales Tax Implementing States and first assistant majority floor leader in the Oklahoma State Senate. "Legislators are excited about introducing legislation to implement the agreement when they convene in early 2003," said Monson.

Related items:

States Looking at Internet, Mail Order Sales Taxes

Local Governments To Lose $13.3 Billion From E-Commerce in 2001

Governors Send Message to Congress on Internet Taxes

Congress Receives Formal Internet Tax Report from ACEC

Experts Advocate Simpler Method of Taxing Electronic Commerce

Cumbersome Internet Sales Taxes Could Impose Disproportionate Burden

Senate Passes Internet Tax Freedom Bill