By Catherine Hubbard, CCH Washington Staff Writer

It's not easy being a state government tax administrator right now. And the situation doesn't promise to get much better anytime soon.

During the heydays of the 1990's bubble, state governments were awash in tax revenues due to high productivity and growth rates fueling the national economy. State governments reacted to this situation of unsustainable growth in a number of ways: Some cut taxes, others created rainy-day funds for the future, and most increased spending to match the rapid inflows of revenues.

Fast-forward to 2000 and beyond, and the bubble has burst. Tax revenues are down as the national economy staggers along. Worse yet for some states, their tax schemes are tied to the federal code, so as the national government cuts taxes to create a stimulative effect in the future, even more short-term state revenues are lost, compounding their problems.

Finally, added into the mix is a changing economy--not that the figures or statisitics are changing, but the way people do business (and are therefore taxed) is changing. Electronic commerce and the relatively sales-tax-free Internet are cutting into revenues as well. In addition, much of our tax code has been structured for a now-antiquated manufacturing economy run by corporations, as opposed to the current climate of service- or knowledge-oriented operations run by pass-through business entities.

It's clear dramatic measures are needed to turn around the deficits that most state governments are facing. But at least misery loves company, and many tax administrators have similar stories to tell.

Beginning next year, states will have to start revamping their tax systems and spending in order to resolve budget shortfalls, according to Federation of Tax Administrators Executive Director Harley Duncan. States have used all of the available one-time measures to make it through fiscal 2003 and prior recession years, but "have not solved" the underlying problems, Duncan told participants at a June 5, 2003 Washington Area State Relations Group meeting in Washington, D.C.

"The large majority of states have not permanently reconciled revenue and expenditure paths," said Duncan. States will realize they cannot "grow [their] way out" of the budget shortfall with higher productivity and growth, Duncan said, predicting that there will be "more fundamental change in the next three years than. . .in the last 10."

Many states could avoid tax increases and across-the-board spending cuts by "right-sizing state governments," said William D. Eggers, senior fellow with the Manhattan Institute for Policy Research and director for Deloitte Research. He emphasized that states need to focus on stabilizing and growing the tax base. "That needs to be a key component of any approach," he said.

Eggers also distributed copies to an Institute report, "Show Me the Money: Budget-Cutting Strategies for Cash-Strapped States," which recommends states consider such options as reforming entitlement programs and opening more services to public/private competition.

What won't solve the budget crisis is relying on taxes alone, said Robert J. Cline, national director of state and local tax policy economics at Ernst & Young, Washington, D.C. He said it would take a 15 percent individual income tax increase to raise the $86 billion need to balance state budgets. "That's not an acceptable political solution."

The business community is a potential target for higher taxes, said Cline. However, it's hard to determine whether businesses are paying their fair share, he said.

New Jersey has instituted a gross receipts tax that is expected to increase revenues by about $1 billion per year--almost double prior revenues, he said. However, the gross receipts tax creates a dual tax structure, since many businesses would revert to a profits tax when the economy recovers, said Cline. He predicted that even after the economy rebounds, the gross receipts tax will not go away. "There will be taxpayers that will be permanently stuck in the gross receipts tax," he cautioned. "That makes no sense in an overall [tax] scheme," he said.

Several states want to move away from their reliance on corporate income taxes, Cline said. For instance Washington and West Virginia are examining the possibility of moving to a value-added tax (VAT), Cline said. However, he said, Michigan has a single business tax, which is a modified VAT, that the state is phasing out due to continued complaints from businesses that they are paying taxes even when they do not make profits. New Mexico is also reconsidering its gross receipts tax and may rework its system, he added. In addition, he said, Pennsylvania is looking at increasing its reliance on consumption taxes and on individual income taxes.

Cline distributed an Ernst & Young study: "A Closer Examination of the Total State and Local Business Tax Burden," dated January 3, 2003, which states that corporate income taxes have declined as a revenue source over the last 20 years due in part to the growth of non-corporate business entities, including S corporations and limited liability companies. Cline noted that a VAT is attractive to some states, since these pass-through entities as well as C corporations would have to pay the tax.

Stay tuned. State tax reform is certainly overdue, but realizing the changes may be painful for many state tax administrators (and taxpayers) in the near-future.

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