Last November, Bob Zahradnik from the Center on Budget and Policy Priorities shed some light on Virginia's fiscal policy in a session organized by the Virginia Organizing Project and attended by people from around the state. In the last newsletter, Part One of this report focused on revenue (the money coming in) and expenditures (the money going out). Part Two focuses on our state's budget and tax policies and some of the problems in our system.

Evaluating Virginia's Budget and Tax Policies

Many state legislatures and governors have agreed on five keys to a quality tax system. A state revenue system should:

• Provide appropriate and timely revenue (enough money, when and where it is needed).
• Distribute burdens equally (everyone pays their fair share).
• Promote economic efficiency and growth.
• Be easily administered (isn't needlessly complicated).
• Ensure accountability (transparent, public and honest).

How does Virginia's system measure up?

1. Provide appropriate and timely revenue.

Tax systems should be stable, so that the state isn't thrown into crisis during hard economic times. They should also provide income that grows at the same rate as the economy.

Over time, states must spend more money to maintain a constant level of services. Growth in population, inflation, rising wages and other factors make government more expensive. Ideally, a state will match its new spending to the growth in the economy as a whole. Virginia's spending has remained flat over the last 20 years when compared to the growth in personal income. Across the board, we have been a low-tax state (45th in the nation compared to the other states). This means that for a long time, we have not taxed and spent the amount of money needed to maintain current services and fund long-term needs, like school construction and transportation.

Virginia Forward (a non-partisan business group concerned with education, transportation and infrastructure) says that Virginia is running a $3.3 billion deficit in regard to unmet public needs this year, and that amount will grow to $4.5 billion by 2008. In fact, Virginia cannot even fund the current level of services, with a $1.2 billion deficit this year, growing to $2 billion by 2008.

Like most states, Virginia maintains a Rainy Day Fund of reserves to be used during an economic slowdown. That fund currently contains $361 million. The Center on Budget and Policy Priorities projects that during a three-year recession, Virginia could face a budget shortfall of $804 million. As you can see, as a state we do not have enough saved up to provide for our rainy day. As the governor is currently demonstrating, resulting budget cuts will first hit those least able to bear it.

2. Distribute burdens equally.

There are different ways to measure this. Progressive tax systems embody the principle that people with a greater ability to pay should pay more. Regressive systems make people with less money pay more as a percentage of their income than those who have more.

Virginia taxes are regressive, as are many state tax systems (see figure 1 below). The lowest fifth of families pays a little over 10 percent of their income in taxes on average, the middle fifth pays a little under 8 percent, and the highest fifth pays about 5 percent. Why? Our property tax, which provides about a third of our revenue, burdens low-income families because they spend a larger share of their income on housing. Second, our sales tax hits everyone equally, regardless of income. That means poor people spend more on sales tax as a percentage of their income. Finally, our income tax, which could balance out the other two, hasn't been adjusted since 1926. The income brackets are still set for 1926 dollars, not 2001 dollars, which means it is beginning to resemble a flat tax.



3. Promote economic efficiency and growth.

State tax systems should contribute to an economy which promotes economic well-being for the whole society, from individual citizens to businesses and everything in between.

In reality, taxes don't strongly influence a state's business climate. They usually represent less than two to three percent of business costs. Differences between states in business tax burdens are even smaller. Labor and transportation costs vary more than taxes when comparing states to one another. Many public services, such as education and transportation, mean much more to business than taxes. Surveys regarding business location decisions usually rank taxes low in importance in comparison to quality labor force, quality of life, good regulatory climate, good transportation systems, labor costs and real estate costs. So cutting taxes at the expense of public services may actually reduce economic growth by driving new businesses away.

What about tax breaks for economic development, or corporate welfare? They reduce revenue for the services described above which actually do attract business. They also discriminate against smaller or existing businesses which don't receive the same tax breaks. And they often don't really affect corporate behavior; most business start-ups or expansions would occur without the tax break, as many corporations have publicly admitted.

A good tax system that promotes economic growth pays for needed services. It is stable, not prone to big tax cuts followed by big tax increases. It doesn't give special breaks for certain businesses. Finally, it discourages activities with social costs (like polluting or exploiting workers) and encourages activities with social benefits.

4. Be easily administered and ensure accountability.

The state legislatures and governors who crafted these guidelines agreed that tax decisions should be explicit, with choices openly arrived at in full view of the electorate. Too often, these decisions are hidden in obscure features of state tax systems, never the object of genuine public debate.

To be transparent, these decisions cannot be rushed through a legislative process lasting only a month or two which does not allow adequate time for public review and input. There has to be a clear understanding of all the exemptions included in the system, who benefits from them, and how much they cost the public.

Take a case study involving America Online (AOL) right here in Virginia. In early 1999, AOL announced they were considering building a new data center in either Northern Virginia or North Carolina. Virginia legislators crafted a bill which would provide sales tax exemptions for a company which exactly matched AOL's profile. The bill passed, even though most legislators did not know that it would only benefit one company. AOL will save an estimated $18 million at startup and $4 million a year after that.

This was a tax decision that was not accountable or transparent. North Carolina offered bigger tax breaks but AOL still located in Virginia, so it may have had little affect on their decision. No other companies received this tax break, so it created unfair competition backed by the state. And finally, it set a precedent: in the wake of the AOL tax break, eight major technology and telecommunications firms requested millions of dollars in state sales tax cuts.

Addressing the Problems with Virginia's System

There are at least six areas in which Virginia could make significant and helpful changes in its tax system:

1. Adjust income tax burdens to shield the poor from state taxation.

This could be done in a number of ways. The most effective would be to adjust the income tax brackets so that they make sense based on current incomes. It would make our income tax progressive rather than flat and eliminate or dramatically decrease income tax on poor families.

Virginia could also adopt a refundable Earned Income Tax Credit (EITC), which would bring most working families out of poverty. Last year, Virginia adopted an income tax credit that effectively eliminates state income taxes for families with incomes below the federal poverty line. But it created a cliff in which a family whose income exceeds that poverty line by a small margin has to pay the full tax. Instead, Virginia should implement an EITC in which benefits gradually phase-out up to about $30,000 of income. This would eliminate the cliff and provide tax relief to families as they leave poverty but continue to struggle to make ends meet.

2. Property tax relief for poor homeowners.

This would help low-income homeowners by exempting them from property taxes on their houses. Currently local governments in Virginia are authorized to give this exemption to elderly and disabled homeowners with income less than $30,000. This exemption could be extended to all homeowners who fit the income guidelines.

Another option would be a renter's credit, in which tax relief would be set as a flat amount or as a percentage of rent paid. It could be targeted via income guidelines or applied to persons paying more than 30 percent of their income on rent. Though this exemption would be politically difficult to enact, it would benefit the population currently under the most economic pressure in Virginia, low-income renters.

3. Reduce sales tax on food.

Out of the 46 states that levy a general sales tax, 28 of them exempt most food purchased for home consumption. Beginning this year, Virginia is reducing the state general sales tax on food by 0.5 percent each year through 2003. The local rate of 1 percent will remain as an essential source of funding for local governments. However, the program requires that revenues exceed the forecast by 1 percent in order to trigger the next phase in reductions. As we have seen in this year's Car Tax debacle, that trigger is unlikely to be pulled in the short term.

4. Maintain adequate funding reserves in the Rainy Day fund.

At least twice in the last 10 years, the governor of Virginia has declared a hiring freeze at state institutions as a result of budget shortfalls. These extreme fluctuations in taxation (car tax cut) and expenditures (budgets slashed by 15 percent) are simply bad government. Virginia must reach some even keel in its fiscal policy, and a crucial ingredient will be sufficient reserves to weather an economic downturn or recession.

5. Increased accountability for tax expenditures.

Virginia must create some system for figuring out who is receiving tax breaks, how much, and what it costs our state in missing revenue. These tax breaks are costly, they usually benefit those least in need, and they are hidden in the tax code so that literally no one knows their impact. The system is open to corruption as a result.

Strategies for solving the problem include: increase scrutiny to establish the costs and determine who benefits; enact performance standards which require that tax breaks provide a clear public benefit; target tax breaks on those taxpayers who most need them; and create sunset clauses which force the legislature to renew tax breaks rather than assuming that they last forever.

6. Improve budget transparency.

Lawmakers and outside advocates need high quality budget and tax information to analyze proposals and make thoughtful decisions. This information would include:

• Budget estimates for revenues and expenditures at current service levels
• Multi-year expenditure and revenue projections for both current service levels and the governor's proposed budget
• Detailed reporting on tax breaks
• A tax incidence report that shows how the tax burden is distributed among income groups.

In the final analysis, the Virginia tax system is inadequate, unstable and inequitable. As a state we can do better.