Fiscal Virginia: The Tax Commission Report

by Bob Zahradnick

This is Part III in a series examining Virginia’s tax system, how it works, and how it doesn’t. Created by the Virginia General Assembly, the Commission on Virginia’s State and Local Tax Structure for the 21st Century was asked to look at the current tax structure supporting Virginia’s state and local governments, and at the division of responsibility between the two levels of government for providing public services. It was charged with evaluating the adequacy of the current system to address Virginia’s future needs, given current social and economic trends. Many thanks to Bob Zahradnick and the Center for Budget and Policy Priorities for their work on this series.

Virginia's state and local government fiscal system is both inadequate and unfair and requires a substantial overhaul, according to a report released last December by the Commission on Virginia's State and Local Tax Structure for the 21st Century.

The report found that Virginia's local governments have limited revenue-raising options, but face growing service needs. At the same time, the state government's long-term fiscal outlook indicates significant budget shortfalls if critical needs are to be met. On the other hand, Virginia is a low-tax state so other revenue options are still available for addressing the fiscal problems.

The Commission also found that Virginia's tax structure is unfair in that lower income residents pay a larger share of their income in taxes than wealthy residents.

Local Government Findings

The Commission found that local governments in Virginia are faced with a shrinking revenue pie for several reasons. First, the local sales tax is declining as a local revenue source as Virginia's economy shifts from being a goods-based economy to a more service-oriented economy. In Virginia, as in many states, most services are exempt from the sales tax. Second, the elimination of the car tax has reduced the revenue-raising options of local governments. Third, the Commission found that state financial support for social services and education is inadequate and places an additional fiscal strain on local governments.

On the expenditure side, Virginia cities and counties face growing service needs that cannot be fully met with locally raised revenue or the current level of state aid. In addition, the study found significant income and poverty disparities across the state. As a result of these disparities, local government expenditures for health, welfare and public safety vary widely across the state. These geographic inequalities are further evidence of the need for additional state aid to support the areas of the state that have significant service needs, but do not have the revenue base to adequately provide needed services.

State Government Findings

As cities and counties struggle to provide adequate services to residents, the state government is also faced with a potential fiscal shortfall. As evidence of this, the Commission cites an analysis that indicates that the state will need an additional $3.5 billion in order to continue providing the current level of services and to address unmet needs in higher education, transportation and Medicaid.

This analysis may be overly optimistic because the conclusions were reached prior to the release of reports that the state's revenues were coming in lower than expected due to the slowing economy and the higher cost of the car tax cut. As further evidence of the need for additional resources, the Commission cites another report that estimates a $40 billion shortfall in the funds available to meet the state's transportation needs over the next two decades.

While the state's long-term fiscal picture looks bleak, the Commission's report indicates that the state has the resources to address the service needs of the residents of the Commonwealth. Specifically, the Commission found that:

“If the citizenry and political leadership of the Commonwealth determine that there exists a necessity to increase investment in public services in Virginia, there appears to be latitude in the state's tax structure to accommodate that desire. Virginia's state taxes are low in relation to its five adjoining states and to the nation generally...(I)t appears to this Commission that Virginia could increase revenue collections to address the needs of its residents without placing the Commonwealth at a competitive disadvantage.”

Thus, the Commission's findings include evidence that there are needs that are not being met at both the state and local level, and that Virginia has the capacity to meet those needs if the political will exists.

The Commission's findings discussed thus far have focused on the inadequacy of Virginia's revenues to meet service needs. Another important aspect of a state's fiscal structure is whether or not it's fair. Fairness in this context refers to how the tax system impacts Virginia families across the income spectrum. On the issue of fairness, the Commission found that Virginia has a regressive tax structure whereby middle- and low-income families pay a greater share of their income in Virginia state and local taxes than do the wealthy.

Overall, the Commission's report found that Virginia has both an inadequate and an unfair revenue system. The report provided several recommendations for addressing these concerns, many of which have merit.

Recommendations

To address the fiscal stress faced by Virginia localities, the report recommends several forms of increased state aid to localities. For example, the report recommends that the state increase substantially its support for both the operational and capital costs of the local school divisions. In addition, the report recommends that the state assume the full operational costs of state-mandated services including public health departments, local and regional jails and public welfare departments.

The report recommends dedicating at least 6 percent of annual income tax collections for return to localities — about $500 million. This recommendation raises some concerns because dedicating or earmarking revenues reduces the flexibility of policy makers to address critical expenditure needs as they arise. However, this recommendation further highlights the Commission's view that the state needs to provide substantially more financial support to localities. All of these recommendations are intended to reflect a net increase in support to localities and are not intended to simply replace assistance currently provided to localities.

In order to raise sufficient revenues to provide adequate support to localities as well as address other needs, the Commission provides several reasonable recommendations for strengthening the sales tax as a revenue-raising tool by broadening the base. Specifically, the report recommends that Virginia should participate in the Streamlined Sales Tax Project that is intended to improve the ability of the state sales tax to capture revenue from sales conducted over the Internet. Next, the Commission recommends expanding the sales tax base by extending the sales tax to include personal services, amusements and repair services. A third recommendation that would broaden the sales tax base is to place a moratorium on sales tax exemptions and to critically review all existing exemptions for possible elimination.

In addition to strengthening the sales tax by broadening the base, the report indicates that if additional revenue is needed, the income tax is the best way to raise additional revenue. This recommendation makes sense because the income tax is the fairest or the most progressive of the major taxes.

The Commission report includes several recommendations for improving the fairness of the state income tax. Many of the income tax recommendations have merit, but one in particular deserves to be highlighted. The Commission recommends replacing the current low-income credit, which effectively eliminates state income taxes for families with incomes below the federal poverty line, with a refundable state Earned Income Tax Credit (EITC) equal to 20 percent of the federal credit. The federal EITC is a tax credit for low- and moderate-income workers, primarily those with children, designed to offset the burden of Social Security taxes, supplement earnings, and complement efforts to help families make the transition from welfare to work. The EITC has been widely praised for its success in supporting work and reducing poverty.

The success of the federal EITC has led a number of states to enact state Earned Income Tax Credits that supplement the federal credit. Altogether, 15 states — including Maryland and the District of Columbia — now offer state EITCs based on the federal credit. In addition, one local government — Montgomery County, Maryland — offers a local EITC. State EITCs have gained support across the political spectrum. EITCs have been enacted in states led by Republicans, states led by Democrats, and states with bipartisan leadership. Business groups as well as social service advocates support the credits.

An EITC would be an improvement over Virginia's low-income credit for three reasons. First, the benefits of an EITC phase-out gradually whereas the low-income credit ends abruptly at about the poverty line and results in high tax burdens on families as they work their way out of poverty. Second, eligibility for the EITC is broader than the low-income credit, up to about $30,000 for a family of four compared to only about $17,000 for the low-income credit. Third, the EITC recommended by the Commission would be refundable. Under a refundable credit, a family receives a refund check if the size of the credit exceeds its tax bill. Thus the EITC provides both tax relief and lifts families out of poverty by providing a wage supplement. Low-income working families frequently struggle with the additional costs associated with making the transition from welfare to work such as health care, transportation and childcare. A refundable EITC can provide an income supplement and assist in meeting these expenses.