Tax Policy Responses to Revenue Shortfalls

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I. Introduction: Fiscal stress drives state tax policy change

Tax policy analysts advise state policymakers to design efficient, equitable and stable tax systems. That is, the tax system ought to be neutral and not favor particular economic activities over others. It ought to be fair to different groups of people and it should provide sufficient revenue for the state to weather economic cycles without undue disruption of basic services. We would like to believe that policymakers listen to this advice, form tax study commissions that consider an array of possibilities and deliberately choose tax systems designed to meet these fundamental goals.

Our reading of history suggests that this idealistic view is badly flawed. While policymakers are aware of - and care about - the criteria outlined above, political gridlock usually makes it very difficult to add to any group's tax burden except in times of immense political stress, while reducing the tax burden of particular groups usually meets little resistance. Most statewide sales and income taxes were adopted only because of the national economic depression of the 1930s. Significant state tax increases usually occur only during economic downturns. The opportunity to increase some groups' tax burden may lead to improved tax policy although tax reductions can also achieve economic goals of fairness and efficiency. Because the latter are more politically palatable than the former, opportunities to decrease taxes are more abundant than opportunities to enact increases. As Kee and Shannon (1992) colorfully argue "recession-induced fiscal crises...smash the iron grasp of the status quo. When ...policymakers are suddenly confronted with a large deficit they must often take drastic and innovative reform actions...in many cases [this generates] long-term institutional gain."

Thus, in our view, times of economic stress present an unusual chance to radically change and possibly improve tax and expenditure policies. Although gradual increases in expenditure certainly contributed to recent fiscal imbalances, the immediate impetus, as documented below, was a dramatic decline in state revenue. In this paper we contrast changes in tax policy following the recessions of 1990 and 2001. We show that the relatively large decline in revenue in the recession of 2001 was partly the result of atypical economic conditions—unusual declines in capital gains—and, when compared to the previous recession, partly the result of an atypical policy response—state legislators' unwillingness to raise taxes.

Note: This report is available in its entirety in the Portable Document Format (PDF).

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