Pew Analysis Reveals Outdated State Tax Systems are Undercutting Economic Vitality

State tax systems are failing to keep up with fundamental shifts in the economy and are impeding states' overall fiscal health, according to analysis released today by The Pew Charitable Trusts' Center on the States.  Pew's research, appearing in the article Growth and Taxes in Governing magazine's January issue, details how some states are adapting elements of their tax structure to meet the changing economy. The data reveal complexities associated with giving businesses tax breaks and highlight ways for states to encourage economic vitality within their borders. The research also points to a number of states that are either leaders or laggards in these efforts.

“State tax systems are the backbone of our national and local economies.  But antiquated tax structures result in lost revenue, an environment that is inefficient and inhospitable to business, and inequitable taxes on some segments of the economy at the expense of others,” said Susan Urahn, managing director of the Pew Center on the States.  “This issue should be at the forefront of all policy makers' minds.   Well-designed tax systems can boost economic vitality.”

The U.S. economy has changed dramatically in the past three decades, largely due to new technology and telecommunications that enable instantaneous transactions in the global market.  The economy in many states has shifted from manufacturing jobs to services and professional jobs.  These changes place greater pressure on states to diversify their tax base and encourage newer, more innovative industries to take up residence within their borders. 

Some states have taken steps to improve the way they tax citizens and corporations in an effort to encourage a broader and more equitable tax base and ensure stable revenue streams.  However, many changes still need to be made. 

“A successful tax structure—one that supports economic growth and meets states' fiscal needs—has at least four key components: transparency of tax incentives, efficient tax collection, stable revenue streams, and localities that have a say in how their communities are taxed,” said Richard Greene, co-author of Growth and Taxes.

Other promising approaches highlighted in Pew's research include:

• Combining reporting of corporate income by requiring parent companies and their subsidiaries to add profits together.  This enables the state to tax the percentage of an out-of-state subsidiary's profits that can be attributed to the corporation's in-state operations.  States that do not use combined reporting, such as Iowa, lose out on a sizable chunk of corporate taxes. What's more, it gives multi-state firms that can take advantage of loopholes a leg up on smaller, local firms.
• Giving localities flexibility to control tax rates and invest revenues as they see fit without state earmarks, which can help encourage economic vitality at the local level.  Missouri, Washington, New York, Pennsylvania and Alabama give local governments authority over funds generated from property, sales and income taxes while Massachusetts, Florida, Nevada and others keep localities dependent on one tax or stream of revenue.
• Providing full disclosure and transparency about business tax incentives, and requiring reporting on how corporations receiving tax breaks are fulfilling their obligations to the state.  For example, last November, New Jersey passed legislation requiring companies that received subsidies to report on details such as job creation numbers, benefit rates on subsidized jobs and the number of employees who receive health insurance and are represented by a union. 
• Reducing volatility in revenue streams, which can make it difficult for businesses to plan effectively for growth. This involves building a diversified portfolio of taxes, relying not just on a single tax on a single industry but instead using several taxes, such as an income tax, a sales tax and selective excise taxes.  For instance, Arizona has less volatility than many other states because of its diversification, while Oregon has the seventh-most volatile state tax system because it relies on the individual income tax for about 67 percent of its revenue.
• Using technology to automate audits and collect individual and business taxes.  Six states—Nevada, New Jersey, New York, Pennsylvania, Tennessee and Virginia—already have fully electronic systems that assign, track, complete, review and transmit audits.

“State tax structures have not kept up with changes in today's economy.  Pressure exists to maintain the status quo and some corporate interests lobby hard to protect tax breaks and incentives that work to their advantage,” said Urahn.  “To thrive financially, states need to create a pro-business environment and generate stable revenue streams that support critical investments and fuel innovation.”

The Pew Charitable Trusts applies the power of knowledge to solve today's most challenging problems.  Pew's Center on the States identifies and advances effective policy approaches to critical issues facing states.  Online at www.pewcenteronthestates.org.

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