© 2006 Virginia Review, LLC

STATE BUDGET

The Other Side of the Coin–What Does the Future of Virginia’s Budget Really Look Like?

By Michael J. Cassidy

Editor’s note: The author wishes to thank Cory Kaufman, a policy intern with The Commonwealth Institute and a graduate students in public policy at The College of William and Mary for his help researching this article.

Governor Tim Kaine and the General Assembly will be grappling with a signifigant shortfall in the coming budget. Our analysis at The Commonwealth Institute estimates the shortfall to be $1.2 billion. As they begin the next biennium budget cycle this fall, uneasy policymakers face important questions about whether this is an early indicator of a long term problem or simply a short term revision in revenue estimation.

Historically, the knee jerk reaction to budget shortfalls has focused onslashing expenditures. There are those who would argue the rapid growth in the state’s budget has spiraled out of control and that a cut in spending is needed to bring the state back into fiscal balance.

While expenditure cuts remain an option, a growing constituency within the state points to the increasing number of programs that are underfunded, including transportation, education, Medicaid and mental health services. Therefore, a more long term remedy would include an objective appraisal of the state’s revenue sources. Let’s discuss where there is room for improvement in the state’s tax structure that would better stabilize the state’s resources and contribute to long term fiscal health.

The author is The Commonwealth Institute for Fiscal Analysis Executive Director based in Richmond, VA. It is a nonprofit think tank focused on providing independent research, analysis, and public education on budget and tax issues, with emphasis on the impact of fiscal decisions on low and moderate income Virginians. He was previously with the state Department of Planning and Budget where he was a fiscal analyst.

FROM SURPLUS TO BUST

After back to back years of rather sizable budget surpluses, the recent announcement by Governor Kaine of a $641 million shortfall for the current biennium may have been surprising. Although a gradual slowdown was widely anticipated, given indicators in the state’s economy like the slowing housing market, and smaller growth in personal income, policymakers had been confident that Virginia was prepared for the slowing trends. However, the 2007 Session Budget and Economic Outlook revealed that tax collections were lower than anticipated, largely due to higher than normal refund payments being made and a faster than expected slowdown in the housing market. Consequently, it appears the state is not going to meet its original revenue projections.

Yet, this shortfall should not come as a surprise considering the string of policy decisions made since 1999. In particular, since passage of the Personal Property Tax Relief Act (“car tax relief”) the state has struggled to generate sufficient revenue to pay for this local tax relief, while also maintaining an adequate level of state services. Although this relief effort does not directly impact the state’s revenue, the $950 million needed annually to fund the program means that these resources are not available for state financed programs (since this money is turned over to local governments).

In addition, the land preservation tax credit passed during the same year also resulted in significant lost revenue for the state. Rising property value assessments combined with the widespread practice of repackaging and selling these credits has caused the program to expand immensely. Despite the recent efforts by the General Assembly that passed legislation capping the annual credits granted by the state, reducing the amount of qualifying property value and implementing a transfer fee, the costs of this program continue to grow.

Whereas many argue that the tax reforms implemented by Governor Mark Warner during 2004 already addressed these issues, Table 1 paints a different picture. Illustrating the estimated annual financial impact of key legislative actions since 1999, Table 1 demonstrates that Virginia has never fully replaced the resources consumed by the car tax relief effort. In fact, subsequent tax relief efforts have eroded a significant portion of the new revenue generated by the 2004 reforms. In addition, the 2005 General Assembly advanced the phased 1.5 percent reduction in sales tax on food to July 2005, shrinking revenues by an additional $100 million per year. As a result, the state is still almost $500 million worse off than it was prior to 1999.

Furthermore, many of the reforms outlined in Table 1 that were heralded as “tax relief” packages have also made the Virginia income tax more regressive. Other than the income tax reforms of 2007 that raised the income tax filing threshold on low income Virginians, the other tax cut changes have disproportionately benefitted the wealthy. For example, the estate tax threshold was already high in Virginia (only affecting estates worth more than $2 million), yet it was eliminated all together.

While expenditures continued to grow in recent years, the economy provided sufficient revenue so that the state’s budget was more than capable of handling the higher expenditure totals. Unfortunately, this extraordinary economic growth has masked the existence of a serious underlying budget problem. Therefore, as the economy slows it is not entirely clear whether the state’s revenues will be able to keep pace with continued state expenditure growth. For example, during the current biennium, Secretary of Finance Jody Wagner has estimated that Medicaid, K–12 education and state employee compensation will account for an increase in spending of approximately $2.5 billion, that is 60 percent of the total growth in expenditure expected. At the same time, at an overly aggressive revenue estimate of a 5.5 percent and a 4.8 percent growth rate during FY 2009 and 2010, respectively, revenue is only expected to increase by $2.3 billion, as illustrated in the state’s six year fiscal plan. Assuming that these three major expenditure drivers will grow at a similar pace over the next budget biennium based on these preliminary estimates.

Where has the money gone?
Table 1: Fiscal Impact of Recent Revenue Changes


1999 Car Tax Relief Program
2004 Tax Reforms
Acceleration of Tax Cut on Food Sales
2006 Estate Tax Repeal
1999 Land Preservation Tax Credit
2007 Tax Reforms
Net Fiscal Impact

Note: All values shown in millions Source: Author prepared based on review of Legislative Impact Studies and the 2006 Senate Finance Committee Retreat presentation




(950.0)
(750.0)
(100.0)
(160.0)
(100.0)
(27.0)
(587.0)

THE BREAKDOWN

While this $200 million shortfall is worrisome, it is not the entire picture. In particular, this estimate does not fully account for the various tax changes passed by the legislature or the missed revenue targets during the current budget biennium. As a result, when these impacts are extended out to the 2008–2010 biennium budget an even more alarming picture emerges.

Using the state’s current six year financial plan, published by the Virginia Department of Planning and Budget in January 2006, Table 2 updates the original estimates for the 2008–2010 budget revenues and expenditures by accounting for the known changes that will impact the budget. When accounting for these changes a much larger deficit of $1.2 billion is predicted, even without fully updating the estimates for biennium expenditure levels, which have also increased for certain programs.

Why is the State Falling Short
Table 2: Emerging Budget Shortfall


Original 2008–2010 Biennium Revenue Estimates

Revenue Impacts of Enacted Legislation:
Estate Tax Repeal
2007 Income Tax Changes
Tobacco Tax & Settlement Payment Shortfalls
Lottery Sale Shortfalls
FY 07 Revenue Shortfall
Revised Revenue Estimates



New Estimated Biennium Revenues


Original 2008–2010 Current Services Budget
Known Expenditure Increases:
Transportation Package
Revised Standard of Quality Increase
New Estimated Biennium Current Services


Projected 2008–2010 Budget Deficit

Note: All values shown in millions Source: Author prepared based on review of Legislative Impact Statements, 2006 Six Year Financial Plan, 11/13/06 presentation to the House Appropriations Committee, and Secretary Wagner’s 8/07 presentation to Sen. Finance, House Appropriations, and House Finance Committees




37,283.1


(320.0)
(54.0)
(48.0)
(25.0)
(234.0)
390.0



36,926.1


37,332.9

200.0
600.0
38,132.9


(1,206.8)

As shown in Table 2, the Governor’s original six year plan predicted that the state would collect approximately $37.3 billion in general revenues in the 2008–2010 biennium. When combined with an estimated carryover balance (unspent resources) of $44.7 million from FY 2008 and miscellaneous transfers of $112.7 million, the resulting $37.44 billion in revenue was supposed to be sufficient to cover the expenditure needs of $37.33 billion. However, as noted earlier, these original budget estimates need to be updated to account for legislative changes and revised revenue projections formally adopted by the state legislature.

In particular, there have been several important revenue changes that have occurred since the original six year plan was constructed, and these changes have dramatically altered the state’s revenue landscape. Following review of the General Assembly’s legislative fiscal impact statements, that document the estimated revenue changes expected to occur from changes to the state tax code, as well as the known revenue shortfalls highlighted in presentations made to both the Senate Finance and House Appropriation Committees prior to the 2007 legislative session, the new revised revenue estimate for the 2008–2010, according to our analysis depicted in Table 2, is only $36.93 billion. This estimate also includes the amended revenue projections accepted during the 2007 legislative session and the estimated $300 million shortfall predicted for FY 2007.

On the expenditure side, only two major revisions were made to the original 2008–2010 biennium estimates in arriving at the projected expenditure total highlighted in Table 2. The first adjustment represents the additional $200 million committed by the 2007 legislature to help cover the insufficient resources for highway maintenance and construction projects usually supplied by the state’s Transportation Trust Fund. The other $600 million increase represents the revised estimate for the mandated Standards of Quality (SOQ) rebenchmarking that takes place each biennium. This required increase represents the state’s portion of the obligation to maintain existing service levels in K–12 education. The estimate used by the state was originally only $800 million compared to the most recent estimate suggested by the Senate Finance Committee of $1.5 billion. While no single factor has been identified to account for these adjustments, the expectation is that the $1.2 billion increase in 2004–2006 and the $1.3 billion increase for 2006–2008 will continue in the next biennium.

Once all of these legislative changes are incorporated into the original estimate of the 2008–2010 biennium budget, the revised expenditure total of $38.12 billion significantly outpaces expected available resources of $36.93 billion, resulting in the projected deficit of $1.2 billion, which is approximately 3 percent of the total general fund budget.

It is important to emphasize that this projected $1.2 billion shortfall represents a fairly conservative estimate. In particular, the six year financial plan is traditionally built on overly conservative expenditure assumptions. For example, the expenditure growth rate used by the state to estimate the increased spending between FY 2008 and FY 2009 is only 5.65 percent. However, when compared to the actual growth rates experienced in 2006 and 2007 (of 9.7 and 15.4 percent, respectively), the six year plan is clearly optimistic in its predicted level of state spending.

While the state could arguably rely on Virginia’s Rainy Day Fund to cover any impending shortfall in the 2008–2010 biennium budget, these resources can only be used for limited purposes and merely provide temporary relief. In addition, it is not clear whether the $1.2 billion shortfall would be large enough to meet the constitutional criteria needed to draw these funds, which requires 50 percent of the actual shortfall to exceed 2 percent of the previous fiscal year’s total collected tax revenue.

ABOUT THE COMMONWEALTH INSTITUTE


The Commonwealth Institute for Fiscal Analysis provides credible, independent, and accessible information and analyses of state fiscal issues with particular attention to the impacts on low and moderate income persons in Virginia. They inform state fiscal and budget policy debates and contribute to sound decisions that improve the well being of individual, communities, and Virginia as a whole. It is a program of the Virginia Interfaith Center for Public Policy.

BEYOND THE CAR TAX

Although it is easy to point to the car tax relief program as the primary source of the state’s emerging financial struggles, it is true this program created a significant burden for the state, closer examination reveals that the structural imbalance is due to more fundamental problems within the state’s revenue structure. In particular, the Center on Budget and Policy Priorities has identified several “weaknesses” that put Virginia at significant risk for structural imbalance, including a declining sales tax base, overly beneficial corporate tax loopholes and a highly regressive tax structure with a very low threshold for the highest tax bracket.

The individual income tax, corporate income tax and general sales tax comprise the primary sources of revenue for the state budget, providing 87 percent of the state’s nonfederal revenue in FY 2006. Individual income tax collections led the way followed by general sales tax and corporate income tax collections.

Since 2004, revenues have been largely driven by an increased proportion of general sales tax and corporate income tax revenues as a percentage of total operating revenue. In particular, these two sources have grown in importance by approximately 1.7 percent compared to a more meager increase of 0.5 percent coming from individual income tax collections. As a result, corporate income tax and general sales tax revenues have provided an additional $4.7 billion in available resources for the state compared to an increase of only $2.5 billion from individual income taxes over the same period. While these revenue sources have experienced phenomenal nominal growth rates since 2004, general sales and corporate income taxes also tend to be volatile and highly dependent on economic conditions, meaning that as the economy slows these sources also tend to slow.

The role of each of the primary taxes over time has changed as a source of state revenue. In particular, despite the increase in sales tax rates, including an increase of 0.5 percent in 2004, and accounting for inflation, the growth in this source of revenue has actually declined in recent years. Partly due to a shrinking base resulting from various exemptions such as food purchases and partly due to the shift in the state’s economy from manufacturing to service based industries, growth in general sales tax has decreased significantly since 1992.

Likewise, the real growth in revenue from individual income taxes has also decreased slightly in the more recent period, 1992 to 2005. Some of this is attributable to the various reforms implemented that, among other things, have helped reduce the burden on lower income individuals. However, Virginia still maintains a fairly flat income tax structure, the core of which was put in place in 1926. As a result, the top individual tax rate of 5.75 percent kicks in at the very low income amount of $17,000. Based on 2004 filing data in the Department of Taxation’s Annual Report for FY 2006, more than 60 percent of Virginians pay the highest rate.

Although corporate income tax revenues have fared better in recent years, much of this change has been driven by unusually high growth rates experienced in the last two years (more than 40 percent growth in both FY 2005 and 2006). Since these higher rates are unsustainable, it is likely that the growth rate in corporate income taxes will eventually fall back to the historical average of 3.09 percent.

While the state is predominantly funded through individual income tax collections, continued expansion of state expenditures results in the state being highly dependent on both corporate income tax and general sales tax revenue for funding current state service levels. Because the 2004 tax reforms were heavily reliant on both of these revenue sources, which also include recordation taxes and cigarette and tobacco taxes, the state never fully addressed the structural imbalance that emerged in 2002 during the state’s economic recession. In fact, these combined sources accounted for 97 percent of the additional revenue generated by this reform package.

Finally, The Urban InstituteBrookings Institution Tax Policy Center estimates that since 1984 the average real growth rate in state revenue has been approximately four percent. As noted earlier, even at a less conservative estimate of 5.5 percent and 4.8 percent growth in FY2009 and 2010, respectively, the state is headed toward a significant budget deficit at the current spending level.

GROWING NEEDS

Traditionally, the first response to a state budget deficit is to focus on reducing expenditure levels. Yet, this discussion here indicates that a more appropriate policy alternative may be to focus on reforming the tax system to make it more structurally sound.

While Virginia’s state budget has grown rapidly during the last decade, it is important to consider this growth in its entire context. A 2006 Joint

Legislative Audit and Review Commission (JLARC) study found that in the past decade Virginia’s budget grew an average of three percent a year, when controlling for population increases and inflation. Much of this growth has been relatively concentrated, however, with only a handful of agencies and programs accounting for a significant portion of the budget growth (60 percent since 1997). Additionally, what is often overlooked is that growth in the two largest areas, education and health and human services, is attributable to simply maintaining a baseline level of services, not implementation of new programs.

Growing federal mandates have also played an important role. As the federal government continues to push down greater responsibility for programs historically funded at the government services, there is little support for the argument that Virginia’s spending is abnormally high, especially when compared to other states.

HOW MUCH DO WE INVEST?

Based on this analysis, spending levels in key areas in Virginia are still quite modest compared to most other states. As a result, if adjusting revenues is the key to solving the developing structural deficit in the budget, the next logical question is whether the current state government in Virginia is already too “expensive,” or if there is untapped capacity to generate additional revenues. To answer that question it is necessary to evaluate the current price of government observed in Virginia under the existing tax structure.

Defined as the overall tax burden levied on all residents of the state, the price of government is calculated as the total state tax revenue divided by the total personal income level. According to the Federation of Tax Administrators, in 2006, the percentage of personal income devoted to funding only state government was 6.1 percent. When compared to the national average, Virginia represents one of the lowest taxing states in the country, ranking 43rd in overall state tax burden. Even when the local tax burden is included, since 1980, Virginia’s price of government has been well below the national average. Such a relatively low tax burden coupled with a high level of personal income ($39,173 in 2006 ranks Virginia tenth highest in the nation), it is apparent there is potential for generating additional tax revenue within the state, while still maintaining a relatively low tax burden.

CONCLUSION

News of the projected $641 million shortfall in revenues for the current biennium has raised concerns about an impending structural imbalance in the state budget. As evidence reveals, an even larger deficit is emerging for the 2008–2010 biennium, unless fundamental changes are implemented. As part of a comprehensive response to this shortfall, it is always prudent to re–examine base budget spending patterns. However, while some will argue for spending cuts, a look at the other side of the coin, the state’s revenues, provides a more comprehensive view of the Commonwealth’s budget situation.

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