Connecticut has been in a fiscal crisis pretty much non-stop for the past eight years. It is likely that the state would have started looking at red ink before that, but the real estate and financial bubble of the 2000s masked the underlying reality. For close to a decade, and probably for longer, our state has been constantly on the edge of a fiscal chasm, with the General Assembly muddling through with a mix of tax increases and spending cuts.
The thing is, this is not really normal. Connecticut is one of the wealthiest states in the wealthiest country in the world. Even if the state´s economy hasn´t fully recovered, unemployment is relatively low, growth is weak but not anemic and labor productivity is still high. We have an economy in a mild slowdown enough to produce a shortfall that could be sorted out with some tweaks. Instead, we have a Groundhog Day of budget deficits.
For starters, it is not true that we have a state government we cannot afford. It is hard to stress enough the fact enough that Connecticut is really wealthy and we are not doing anything that other states aren't able to pay for, but it goes beyond that. Measured both in terms of state and local taxes as percentage of personal income and as size of state and local government as percentage of the state economy, we rank in the bottom half in terms of how much we tax and spend.
Of course, it is not that we have not raised taxes. The state, in fact, went through two rounds of pretty hefty tax increases, one just after Governor Malloy got elected, a second round last year. The Governor and legislature have been looking for money all over the place, and they have bitten the bullet (twice!) with unpopular tax increases. And yet, the budget hole does not get any smaller. Why?
The answer is a tad complicated, and requires having a closer look at how we tax and spend in the state. The main issue, however, is less that we spend too much or tax too little, but that we do both in really outdated, inefficient ways. We have a state budget based on 20th century assumptions, not 21st century realities. Let´s start today with taxes.
1. Taxing objects in the age of ideas
If we want to see how the Connecticut tax structure is designed for a 1960s style economy, look no further than the sales tax. About a quarter of the total tax revenue of the state comes from the sales and use tax, collecting a bit north of $4 billion a year. It is a fairly regressive tax, with families at the bottom of the income distribution paying much higher effective rates than anyone else.
This is due to the very nature of taxes on consumption (the poor dedicate a higher percentage of their income to it), but also because we happen to exclude a lot of things from it: primarily, many services. Connecticut´s tax code has a monumental amount of carve outs, exemptions, loopholes and special provisions that leave a huge and increasing percentage of our economy untaxed. This means that a diaper, sofa or cell phone has to pay sales tax, while things like repairing a boat, hiring an interior decorator or going to the gym are untaxed. In a sense, the state is raising money from tangible products in an economy that is more and more focused on services and ideas.
If we eliminated all the sales tax exemptions but the one for food purchases, Connecticut would be able to collect close to $2.5 billion in extra revenue a year at current rates – or it could cut the current rate by close to two points, giving a significant tax cut to low income families while still raising close to half a billion in additional revenue. To put it in one sentence, broadening and simplifying the sales tax makes sense.
The sales tax, however, is hardly unique. If we look at the state and local tax system as a whole, the property tax is by far the biggest source of funding for Connecticut´s public sector, with 45% of all tax revenue. Four or five decades ago, when Connecticut had a much more egalitarian income distribution and wealth was much less geographically segregated, it made sense: the core cities concentrated business, trade and industry and could raise revenue effectively. Today, cities have lost much of their former tax base, suffered years of underinvestment and concentrate most of the need, so they end up having higher mill rates. As a result, nearly 60% of Connecticut towns cannot cover the cost of their services on their own.
Things have changed in the past few years. Today, many business favor dense, vibrant urban areas instead of suburban campuses. GE left the state not looking for a low-tax haven, but for vibrant, urban Boston. Knowledge workers value active, diverse, lively, dense communities, and clustering creates strong network effects that promote innovation. In Connecticut, however, we are taxing those urban areas heavily, while leaving the most expensive suburban communities in the country paying much lower mill rates. Again, we have an outdated tax system, raising money in a way that doesn´t make much sense.
2. Giving tax breaks to fading industries
The rest of the state´s tax system is similarly geared to either raise money from a 1960s-style economy or promote growth like we used to have in last century. Connecticut´s business tax code heavily favors manufacturing over any other kind of industry: while the total effective tax rate for a factory (adding up business, property, sales and unemployment taxes) is 9.8%, a research facility or corporate headquarters ends up paying 22%.
This might have made sense decades ago, when manufacturing was both labor intensive and did not face international competition. Today 80% of the U.S. labor force is in the service sector, while manufacturing barely employs 8% of workers. Connecticut, even with all this help, barely looks any different, with less than 10% of the labor force in factories. Our business tax code is needlessly complicated for no good reason.
3.Taxing (some) income instead of wealth
Connecticut has the largest income gap of the nation. The state tax system takes this into account thanks to a progressive income tax that raises roughly 60% of its revenue. The income tax does its job in making those that have the most pay more, but not terribly so: the effective tax rate for households in the top income decile (4.52% in 2011) is only three and a half points higher than those at the bottom (1.11%). Trouble is, wealthy, affluent households tend to receive a very high percentage of their income from investments, and Connecticut is not taxing capital gains that much.
In addition, in a state with very high levels of concentrated wealth, our property taxes remain firmly local. As a result, the more expensive the average median price of a house is in a town, the lower the mill rates are. As most of household wealth in the state is tied to housing, we are again raising revenue the wrong way from the wrong places.
Fixing these imbalances and modernizing Connecticut´s tax system to make it more efficient, fair and predictable won´t be easy. Even a non-binding, non-partisan tax panel this year had trouble producing a revenue-neutral set of proposals, and sidestepped proposing significant changes to the property tax. We are at a point, however, where Connecticut can no longer afford standing still. Our state and local tax system is regressive, inefficient and often just raises insufficient funding from the wrong things and places. It is time for state and local leaders to step up and start thinking big, not just look at piecemeal reforms. The current tax system will never be able to raise enough revenue to fund our current needs on the long run, or to foster sustainable economic growth.
Not everything is taxes and taxation, however – Connecticut might not be the big spender that is often suggested, but we do manage to use our money in surprisingly inefficient ways sometimes. That, however, is for the next article. Stay tuned.
Paul Ryan released today the House Republican budget. In Ryan´s own words, the main objective of his plan is reducing the deficit, the biggest issue that the country is facing right now: "Yet the most important question isn't how we balance the budget. It's why."
Well, it turns out that "how" happens to be a fairly big deal, as Ryan´s budget includes a bold, radical redefinition of how the Federal government works and what it does. The main bullet points on this plan are fairly straightforward:
What remains the same:
- Social Security is held harmless.
- The cuts on military spending from the sequester remain largely in place, with only modest changes.
- Medicare cuts from the Affordable Care Act remain in place.
- Huge, harsh cuts on Medicaid, turning the program into a block grant state program.
- It turns Medicare into a voucher program (it is a voucher program, not premium support) to anyone under 55.
- Repeal of the Affordable Care Act, but leaving its tax increases in place. The nonpartisan Kaiser Family Foundation estimates that cuts on the order of what Ryan is proposing will mean around 35 million people lose their health-care coverage.
- Block granting SNAP (food stamps) and passing it on to the states, with huge spending cuts.
- Big spending cuts in education, infrastructure, research, public-safety, and low-income programs.
To complement these changes, Ryan also proposes a vaguely defined tax cut on the wealthy and lowering corporate tax rates, just in case the list above was not regressive enough. Ezra Klein describes the proposal as "social engineering with a side of deficit reduction", and he is right. For a party that spends most of its time bemoaning any tax increase as "class warfare", the budget truly looks like class warfare on behalf of the rich.
The House Republicans have decided to double down on the list of proposals that led them to defeat in last year´s election. The Affordable Care Act and increasing some revenue to pay for government programs were clearly on the ballot, and they won. The GOP negotiating position, however, remains the same, as the election never happened. The only significant change is that Ryan now seems to support the cuts to Medicare included in Obamacare that he opposed on the campaign trail.
The cuts would have devastating effects both on low income families and the middle class. The cuts on Medicaid and SNAP would really hurt the poor. Repealing the affordable care would be a major blow to working families, as the health care subsidies cover households making up to $92,000 for a family of four (400% FPL, to be more precise). Gutting Medicare will endanger retirement for all but the very wealthiest Americans.
The fact that most of the money saved from these changes is used to pay for a gigantic tax cut for the rich is just the icing on the cake; in a country were income inequality has risen to almost insane levels, putting forward a budget proposal that redistributes level upwards at this rate is beyond belief.
Budget deficit at the Federal level are an issue, but not on the short run. Interest rates are extremely low (the 10 year treasury note is at 2%; essentially zero, if we account for inflation), and they don´t seem to be going moving up in any meaningful way. Congress has passed, in the past few months, more than $2.4 trillion dollars in deficit reduction, to the point that the medium term budget outlook is basically stable. Inflicting untold amounts of pain on American families trying to solve a problem that is years in the future in a context of sluggish growth and high unemployment is deeply irresponsible.
If we were to cut deficit and reduce debt levels, Congress does need to use a balanced approach. First of all, it needs to make sure that any reduction happens down the road, not in the midst of a slow recovery. Second, the cuts need to be targeted and focus on truly wasteful programs, without hurting those that are the most vulnerable. Third, it needs to include revenue, either with higher rates (not just on the rich - Clinton-level middle class taxes were slightly higher than today, and it did not hurt the economy one bit) or reducing tax expenditures, closing loopholes and eliminating inefficient tax deductions. The Senate Democrats proposal, although with some flaws, is a much better model than they Ryan plan.
I wonder if the media will pay the same level of attention to both documents, or they still think that Paul Ryan is a reasonable guy with a reasonable plan. We will see tomorrow.