Where does the budget crisis come from? A 20th century budget in a 21st century economy

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.

Local and state government spending as percentage of Gross State Product, 2012

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 The main issue, however, is less that we spend too much or tax too little, but that we do both in really outdated, inefficient ways.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.

CT tax revenue, state and local taxes, 2011

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.

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