Tim Henderson | (TNS) Stateline.org

From health care for immigrants in California to universal school vouchers in Tennessee, states are being forced to rethink expensive projects as tax revenues decline and federal pandemic aid ends.

State tax revenue fell last year by 4%, according to a Stateline analysis of U.S. Census Bureau estimates released this month. Revenue is still up since 2019 by about 28%, though, higher than the inflation rate of about 18% in that time.

California and New York bore a disproportionate share of the loss, even accounting for their large populations. Those states lost a combined $56 billion in state tax revenue, the bulk of the $66 billion national loss.

California Democratic Gov. Gavin Newsom, confronting a budget deficit that has ballooned to $73 billion, called on lawmakers to reopen the state budget for changes, including a proposed $1.5 billion increase in taxes on health insurers to maintain an expansion of state health insurance for low-income people regardless of immigration status.

Republican Assemblymember Bill Essayli called the expansion, which would include $4 billion in state funds, “money we don’t have” for “illegal immigrants” in a March 14 budget committee meeting ahead of an Assembly vote. Democratic Assemblymember Akilah Weber, who is also a San Diego physician, said the expansion would mean “we can keep on doing our work and helping patients without having to cut services.”

The higher tax would need to be approved by March 21 to get federal approval. The governor and lawmakers are negotiating other budget changes, which could include more taxes or billions of dollars in cuts to school construction, homeless housing, broadband or transit funding.

Conservative agendas also are under scrutiny as tax revenues dipped in 32 states last year and failed to keep up with inflation in 40 states and the District of Columbia, according to the Stateline analysis.

Tennessee Republicans favor Republican Gov. Bill Lee’s $140 million proposal for universal school vouchers. But a budget deficit has some GOP members questioning increased public school funding meant to sweeten the deal and dampen opposition from Democrats and others who fear the program will harm public schools.

Republican state Rep. Charlie Baum noted that the current House version of Lee’s voucher plan includes an extra $320 million for public school funding in rural areas, staff health insurance subsidies and construction costs — spending the state can’t afford given its $400 million budget deficit, he said.

Some states are adding taxes to find more money as surpluses dwindle: In New Jersey, where state tax revenue dropped 4% last year but remains 32% higher than 2019, Democratic Gov. Phil Murphy asked lawmakers to approve a tax on large businesses to support the state transit system by raising about $1 billion this year. The extra funds may help preserve a program to lower property taxes for older people.

In Arizona, a projected $1.7 billion budget deficit looms after a flat income tax enacted by Republican Gov. Doug Ducey in 2021 took effect last year. Current Democratic Gov. Katie Hobbs proposed clawing back money from road projects and school vouchers approved under rosier forecasts. The Stateline analysis shows Arizona state tax revenue was down 8%, or about $1.9 billion, last year compared with 2022, but up 26% from 2019.

Tax cuts may be “coming home to roost” for states such as Arizona that cut deeply during the pandemic, slowing states’ ability to improve things such as schools and housing, said Wesley Tharpe, senior adviser for state tax policy at the left-leaning Center on Budget and Policy Priorities.

“More than half of states used the cover of temporary surpluses coming out of the COVID-19 recovery to enact permanent reductions in their state income tax,” Tharpe said. “In several states the reductions are really, genuinely historic like Arizona, North Carolina, West Virginia. It’s not only that states might have to cut services, when they cut taxes this deeply — it’s also that they’re forgoing revenues that could be used for unmet needs.”

But conservatives insist cutting taxes will help states in the long run by putting more money back in the hands of consumers and attracting more high-income workers.

“Most states which cut taxes found ways to deliver responsible, sustainable tax relief,” said Jared Walczak, vice president of state projects at the pro-business The Tax Foundation. “Tax competition matters more than ever, and if you’re balancing a budget, you’d much rather be dealing with the tax-cutting Mountain West than some of the tax-hiking states on the coasts right now.”

Utah and Iowa also had double-digit state tax revenue decreases.

Falling oil prices in 2023 hurt some states. Alaska had the largest percentage drop in state tax revenue last year: 50%, or $2.1 billion, though the state expects a boost this year from higher oil prices, and state tax revenues are still 32% higher than in 2019.

Maryland, which — like California — is unusually dependent on income tax revenue from high earners, is facing political battles over whether to cut spending or raise taxes in light of continuing tax revenue disappointments that created a $500 million deficit in the proposed budget.

States got used to having their revenue and giving it back, too, as most states were able to cut taxes and increase spending at the same time because of stimulus funding, a booming economy and consumer spending that boosted tax collections. Now decisions are getting harder as consumers tighten their wallets, tax cuts take effect, stimulus spending is over, and some sources of high-income jobs such as energy and tech have fallen back to earth.

One worrisome new trend in late 2023 continuing to this year: lower sales tax revenue as consumers spend less on retail items, said Lucy Dadayan, principal research associate at the Urban-Brookings Tax Policy Center.

“This is alarming,” Dadayan said. “The two holiday months, November and December, saw declines in sales tax, indicating that consumers are tightening their wallets.”

Texas reported a 2% drop in March sales tax revenue distributed to local governments based on January sales, and Arizona retail sales tax revenue grew by only 1% in January, the lowest growth in a decade. Maryland is considering expanding its sales tax to more services in light of a retail slump.

The puzzling sales tax dip is especially hard on small towns that depend on it to pay for basic services such as police and firefighters. Sales tax revenues make up more than 43% of the budget for Greenwood, Arkansas, a city of about 9,600 near the Oklahoma border. Sales taxes are about flat so far this year instead of growing 4.5% as forecast, said Finance Director Thomas Marsh.

Greenwood’s sales tax revenue soared 50% during the pandemic as big-box stores and restaurants in the nearby city of Fort Smith closed and residents did their shopping and eating out closer to home or online — an Arkansas state law required local sales tax for online purchases starting in 2019. City officials expected growth to slow, but they were caught off guard when growth stopped in January and February, which could force a hiring freeze and postpone building projects if the situation continues, Marsh said.

David Thurman, director of Tennessee’s Budget Analyst Agency and president-elect of the National Association of State Budget Officers, said Tennessee and other states need to take a step back on ambitious programs for a “reset year” while taxes drift back to pre-pandemic growth levels.

“We’ve structured the [fiscal] 2025 budget to allow taking care of the normal cost of government but do very little else,” Thurman said. “I think we should all move forward more cautiously until we get a better read on what the new normal will be like.”

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