The Federal Role in State Tax Reform

Abstract

During the most recent economic downturn, state and local governments have experienced fiscal imbalances of a magnitude not seen since the Great Depression. The principal cause of the current state fiscal crisis is the profound macroeconomic shock of 2008-2009. Yet macroeconomic conditions alone cannot explain the historic decline in state tax receipts over the past few years. As various commentators have noted, state tax structures developed over the past century have become hyper-sensitive to cyclical variability in the economy, with tax receipts exhibiting greater volatility than warranted by changes in underlying economic conditions. This article considers the federal government’s role in promoting the adoption of volatile state tax structures. Through various inducements and limitations embedded in federal law, the federal government has stacked the deck in favor of state revenue volatility, unwittingly exacerbating the subnational fiscal crises that it is then called upon to mitigate through bailouts and general fiscal relief. If the federal government is interested in reducing the likelihood and severity of future state fiscal crises, it should consider changes to federal law that would eliminate the current bias in favor of volatile state tax systems. The article considers various options for reforming the federal government’s policy toward state taxes, ranging from a more neutral federal stance toward state tax design to policies that would explicitly favor the adoption of more stable revenue sources by state and local governments.

Keywords: tax reform, tax structures