Moody's: Taxation Shift Spells Trouble for Underfunded States

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Moody’s Analytics recently conducted a series of stress tests on each state in the US and found that only 16 of the 50 have the funds they need to weather an economic downturn.

Financial Sense spoke with Dan White at Moody's to discuss which states failed the test, lessons learned from the Great Recession, and why their analysis of state preparedness is a "best-case scenario" in the event of another recession.

Lessons of the Great Recession

One thing we learned from the last downturn in 2008 and 2009 was that it matters whether or not states are fiscally prepared for the next recession.

For one, unprepared states’ ability to recover was greatly impacted because they had to take more desperate measures, either by raising taxes or cutting spending to make up for the loss of economic activity.

“That’s one of the reasons why the Great Recession was followed by the not-so-great recovery,” White said.

Poor state preparation led to extraordinary fiscal action to balance budgets, and layoffs followed, with over 750,000 total in the public sector.

“The reason those job losses were so severe was because states just weren’t prepared and didn’t have any reserves or way of buffering themselves,” he said.

Which States Are in Danger Now?

Moody’s stress tests looked at changes in revenue and increases in spending, especially Medicaid, when the economy enters into recession. Moody’s found that only about 16 states have the capital they need to get through another recession relatively unscathed. Another 19 have within 5 percent of what they would need to weather another recession.

Alarmingly, Moody’s found that 15 states have significantly fewer funds available for the next recession, and a handful of states have no money on hand. The states that are worst off, under a moderate recession scenario, are Louisiana, North Dakota, Oklahoma, New Mexico, and Illinois.

“These are states that will have basically nothing to throw at that next recession, whenever it does come,” White said. “They’re going to have extraordinary tax increases or extraordinary cuts in spending.”

stress test
Source: Moody's Analytics

Taxation Shift Makes Problem Worse

Most states either rely on income taxes or sales taxes. However, income taxes tend to be much more volatile than sales taxes, White noted.

The problem is, states are relying much more on personal income taxes and, as a result, see a greater decline and more volatility.

Here's what they had to say on their Stress-Testing States report:

...as part of more explicit tax reforms taking place largely over the past two decades, states have exacerbated that volatility by relying more heavily on a smaller number of high-income taxpayers for revenue. A growing number of states have added new tax brackets or raised rates in an effort to enact tax hikes on their highest-income earners. This in and of itself is not necessarily a bad thing from the perspective of tax policy. Though it can obviously be overdone and limit competitiveness with other states, to maximize fairness, most tax structures should be at least somewhat progressive. However, an often unintended side effect of that progressivity is the introduction of more volatility. Think of it in the context of portfolio theory in the field of finance. By putting more of their eggs in one basket, states have become less diversified in their tax portfolios. More important, they have become more dependent on taxpayers with extremely volatile incomes. Taxpayers in the top 1% of the income distribution can easily swing from a $15 million gain one year to a $15 million loss the next. That manifests itself in higher highs and lower lows for state tax collections.

What Will Recession Mean for High Income Tax States?

States with high income taxes that don't already have ample reserves will likely need to raise taxes even further and/or cut spending by laying off workers, for example, which will only exacerbate the downturn.

Another consideration is, Moody’s didn’t include state pension information in its calculations because of the difficulty of acquiring the information and how many variables it would affect.

Moody’s also left out the possibility of a change in the Federal Tax Code, which could impact whether state and local taxes remain as write-offs.

Without being able to account for those two major variables—pensions and changes in Federal taxes—White explained that their stress test is more likely a best-case scenario.

One thing a lot of state and local governments are very worried about is the elimination of the state and local government tax deduction.

“That could help on the margins to drive people from those states to lower tax states because their burdens are going to increase significantly,” White said. “What’s more, it’s going to make it more difficult during the next recession for states to increase taxes without being burdensome to the underlying economy. … That’s going to make the next recession, especially for those states that are most underprepared, very tricky to navigate from a policymaker perspective.”

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