Are Recent State Tax Cuts Financially Feasible?

As state tax revenues taper off from their peak levels, there’s a growing debate over the financial viability of the tax reductions implemented in recent years. Interestingly, there hasn’t been comparable scrutiny regarding the affordability of the substantial spending hikes during the same period. Nonetheless, it’s imperative to explore whether the tax cuts in 27 states between 2021 and 2023 raise valid concerns.

Fortunately, this issue can be analyzed empirically, and the data strongly indicate otherwise

Tax revenues still surpass pre-pandemic levels significantly, even when adjusted for inflation. Notably, states that implemented tax cuts experienced a more pronounced increase in tax revenues compared to those that didn’t. Between 2019 and 2023, the 27 states that reduced major tax rates (such as individual income, corporate income, or sales tax) saw a real-term tax revenue surge of 9.8 percent. Conversely, states that maintained or increased these tax rates experienced a growth of 6.2 percent.

This implies that states with tax reductions managed to boost revenue growth despite lower tax rates.

However, it’s crucial not to oversimplify this correlation by assuming that tax cuts entirely pay for themselves. Yet, it’s undeniable that states prioritizing tax competitiveness have fared better.

In recent years, state policymakers faced three main choices: augment spending, decrease taxes, or pursue both avenues. With state general fund budgets inflating by 21 percent in real terms between FY 2019 and FY 2024, it’s evident that expenditure hikes have been prevalent across states of different political leanings. Consequently, the real dilemma lay in either channeling all increased revenue towards spending or balancing expenditure increases with returning some gains to taxpayers.

This dilemma is reflected in the statistics. States that refrained from cutting major tax rates since 2021 witnessed a 24.0 percent real-term budget growth, while those that implemented tax cuts experienced a 15.1 percent expansion. In essence, most tax-cutting states managed to reduce taxes while still increasing government spending, albeit at a slower pace, rather than resorting to spending cuts.

Although most states bolstered their revenue reserves, the influx of money was predominantly directed toward either increased spending or tax reductions. In the event of an economic downturn, states prioritizing economic competitiveness through tax reform might find themselves in a more resilient position.

Several factors contributed to the recent surge in state tax revenues. The Tax Cuts and Jobs Act (TCJA) broadened tax bases, which reflected in state tax codes, and stimulated domestic investment. The Wayfair decision expanded states’ jurisdiction to tax remote sales at an opportune juncture. Moreover, broader economic shifts in recent years generally led to higher taxation. Unfortunately, inflation has unfairly inflated tax burdens in real terms. Additionally, federal pandemic relief temporarily boosted state tax revenues indirectly by subsidizing taxable activities. As pandemic relief wanes and inflation stabilizes, the decline in state tax revenues from their peak levels shouldn’t be alarming. While 2023 revenues dipped compared to 2022, they still substantially surpassed 2019 levels when adjusted for inflation, indicating a favorable trajectory.

Furthermore, the decline has been less pronounced in states that implemented tax cuts. In 2023, tax revenues in these states dipped by 4.9 percent from their peak (remaining 9.8 percent higher than pre-pandemic levels), whereas states that didn’t implement tax cuts experienced an 8.8 percent decline.

Hence, concerns regarding the tax cuts in the 27 states between 2021 and 2023 appear unwarranted. However, this doesn’t imply that all tax cuts are prudent or that states cannot overextend themselves financially.

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