State's Revenue System Needs Modernizing, According to Latest Virginia News Letter

December 19, 2011 — Although a sluggish economy and high rates of unemployment are exacerbating Virginia's financial problems, the economic downturn has revealed serious weaknesses in the state's revenue system, according to the latest Virginia News Letter, published today by the University of Virginia's Weldon Cooper Center for Public Service.
By adopting a number of reforms in personal and corporate income taxes, updating sales-tax policy to reflect an increasingly service-driven economy and better managing tax credits and other preferential treatment, Virginia can address not only the massive revenue shortfall in the coming biennium, but can position the state for a better future, writes Sara C. Okos, policy director of the Commonwealth Institute for Fiscal Analysis and author of the article, "Richmond, We Have a Problem: Modernizing Virginia’s Outdated Revenue System" in the current Virginia News Letter.

The Virginia News Letter, issued six to nine times per year, invites authors drawn from the Cooper Center, U.Va. and other public and private higher education institutions in Virginia, and non-academic experts to comment on Virginia public policy issues.

As Gov. Robert F. McDonnell and the General Assembly work to craft a 2012-14 budget this winter, they will face hard choices about the state's funding priorities in the face of a shortfall estimated to be more than $800 million, Okos writes.

Many of the tools used to balance the state budget in recent years are no longer available, she notes. Funding from the federal American Recovery and Reinvestment Act has expired. Virginia's Revenue Stabilization Fund, often referred to as the "rainy day fund," is mostly depleted. And the state is reaching its legal borrowing limit.

Furthermore, many of the financial tactics and accounting tricks used during the recession (such as borrowing from the Virginia Retirement System and shifting Medicaid payments around) will require re-funding before money can be spent on other needs. The prospect of significant cuts in federal spending over the next few years spells even more trouble.

"These factors present serious risks to critical state investment in key areas like education, health care and economic development – all of which play important roles in positioning Virginia for the best possible future," she writes.

Okos, who coordinates tax research for the Richmond think tank, targets four key revenue areas that she says need revising because they are limiting the ability of the state's general fund revenue structure to produce adequate resources. They are:

    • the state income tax, which hasn't been updated in 25 years;
    • the sales tax, which hasn't kept pace with consumer spending trends;
    • the corporate income tax, which is vulnerable to accounting tactics that limit tax liability;
    • and the many "tax expenditure" programs that offer exemptions, credits and other preferential tax treatment to certain types of income.

Among the changes she recommends:

• Update the individual income tax structure. Because Virginia hasn't changed the brackets or rates of its individual income tax in more than two decades, more and more people are shift into the highest bracket and more of their income is taxed at the highest rate. In addition, Virginia does not follow the federal practice of indexing the standard deduction or personal exemption for inflation, meaning that their values decrease over time.

Furthermore, income growth has been concentrated among upper-earners. "This means that by failing to adjust income tax brackets and rates to capture this high-end growth – the epicenter of income growth in our economy – our revenue system has not grown in tandem with the economy," Okos writes.   

• Adjust the retail sales tax to reflect consumer activity. A shift in consumption from goods to services, and from purchasing in stores to online retailers, has highlighted some major gaps in the sales tax structure. Virginia ranks at the bottom nationally in the number of services included in the sales tax base. The majority of states with a sales tax levy it on an average 55 of the 168 services included in a recent survey. Virginia taxes a mere 18.

More on her recommendations can be found in the article online.

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