The New York Times gave front-page coverage, on July 18, 2012, to a recent report by the State Budget Crisis Task Force. This report argued that states faced major long-term budget problems due to “rising health care costs, underfunded pensions, ignored infrastructure needs, eroding revenues and expected federal budget cuts”, to quote the New York Times’ summary.

I have argued in this blog that states should make major investments in early childhood programs and other human capital investment programs. The Task Force report might raise the issue of whether states will have the capacity to do so.

After reading through the report, I think that if one looks at the overall data on state governments’ fiscal situations, that states will have the capacity to make the needed investments in human capital development, if they make wise budget decisions.

To gauge state revenue capacity, one needs to compare state revenue to the economy. A common way to do so is to compare state revenue with personal income.

If we do this calculation, total state government tax revenue has averaged 6.4% of personal income over the period from 1977 to 2007. There is not much long-term time trend in this percentage. At the various business cycle peaks, state government tax revenue has stayed in the range from 6.4% to 6.6%. 1979 business cycle peak: 6.4%; 1989: 6.5%; 2000: 6.6%; 2007:: 6.5%).

(Note: These calculations are done using data downloaded from the Tax Policy Center of the Urban Institute, which ultimately comes from Census of Governments data. I also downloaded more recent Census of Governments data for FY 2010. These data were combined with personal income data by quarter from the U.S. Bureau of Economic Analysis. Percentages were calculated for fiscal years.)

As of the latest date with available Census Bureau data, fiscal year 2010, state government tax collections were only 5.8% of personal income. The more recent data available in the Task Force report appears consistent with these data.

The unusually low state tax revenue figures for fiscal year 2010 probably have mostly to do with the excess cyclical sensitivity of most state tax systems to the economy.  It may also have something to do with state budget decisions during this time period from 2007 to 2010 to either cut taxes or avoid tax increases. The unusually low state tax revenue figures probably don’t have much to do with long-term trends that might adversely affect state tax revenues, such as more consumption of less heavily taxed services or of goods sold over the internet.  These long-term trends would be of secondary importance over the short-time-period of 2007 to 2010, and in any event, there are many revenue measures that states can take to react to these long-term trends.

As the economy recovers, states certainly will have the capacity to move state tax collections closer to historical averages for state tax revenue. This by itself should raise average state tax revenues by about 10% per capita. (An increase from 5.8% of personal income to 6.4% is an increase of about 10 percent).

In addition, as the economy recovers, the expanded output per capita and personal income per capita will also increase state revenue capacity. According to the Congressional Budget Office, the U.S. economy is currently at least 5% below its potential output (Figure 2-1, The Budget and Economic Outlook, Fiscal Years 2012 to 2022.) As the U.S. economy recovers from the Great Recession, this will increase state government fiscal capacity another 5% or so.

State government tax revenue is currently a little over $700 billion per year. A 15% boost in state revenue capacity due to economic recovery would boost available state tax revenues by over $100 billion annually.

Furthermore, we expect some long-term growth in real per capita incomes. The long-term economic assumptions of the Social Security Board of Trustees are for the U.S.’s economic productivity to increase by 1.7% per year. This is in line with other long-term forecasts. Even if we are pessimistic, we would expect real per capita incomes to grow by 1% per year or so over the long-term. Over the next 20 years or so, such growth would add over 20% to state’s capacity to raise real per capita revenue. That will add another $100 billion to $150 billion to state revenue capacity.

In order for states to actually use this revenue capacity, they may need to make tax reforms to broaden tax bases or raise nominal rates. For example, some state taxes, such as the sales tax, are tending to decline as a percent of personal income over time.  State tax changes to broaden the base of the sales tax or to raise tax rates may be needed if sales tax revenues are to maintain the same percentage of personal income over tax. Maintaining a stable state tax revenue share of personal income requires active state policy measures. This may involve policy actions that could be perceived in the political arena as “raising taxes”. However, if a state’s tax revenue as a percent of personal income is not going up, then a state’s overall real tax burden on its various taxpayers is not really increasing.

The Task Force properly points out that states will face many competing demands for funds, due to the rising costs of Medicaid, the possible loss of federal grants with federal fiscal retrenchment, rising costs of public employee pensions, and infrastructure needs. The wild card here is Medicaid and health care costs. If health care reform can lead to a slowing in health care costs growth, this will help both the federal fiscal situation, as well as the state fiscal situation.  Pension reform will also be needed.

However, states will not be without considerable revenue capacity, of hundreds of billions of dollars per year, to deal with these many important issues.  If we have reasonable health care reforms and pension reforms, state governments should have the fiscal capacity to make needed investments in infrastructure as well as in early childhood programs and other human capital investment programs.