At first, Ohio's new tax law appealed to Michael Kovach. Under the plan, which was enacted in 2005 and is being phased in gradually, Kovach, president of City Machine Technologies in Youngstown, Ohio, would no longer have to pay tax on machinery and equipment. The state scrapped its outmoded tangible personal property tax and several others and replaced them with a new tax on gross receipts. For Kovach, whose company manufactures and repairs industrial magnets and other parts and brings in about half of its $10 million in annual sales in Ohio, the change would seem to knock $10,000 off next year's tax bill. Not bad, he thought.
But as is often the case with state finances, the benefits of tax cuts passed during prosperous times often seem fleeting when the economy turns. Today, Ohio faces a budget deficit that some estimate could reach $1.9 billion in the coming fiscal year. Governor Ted Strickland has said he hopes to eliminate the deficit by laying off state workers, closing two mental health facilities, and legalizing video keno. But if the economy deteriorates this summer, Ohio may have few alternatives but to raise taxes.
The story is much the same throughout the U.S. Already, 28 states appear to be headed for budget trouble, with deficits totaling $35 billion, according to the Center on Budget and Policy Priorities, a research institute in Washington, D.C. The situation would appear to be not as bad as in fiscal year 2004, when state revenue was off by up to $85 billion. But nearly all the states join Ohio in being barred by law from running a deficit, and the rainy-day funds maintained by most of these states have not been fully replenished since they were last called upon. When the current fiscal year draws to a close, aggregate reserves will drop to just 6.7 percent of states' year-over-year spending. That's a big decline from fiscal year 2006, when states reported rainy-day funds equal to 11.5 percent of their budgets.
To make up for that revenue shrinkage, many states are already slashing funding for programs and services, including education, health care, and state parks. Legislators are also looking to raise additional revenue through higher fees and to eliminate loopholes and tax credits that benefit businesses. Ultimately, some states will end up contemplating tax hikes of all kinds, if reluctantly at first. Four years ago, the last time a large number of states faced deficits, corporate income and other business taxes were among the most frequently raised, along with state sales taxes.
This time around, Maryland has been among the first to act. In a special session of the legislature last fall, the state raised the corporate income tax rate to 8.25 percent from 7 percent. The state also boosted the sales tax to 6 percent from 5 percent and expanded it to include some computer services. Finally, Maryland raised the personal income tax rate for joint filers earning more than $200,000 a year and individuals earning more than $150,000 a year to 5 percent.
State budget woes could be further exacerbated by the $152 billion federal economic stimulus package, which was hailed by President Bush and members of Congress as a boon for small businesses. The legislation, best known for those rebate checks, seems to create several nice benefits for businesses. For example, Congress increased to $250,000 the amount that businesses may deduct from their annual income if they spend $800,000 or less on capital equipment. The stimulus package also includes a bonus depreciation provision, which allows businesses of all sizes to deduct 50 percent of the cost of equipment purchased in 2008, rather than depreciating the cost over several years.
The bonus depreciation is a problem for the states, however, because many of them adopt a policy of "rolling conformity" with the federal tax code in terms of corporate taxes. In other words, a bonus depreciation provision created at the federal level is automatically reflected at the state level as well. According to the Center on Budget, 22 states could face a potential loss in revenue of a combined $1.7 billion as a result of that one new rule. North Carolina alone could see $282 million in tax revenue disappear, unless the legislature votes to separate the state's depreciation timetable from the federal government's. "The federal budget is adding insult to injury," says Iris Lav, the Center on Budget's deputy director. "If states want to maintain services, they're going to have to make additional cuts or hike taxes."
That prospect unnerves business owners like Kovach, who was just getting used to Ohio's new gross receipts tax. "Now," he says, "I'm afraid the legislature will look at it as a cash cow."
Laura Cohn is a writer based in Washington, D.C.
Correction: The original version of this story, which appeared in the April 2008 issue, incorrectly stated that Ohio's tax commissioner can unilaterally raise the rate of the state's commercial activity tax (CAT). The original law did establish this authority, but legislators recently passed a provision to the state's transportation budget that stripped the commissioner's ability to raise the CAT rate.