Budget Basics: Where the State Gets Its Money (part 2)
A series that details the fundamentals of New Jersey's budget, as well as its current budget woes
This is the third in a 10-part series outlining New Jersey’s fiscal fundamentals. The goal is to demystify some of the state’s financial challenges, and put them in context of the broader issues New Jersey faces. This series is also intended as a way to underscore the importance of state government in a year that will see a new governor and a new Legislature chosen by voters. Follow this link to see the.
Where does the state get its money?
Projected revenue for fiscal year 2018 is $34.7 billion — not counting federal aid.
Seventy percent comes from two taxes — the income tax ($14.4 billion) and the sales tax ($9.8 billion). The next-largest tax is the corporate income tax ($2.4 billion). These three taxes represent almost 77 percent of all revenues.
The remaining 23 percent comes from 11 other “major taxes” (such as Insurance premiums, transfer inheritance, realty transfer, motor fuels) and 300 miscellaneous taxes and fees.
The trend for the other major taxes, as well as the 300 miscellaneous taxes and fees, is relatively static, and while the $8.1 billion from these sources is an important flow of revenue — each individual revenue item is relatively small and has little growth potential. Further, recorded in this category are many one-time revenue sources that the state has used over the years to balance the budget; for example, use of environmental settlements with Exxon, sales of assets, telephone taxes intended to upgrade the 911 system, diversion of monies from the Clean Energy Funds, and similar one–time revenue items.
Basically, the state relies on the big two (income and sales tax) — plus the corporate income tax — for any revenue growth.
Further, per constitutional amendments, all of the income tax and one-half of one penny of the sales tax must be expended for property-tax relief — principally for assistance to local school districts.
During the past 10 years, total revenues have increased from $31.2 billion in fiscal 2007 to an estimated $34.0 billion in fiscal 2017 — or 8.9 percent, on average less than 1 percent a year. The U.S. recession of 2008/2009 led to a dramatic decrease in tax collections, and it took seven years for the state to recover to previous levels. The growth in the past three years has been better but still only 2.8 percent per year.
Since the two major spending programs of the state — K-12 school aid and Medicaid plus retirement costs — are driven by forces that exceed current revenue growth, the revenue situation has and will continue to present significant budget challenges to the governor and the Legislature.
Of particular relevance in the New Jersey tax code is the high dependence on the income tax which is 41 percent of all state revenue. As the total income tax collection has become more dependent on income other than wages (capital gains, interest, bonuses, pass-through business income, and the like), it has also become more erratic and volatile and subject to unpredictability, since a small percentage of large taxpayers account for the bulk of income tax collections. For example during the recession of 2008/2009, income tax collections decreased by over $2 billion in one year.
The sales tax (28 percent of all state revenue), while less volatile, is very dependent on a narrower mix of goods and services than overall spending in the state. For example, New Jersey excludes food and clothing and many services. And like all states, it has limited authority to require collection of taxes on purchases made through mail and the Internet unless the entity has a nexus or presence in New Jersey.
The corporation tax is 6.5 percent of total revenue and is impacted more by tax policy than the economy, albeit in a down economy this revenue declines. Volatility is relatively low, but erosion is higher than most revenue sources principally because of pressure and policy decisions to enact credits and exemptions to foster or target development.
For example, corporate deductions and credits have reduced state revenues by an estimated $135 million per year for the past eight years for a cumulative budgetary loss of $1 billion — with the hope that over a period of time these decisions will induce corporations to locate to or stay in New Jersey. Another factor is the erosion introduced by having large corporations operating on a national basis and the method of accounting, which allocates income to and among states. Corporate tax collections in fiscal 2017 are 29 percent less than 10 years ago.
Like every tax code in the country, New Jersey's has numerous credits and deductions. These are referred to as “tax expenditures” — or, expenditures through the tax code. These expenditures are often enacted for good and specific reasons to encourage desired behavior or social outcomes. The problem, however, is that unlike recurring budget appropriations, the expenditures tend to persist once enacted whether they continue to be needed or have proven to be ineffective.
Annually, the state produces a report that lists these credits, exemptions, and deductions. This report indicates that New Jersey has almost $28 billion of these tax expenditures — meaning if any of these tax expenditures were repealed, monies could be raised without increasing tax rates — or rates could be reduced. But many of these exemptions have significant political support and would be difficult to reverse. For example, property taxes (up to $10,000) are deductible on income tax filing; haircuts are not subject to the sales tax, as well as clothing and footwear; corporations can deduct net operating losses, and 60 percent of investment company income. At the very least, these tax expenditures should be carefully examined on an annual basis to determine their value.
One final major observation: Last year the state increased the gasoline tax and made adjustments to related diesel taxes to raise $1.2 billion for transportation projects. Also, on phased–in bases, the estate tax was eliminated, sales tax rate reduced, and additional deductions or credits added to the income tax (a projected decrease in revenue of $1.1 billion by fiscal 2019).But from a budgetary viewpoint the impact is different and very consequential. The gasoline tax increase is dedicated by constitutional amendment for transportation, which is funded by the Transportation Trust Fund — not the General Fund. So, that is good news for transportation construction, but bad news for the General Fund: Once these deductions and credits are phased in, it is projected to lose $1.3 billion by fiscal 2021. All things being equal (they never are) — such decreases will all but wipe out most of any projected revenue growth in the three major taxes.
Let’s look a little more closely at the two largest taxes and consider a few major issues with each.
In addition to wages, the law taxes capital gains, pensions, and most retirement plans, but not Social Security. Only four deductions are allowed: personal exemptions, medical expenses, alimony, and property taxes (up to $10,000) on principal residence. Recent changes, effective in 2018, will increase pension and retirement exclusions, $3,000 exclusion for qualified veterans, and increase the earned income tax credit (EITC). All income tax proceeds, per a constitutional amendment, must be used for property-tax relief and not expended for state-operated programs.During the past decade, the income tax growth has increased by an average of less than 1 percent per year, influenced dramatically by the decrease of $2.1 billion fiscal 2009 and subsequent years of very slow recovery in jobs and wages. During the past three years, growth was 4.0 percent — and, the estimated growth for the current year (fiscal 2018) is 3.9 percent.
The New Jersey income tax is very progressive and thus highly concentrated. The tax rate structure ranges from 1.4 percent below income of $20,000 to 8.9 percent over $500,000. Based on almost 4.1 million full-year resident returns filed in 2014, the following facts describe the distribution of the net charged tax burden ( paid after credits):
1.5 percent of filers making more than $500,000, with 24 percent of all income, pay 41.4 percent of all income taxes.
6.2 percent of filers making between $200,000-500,000, with 21 percent of all income, pay 24 percent of all income taxes.
15 percent of filers making between 100,000-200,000, with 26 percent of all income, pay 22 percent of all income taxes.
76 percent of all filers making less than $100,000, with 30 percent of all income, pay 12.6 percent of all income taxes
But this data does not tell the full story. Yes, taxpayers with more than $200,000 in annual income pay most (65 percent) of the income tax, but they also have the most of the income (45 percent). The key point about progressivity is not how much of the tax a given income cohort pays, but how much of their income is taxed. For example, the average tax rate (net tax paid divided by gross income) was:
1.32 percent for taxpayers with gross income under $100,000
2.68 percent for taxpayers with income between $100,000 and $200,000
3.60 percent for taxpayers with income between 200,000 and $500,000
5.47 percent for taxpayers over $500,000
The New Jersey tax structure is very progressive, and one might argue that a 1.32 percent average tax rate on 76 percent of the lowest-income residents and a 5.5 percent average tax rate on the richest residents does not seem an unreasonable distribution or burden.
In fiscal 2018 the sales tax is projected to produce $9.8 billion in revenue. The current tax rate is 6.875 percent. (It was reduced from 7 percent on January 1, 2007; by January 1, 2018 it will be reduced to 6.625 percent.) And, per a constitutional amendment, one-half of one penny of the sales tax must be used for property-tax relief. The statute spells out in precise detail what items are subject to the sales tax, but it can be summarized as follows: The sales tax is imposed on receipts from sale, rental, or use of tangible personal property not specifically exempted. The retail sale of services is exempt unless specifically enumerated in the statute. Businesses pay sales tax on purchases just like consumers unless the purchases are for resale.
Over the course of several years, the law has been amended many times to expand the scope of the sale tax to include certain services, including parking and storage of motor vehicles, tanning services, information services, limousine services, and the like. Exemptions to the sale tax are extensive and include food, clothing, prescription drugs, telephones, household paper products, and so on. According to the Tax Expenditure Report the extension of the sales tax to all services that are currently exempt would raise $13 billion.
During the past 10 years sales tax growth has averaged less than 1 percent. In the past three years, the average has been 1.7 percent. For fiscal 2018 the budget assumes a growth rate of 5.7 percent.
Although based on consumption, the sales tax is not necessarily well tuned to economic conditions. The sales tax does expand when wages grow but not necessarily proportionally, especially if that growth is in high-income households. But it still decreases substantially in recessions. That is partly due to the limitations of the sales tax base, which focuses on discretionary purchases rather than necessities. To the extent that remote sales over the Internet have grown and will continue to grow more rapidly in the future, this disconnect and erosion in the sale tax base will accelerate. A combination of people seeking money-savings deals, and the ability to avoid tax on the Internet means the problem is getting harder to solve.
The taxation of sales on the Internet is determined by the federal courts. To summarize two separate U.S. Supreme Court decisions, state and local government cannot tax Internet or mail transactions unless the entity selling the product has a “nexus” in the state — in other words, it has a specific place of business in the state. The 1992 Quill v. North Dakota Supreme Court decision further ruled that the decision can be stayed if the U.S. Congress enacts a law that simply states all products of any kind sold on the Internet are subject to state or local sales tax. To date, Congress has not acted despite lobbying by almost every state in the country and most “neighborhood” businesses.
Tax dedication policy
Proposals to increase taxes are many times linked with a voter-approved initiative to dedicate the revenue for a favorite purpose. In New Jersey, for example, that would be transportation, education, and senior citizens. Many times the dedication is proposed because politicians know that people distrust them, but if the tax is linked to a favorite issue it might be approved — consider the recent gasoline tax. Sometimes that is what is necessary to generate revenue to get done what needs to be done. But in the long run, in my opinion, it limits fiscal flexibility for setting and managing overall priorities. Carried to its extreme, dedication will lead to less accountability from our elected officials.
In short, the state is highly dependent on the income tax and sales tax, and if any significant increase in revenue is proposed to meet program demands it must necessarily come from one or both of these taxes.
Total state revenue can be summarized as follows:
Fiscal Year 2018 Revenues (in billions of dollars) Income tax $14.4 Sales tax $9.8 Corporate tax $2.4 All others $8.1 Total $34.7