In Richmond, Annapolis and virtually every other state capital, governors are getting down to work this week under the shadow of deficits far worse than those seen in any downturn since the end of World War II. Many will blame this on the soft economy, but that won't do as a full explanation. Even after being set back by a mild recession, economic growth has averaged a respectable 2.8 percent since the business cycle peaked in the first quarter of 2001. So what gives?
Governors, as well as hard-pressed local officials, rightly complain about the cost of unfunded mandates from Washington and about declining federal aid. The states are also on the hook for runaway Medicaid costs and for more than a few boondoggles conceived during the boom years of the late 1990s. But a deeper, structural deficit is also at work -- driven by demography and changes in the world economy -- that will continue eroding the finances of state and local governments even if boom times return. Unless this deficit is closed, state and local governments will wither, and more governmental power will likely wind up concentrated in Washington.
The largest single cause of the structural deficit is the shift toward a service economy. As recently as 1979, services accounted for 47 percent of personal consumption. Now health care costs, legal fees, education and other services account for roughly 60 percent of what we collectively spend on ourselves. And because the fast-growing service sector is largely exempt from sales taxes, this shift in consumption patterns makes the financing of state and local governments ever more difficult, even as the demand for the services provided by such governments goes up every year with growing populations and economies.
In the future, two additional trends will further erode the ability of state and local tax revenues to keep up with the cost of government: the aging of the population and the growth of e-commerce. As state policy consultant Tom Bonnett notes, older people typically consume fewer goods but demand more services -- particularly health and nursing home care. These last services are not only exempt from sales tax but also substantially subsidized by state and local governments. Moreover, in most states, retirees have also proven adept at securing property tax relief for people over 65, as well as exclusions of pension income from taxation. Among the 41 states with broad-based income taxes, 34 offer exclusions for at least some amount of pension income.
Meanwhile, an estimated 6 percent of all U.S. retail spending will be done over the Internet by the end of this year, and almost all of it will escape sales taxes. Though some states might try taxing Internet transactions if federal law allowed it, they would stand little better chance of collecting revenue from offshore retailers than Britney Spears does of collecting royalties on her CD sales in China.
The shift to a knowledge-based economy also imperils state and local finances. High-tech and professional service industries typically require far less real estate to operate than manufacturing concerns. Their primary assets aren't land or structures, which are subject to property taxes, but "soft" capital such as patent rights, the knowledge in a doctor's head or the connections in a lawyer's Palm Pilot. Most of this soft capital escapes taxation, as perhaps it must. But as it accounts for a growing share of the wealth of any region, its tax-free status leaves a growing hole in the coffers of state and local governments. A software company whose workers take its capital out the door with them every night may well create just as much traffic, and just as much of a burden on the public schools, as a similarly sized factory next door, but it pays taxes on a far smaller share of its actual assets.
Finally, the mobility of both people and businesses in today's global economy puts major limits on the ability of state and local governments to raise new revenue. As states and communities find they must offer major tax concessions to attract new businesses or to keep local firms from moving, corporate taxes account for a diminishing share of all taxes paid at the state and local levels and are in danger of becoming unworkable. Eventually, even revenue from personal income taxes will come under threat if an increasingly networked economy allows more workers to move wherever the climate and tax structure suit them. Many Americans will welcome such trends, but those who don't want state and local governments to be usurped by federal power need to get behind bold new ideas for how to keep them solvent.
The writer is a senior fellow at the New America Foundation.