Revised May 8, 2010

Long-Term Economic Growth and Stability

This year, Tennessee is facing yet another budget shortfall of up to a billion dollars.

The long-term trend in Tennessee has been toward declining revenue and chronic budget shortfalls.

This year, legislators and the Governor have proposed severe budget cuts due to the lack of revenue. We need more revenue not budget cuts!

A well-balanced, reliable tax system should, at a minimum, raise sufficient funds over the long term to meet the state’s needs. Tennessee’s tax system, which depends heavily on sales tax revenue, fails to meet this criterion. This failure is the prime cause of Tennessee’s continuing budget fragility.

As a general rule, the sales tax and property tax are slow-growing revenue sources over the long-term. April 2010 was the 23rd consecutive month sales tax revenues have declined in Tennessee. Revenue from these taxes grows so slowly that it fails to keep pace with the economy as a whole. By some estimates, sales tax revenue grows by only 7 to 8% for every 10% of economic growth we experience.

This dynamic is driven in part by a shift to a more service-oriented economy. The sales tax generally applies only to tangible goods. The growth of Internet sales only exacerbates this problem, as does our high sales tax and cross-border shopping. The end result is that the sales tax base is shrinking over time (See Figure 11), along with the revenue we raise at any particular rate.

At the other end of the spectrum are personal income and business taxes. These taxes, in addition to being more fair, keep better pace with the overall economy. In fact, revenue from a well designed, personal income tax would actually exceed economic growth. Absent gross tax evasion, business taxes have similar long-term growth benefits since they are tied to the growth of corporate profits.

While income and business taxes tend to grow faster over the long term, they tend to fluctuate more on a year-to-year basis, as they are more closely tied to the ups-and-downs of the economic cycle. These year-to-year fluctuations can be addressed with wise use of rainy-day funds and a diversified revenue stream that includes a mix of both fast-growing and slow-growing (but more stable) revenue sources. That’s what a balanced, common sense tax system would look like.

While most states take a balanced approach to funding state services, Tennessee relies heavily on the sales tax. Roughly 60% of Tennessee’s state revenue is comprised of sales tax revenue. This number climbs to 70% when selective sales taxes on gasoline, alcohol, and cigarettes are included. The result of this heavy dependence on slow-growth revenue sources is that the overall tax system in Tennessee fails to keep pace with economic growth, leading to chronic budget shortfalls.

This may come as a surprise to many, but even with the sales tax increases of 1976, 1984, 1992, and 2002, tax collections in Tennessee have remained roughly 5 to 6% of total personal income (UT Center for Business and Economic Research, 2003. See Figure 10). Without these legislated increases, tax collections in Tennessee would have dropped to near 3% of personal income, with dramatic implications for public infrastructures.

Creating a more balanced tax system will better equip Tennessee to make the kind of long-term investments needed to maintain healthy communities and a strong economy. Ultimately, the state must pass some kind of comprehensive tax reform that would include the elimination of the food tax, reduction of the sales tax on other items and creation of a progressive state income tax.

While such reform remains TFT’s long-term goal, there are some short-term initiatives that will move us in the right direction. The Food and Business Tax Fairness Act and Internet Parity Act is one of those initiatives. Replacing a portion of the slow-growing sales tax with faster-growing business taxes will generate a sounder and more reliable economic base. A fiscally responsible tax system will enable us to meet tomorrow’s challenges.

Figures 10 & 11 are excerpts from The Structure of State Taxes in Tennessee: A Fiscal Primer. February 2003. A joint publication of the Tennessee Advisory Commission on Intergovernmental Relations (TACIR) and the University of Tennessee, Center for Business and Economic Research.