Time for a State Income Tax to Address South Dakota’s Budget Woes

Friday, 22 January 2010 19:54

Written by Thomas L. Dobbs, Professor Emeritus of Economics, South Dakota State University

Professor Thomas L. Dobbs

At the risk of being tried for heresy by the South Dakota "Court of Political Economy Orthodoxy", I propose that South Dakota's elected leaders pass legislation to enact a temporary state corporate and individual income tax to address the state's impending budget shortfalls.

South Dakota's politics will tolerate any tax that is regressive, but the words progressive state income tax cannot even be uttered, to say nothing of being meaningfully debated. Even a modest corporate or personal income tax at the state level would violate the deeply entrenched rules of trickle-down economics, the political economy philosophy held so dear in South Dakota. South Dakota remains one of only seven states in the nation without an individual income tax. Nor does the state have a corporate income tax, though the bank franchise tax does affect one sector of the corporate economy. The South Dakota Democratic Party, the natural constituency that should support a more progressive tax structure, has for the most part been afraid to touch the issue of a state income tax since the narrow defeat of an income tax proposal in the 1970s. Now is the time for both parties to break with more than thirty years of political timidity and put the state income tax issue squarely on the table.

Governor Mike Rounds' proposed budget calls for using $32 million in reserve funds to balance the Fiscal Year 2011 budget that begins July 1. State legislators on both sides of the aisle have questioned the wisdom of relying so heavily on these reserve funds, since there is a $100 million projected budget deficit for the following year, FY 2012. With Rounds being a lame-duck governor, members of his own party - some of whom plan to run for governor - have been more outspoken than normal in opposing the governor's budget proposal. A big concern is that federal government economic stimulus funds that have helped the state through the current fiscal year and will continue to provide some help in FY 2011 will run out by FY 2012. Of course, there could be another federal stimulus package that would change that picture, but state-level elected officials cannot count on that at the present time.

Both Republican and Democratic legislators are calling for budget cuts, rather than tax increases, to deal with the looming deficits. If that view prevails, the battles in this legislative session will be over where and how to make the cuts. Which public services will bear the biggest brunt of budget cuts? One major budget priority issue is whether to change the formula for state funding of K-12 education. The governor's budget proposal calls for no increase in state K-12 funds next year, which would require a change in the inflation formula used to calculate state aid to education. Under Rounds' proposal, education's share (including K-12, higher, and technical education) would drop from 51 to 49 percent of the state's general fund.

Though elected leaders do not want to talk about possible tax increases, the reality is that tax increases are not really off the table. If the governor's K-12 education funding proposal were implemented, this would force more of the education tax burden back onto local schools districts. There has been a proposal to raise the state gasoline tax by ten cents a gallon to fund road construction and repair, as well as a proposal to raise the excise tax on vehicle purchases. Some cities would like the ability to raise their sales tax by one percentage point for specific projects. And though most legislators have indicated opposition to increasing the state sales tax by one percentage point as one means of addressing the projected deficits, there could be discussion of that possibility before the legislative session is over. In other words, when push comes to shove, the state's political structure often does make way for tax increases. Just not imposition of an income tax!

It is long past time to change that political attitude. Although the adherents to the state's dominant political philosophy will never admit it, they really do like one particular income tax - the federal income tax. That tax allows South Dakota to consistently rank in the top dozen states in terms of federal spending received per dollar of tax paid. That ratio ranged from $1.45 to $1.53 in the years 2000 to 2005, and was never less than $1.25 going back at least to 1981 (http://www.taxfoundation.org/research/topic/58.html). While South Dakota's politicians and much of the public love to rail against federal taxes and spending, they love the federal money that comes in for farm commodity subsidies, ethanol subsidies, and all kinds of state and local projects. In effect, this is made possible by federal income taxes paid by citizens of other states. So let's get real about this business of an income tax. We're not really against income taxes in this state. We're just against income taxes that we, ourselves, might actually have to pay. Perhaps the greatest hypocrisy in South Dakota's dominant political philosophy is the strident advocacy of low taxes and self-reliance, while the state's economy is, in fact, hugely reliant on federal revenues made possible by an income tax.

Federal economic recovery dollars have been critical to sustaining the economies and public budgets of South Dakota and many other states during the worst economic recession since the Great Depression of the 1930s. And some nationally prominent economists whom I respect are calling for more federal stimulus or economic recovery dollars to further strengthen what is clearly only a tentative and weak economic recovery thus far. But it is time for South Dakota to also step up to the plate to do its own part in funding education and other public services while the economy slowly works its way back to a more healthy position. The fairest way to do that is with a modest corporate and individual income tax, with the individual income tax structure set to exempt low and lower middle income people. At the same time, the sales tax on purchases of food for home consumption should be removed. According to The Tax Foundation (same website as above), South Dakota's state/local taxes are 7.9 percent of income, well below the national average of 9.7 percent. The tax change I am proposing need not take South Dakota above that national average. If South Dakota were to simultaneously implement a modest corporate and individual income tax and exempt food from the sales tax, that would help accomplish three things: (1) shore up state revenues while sales tax revenues remain weak during a recovery period that could last several years; (2) deal with what leaders on both sides of aisle assert has been a structural deficit in Governor Rounds' budgets, even before onset of the recession; and (3) make the state's tax structure much more fair, by shifting somewhat more of the tax burden to ‘ability to pay'.

Of course, the argument against a state income tax always is that it would cripple economic recovery and growth efforts. That old argument just doesn't square with economic reality, however. Paul Krugman, in his 2007 book The Conscience of a Liberal, presents solid evidence demonstrating that U.S. income and employment growth was especially strong in the initial decades immediately following World War II, when a more progressive federal income tax structure was in place. This led to expansion of a strong middle class. The dominant national political economic philosophy of those decades was not trickle-down economics. I also would argue that individual states that have balanced and progressive tax structures - which enable public services to be adequately supported over time - are the most successful in creating quality jobs and a strong middle class.

It is no doubt unrealistic to expect state income tax legislation to pass this session, especially given the two-thirds majority required in both houses of the legislature. That means there is little chance of a state income tax providing budget relief over the next year or two. But it is time to start meaningful discussion. As soon as possible, we should enact the necessary legislation. If necessary to obtain passage, we could make a state income tax temporary - say, for three years or so - and decide later whether to extend it, and if extended, how to modify the corporate and individual tax structures and rates.

Let the debate begin!