Vermont’s Budget and Revenue Problem

By Scott Mackey

Vermont has a budget and revenue problem – one that is simple to explain but difficult to solve. The problem is that our revenue system does not produce enough money to fund the spending we are accustomed to without constant tax increases. It is difficult to solve because Vermont citizens and the interest groups that support the spending status quo are not going to like the fact that the new Governor is unwilling to raise taxes or fees to keep revenues growing.

Revenue systems are sometimes described as a “three-legged stool” supported by taxes on income, consumption, and property value. A balanced system tends to be more resilient throughout economic cycles, as income taxes tend to produce strong revenue growth during economic expansions but perform poorly during recessions; sales taxes and other consumption taxes tend to grow more slowly during expansions but perform better during recessions; and property taxes hold up very well during recessions because changes in property values tend to take a long time to hit taxpayers’ bills. Balancing these three sources helps stabilize revenue systems over economic cycles.

However, Vermont’s revenue stool is tilted. It has two long legs (property and income taxes) and one short leg (sales and consumption taxes). This structure – especially with Vermont’s steeply progressive income tax and property tax rebates based on income – is intended to keep tax burdens manageable for low- and moderate- income Vermonters.

In theory, states like Vermont with a heavy reliance on income taxes should experience strong revenue growth during economic expansions and weak performance during recessions. The U.S. economy just passed its 75th consecutive month of job growth, the longest streak since the 1930s, so one would expect that Vermont’s income tax would be preforming quite well right now. But for some reason this is not the case. Despite our progressive income tax with relatively high rates, Vermont’s income tax – and thus its revenue system – has been producing weak revenue growth for the last few years.

Through the first six months of the current fiscal year — which began July 1 — income tax revenues were only 1% above the prior fiscal year. In the 2012 and 2014 sessions, the legislature raised taxes to keep revenues growing enough to balance the budget. For the budget year ending last June 30, income tax revenues grew by 5.8% ($41 million) but most of that growth was due to a $23 million tax increase. Without that tax increase, income tax revenues would have grown by only 2.6%. The sales tax, while less important in the state’s revenue structure, is also underperforming. It grew by only 1.7% last fiscal year and for the first six months of this fiscal year revenues are below the same period last year.

Total tax collections for the first six months of the year are essentially flat. The only reason why revenues are growing at all so far this fiscal year is because of the tax increase in mutual fund and securities fees approved in the 2016 session.

Why are revenues so weak in a full employment economy and a relatively strong stock market? In his periodic columns in the Burlington Free Press, UVM Economist Art Woolf hinted at one possible reason for Vermont’s revenue performance. He suggests that Vermont’s aging population and low- to non-existent population growth are contributing factors. This makes sense, since working age citizens pay a lot of income taxes and retirees do not. Also, retirees tend to spend more money on non-taxable services like health care.

Nationally, some economists blame income inequality for the poor performance of some state revenue systems. However, with Vermont’s income tax structure, growing income inequality would actually boost income tax collections since more income would be subject to the higher tax rates that apply to upper income taxpayers.

Another possible explanation is the rising cost of health care. Employers and employees pay for health insurance with pre-tax dollars. As employers pay more each year for employee health insurance, there is less money to compensate employees with (taxable) wage increases. In addition, since health care services are not subject to sales taxes, out of pocket spending on health could be displacing spending on taxable goods and services.

Then there are property taxes. Our education funding system is designed to provide an ever growing stream of revenue to Vermont schools – even as enrollments fall. In the last few years, the legislature added preschool to the programs funded from the education fund which will only add to property tax burdens over time. For taxpayers that itemize their returns, higher property taxes mean larger deductions and less income tax revenue for the state. Higher property taxes can also crowd out spending on other taxable goods if property tax burdens are growing faster than incomes.

Finally, some have questioned whether Vermont’s high income tax rates are themselves partially responsible for weak income tax growth. With more and more businesses organized as “pass through entities,” a growing share of business income is being taxed under the personal income tax instead of the corporate income tax. Vermont’s relatively high income tax rates could be discouraging small business investment and expansion in Vermont. There are also anecdotal reports of wealthy retirees moving the residences to Florida, New Hampshire, or other states to avoid state income taxes on retirement income altogether. However, these claims are notoriously hard to prove.

Even with new executive leadership in Montpelier, it is hard to see many factors that are going to lead to a rebound in state revenues right away. This is problematic because states with progressive income taxes tend to face dramatic reductions in income tax revenues during an economic downturn. If Vermont’s revenue structure is weak during the current economic expansion, it could get really ugly during a recession – especially if the current Republican Congress and Administration in Washington do not provide “stimulus” funding to the states like the Democrats did in 2009 and 2010.

Some tax policy experts and legislators have suggested that an overhaul of the sales tax to broaden the base to services would help. However, there are some factors that suggest that this might not be the case. Business-to-business transactions represent a significant share of service spending, and unless the legislature wants to saddle Vermont businesses with new taxes that businesses in nearby states do not pay, business-to-business transactions would need to be exempt. Also, with our aging population, a growing share of service spending is for health care. I doubt policymakers would vote to add 6% to health care costs. When you take those two items off the table, the resulting revenues may not be worth the political battle that would ensue.

Which brings us to the spending side of the budget. Recently child care advocates released a report asking for over $250 million in new state funding. Other advocates are calling for paid family leave for all Vermont workers funded through a new payroll tax. Medicaid program expenditures continue to grow even as businesses and their employees shoulder higher premiums that are used in part to pay health care providers who are underpaid by the Medicaid program.

And then there is the state’s education system. This month the media will start to report on school budget decisions in advance of town meeting day, and if the past is any guide school budgets will be going up even as student enrollments are falling. As a former school board member, I know that Vermont’s school funding system encourages boards to spend more than they otherwise would because “income sensitivity” protects the majority of local taxpayers from the full tax impact of the spending they approve. Higher school spending and property taxes mean less money available for other state priorities.

This points to a couple of difficult years in Montpelier as the legislature, Governor, and the people of Vermont adjust to this new reality. The Governor will justifiably argue that he has a mandate to limit spending to available revenues. It will be interesting to see how firm the Governor’s resolve is when the spending advocates begin their loud protests over reductions in their programs.

Judging by the outcome of the elections here in Vermont, the majority of Vermonters are hoping that Donald Trump is a one-term President.   If the U.S. economy performs poorly during the Trump presidency, Vermonters will likely get their wish. But for Vermont lawmakers, an economic scenario that makes Mr. Trump a one-term President would mean tough times in Montpelier.

Ironically, the only thing that might solve Montpelier’s budget predicament is an economic boom driven by tax cuts, deregulation and the rollback of federal regulations, including those addressing climate change and environmental protection. A Faustian bargain indeed.

Scott Mackey is Managing Partner at Leonine Public Affairs.