It seems pretty simple: In order to narrow budget gaps, spend less money, and bring in more revenue. Yet in wrestling with their budget crises, many states are disproportionately focusing on spending cuts and ignoring potential strategies for revenue gains.

While it is clear that state revenues are ticking up, they are well below pre-recession levels, according to Phil Oliff, a Policy Analyst with the State Fiscal Project at the Center on Budget and Policy Priorities. The solution to closing state budget gaps lies in taking a balanced approach, he says, encompassing not just spending cuts, but also increases in revenue.

Spending cuts alone have the potential to threaten not only states’ recovery, but also their economic future, he explains. States need quality education, strong infrastructure, and a wide array of public services in order to build a solid future.

Much of state revenue is derived from taxes – specifically, income and sales tax. Where can states “find” extra revenue? The answer will vary from state to state, but strategies include:

  • Progressively raising tax rates through all or some tax brackets;
  • Adding another tax bracket for top income levels;
  • Extending the sales tax base to cover services that are currently not taxed (see sidebar);
  • Eliminating corporate tax loopholes; and
  • Removing ineffective tax credits that yield insufficient benefits.

States could well be facing their worst budget year in fiscal 2012 since the recession began, says Oliff. The good news is that regaining fiscal health is within reach for states that take a balanced approach to narrowing their budget gaps.

Expanding the Taxation of Traditionally Non-Taxed Services

The Federation of Tax Administrators periodically surveys tax rates for services within the 50 states. In its most recent report, covering 2007 data, the FTA found that utilities are taxed in most states, while few states tax personal and business services. Its website includes a detailed, searchable database of sales tax rates for services by state.

At the time of the most recent survey, for example, in the state of Kansas, pet grooming services were taxed at a rate of 5.3 percent, while veterinary services were tax-exempt. In New Mexico, both pet grooming and veterinary services were taxed at 5 percent, while in Virginia, neither services was taxed.

In an August 2009 Center on Budget and Policy Priorities report entitled, “Expanding Sales Taxation of Services: Options and Issues,” Michael Mazerov, a Senior Fellow with the Center’s State Fiscal Project, says, “Most states could improve their sales taxes and their tax systems with some expansion of the tax base to include services.”

In addition to generating new tax revenue, Mazerov points to several reasons supporting the taxation of services, including reducing the year-to-year volatility of sales tax collections; making the sales tax more equitable; and even simplifying the process of administering and complying with the sales tax.