Federal Aid Biggest Source of Revenue for States

May 5, 2009— -- In a historic first, Uncle Sam has supplanted sales, property and income taxes as the biggest source of revenue for state and local governments.

The shift shows how deeply the recession is cutting. Federal stimulus money aimed at reviving the economy and a sharp drop in tax collections have altered, at least temporarily, the traditional balance of how states, cities, counties and schools pay for their operations.

The sales tax had been the No. 1 source of state and local revenue since the mid-1970s, according to the Bureau of Economic Analysis. Before that, property taxes were the primary source. That changed in the first three months of 2009.

Federal grants -- early stimulus money plus conventional federal aid -- soared 15 percent in the first quarter to a seasonally adjusted annual rate of $437 billion, eclipsing sales taxes, which fell 2 percent.

The dominance of federal money is set to expand dramatically this year because tax collections are sinking while the bulk of federal stimulus aid is just starting to arrive.

"This money isn't manna from heaven. It comes with a price," says Indiana state Sen. Jim Buck, a Republican. He worries that the federal money will leave states under greater federal control and burden future generations with debt.

Nick Johnson, a state finance expert at the liberal Center on Budget and Policy Priorities, says the federal aid is well-timed.

"This has more to say about the severity of the recession than anything else," he says. "Congress stepped in on a temporary basis to help states."

The federal government plans to provide about $300 billion in extra aid to state and local governments over the next two years, mostly for health care, education and transportation projects. State and local governments spend about $2 trillion a year, and the federal government is now paying about 23 percent of those costs.

States are counting on tax collections rebounding by 2012, when stimulus money starts to run out.

The early flow of stimulus money helped lift total state and local revenue by 1.6 percent in the first quarter compared with a year earlier despite a 2.9 percent drop in total tax collections. Spending rose 1.5 percent.

Things are getting worse for states that rely on the income tax. Reason: Unexpectedly large refund checks in March and April are going to workers who lost jobs or had wage cuts last year.

Michigan's income tax collections are down $200 million and refunds are up about $200 million -- a $400 million swing. Connecticut has paid nearly $1 billion in tax refunds this year, about 20 percent more than expected. "These are big numbers. It's put us in a very bad situation," says Connecticut Comptroller Nancy Wyman.

Key state and local taxes:

• Sales tax. Collections started falling at the end of 2008 for the first time since the Bureau of Economic Analysis first reported data in 1958. The drop in sales of automobiles and construction materials has taken a big bite out of sales tax revenue.

• Property tax. The most stable tax is generating increasing revenue, mostly for schools, despite plunging property values. One reason: Forty-six states limit how fast property taxes rise or fall.

• Income tax. The most volatile tax produces big increases during boom times and giant declines during hard times. California, New York, Oregon, Connecticut and other states that depend heavily on taxing year-end bonuses and capital gains on investments have been hardest hit by the worst income tax drops since 2002.