The Institute's 2nd quarter state tax collection update indicates that, while income tax revenues remained fairly healthy earlier this year, tax collections were "superficially strong" with states effectively living off the US economy as it was in 2007.

Taxes collected by the 50 states during the second quarter of 2008 rose about 3.6% overall as April income tax payments on 2007 earnings overshadowed falloffs in sales, fuel, and corporate income taxes, the Institute reported. Income tax collections by the states grew by 6.6% over the same period a year earlier as residents met the April 15 deadline to pay 2007 taxes. However, state sales taxes dropped 1.4%, corporate income taxes fell 8.3%, and motor fuel taxes declined by 3.4%. When adjusted for inflation, overall state tax collections rose 1.5% compared to a year earlier.

“As noted in our report last quarter, April-June tax collections reflected strong payments with income tax returns for 2007 due on April 15 — last year’s economy is doing well,” said Rockefeller Institute Senior Fellow Donald Boyd, co-author of the report. “But payments based on current economic activity have been much weaker.

“Superficially, tax collections appeared to be doing okay — certainly not the leading edge of a fiscal crisis. But below the surface, great trouble is brewing,” Boyd added. “Some states have already made mid-year budget cuts, and more widespread cuts are virtually certain as revenues deteriorate further.”

Current indicators show that overall state tax collections in the third quarter will weaken considerably, according to the Institute.

On top of the current tax picture, Boyd said the prices state and localities pay for goods and services rose by 6.6% during the second quarter, 4.6% higher than economy-wide inflation — the largest such difference in 60 years.

“States are again facing the classic nutcracker effect of slowing revenue and rising prices,” he said.

According to the new report, Arizona, California, Florida, Michigan, and Rhode Island have been suffering the most. It is expected that these fiscal problems will spread to Connecticut, New Jersey, and New York, due to those states’ reliance on the financial services industries and steeply progressive income taxes that extract much of their revenue from individuals with high wages and investment income.

“These states — in addition to California — are expected to face extreme difficulty in the wake of the financial services industry meltdown,” Boyd said.

Indeed, last week California's Governor Arnold Schwarzenegger wrote to Treasury Secretary Henry Paulson telling him that California might need to approach the Treasury to buy USD7bn worth of 'Revenue Anticipation Notes' to see it through the next couple of months.

“While states already have faced revenue shortfalls from the slowing economy, three more shoes have yet to drop,” Boyd added. “The financial sector meltdown will lead directly to reduced corporate and other taxes on businesses in the industry, and to reduced taxes on bonuses and other compensation of participants in the industry; the stock market decline and other factors affecting investment income will likely lead to a very large drop in investment income on 2008 tax returns to be filed in April, and therefore to large declines in income tax revenue in the final quarter of the fiscal year; and the loss of income and employment in the industry and the related credit crunch is likely to make the real economy even weaker.”

“The last fiscal crisis for states, which occurred in the midst of a mild recession, was dubbed a perfect storm,” Boyd said. “This one could be more perfect.”