Jefferson Policy Journal

While there has been much celebration at the passage of a new $188 billion biennial budget for Virginia, this deal would not have been possible had there not been close to $1.06 billion in higher-than-expected tax revenue ($1.2 billion by the end of the year) to cover the massive spending increases sought by the Democrats in the General Assembly. This bonus revenue allowed Gov. Glenn Youngkin (R) to achieve his goal that taxes not be raised, and Democrats to get their demand that spending be dramatically increased. It is like magic! What no one is discussing is the source of this “magic” revenue. It is not just from a growing economy. Put simply, there is a “stealth tax” in Virginia that is leading to an increased tax burden for Virginia residents, and thus, higher revenue for the Commonwealth’s appropriators. This stealth tax is the bracket creep that occurs with higher inflation when the tax code does not index their brackets, deductions, and exemptions to account for that inflation. Virginia and sixteen other states with graduated income tax schedules, do not adjust those brackets for inflation. Thus, as inflation pushes wages nominally higher, taxpayers get pushed into higher tax brackets even though their purchasing power has gone down. Unindexed deductions and personal exemptions add to the problem. Standard deductions lose value with inflation. If the deduction does not increase with rising costs due to inflation, taxpayers get less tax relief, effectively raising their taxable income. Inflation also increases the government’s take from real estate and motor vehicle taxes, based on fair market values, but local governments can and often do reduce those tax rates to minimize the impact on their citizens. The state has proven far less likely to do that with its income tax collections, or its own taxes based on property values. Inflation results in a massive tax increase. Fortunately, in the previous two years, as inflation has skyrocketed under President Biden, Governor Youngkin with bipartisan support has been able to return a large portion of this “overpayment” of taxes due to inflation to taxpayers in the form of tax rebates. The standard deduction has also been raised, but the changes only compensated for prior inflation. It is already eroding again.  Personal exemption amounts and the tax brackets were not adjusted. The newly elected General Assembly, with Democrats in control of both chambers, had no interest in returning this overpayment to taxpayers as sought by Governor Youngkin, instead opted to use these funds to increase government spending. From across-the-board teacher and government employee pay increases, reduced tolls in Hampton Roads, and increased mental health spending — the added revenue without an explicit tax increase gave the appearance of “free money” that allowed this spending spree by the General Assembly. Without action, this stealth tax will only get worse. Just yesterday, the Labor Department reported that wholesale prices (PPI) jumped to their highest level of the year. Today, it is expected that the consumer price index will also show a higher-than-expected increase. These numbers will almost guarantee even more surpluses, leading to even greater spending unless Virginia reforms its tax code. Inflation impacts the poor the most as they spend a greater percentage of their income on essential goods like food, rent, and utilities – where cutting back is impossible. The wealthy can merely cut back on non-essential items to account for price increases, the poor cannot. Compounding this issue for the poor is the added taxes they face as the value of their deductions is reduced by inflation, and as their added wages to make up for inflation push them into higher tax brackets. There is a joint tax policy subcommittee that the Democratic-controlled legislature established in 2021 to review potential changes in the tax code.  So far it has been inactive, but the new budget included language directing it to begin work on exploring revenue options and needs, with a reporting deadline of November 1, 2024. Of concern is the following paragraph:

4. The Joint Subcommittee shall explore efforts to modernize the Commonwealth’s income and sales and use taxes during the 2024 interim. The goals and objectives shall include: (i) evaluating existing sales and use tax exemptions; (ii) applying sales and use tax to digital goods and services, including transactions involving businesses; (iii) evaluating efforts to increase the progressivity of the income tax; (iv) and long-term revenue growth to maintain core government services.

Sen. Louise Lucas (D-Portsmouth), who chairs the Senate Finance Committee, highlighted this effort in her remarks after the passage of the budget. She and others wish to ensure there is enough revenue for their growing list of spending priorities – including an economically destructive expansion of the sales tax to “business to business” digital transactions. She and fellow Democrats may be worried the next President will break the inflation cycle and the “stealth tax” will stop producing its bumper crop. Before any new tax is considered, the existing code should be indexed so that taxes are more transparent to taxpayers, the true value of deductions remains consistent and any new spending requires either a booming economy or a tax increase properly approved by legislators and our governor.

After much political theater, the Virginia General Assembly and Governor Glenn Youngkin (R) have now compromised on a $188 billion state budget based simply on the revenue projected from current tax law, with neither tax hikes nor tax reductions.  Making those revenue projections slightly more optimistic eased the path.

With both sides backing off their desire to change the tax rules, it became clear there was less controversy over how to spend the state’s money in the new biennial budget from July 2024 to June 2026. The top shared priorities of legislators in both parties include education, public employee salaries and benefits, transportation, and capital improvements. Medicaid is also a huge budget growth driver which the Assembly really does not control.

The Democrats in the majority in both chambers will celebrate that the plan achieves the spending they included in the budget they passed in March. Youngkin will celebrate that it did so without either the sales tax or carbon tax provisions that budget included. His success looks even more impressive when you recall the two other major tax hikes Democrats approved and he vetoed, one to impose a massive payroll tax and the other to allow localities to hike the general sales tax.

With a slight hint of sour grapes, a budget summary from the House Appropriations Committee opens with: “The adoption of the digital economy modernization was not driven by a systematic look at Virginia’s tax structure.” That is a euphemism for the expansion of the state’s sales tax to digital transactions, which just a few weeks ago was deemed by Democrats to be vital to the Commonwealth’s future.

The idea is hardly dead. One provision in this final budget, which was not included in previous versions, directs a 12-member legislative study committee to revisit the digital tax. It is also directed to review “existing sales and use tax exemptions” and evaluate “efforts to increase the progressivity of the income tax.” The goal is a tax package with some actual consensus behind it to consider in 2025.

There is no effort in the document to rationalize the Democrats’ decision to abandon their push to return Virginia to the Regional Greenhouse Gas Initiative, which imposes a carbon tax on electricity. Presumably, as with the digital sales tax, including that was a deal killer and veto magnet for Governor Youngkin.

More telling is this. Democrats did not apply any of the additional “found” revenue used to balance the budget to cover the existing programs funded by RGGI tax money. Perhaps they are not as high among their priorities as they claim, bound to infuriate those enriched by RGGI dollars. RGGI has always been more about money than any climate concerns.

What remains in the budget is still a massive spending increase over previous years, fueled in large part by inflation and by the lingering residue of the federal pandemic spending explosion. Both the 2022 and 2023 General Assemblies approved bipartisan tax reductions, mainly by raising the standard deduction on the income tax. Tax revenue has continued to grow.

When the Assembly adopted a similar budget two years ago, it assumed general fund revenue (after the tax reductions) of just under $25 billion for Fiscal Year 2023. The projection for general funds in Fiscal Year 2026 is now $30.3 billion, a 22% increase in three years.

Despite that growth, the general fund (income and sales taxes) continues to be a shrinking percentage of the overall state budget. The non-general fund portion – federal funds, transportation taxes and fees, college tuition and fees – is now almost two-thirds of the total. All take additional dollars out of people’s pockets because of inflation, and all may continue to grow faster than even this budget assumes.

Perhaps by the time of next year’s budget amendments, and certainly in the 2-year budget developed after the 2025 election, the bottom line will be over $200 billion. And that budget summary document written by the Democrats on the money committee predicts “additional funding could be needed…to expand upon current initiatives and revamp the K-12 funding system.”

To their credit, Democrats have now laid out a legislative pathway to give all concerned a chance to be heard. Previous tax reviews have sputtered out and produced no changes, but this one might prove energetic. When major changes have happened, they result because somebody – usually a governor, but it can be legislators – has done the hard work of building consensus.

Some version of the digital sales tax expansion is in Virginia’s future, as more of the economy moves online. Many, but not all, other states have adopted some version of this tax. Most, however, have been careful about the taxes they have imposed on digital business transactions. What the Democrats were recently pushing was overly broad in its application, broad enough to raise concerns it would make Virginia uncompetitive.

It will be easier to convince Virginians to accept the new digital taxes if they are coupled with some level of income tax reduction, which is how Governor Youngkin sought to proceed in his original budget proposal. The Thomas Jefferson Institute’s top priority remains indexing the tax code to inflation, so that brackets and deductions automatically rise with the cost of living. That would check the box of making the tax more progressive.

Even if this new legislative effort at consensus fails to produce a successful package of tax changes for the 2025 session, the issue will become a central debate in the 2025 election season. This is appropriate as voters should ultimately decide if taxes are too low, too high, or just right.