Return to Virginia Business - January 2004

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- Budget woes put Virginia's top credit rating at risk

by Garry Kranz
For Virginia Business
January 2004

Three times last year Bob Hedrick had to pick out a few workers and send them home for good. Layoffs were the only choice for his Chesapeake-based Sprinkle Masonry Inc. when a weak economy slowed the flow of construction work. Lately business has picked up, but talk of tax increases worries Hedrick, 63. “If we don’t have enough money to pay employees we’ll have to lay them off,” he says. “People could get hurt.”

Others counter that the damage is already being done, in part because people aren’t taxed enough. Slumping revenues over the last two years created a record revenue shortfall of $6 billion, prompting painful cuts. Colleges and universities pared back programs and faculty. There is less money for schools and Medicare. Major transportation projects are stalled — there’s not enough money to fix state roads, much less build new ones. “The picture for the state is not good,” says W. Rodger Provo, a Fredericksburg-based real estate broker. “Virginia is going down the road that California’s been headed down the last 20 years. We’re seeing a decline in the efficiency of our infrastructure and our ability to move goods and people.”

Amid such dire predictions the General Assembly will begin this month to make another round of spending cuts, $1.2 billion by one estimate. That task alone is enough to produce a brutal session of bare-knuckle politics. But Gov. Mark Warner’s proposal, unveiled after the November elections, to revamp the tax code and raise more than $500 million a year in new revenues, is making political divisions even more intense.

Democrat Warner, of course, has a tough sell in pitching anything to the GOP-ruled General Assembly, much less a package that includes tax increases. But it’s the division inside the GOP — with pragmatists in the Senate and anti-tax true believers in the House of Delegates — that may ultimately shape what emerges from the session. And for the business sector, that split is making it harder to continue the cozy influence it has long enjoyed in Richmond.

Many conservative lawmakers signed pledges vowing to reject any form of tax increases, a move that angers party loyalists in the business community. “I believe we should have low taxes, but it is irresponsible for any politician to declare that he’s (never) going to favor any tax increase,” says Beverly W. “Booty” Armstrong, vice chairman of Richmond-based investment firm CCA Industries Inc. and a self-described “card-carrying Republican.”

Adding to the uncertainty is distrust of many fiscally conservative business people about what Warner and his allies might have in store once they start tinkering with the tax code. “Any hidden agenda to raise taxes is unfair,” says J. Peter Clements, president and CEO of The Bank of Southside Virginia in Carson. “I don’t think we need to run a Trojan horse through the General Assembly.” Adds Steve Haner, vice president of public policy with the Virginia Chamber of Commerce: “The business community that I’m familiar with is extremely reluctant to raise taxes and extremely skeptical of the need to do so.”

Still, Warner has dropped his cautious approach and has threatened to keep lawmakers in session past their spring adjournment date unless a solution is hammered out. The coming debate presents a dilemma for the GOP majority: side with Warner and alienate its conservative base, or oppose him and risk being branded as obstructionists.

What’s more, Warner comes to the table with substantial support in the private sector. “I’m counting on the business community as a big ally to take this debate out of the realm of politics,” says Warner, amid a flurry of last-minute meetings around the state to sell his ideas. “They get it when they see that our revenue and expenditure lines don’t meet. They understand the threat to our bond rating. I’ve not talked to a single business yet that opposes this plan.”

His business acumen helped get him elected in 2001, and the trend has carried over to other candidates. Democrats picked up a net two seats in the assembly in November, and some business groups threw more money to Democrats than to Republicans. “Business people have been turning for quite some time from Republicans to Democrats, at least on the statewide level,” says Larry Sabato, director of the Center for Politics at the University of Virginia. “Many of the Republican lawmakers are defining (their philosophy) simply as ‘no new taxes,’ plus tax cuts. What businessmen are saying is that good roads, a first-rate educational system and other services are also important.”

There is strong opposition to some elements of Warner’s plan. Retailers and the tobacco industry aren’t thrilled with Warner’s call to hike cigarette taxes from 2.5 cents per pack to 25 cents per pack, although the state would reap millions of dollars in new money. The devil is in the details, though: It’s unclear whether cigarette retailers would pay the increased tax on new inventory or be forced to scare up additional money if existing inventories are subjected to the adjusted tax.

Warner also wants to raise state sales taxes on non-food items one cent, from 4.5 to 5.5 percent, a move the Warner camp predicts will bring in about $750 million a year in new money. Conservatives wasted no time blasting some of Warner’s ideas. The Republican Party of Virginia has denounced Warner’s sales-tax idea as a “potentially devastating tradeoff of Virginia jobs for short-term revenue growth.”

Corporate loopholes also are targeted. Warner proposes adding a “throwback rule” that would force Virginia companies to pay state income taxes on profits from sales made in states that don’t require corporate tax filings. Such a move would reverse legislative action taken more than 20 years ago. Deductions for Delaware holding companies also are under fire — a way that some corporations have avoided paying state taxes in the past.

Warner’s quest to raise sales taxes is especially audacious. Warner championed separate referenda in 2002 in Northern Virginia and Hampton Roads that would have raised local sales taxes 1 cent, with the additional money used to solve congestion in the traffic-choked regions. Voters in both areas resoundingly rejected the idea, so Warner is trying to go through the legislature.

Even so, some of his initiatives will be hard for no-tax Republicans to oppose. He vows to complete by 2008 the phase-out of the state’s car tax, a cut begun by his predecessor, Republican James Gilmore. He proposes eliminating estate taxes for working farms and family-owned businesses (although he vetoed an outright repeal of the levy for all Virginians last year). Warner also wants to abolish the onerous requirement that retailers with more than $1.3 million in sales prepay 90 percent of their tax liability in June. And, he wants Virginia to adopt the provisions of a streamline sales tax. The move aims to standardize sales-tax laws for transactions made between different states and help retail stores collect sales taxes on purchases made using the Internet. A larger purpose is to force out-of-state Internet retailers to pay the same tax as bricks-and-mortar stores in Virginia.

By making concessions and not imposing a much-maligned sales tax on services companies, Warner appears to be building consensus among those who normally might oppose his agenda. “Typically we would out and out oppose raising the sales tax, but we haven’t taken a position yet. That’s because it’s part of a larger package that could bring other benefits to our members,” says Laurie Peterson, president of the Virginia Retail Merchants Association, a trade group with 7,500 members.

Warner has another unlikely ally in Sen. John Chichester (R-Stafford County), the powerful chairman of the Senate Finance Committee. Chichester rankled some in his party by wielding his considerable influence to curtail the state’s repeal of car taxes two years ago when the economy hit rock bottom. He appears ready to take on his party compatriots again over the issue of tax restructuring, saying Virginia’s code needs to be brought in line with a modern economy. “Our revenue is not meeting our spending requirements, some of which are constitutionally legislated,” Chichester says. “The tax code is antiquated and some tax brackets need to be changed.”

Where Warner and his supporters might hit a wall is in the House, led by Speaker William Howell and a core of anti-tax delegates. Howell concedes only that the tax code “needs tweaking” but opposes anything but minor changes, pointing to the go-go 1990s as proof the system works fine. “It’s the same system that generated record revenue just a few years ago. It didn’t suddenly break,” says Howell. He says the state should simply spend less, noting that its current two-year budget of $52 billion reflects a 10 percent increase from the previous one. “This is the wrong time to be raising taxes. We’re coming out of a significant recession and are in a fragile recovery.”

Instead, Howell is pushing a plan to complete the phase-out of the car tax in 2004, effectively eliminating the local property tax in Virginia. However, localities stand to lose hundreds of millions in the process, since they impose the levy and are recompensed from the state treasury. Under Howell’s plan, localities would be compensated with a percentage of revenue from state income tax collections.
Howell advocates dedicating 2 percent of general fund revenues to help localities fund construction of new schools, similar to a measure that Chichester introduced for making capital improvements to state government facilities. Howell also wants to declare the state’s Literary Fund – the pot of money used to provide low-interest loans to localities for school construction – off limits for discretionary spending. Lawmakers diverted $65 million from the Literary Fund to provide for boosts in education funding.

Howell also questions the notion that businesses are clamoring for tax reform. “What exactly is the business community? It’s the small-business owners and mom-and-pop stores as much as it is the big companies. No one seems to be speaking for them,” says Howell.

Political and business leaders also share concern about Virginia’s prized AAA credit rating, which affects the interest rates on borrowing for capital projects (see sidebar). Moody’s Investors Services recently put Virginia on its watch list, citing “significant deterioration” in its balance sheet. The move is a possible precursor to downgrading Virginia’s bond rating, although the state also has AAA ratings from Fitch’s and Standard & Poor’s, two other leading credit-rating houses.

One solution that could get lots of attention this session is boosting the state’s 17.5-cent fuels tax, which hasn’t been adjusted in 30 years and is among the lowest in the nation. The state’s transportation budget is woefully underfunded and the GOP so far hasn’t offered a funding solution. Warner’s plan makes no provision for this, but there is broad support for it among businesses. Construction companies, real estate firms and even many trucking companies favor it. The Virginia Chamber of Commerce endorses a “significant increase” in gasoline taxes in a resolution that will be presented to legislators. “We think it can provide an additional $400 million to $500 million, which would make a big difference,” says Haner.

More funding would make a difference in keeping the state’s premier schools competitive and affordable, something businesses worried about maintaining the state’s work force would like to see. “We’ve provided no (new) money for higher education in two years,” Chichester says. Faculty members have had to forgo raises, while curricula programs were slashed at some schools. The state’s only top-50 school for research and development, Virginia Tech, dropped from the National Science Foundation rankings recently — a huge backward step for a state that fancies itself as a center of technology.

State budget cuts have forced schools to raise college tuitions — an average of 22 percent in the last year — prompting concerns that some colleges may wind up taking more out-of-state students (who pay higher tuition) possibly shutting out Virginia students. A national consulting firm hired by JLARC to compare Virginia’s higher education funding with other states arrived at a stunning conclusion. The verdict: Virginia’s educational institutions are underfunded to the tune of $350 million a year. “We can’t balance the budget on the backs of our colleges and universities,” says Clements, the bank president, who serves on the board of visitors at The College of William and Mary.

The federal government is to blame for some of Virginia’s travails, although that’s cold comfort. Federally required Medicare payments sap nearly $3 billion from the state’s general fund every two years, or about 12 percent. Health care inflation propels those costs skyward. Virginia is bracing for annual growth rates in Medicare spending of 7 percent during the next two years. That means Virginia needs to drum up an additional $300 million to fund the health plan for low-income families, the disabled, and the elderly in Virginia.

Finding money for that and other obligations will inevitably run into party politics. Although it’s unlikely they’ll hand Warner an easy victory, Republicans risk bungling away their advantage if all they do is oppose him. Since claiming the majority in 1998, Republicans have proved inept at balancing the budget or ginning up new revenue, and running a deficit like their compatriots in the U.S. Congress isn’t an option under Virginia’s constitution. Strategists say the GOP leadership either needs to hammer out a compromise with Warner or submit its own comprehensive solution to fix the state’s tattered finances.

The question is how party leaders will respond. Although voicing support for tax reform, Chichester may decide that fighting for Warner’s proposal isn’t worth the political fallout of a messy internecine battle with other GOP members in the House. He could use his enormous clout to marshal support from business alliances for an alternative tax-reform package — one that resembles Warner’s but appeals to the conservative base of his party as well. Skeptics, though, expect little. “There may be some minor changes, but there won’t be any major tax reform,” predicts Larry Sabato.

Indeed, getting Republicans to support tax hikes would be a delicious triumph for Warner and the Democrats. He’ll take heart in the failure of the GOP’s staunch anti-tax wing to unseat Chichester and other moderate Republican incumbents in elections last year. In one sense, Warner has nothing to lose by floating his proposal. If nothing happens, he and his fellow Democrats can blame the Republican majority with failing to fix things. That would be a fun reversal for Democrats, who were routinely criticized by the GOP for failing to lead when their party held most of the power slots.

Party politics aside, business owners are trying to calculate the impact any changes may have on their bottom line. Hedrick, the Chesapeake masonry contractor, has terse advice for Virginia lawmakers: “Manage what you have and live within your means.” Sounds a lot like pay-as-you-go, Virginia’s mantra for years under the Democratic-dominated Byrd machine. Whether Warner can carve out a legacy as a tax reformer may depend on convincing skeptics that his plan is not just good government in the state’s tradition, but also good business.

Return to Virginia Business - January 2004