The worst hit by far will be New York, which stands to lose more than $2.6 billion between now and September 2004. Trailing at a distance, but still hurting, will be Illinois, Pennsylvania and Texas, whose losses will all top $800 million. Forty-two other states will also lose money. Only California, Nevada, Washington and Wyoming don't link their corporate income taxes to federal definitions.

The recovery will bring some relief for states as workers are rehired and personal income tax revenue recovers, but money will remain tight in most states through the next two budget cycles—into the summer of 2004. That will mean more spending cuts, including reductions in education and Medicaid, the most popular and most expensive state programs.

The corporate tax hit would be bad enough by itself, but it is only the latest development in a long-term deterioration of state revenue bases. Last year's rollback of the federal estate tax will cost 38 states a total of $6.5 billion in fiscal year 2003. The loss will continue to grow each year if the federal estate tax is allowed to phase out, as current law mandates.

The biggest problem for most states, however, is the sales tax, which consistently brings in more than a third of state tax revenue in the 45 states that impose it. (The exceptions are Alaska, Delaware, Montana, New Hampshire and Oregon.) Most sales tax states apply the levy only to tangible goods. And most have exempted necessities such as food, prescription drugs, utilities and, in some cases, even clothing, in response to charges that sales taxes are inherently regressive, falling most heavily on lower-income consumers.

That was a reasonable strategy when sales taxes were first implemented decades ago. The national economy was driven primarily by manufacturing back then. But today, services account for close to 60% of U.S. economic activity. Yet only three states–Hawaii, New Mexico and South Dakota–apply sales taxes to most services.

The booming economy of the 1990s generated ample income and sales tax revenues for states, allowing them to ignore the shrinking sales tax base. But with last year's layoffs squeezing income tax revenues, the reliance on sales tax receipts is more pronounced, and the long-term problem is rearing its head.

The most direct solution to the predicament would be for states to lower their overall sales tax rates while broadening the tax to cover services and intangibles. Although this approach would be a better fit to today's economy, it's a hard sell.

"Trying to tax someone who hasn't been taxed before is a difficult political fight to make," explains Scott Pattison, executive director of the National Association of State Budget Officers. The sectors that would face new taxation—health care, legal services, accounting and construction—have considerable lobbying clout. And since businesses account for a significant majority of service purchases, any broadening of sales taxes would face widespread resistance from business buyers.

Most governors and state legislators won't take on such a formidable array of corporate and professional lobbying interests, particularly in an election year. In the few states where the issue has been broached recently, advocates of taxing services have taken a sound beating.

In Florida, a state Senate proposal to reduce the sales tax to 4.5% and apply it to services has run into heavy opposition from Gov. Jeb Bush (R) and the state House of Representatives. "The guy leading the reform effort in Florida, [state] Sen. [John M.] McKay, is no liberal," says David Brunori, a contributing editor to State Tax Notes magazine. "He's a good conservative, Republican leader of the Senate, and they're painting him as the second coming of Karl Marx."

In Minnesota, Gov. Jesse Ventura (I), up for reelection this year, made a similar proposal in his "state of the state" speech in January. Both the Republican House and the Democratic Senate oppose the change, and Ventura's popularity rating has sunk below 50% for the first time in his tenure.

With little appetite for fundamental reforms, state legislators will focus on resolving only the immediate budget crisis. "They get in a 'hunker down' mood," explains Ray Scheppach, executive director of the National Governors Association, "thinking, 'Let me just get through these two budget years,' rather than looking down the road five, six, seven years."

That will work well enough for a while, as state budgets reap benefits from the recovering economy. But it bodes ill for state governments down the road. "Economic downturns for states will get progressively worse until they finally force someone's hand," predicts Brunori.