State Taxes Produce Wild Revenue Swings

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Another quarter has passed, and another report is out from the Rockefeller Institute showing the sorry state of state revenues. Yesterday the Institute released third quarter collections data for 44 states, all of which posted revenue declines compared to the same quarter a year earlier. The average decline was 10.7%. But performance varied widely across states, with revenues falling off 52.4% in Alaska, but just 1.3% in New Hampshire.

The report teaches two key lessons about state income tax, the largest component of state tax collections. One is that going without a general income tax promotes revenue stability. The other is that progressive income taxes are particularly bad for revenue stability.

Broken down by major tax area, the report confirms what we already know: corporate income taxes are the most volatile major state-level tax, followed by personal income taxes and then sales taxes. (Property taxes, levied mostly at the local level, are not broken out in the report but tend to be even more stable than sales taxes).

In the third quarter, state corporate income tax collections were off 19.4%, personal income taxes were off 11.4%, and sales taxes were off 8.2%. But because personal income taxes generate between four and five times as much revenue for states as corporate income taxes, they are the largest driver of revenue instability.

First, the good news: of the 44 states with data available, 6 impose no general tax on income. Five of these (Florida, New Hampshire, South Dakota, Tennessee, and Washington) have otherwise "normal" tax systems that broadly rely on sales, property, and/or business activity taxes to finance government. These states have seen relatively stable tax revenues, off by margins ranging from 1.3% to 8.8% for the current quarter.

Alaska is a bizarre exception, with state tax revenues that fell by more than half. However, it is the exception that proves the rule that eschewing income tax promotes revenue stability. While the state levies no personal income tax, it relies more than any other state on even-more-volatile corporate income taxes. Hammered by poor economic performance and particular weakness in the petroleum sector, Alaska's corporate tax revenues fell 68% this quarter, dragging overall revenues down with it.

Alaska is a frozen petro-state and is not instructive for the Lower 48. Nevada, another no income tax state that relies heavily on a hard-hit industry, has not yet released third quarter revenue numbers, but we can expect them to be ugly. Otherwise, states without income taxes are generally showing admirable (and unsurprising) revenue stability.

More surprising, but ultimately logical, are the results from states with flat income taxes. The usual expectation is that flat taxes will produce more stable revenues than progressive income taxes that rely disproportionately on high earners. This is because high income people tend to have volatile incomes that move sharply with overall economic performance.

However, five of the seven states with flat taxes saw income tax revenue drops above the 11.4% national average. While Pennsylvania and Utah outperformed most states with drops under 9%, Indiana's flat tax saw a 20.3% drop in collections, and the four others ranged from 11.7% to 14.3%. Meanwhile, New York and New Jersey (which have graduated income taxes that rely heavily on high-income taxpayers) saw revenue drops under 9%.

Progressives will point to these results as evidence that graduated taxes do not promote revenue instability. They are wrong. What has happened is that states with flat income taxes have resisted political impulses to raise income taxes. Meanwhile, states with sharply graduated taxes have tended to impose (often sharp) income tax hikes for the current fiscal year. If states like New York and New Jersey hadn't raised taxes, their revenue performance would be among the worst in the country.

No state with a flat tax raised its income tax this year. However, eight states with graduated income taxes raised rates: Connecticut, California, Delaware, Hawaii, New Jersey, New York, Oregon and Wisconsin. Most of these personal income tax increases were in the form of new or increased "Millionaire's Taxes", which contrary to the name may be imposed on incomes as low as $125,000. The sole exception is California, which raised tax rates across the board including in its millionaire bracket.

These tax increases are reflected in the Rockefeller report and have mitigated third quarter revenue drops. (Connecticut is an exception: its tax increase was enacted at the end of the third quarter and is retroactive to the start of the year; new receipts from the tax increase are not reflected in the report, but will show up next quarter.)

The effects are drastic. New York's income tax revenues were off just 7.4%, the 12th best performance among states with an income tax and better than every flat tax state. However, the state enacted a tax increase for 2009 that was expected to boost revenues by 11.8% over baseline. Without that increase, New York's income tax revenues would have fallen off by about 17.2%, behind only Alabama and Indiana.

A similar tax hike in New Jersey allowed the state to hold its decline to 8.9% instead of 17.8%. California, whose income tax revenues were off 16.0%, would have seen a 22.2% drop without its income tax hike. If they hadn't raised taxes, these three leaders in progressive income taxation would have been the country's second-, fourth-, and fifth-biggest income tax revenue losers. This does not inspire confidence in the soundness of progressive income taxes at the state level.

States, which must balance their budgets every year, should prize revenue stability and therefore be drawn to taxes on property and consumption. To the extent that the tax code should include progressivity, it makes sense to do so at the federal level. This is because the federal government can borrow its way through revenue drops, and because taxpayers can't avoid federal income taxes by moving.

Progressives have made increased tax progressivity a key part of their agenda at the state level, winning enactment of millionaire's taxes around the country. But this report should give legislators pause, as it provides further evidence that more progressivity means more volatility. Long-term solutions to budget shortfalls require tax reforms that promote revenue stability, including a move away from dependence on state income taxes.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.

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