Cash strapped U.S. states can thank the fiscal cliff for a revenue windfall this year but the road ahead remains bumpy, according to a new report by the Rockefeller Institute. Taxpayers’ strategy in late 2012 that aimed at avoiding federal income tax hikes in 2013 produced a 10.8% jump in state personal income tax collections in the fourth quarter of 2012 compared to the same period the previous year, researchers found. That tax bonanza, though, is likely to depress revenues in 2013-2014: states, warned the Rockefeller Institute, are on a revenue roller coaster.
In fact, regional government revenue in the U.S. had been on a roller-coaster since at least 2000, and America’s rich are responsible for much of that volatility. Much the year-end maneuvering noted by the Rockefeller Institute involved the country’s millionaires and billionaires rearranging their finances to maximize the portion of their income that would be taxed in 2012, at lower rates, rather than in 2013, at potentially higher rates. But the wealthiest taxpayers have been a source of wild revenue swings in many states for long before that.
The crux of the problem, Richard Mattoon, a senior economist at the Chicago Fed and a lecturer on real estate at Northwestern University told Canadian Business, is that dividends and capital gains make up a much larger share of top earners’ pay than they did in the past—and that part of their compensation package tends to be very volatile. The wealthy don’t depend on their bonuses for their living, continued Mattoon, so they have wide flexibility to realize those gains when it’s most convenient from a taxation point of view, as happened with the fiscal cliff. More importantly, though, dividends and capital gains tend to go up and down with the economy, which has translated in wild tax revenue swings for states that rely heavily on personal income taxes.
“State government revenue has grown far more sensitive to economic conditions during the past decade,” Mattoon and another Chicago Fed economist noted in a 2009 report. This happened both because soaring salaries for the rich meant that the wealthy automatically came to pay a larger and larger share of income taxes, particularly in states with progressive rates, and because politicians in a number of regional jurisdictions raised income taxes, especially—you guessed it—on the biggest earners.
The first realization that state income tax revenues weren’t what they used to be came with the dot-com bust of 2000-2001. As far as recessions go, that was a fairly mild one: it was over in less than a year and GDP didn’t dip below -1.3%. But you wouldn’t have known that looking at U.S. state coffers. Tax revenues dropped about 14% in California and Massachusetts and 4.8% in New Jersey. The economy had caught a cold, but a number of states suddenly found themselves on fiscal life support.
History repeated itself in the Great Recession. Between 2007 and 2008, the incomes of the top 1% of earners dropped 16%, compared to a 4% decline for U.S. earners overall, the Wall Street Journal reported in 2011. In 2009 tax receipts were down 13.9% in California, 11.2% in New Jersey and 10.8% in Massachusetts.
Swings at the top of the income ladder are a big problem for U.S. states, most of which are formally required to balance their budgets every year. (Yes, there are many ways to get around that to a certain degree, but carrying over deficits, however disguised, remains difficult.) Of course, the issue isn’t so much that the rich can’t be taxed, but rather that states must find ways to work around top incomes’ ups-and-downs, says Mattoon.
Massachusetts, in that respect, seems to have learned the lesson. The state now requires that capital gains tax revenue feed into a rainy day fund. Not only does that build a cushion for the hard times, it avoids the problem on relying on unstable money for everyday, general fund expenses, says Mattoon. The bean counters don’t have to go crazy trying to predict stock market returns and executive pay in order to forecast state revenues from year to year.
Though Canada’s provincial revenue volatility troubles have much more to do with resource royalties than personal income taxes, Alberta and Newfoundland could perhaps learn a thing or two from the trials and tribulations south of the border—and how the smartest states are trying to fix the problem.