Income Inequality Weighs On State Tax Revenues

Source: Gabriel J Petek, Standard & Poor’s Ratings Direct, September 15, 2014

Overview:
∙ A one-unit increase in the share of income going to the top percentile had a negative impact on tax revenue growth.
∙ We believe that structural, rather than cyclical, forces are leading to slower state tax revenue growth.
∙ From 1980 to 2011, average annual state tax revenue growth fell to 5% from 10%; meanwhile, the share of total income for the top 1% of earners doubled.
∙ State tax revenue trends have also become more volatile as progressive tax states have come to rely more heavily on capital gains from top earners.
∙ Regardless of a state’s tax structure — be it income-tax or sales-tax reliant – the pace of revenue growth is declining across the spectrum.
∙ Reasons for rising income inequality aside, the disparity is contributing to weaker tax revenue growth by weakening the rate of overall economic expansion.
∙ It’s unlikely that states can fully correct for both slower and more volatile tax revenue growth by adjusting their tax policies.

In a recent article, Standard & Poor’s Ratings Services examined income inequality in the U.S. and concluded that rising income inequality is one factor contributing to slower economic growth, and that this represents a structural, rather than a cyclical change.

Extending our analysis to public finance, we find that increasing income inequality is undermining the rate of state tax revenue growth. In addition, it is contributing to volatility in tax revenue collections.

Compared with local governments, which rely to a greater extent on property taxes, states generate the bulk of their revenue from taxes levied on current economic activity, namely personal income and consumption. Therefore, when the economy operates below its potential, state tax revenues tend to suffer. Insofar as income inequality contributes to economic output falling short of potential, it undermines the growth of states’ tax bases.

Our analysis found a negative relationship between income inequality and state tax revenue tends. When we tested the relationship by tax structure, we found the negative effect was stronger and only statistically significant in the sales tax-reliant states. The findings support our view that rising income inequality contributes to weaker tax revenue growth by undermining the rate of overall economic expansion.

In addition to slower revenue growth, Standard & Poor’s believes income inequality has tied the states’ revenue performance more closely to that of the financial markets. Reflecting this linkage, state tax revenues have become more volatile, greatly complicating the task of budgeting.

Thus, inequality appears to be a macroeconomic problem with fiscal implications for states. In other words, because it is a structural economic problem, it is unlikely that states can fully correct for it solely by adjusting their tax policies.