New S&P Report Shows Income Taxes Are Volatile, Sales Taxes Need Reform

September 16, 2014

A new report by Standard & Poors finds that rising income inequality may negatively impact state revenue growth. The report confirms the long-standing consensus of tax economists that high, progressive income taxes contribute to revenue volatility, and also confirms the growing chorus of experts who argue that the current sales tax structure has failed to keep up with fundamental economic changes. While the report has some significant flaws (it doesn’t consider the divergent effect of retirement incomes on inequality and tax policy, for example, and doesn’t consider policy changes over the last 35 years), overall it serves as a valuable reminder to state governments of the trade-off between hefty revenues in good times, and stable revenues in the long run.

The S&P report finds that state revenue growth has declined nationwide, regardless of tax structure. They also find that revenue growth has been somewhat slower in sales-tax reliant states than in more income-tax reliant states. This is not surprising given the amount of special exclusions put into state sales taxes and the general exclusion of faster-growing sectors like services. Notably, the report also found that, in most periods, the more sales tax reliant states had slower growth than more income-tax dependent states, but also had less volatile growth.

This closely relates to our previous findings on state revenue volatility, where we found that states with high reliance on income taxes, excise taxes, or natural resource taxes experienced some of the highest volatility. Numerous studies find that higher income taxes produce more volatile revenue streams, which in turn can lead to unexpected fiscal deficits. Indeed, states with a high reliance on natural resource windfall income must prudentially keep large reserve funds to hedge against frequent changes in resource prices. States with a high reliance on volatile progressive income taxes (especially the potentially erratic revenues of ”millionaires taxes”) would be wise to do the same, and consider marginal revenues from the top rates and brackets a form of windfall income, unsuited for general funding needs. Whatever revenue growth these high taxes provide in the good years can vanish suddenly in tough times when budgets are stretched most thin.

Finally, while the broad findings of the report aligned well with the consensus of tax policy research, it failed to account for a few key factors. A large part of the capital income that drives inequality comes from retirement accounts. As the Baby Boomer generation cashes in their nest eggs, capital income will rise as a share of national income, and inequality will likely rise in tandem. Much of this income, if it is structured as a Roth IRA, is not taxable. Beyond that, many states offer exemptions for retirement income. Indeed, as retirees frequently relocate for retirement, the tax status of retirement income and the role of untaxed retirement plans is a key determinant of the degree to which rising inequality will impact tax revenues. If millions of retirees stop earning taxable wages and then reap untaxed retirement benefits (due to favorable retirement plans or migration to states that don’t tax retirement income), inequality could rise as revenues struggle. But if, instead, retirees remain in states that tax retirement income or set up retirement accounts that yield taxable flows of income, this generational effect may not harm state revenues as much.

Prospective reports like S&P’s are a vital tool for policymakers as they plan for their state’s future in a shifting global economy. The key takeaways we got from the report were essentially in line with the best existing research: narrowly based sales taxes will struggle to raise enough revenues but offer some stability while highly progressive income taxes are a major source of revenue uncertainty and budget shortfalls, even as they yield faster revenue growth.

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