Overreliance on the Rich: As Incomes Drop, State Budgets Drop with Them

March 28, 2011

The weekend Wall Street Journal had a lengthy piece following the warnings of Brad Williams, a former economic forecaster for the state of California. At that job in the mid-1990s, Williams noticed that most income tax revenue growth was coming from very high income earners, and warned that this had serious implications for the volatility of the state’s tax system:

By the late 1990s, Mr. Williams realized that his job had changed. California’s future was no longer tied to the broader economy, but to a small group of ultra-earners. To predict the state’s revenue, he had to start forecasting the fortunes of the rich. That meant forecasting the performance of stocks-specifically, a handful of high-tech stocks.[…]

After the dot-com bust, the state’s revenues from capital gains fell by more than two-thirds, to $5 billion in 2003 from $17 billion in 2001, while personal-income taxes fell 15% over the same period. The recession created a mirror image of the boom, with the wealthy leading the crash and dragging tax revenues down with them. By 2002, California had a budget shortfall of more than $20 billion.

The deficit lingered for years, but its lessons seemed to be quickly forgotten in the state capital. By 2005, California was enjoying another surge in spending fed by the incomes of the wealthy.

Mr. Williams started warning of another government crisis. In 2005, he released a report stating that the state’s tax revenues could vary by as much as $6 billion in a single year, and that such swings were “more likely than not.” He recommended several potential reforms, including flatter income-tax rates, “income averaging,” which allows the wealthy to spread their tax payments for unusual windfalls over a longer period of time, and a rainy-day fund.

His proposals failed to gain any traction with the legislature. Many Democrats refused to consider tax hikes on the middle class and lower rates for the rich. In 2009, voters rejected a proposed spending cap, which among other things, would have helped to create a rainy-day fund.

One of the leading advocates for such a fund is Roger Niello, a former Republican assemblyman who has long been among the top 1% of state earners. He and his family own a chain of luxury car dealerships, and during the recession, his income fell by more than half because of the decline of auto sales. Though he’s still “fine financially,” he said, his personal experience taught him that “people in this income group have the most variable incomes.”

Read the full piece here. Williams retired in 2007 and his recommendations remain unheeded by California legislators.

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