Tax Collections and Economic Growth

June 14, 2005

Today’s Wall Street Journal describes the current improving fiscal situation in the states:

Strong gains in corporate profits, household income and home sales are swelling tax revenues for states nationwide, helping to close budget gaps and boost spending. State-tax revenue for the July-March period of the fiscal year ending June 30 reached $387 billion, up 9.5% from the year-earlier period.

States are enjoying growing tax collections because the economy on the whole is growing. When the economy grows income rises, and because of progressive tax codes tax collections grow at a faster rate than income. In times of economic prosperity states tend to spend all revenue on current programs and services while at the same time expanding spending to new areas. This becomes a problem when the economy enters recessionary periods.

During economic downturns, tax collections decrease at a rate greater than the decline of income, again due to progressive codes. States then face a budget crunch as deficits develop because of the increased spending enacted during boom periods. Often, to counter the lagging tax revenue states raise tax rates. This ratcheting-effect leads to increased spending and increased rates.

Legislators need to be aware of these forces when creating new spending during boom periods. Due to the business cycle the increased tax collections will not last forever. To counter act the forces driving spending and rates higher, law makers need to create rainy day funds and resist the urge to spend every dollar of new revenue during times of economic expansion. See the Tax Foundation’s report on Tax Freedom Day to learn more about tax collections and economic cycles.

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A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.

A recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years.