Income Volatility, Taxes, and State Budget Shortfalls

This article in the Wall Street Journal hasn’t received as much attention as it should have. I haven’t double-checked the Wall Street Journal’s statistics but, if correct, the story helps to explain the severity of some states' recent budget shortfalls.

In general, at both the state and federal levels, people with more income pay more taxes than people with less income. That would be true whether or not the income tax system was progressive, taking a higher percentage of tax from high-income earners than from low-income earners. Even in a flat tax system, people who earn more would pay more. For example, with a flat 10% tax, a person making $500,000 would pay $50,000 and a person making $30,000 would pay only $3,000.

I don’t want to debate how progressive our tax system is or whether it’s a good thing. But it’s clear that, on average, news stories of some big corporations paying no taxes notwithstanding, government derives more of its revenue from high-income taxpayers.

As a result of that, state income tax revenues can be heavily dependent on receipts from high-income taxpayers.  In some states, that can be very dramatic. As the Wall Street Journal article points out, prior to the recent recession, 45% of California’s income tax revenue came from the top 1% of taxpayers (households earning more than $490,000 per year).

The problem with that, as the article points out, is that income at those levels can be very volatile—more volatile than average incomes. From 2007 to 2008, the incomes of the top 1% fell 15%, compared to a drop of 4% for the nation as a whole. States that were heavily reliant on high-income earners saw their state income tax receipts drop precipitously.  Unless spending drops to match that drop in revenues, a budget shortfall results.

One answer, of course, is to plan for that volatility—to set aside tax revenues when times are good to be used when times are bad. But most states don't seem to be very good at doing that.

-Steve Bradford