State Fiscal Problems Pegged to Personal Income Tax Erosion

While states' financial problems are clearly multi-facted, a new research piece by Economy-com says these problems are significantly tied to states' reliance on personal income taxes, which have gone to hell in a handbasket in the past couple years.

With standardized state tax data for the April-June quarter having been released, revenue information is now available through the end of the fiscal year in most states. The most recent figures further cement a clear pattern that has emerged in state fiscal conditions over the past few quarters. Namely, the performance of tax collections across states has been highly correlated with a given state’s exposure to personal income taxes.

Excluding North Carolina and Maine, no state with a large dependence on personal income taxes has been spared from large revenue losses. Conversely, states such as Wyoming, Washington, South Dakota and Nevada that do not collect personal income taxes, and those such as Tennessee, New Hampshire, Mississippi, and North Dakota that collect very little, have avoided the worst of the revenue drought.

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The poor recent performance of personal income taxes represents a sharp departure from what has been seen over much of the past decade. After a seemingly endless flow of tax collections associated with income from stock options and capital gains, personal income tax revenues became more than 15% larger than general sales tax collections by the end of fiscal 2001. Since then, job losses and the equity market correction have knocked personal income tax revenues back below sales tax receipts. Sales taxes are currently a much more popular tool for policymakers, due in part to the increasing likelihood that Internet sales will become broadly subject to taxation in the near term.

While state tax collections remain below trend, there has been widespread improvement in recent months due in part to enacted tax increases. This improvement, combined with federal aid payments and belt-tightening by state policymakers, has sharply reduced the size of state budget shortfalls. According to the Bureau of Economic Analysis, state budget deficits fell by more than $50 billion on annual basis during the second quarter. If this improvement holds, states only have $30 to $40 billion more in fiscal drag left to go before budget gaps are filled and reserve requirements are built back up.

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