Beware the Bouncing Tax Bill

State and local revenues are more exposed to an economic downturn because they're more attuned to nonstop economic growth.
February 2001
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

A few weeks ago, two newspapers hit my front doorstep. The first, a local paper, had an ebullient article on the wonders that a new $14 million eToys distribution center had wrought for rural, depressed Blairs, Virginia. eToys' sales were booming, the story said, 1,200 folks were working the holiday season and the local economy was humming.

Then I picked up the national paper. Its story said eToys was reeling with slow sales, laying off people and, with cash running out, seemed destined to follow a host of other dot-coms into perdition. Its stock, which peaked at $86 in October 1999, had fallen to just above $1 a share in December 2000.

The eToys story is revealing. It illustrates the rapidity with which the economy can reverse and the hardships that creates--for investors, for those hard-working employees in the spanking new plant and for state and local government finances.

States and local coffers have benefited mightily in the economic run- up of the 1990s--37 consecutive upbeat quarters. But they are greatly exposed to the downturns in the economy, more so than in the past, precisely because their revenue systems have become more attuned to sustained economic growth.

A recent study by Donald Boyd at the Rockefeller Institute at SUNY- Albany shows how state government revenues have become more vulnerable. Over the past decade, states have come to rely increasingly on personal income and sales taxes, both of which have been made more "elastic," that is, more sensitive to changes in the economy. If the elasticity is greater than 1, say 1.1, the percentage change in revenues will be 1.1 times greater than the percentage change in the tax base. States have enjoyed the benefits of increased elasticity: Revenues climbed effortlessly and legislators had the pleasure of trimming a tax here and there. But the reverse side of elasticity is that as the economy nose-dives, revenues fall at an even faster rate.

Take the individual income tax. It constitutes about 20 percent of combined state revenues, and almost all of the 43 states that levy it use rate structures and exemptions that make it progressive. That is, higher incomes are effectively taxed at higher rates. The median elasticity is currently 1.2 for state income taxes, but it can go higher. The great prosperity has made the highest-income taxpayers increasingly important to total revenues. Capital gains and bonuses were a significant driver of the huge growth in the late 1990s, actually pushing the elasticity up to 2.0, which means revenues were growing twice as fast as personal income. And that's the rub: They'll tumble twice as fast when income growth sags or, worst of all, goes negative.

Dependency on the general sales tax, which accounts for 18 percent of state revenues and is used by 45 states, has not grown by as much as the income tax. But the nature of the tax has changed. Although it's traditionally less volatile than the income tax, over the years there has been a narrowing of its base and an inching up of rates. True, economic growth was occurring fastest in the lightly taxed services sector. But people, feeling richer, have been spending more of their income on discretionary goods and going into debt to buy even more. So the effective elasticity of the sales tax is greater than if consumption patterns and broader bases had stayed in place. Recently, the median elasticity of state sales taxes in relationship to GDP was calculated at 1.1, but the effective elasticity can swing wildly over the economic cycle when folks start spending less, particularly on purchases they can defer.

The recent focus of sales-tax worries has been on the tax-avoidance impacts of the growth in e-commerce. But, as the economy and population continue to mature, that challenge will prove less important than not taxing services and taxing the narrowing base at high rates.

Not all the problems are with the structure of the general sales tax and income tax. States with economies dependent on particular industries or activities also tie their tax bases to the fates of those limited sources of income. It was only a decade ago that California's highly elastic tax system took a huge hit from the slowdown in defense spending and the devastating collapse of its growth-dependent real estate market. The Oil Patch disaster of the 1970s, the financial sector meltdown of the early 1990s in the Northeast, and jolts taken by food-exporting Midwestern states as a result of the 1997-98 Asian crises serve as reminders that the economy is dynamic and today's winners can be tomorrow's losers.

Add to that another fact: State and federal policies have painted the states into a corner where they will be faced with picking up more of the counter-cyclical spending burdens.

What to do? Where taxes must be raised, broaden the base, keep the rate low and tax what your neighbors tax.