Individual Income Tax: a Driving Force for Most States’ Finances
Individual income tax collections - the largest source of state government tax revenues - declined 4.5 percent nationally between 2009 and 2010, according to recently released U.S. Census Bureau state government tax collections data.
Individual income tax (also referred to as personal income tax) comprised 33.5 percent of total state tax revenue in 2010, according to the Census Bureau’s State Government Tax Collections Report. It was the largest source of tax revenues in three of the four regions of the country in fiscal 2010. Only in the Southern region did general sales and gross receipts taxes comprise a greater percentage of tax revenue.
Nine states - Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming - do not collect a broad-based individual income tax. These states often rely on other types of tax collections to make up the shortfall, or, in some cases, simply provide fewer government-sponsored programs.
In the interview that follows, Donald Boyd, a senior fellow and former director of the State and Local Government Finance research group with the Nelson A. Rockefeller Institute of Government, discusses the recent trends in state individual income tax collections and their impact on state finances.
MuniNet: How do trends in the economy affect trends in personal income tax collections? Is there a lag between signs of an economic recovery and actual tax collections?
Boyd: Roughly three quarters of income subject to the individual income tax is derived from wage income. A simplistic answer would be that if people are out of work, they make less money, and therefore pay lower income taxes, but other factors can also influence income tax collections during economic crises and in times of recovery.
Because most payments are made through employer withholdings, wage-related income tax collections are pretty current. But while they may closely parallel labor trends, wages do not necessarily recover as quickly as other economic indicators, such as gross domestic product (GDP). As wages begin to pick up, income tax collections will also start to increase, and we have been seeing that in recent quarters.
One important point to note is that not all wage income is the same. Take the case of bonus income, which can really accentuate trends in the economy. Bonus income usually involves a large sum of money coming in quickly, and often going right back out into the economy. After the financial services industry was hit hard by the economic downturn, wage income fell steeply in the first quarter of 2009, as fewer people were bringing home the types of bonuses they had in prior years. This trend had a big effect on state tax collections.
MuniNet: You say that three quarters of income subject to the individual income tax is derived from wage income; what about the remaining quarter?
Boyd: Non-wage income includes but is not limited to capital gains, interest, dividends, small business profits, unemployment compensation, and rental income. This recession, along with the one immediately preceding it, were unlike any others we’ve seen in history, due, in part, to states’ increased reliance on income taxes collected on non-wage income, particularly capital gains. Non-wage income is far more volatile than wage income, and carries the potential to have a huge impact on state tax collections.
State tax revenues experienced a boom as capital gains rose quickly through most of the last decade. But the recession began in the fourth quarter of 2007, leading to a very bad year for the markets - and capital gains income - in 2008. This was particularly bad for taxes paid with tax returns filed in the subsequent April. The numbers speak for themselves: In the April-June quarter of 2009, income tax payments declined 27 percent on a year-over-year basis, but in April-June 2008 they were up 8.1 percent year over year - and in April-June 2006 they were up 18.8 percent.
Among all types of non-wage income, capital gains had the most significant negative impact on individual income tax collections throughout the past few years, although we are beginning to see evidence of recovery.
MuniNet: Are the states that do not collect a personal income tax more or less vulnerable to fluctuations in the economy?
Boyd: In general, states with a greater reliance on sales tax have a somewhat less volatile revenue stream than states that depend on revenues from income tax collections. Once a state imposes an individual income tax, it puts itself on a sort of fiscal roller coaster. When times are good, these states reap the benefits. However, in times of economic challenge, they will likely feel the strain more than states that don’t rely on individual income tax collections.
But to say that states without a personal income tax are immune to economic shifts would be untrue. Sales tax revenues tend to be a bit more stable than income tax revenues, but changes in the economy and labor force certainly influence consumers’ spending habits.
The types of alternate sources of tax revenue vary even among these states. For example, Alaska does not impose an individual income tax - or a sales tax. Instead, the state relies heavily on oil and gas-related taxes, which are extremely volatile from year to year.
MuniNet: While states without a personal income tax may not feel the effects of the economic downturn to the same degree as those with that tax, how can they cope with fiscal challenges?
Boyd: Since these states cannot raise income tax rates, they have to find ways to increase revenues through other types of taxes, including sales and business taxes. In the absence of opportunities to increase revenues, these states may be focusing on deeper spending cuts.
MuniNet: In an effort to face Illinois’ growing budget crisis, Governor Patrick Quinn recently signed legislation approving a 66 percent tax hike in the individual income tax rate. Do you expect to see other states following suit?
Boyd: I think, at least in the short term, that very few other states are likely to follow suit. Illinois was a special situation, with even larger budget problems than most other states. Its overall tax burden was lower than the national average by several measures. And I think there was widespread recognition in the business community that a tax increase was a likely element of any broader effort to close its budget gap. Meanwhile, in most of the rest of the nation anti-tax sentiment seems extraordinarily strong. Some of the states that might ordinarily be expected to support tax increases - I am thinking California, New Jersey and New York, in particular - have done so earlier in the recession. Their current governors have either opposed tax increases or have, in the case of California, said they will only accept them if the voters approve. There may be a few exceptions in other states, but tax increases this year will be rare. As for next year and beyond, that’s much harder to predict.
About the Expert
Donald J. Boyd is a senior fellow and the former director of the State and Local Government Finance research group at the Nelson A. Rockefeller Institute of Government. Boyd has over two decades of experience analyzing state and local fiscal issues, and has written or co-authored many of the program’s reports on the fiscal climate in the 50 states.
His previous positions include director of the economic and revenue staff for the New York State Division of the Budget and director of the tax staff for the New York State Assembly Ways and Means Committee. Boyd holds a Ph.D. in managerial economics from Rensselaer Polytechnic Institute.
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