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Don’t Blame State Budget Problems on Progressive Income Tax

March 28, 2011 at 1:42 PM

A Wall Street Journal story on Saturday suggested that some states set themselves up for budget problems by relying too heavily on income tax revenue from wealthy residents.  The reality is far more complicated.

The story focused on California, which has had legendary budget problems and — yes — a progressive income tax, which taxes higher incomes at higher rates.  On the other hand, Nevada, Florida, New Hampshire, Texas, and Washington have no income tax, yet all have had above-average budget shortfalls in one or more recent years, as our analysis of state budget conditions shows.  So a state can’t protect itself against revenue busts by doing without an income tax.

Nor does it help much to have a flat-rate income tax instead of a progressive one.  Several states with flat systems like Illinois, Michigan, and Pennsylvania, which tax all income at the same rate, have faced budget gaps comparable to states with progressive income taxes.

Volatility in state revenue systems reflects a number of factors:  the nature of a state’s economy, the structure of its tax system, the nature of its spending programs, and so on.  The last two recessions were accompanied by steep drops in the stock market resulting in large declines in income tax revenues, but the next recession might be different — it might hit hardest at states that rely on sales taxes or natural resources taxes, for instance.  That’s why states should — and often do — choose a balanced portfolio with a diverse array of revenue sources, just as smart private investors do.

And there are very good reasons why states should enact progressive taxes.  While states with a progressive income tax face a short-term cost if the stock market crashes, states without a progressive income tax face an even greater long-term cost. Without a progressive income tax, state tax systems tend to erode over time and become more dependent on sales and excise taxes, both of which generally grow more slowly than the economy.  That makes it harder and harder for a state to continue providing health care, education, and other necessities to a growing population.

It’s wise for states to address revenue volatility and the threat of recessions without abandoning progressive income taxes.   One way is to shore up “rainy day” reserve funds.  Another is to set aside more money in boom years for one-time expenditures, debt repayments, and the like.

Blaming progressive income taxes for state problems masks an important issue:  large and growing shares of the nation’s income and wealth are in the hands of a small number of taxpayers.  If more people had higher incomes, the progressive tax couldn’t be attacked for relying on a relatively small number of households to provide much of the revenue. While states can’t address growing inequality all on their own, a progressive income tax is part of the solution — not part of the problem.