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Income Taxes Show Their Value

State revenues — especially income tax collections — are beginning to recover from the worst recession since the 1930s.  As we described in our recent paper, at least 28 states have reported that tax collections for the just-ended fiscal year will exceed the amount expected when their budgets were adopted last spring.

In at least 23 of those states, the higher revenues are driven by gains in income tax collections — a result of rapid increases in the incomes of wealthy individuals and corporations over the last year.  The better-than-expected revenue picture means that states could reduce the spending cuts they have planned for schools, health care, human services, and other areas.  This new revenue data illuminate the important role that income taxes — a critical part of state tax systems—will play in states’ fiscal recovery.

The Great Recession appears to be following the pattern of recent recessions in which the incomes of the wealthy recover well before those of low- and middle-income individuals and families.  Many experts expect a similar pattern now and income trends support this.  Wages — the primary form of income for low- and middle-income households — have grown slowly over the last year, but other forms of income disproportionately received by wealthy individuals have grown rapidly.

In addition, by the end of 2010 private corporations’ profits were 21.7 percent higher than before the recession, boosting collections of corporate income taxes.  Higher corporate profits also contribute to the jump in the incomes of the wealthy from increased corporate dividends and higher share prices that generate higher capital gains.  This combination produces more income subject to personal income tax.

By contrast, collections of sales taxes — states’ other major source of revenue — are rebounding more slowly.  Consumer spending has recovered more slowly than after other post-World War II recessions.  In addition, many individuals and families are using their disposable income to pay down debt—not for spending.

As a result, personal and corporate income tax collections are far likelier to exceed estimates than are sales tax collections.  States that rely on personal income taxes and robust corporate taxes are seeing positive results.

Still, despite the recent improvement, it will take years for states to overcome the damage that the recession did to their ability to make fundamental public investments.  The good news is that those states that rely on income taxes and corporate taxes can make a speedier recovery by harnessing the economic gains flowing primarily to the wealthy.