Why More Inequality Means Less State Revenue — And How States Can Respond

Growing income inequality in recent decades has slowed state tax collections, a new report from Standard & Poor’s finds, making it harder to fund public services ― like education ― that lay the groundwork for a strong future and help push back against rising inequality. States need to adapt their tax codes to take growing inequality into account.

Virtually all states collect more taxes (as a share of family income) from low- and moderate-income families than from high-income families.  So it makes sense that collections would slow when, as we’ve documented, the lion’s share of income growth goes to the richest families.

• Many states have a flat-rate or nearly flat-rate income tax.  A flat income tax raises less revenue from economic growth — especially when most of the gains go to people at the top of the income scale — than a graduated income tax, which taxes higher incomes at higher rates.
• Growth in sales tax collections weakens when low- and middle-income families’ incomes stagnate or grow more slowly, since they spend (rather than save) a larger share of their income than wealthy families do.
• States’ antiquated sales tax rules favor high-income consumers.  Those at the top tend to spend more on services, like lawn care or health club memberships, which remain exempt from sales tax in many states.  They also spend a larger share of their income online — purchases that often are effectively tax-free.

States can respond to slowing tax collections by making their income tax more progressive through a more graduated rate structure.  This would make tax collections more responsive to economic growth, bringing faster revenue growth when the economy expands.  Tax collections would also fall more when the economy slows, but states can address this with stronger reserve funds, better mechanisms to manage surpluses, and other policy tools, as we have explained.

States also can broaden their sales tax base to include more services, including those used by high-income families, and extend the sales tax to Internet sales.

Over time, these changes would give states more resources to push back against rising inequality by investing in education and training, providing supports like child care assistance for low-wage workers, and adopting or expanding state earned income tax credits.

Conversely, if states fail to adapt their tax systems to this growing problem, they will have an even harder time stemming the harmful rise in inequality.