States are seeing crazy income tax growth. Will it last?
I have spent the last few days thinking about the income tax and the astounding growth states are reporting in that revenue stream. There’s a lot going on here and this week’s edition looks at some of the top themes I’m seeing.
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Double-digit growth with lots of caveats
States collected nearly $455 billion in total income tax revenue in fiscal 2021—an astounding 14.7% increase over the prior year. That’s according to the latest report from the National Association of State Budget Officers (NASBO), which covers spending through June 2021. Over two years, income tax revenue is up 15%.
Here comes the caveat: The last two years have been really weird. For starters, states delayed their tax filing deadline by several months when the pandemic began. For most, this pushed their 2020 income tax revenue into the next fiscal year. This artificially deflated 2020’s numbers while inflating 2021 collections.
OK, but what about that two-year growth? That’s where the federal stimulus comes in. Since March 2020, the feds have doled out $867 billion in cash to households via three Economic Impact Payments. While those payments weren’t taxable, they could indirectly increase state tax liability for some. (The New York Times has a good explainer on that.) Plus, unemployment insurance -- which most states do tax -- received a massive boost for about 15 months.
Last, there’s the stock market. The S&P 500 is up more than 40% from a year ago and up nearly 70% from three years ago. Most states tax capital gains at the same rate as ordinary income and those with a high concentration of wealthy individuals (i.e., California) are reaping the tax revenue benefits of the bull market.
Other takeaways from the NASBO report:
Total state general fund revenue increased in 2021 by an estimated 12.8%
Total state spending in 2021 increased by 16.2%, the highest annual jump in the 35-year history of the State Expenditure Report.
Over the past two fiscal years, states spent $427.9 billion in federal COVID-19 aid.
Will the income tax boom last?
Income tax revenue was increasingly volatile even before the pandemic hit. Now that things are super weird, budget forecasting has become even more of a guessing game. All we can really do is look at what the numbers say -- here are some of the highlights.
It hasn’t slowed down—yet. Between April and September of this year, 37 of the 43 states that tax personal income saw continued growth in that revenue stream, according to the latest analysis from the Urban Institute’s Lucy Dadayan. Eleven of those states saw growth of more than 20%. Utah, for example, is forecasting income tax revenue of $5.7 billion for the current fiscal year. That’s a decrease over 2021 (remember, that’s an inflated number), but one-third higher than 2019 (not adjusted for inflation).
But analysts are bracing for a deceleration. Most states are forecasting strong growth for the remainder of the fiscal year but those reports are coming with warning labels about the out years. Utah’s economic impact report notes that “a decline in personal income seems likely in the national labor market.” The extent will depend on whether the economy is readjusting back to pre-pandemic trends or if another wave of the virus forces a contraction.
Bond buyers are concerned about longevity. The federal aid that’s also boosting state and local government revenues will expire in 2026. Recent academic research has found that the fiscal interventions over the past year eased short-term credit risk concerns in the municipal market, but that long-term bonds saw an increase in premiums. This indicates that municipal market investors have “expectations of long-lasting recessional impacts on state and local government budgets,” the research said.
States are cutting income tax rates anyway
Unsurprisingly, 12 states passed income tax rate cuts this year. Many of those were deeper cuts than originally proposed. According to a recent analysis by Fitch Ratings:
Minnesota and Wisconsin proposed tax increases in their fiscal 2022 executive budgets but ultimately reduced taxes in their final adopted budgets.
Iowa and Missouri accelerated the phase-in of pre-existing income tax cuts.
Iowa, Montana, Nebraska, New Hampshire and Oklahoma cut income and other taxes
Arizona, Iowa, Idaho, Montana and Ohio reduced tax rates while also eliminating or consolidating entire tax brackets.
Other states, including Colorado, Indiana and Utah, are expected to take up income tax cuts in the upcoming legislative session.
The takeaway: Income tax cuts always come up when lawmakers have surplus money to spend. But for all the reasons above—and then some—cutting income taxes now is a risky move. A permanent cut based on a couple good years could ultimately leave state budgets more vulnerable if revenue returns to pre-pandemic patterns.
“Budget challenges, such as the rolling off of federal aid and a shift in consumer spending away from goods toward services, many of which are not taxed, are likely to curb state revenue growth over the medium term,” warns Fitch.
Learn more: Using one-time revenue to pay for a recurring expense is one of the “7 Deadly Sins of Public Finance.”
What I’m watching
The SALT cap debate. The House of Representatives passed a much more generous cap ($80,000) on the deduction of state and local taxes from federally-declared income. But it’s not expected to hold in the Senate. The Tax Policy Center says the tax cut will benefit primarily the top 10% of income earners, with almost nothing flowing to middle- and lower-income families.
The Big Quit. Remember all those predictions in the last decade about the “Silver Tsunami” of baby boomers retiring from government? It might really be here. Stay tuned for more in an upcoming piece I’m writing for the Rockefeller Institute of Government.
Marion Barry and Thanksgiving
Tomorrow is Thanksgiving and it often reminds me of former Washington, D.C. mayor-turned-councilmember Marion Barry, who I used to cover as a local reporter some years ago. Barry died in 2014 just before Thanksgiving, just days before his annual turkey giveaway. Stunts such as these, where Barry would personally hand over thousands of turkeys each year, was one of the many reasons he was loved by his constituents.
Barry wasn’t the only D.C. councilmember doing this but his events always generated media coverage—probably because he liked to taunt reporters when they asked him questions he didn’t like, such as who was paying for the turkeys. Only “liberal white folks” are interested in that, he’d retort, serving up headline quotes along with the birds.
Barry was deeply flawed. But he was loved almost unconditionally by those he represented because he was a master of engagement. His office was accessible and he was really good at getting people what they wanted (and making sure media reported it). When I attended a remembrance for him, every resident I spoke with had a personal story about the “Mayor for Life.” As policymakers think about ways to change policy equitably, it’s a reminder that the smaller rewards also go a long way toward keeping the faith.
That’s it for this week and if you’ve made it this far, I’d love your feedback. Was this too long? Too short? What did you like and what could you have done without? Please don’t hesitate to reply to this message with your thoughts.
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