Potomac Fever is the blog of the Hamilton College Semester in Washington Program.
As I’m sure was anticipated, I have a response. Overall this article included some great data (and topic for me to tackle), though its presentation was unfortunately quite biased- particularly towards the beginning of this very long article (for a newspaper). Hopefully people reading my response, and all the research and evidence I provide, find it convincing. Please let me know (as I’m sure someone will….) if you have any questions, comments, or concerns. The summary of my response: This article (and blog post by extension) falsely emphasized that since state revenues have grown more volatile over the past few years because high-income households have volatile incomes, states should reduce the tax contributions they expect high-income households to make. This argument was made in a variety of ways throughout the article, including first under the photo caption which read: “Brad Williams, above, a former economic forecaster for California, warned that the state was overdependent on the rich.” That’s wrong- the state was not overdependent on the rich. The correct commentary for the article would have been to point out that due to rising inequality, states’ historically consistent level of progressive income taxation is now going to result in an increasing level of revenue volatility. States should take advantage of the many alternative ways for compensating for this increasing volatility, and not make the mistake of worsening the actual problem by reducing the modest progressivity of their income tax systems and thereby increasing inequality.This WSJ article argued that states’ tax revenues have grown increasingly dependent on revenues from high-income earners whose incomes are more volatile in a recession. The article then suggests that because of this increased volatility, states should move away from being overly dependent because it causes so many problems in a recession. Let’s break this argument down:Question: Have states’ tax revenues grown increasingly dependent on revenues from high-income earners? This article only reports tax data for New York (Top 1% pay 41% of income taxes in 2007 versus 25% in 1994), New Jersey & Connecticut (top 1% pay 40% of income taxes pre-recession- 2007?), and Illinois (top 15% paid over 50% in 2007?). Why might there be such high levels? The WSJ actually gives us a really good clue when it describes Illinois’ dependence on high-income households. The article said: “In Illinois, which has a flat income-tax rate of 5%, the top 15% paid more than half the state's income taxes.” So wait, a FLAT TAX still has huge disparities and dependence on high-income households. Why, because they have so much of the state’s income- duh! The only way to not have that result is to actually have a REGRESSIVE INCOME tax system- which you’d then be adding to the other major state revenue source: REGRESSIVE SALES TAXES. Is the WSJ arguing for a regressive state tax system as the solution? Does anyone favor a regressive tax system? I know a tiny fraction of Americans favor a flat tax system, but even I didn’t know that the extremes of the conservative movement (like the WSJ apparently) had move to favoring a REGRESSIVE tax system. Thank goodness the vast majority of Americans still favor a progressive tax system…
Ok, so I’ve pointed out with the Illinois example why a state might be dependent on high-income households even if it had a flat or minimally progressive income tax system (which the vast number of states have, see: http://www.taxpolicycenter.org/UploadedPDF/1001064_State_Individual.pdf ). Basically, high-income households have so much of a state’s wealth so any income tax system is going to depend on them heavily. The only way to avoid that dependence would be a REGRESSIVE income tax system- aka, punishing the most disadvantaged families for being… disadvantaged? Let’s look at a specific state the WSJ article cited: New York (The one for which the article provided the most detail, so the most logical one for me to also closely examine. My findings are applicable to other states as well- and if necessary I will do the research to extend my findings to these other states). The WSJ reported that in 2007, the top 1% of New York households paid 41% of all income taxes. The first question you’d obviously want to ask is how much of all income did these households have? With a flat tax, if they paid 41% of all income taxes, it would have been because households had 41% of all income. Btw, I’ll be making lots of comparisons to a flat income tax system because it’s arguably the most neutral system (everyone pays the same rate), and because it’s what many conservatives would prefer to our current progressive system. Of course, note that the vast majority of Americans strongly favor a progressive tax system. By considering how much income these households started out with, we’ll get a better understanding of just how progressive New York’s income tax system really is. Unfortunately I wasn’t able to find data on just the top 1%- but I did easily find data on a very similar group- the top 1.12% (households making over $500,000), who paid 48.88% of all income taxes in 2007 (source: http://www.tax.ny.gov/research/stats/stat_pit/county_of_residence/analysis_of_2007_state_personal_income_tax_returns_by_place_of_residence.htm ) Of course, you can see that their share of the state’s adjusted gross income equaled 36.88%. That means the ratio of taxes they paid per their share of income was only 1.32. Obviously some of that is a value question, but even in a flat tax system these households would be paying 36.88% of all income taxes. Under New York’s progressive system they pay 48.88%. Are these numbers really shocking? Is this an outrageously progressive distribution? In 2007 New York’s lowest income tax rate (which applied to people making as little as $1) was 4%. The highest tax rate was 6.85%. Is a system that taxes income at varying rates between 4% and 6.85% really that progressive? Or is the California system the WSJ article describe really that progressive (“The income-tax rate on Californians making more than $1 million a year is 10.3%, compared to less than 6% for those making under $26,600”)? I’ve shown why New York’s tax system is so dependent on the wealthiest 1% of households- the vast majority of this dependence is due to the distribution of income, and only a much smaller degree is because of the income tax system’s modestly progressive nature. Wealthy households largely pay a lot of taxes because they are WEALTHY, not because the state is massively concentrating its taxes on these households. Once again, the WSJ failed to bring in this ESSENTIAL piece of context- when analyzing income taxes, you must consider the income distribution underlying the tax system. IT ALWAYS EXPLAINS THE VAST MAJORITY IN VARIATION OF INCOME TAXES PAID.
It’s also important to note that in 2007, only 62.5% of all NYS tax revenues came from personal income taxes; another 21.3% came from regressive “Sales, excise, and user” taxes- all of which reduces the progressivity of New York’s tax system. (Source, p.1, http://www.tax.ny.gov/pdf/stats/stat_fy/2007_08_annual_statistical_report_of_ny_state_tax_collections.pdf ) For instance, the Institute on Taxation and Economic Policy (once again, I’ll go out of my way to enhance the debate by letting everyone know that this source is liberal) studied the state and local tax burden in New York (and across the entire country). ITEP found that New York’s incredibly regressive sales, excise, and property taxes (primarily the state’s very high 4% sales tax rate) combined with the state’s progressive tax rate to generate the following effective tax rate distribution: The bottom 20% of all households paid 9.6% of their income in state and local taxes, while the top 1% paid an effective rate of 9.4%. This is just one piece of evidence showing that New York is not OVERLY DEPENDENT on the wealthiest households. In fact, New York taxes the richest 1% of all households at levels similar to those for the poorest 20% of all households. Once again, it’s quite clear that wealthy households pay a lot of taxes because they are WEALTHY, not because the state is massively concentrating taxes on them. (Source: http://www.itepnet.org/wp2009/ny_whopays_factsheet.pdf )The WSJ article also argues that this dependence (by insinuation related to state tax policy decisions) has been growing over time (Quote: “In New York before the recession, the top 1% of earners, who made more than $580,000 a year, paid 41% of the state's income taxes in 2007, up from 25% in 1994”). However, is this trend really related to tax policy changes? Or is it largely related to an increase in the inequitable distribution of income? Luckily, this question is answerable (too bad the WSJ neglected to examine why dependence on high-income households has grown over time). Unfortunately, the smallest fraction of households for which I can find data from 1994 is the top 4.85% of all households. This means that we will only be able to make rough comparisons of the income-tax system’s dependency on the wealthiest households (top 1.12% in 2007, top 4.85% in 1994)- but they will still give us a very good idea about whether New York has grown more dependent on the wealthiest households because of tax policy changes over time, or because of income distribution changes (aka, inequality has increased).
In 1994 the top 4.85% of all households earned 31.83% of all income and paid 43.57% of all income taxes. (Source: http://www.tax.ny.gov/pdf/stats/stat_pit/cor/analysis_of_1994_ny_state_personal_income_tax_returns_by_place_of_residence.pdf , p. 9) This means the ratio of taxes these top 4.85% of all households paid per their share of income was 1.37. This compares to the 1.32 ratio of the top 1.12% of all households in 2007 (or the 1.31 ratio of the top 3.82% of all households, or the 1.26 ratio of the top 12.65% of all households). These ratios are a measure of progressivity, with the farther the number being away from 1, the more progressive a system is (with a flat tax you’d find a ratio of 1, with a regressive tax system you’d find a number lower than 1). In 1994 the ratio was 1.37- in 2007 the ratio for the households most similar to the 1994 group was either 1.31 or 1.32. This evidence suggests the New York’s state income tax system has actually gotten LESS PROGRESSIVE over time. (It does not prove this since we’re not comparing apples to apples, since data limitations force me to use different groupings in 1994 [4.85%] and 2007[1.12% or 3.82%]). At the very least, the evidence is quite clear the New York’s income tax system has not gotten noticeably more progressive over time- any increasing dependence on the wealthiest households is due to changes in the distribution of income over time, not in tax policy. This result is applicable to other states, and if necessary I'm willing to do the hours of research to establish this point. However, for now I've just started with New York since the WSJ saw fit to include the most data on this state. State finances have grown more dependent on the wealthiest households because INEQUALITY is increasing. The wealthiest households are dramatically increasing their share of the states and nation’s income. Any problems in revenue volatility that states are experiencing are not because tax policy is becoming more progressive. State revenue volatility problems are due to increasing inequality. This is ironic- because the thrust of the WSJ article is that states are overly reliant on wealthy households, so states should reduce the tax burden on the wealthiest households. Of course, this would actually INCREASE INEQUALITY. Essentially, the WSJ is arguing that the solution to the problem is increasing the problem. Talk about your faulty logic.
Interestingly enough, the WSJ article actually found evidence of this trend (increasing inequality), although they didn’t make or emphasize the connection. Here I’ll quote the relevant passage:“Historically, California's tax revenues tracked the broader state economy. Yet in the mid-1990s, Mr. Williams noticed that they had started to diverge. Employment was barely growing while income-tax revenue was soaring. "It was like we suddenly had two different economies," Mr. Williams said. "There was the California economy and then there were personal income taxes."In all his years of forecasting, he had rarely encountered such a puzzle. He did some economic sleuthing and discovered that most of the growth was coming from a small group of high earners. The average incomes of the top 20% of Californian earners (households making $95,000 in 1998) jumped by an inflation-adjusted 75% between 1980 and 1998, while incomes for the rest of the state grew by less than 3% over the same period. Capital-gains realizations—largely stock sales—quadrupled between 1994 and 1999, to nearly $80 billion. “ So did the WSJ article discuss this underlying problem (increasing inequality, a two-tier economy) in-depth? No, the article proceeded to make the broad statement: “Mr. Williams wasn't the only one noticing the state's dependence on the wealthy. Economists and governors had for years lamented the state's high tax rates on the rich, and in 2009 a bipartisan commission set up by then Gov. Arnold Schwarzenegger recommended an across-the-board reduction in income-tax rates and a broader sales tax to reduce the state's dependence on the wealthy.” Did the WSJ point out the irony that this proposed solution to the problem was based on exacerbating the problem? No. Did the WSJ discuss why this solution might be a bad policy change, and why there might be better alternatives? No- although this article presented glimpses of the appropriate and more sensible solution, the WSJ in its rhetorical approach emphasized the solution of reducing taxation on the rich. It did so with its title “The Price of Taxing the Rich,” and lines like “The working class may be taking a beating from spending cuts used to close a cavernous deficit, Mr. Williams said, but the root of California's woes is its reliance on taxing the wealthy.” The article constantly tried to make rhetorical points emphasizing these states’ progressive income tax systems (lots of revenues coming from the richest households for instance). It presented history as simply “Many Democrats refused to consider tax hikes on the middle class and lower rates for the rich.” The article did not explain why Democrats took this stance, and why in fact it’s the sensible one because there are alternative solutions to the increasing volatility of state tax revenues that don’t rely on worsening the underlying problem- increasing inequality.
Robert Frank is wrong when he argues that states’ problem is revenue volatility due to over-dependence on high-income households- the real problem is increasing inequality. The solution is not to increase inequality by reducing the minimally progressive income tax system currently in place. I noticed how the WSJ article failed to discuss state’s options if they reduced taxes on high income households. Since state tax systems are so minimally progressive (See previously cited Tax Policy center report), to accomplish this states would probably have to make their income tax systems flat. To maintain the same level of services, states would have to increase taxes on middle-income and lower-income residents. Or states could cut spending (primary expenditure for states: education, just to name useless area states spend money). However, spending primarily benefits low- and moderate-income residents. Either way, the WSJ is essentially arguing that because inequality has increased, states need to increase the burden on low- and middle-income families. What a great idea! This is after the CBO has demonstrated that from 1979 to 2007, the top 1% of all households saw their real income increase by 281% while the middle quintile saw an increase of 25% and the bottom 20% only saw a gain of 16% (original source: http://www.cbo.gov/publications/collections/collections.cfm?collect=13 ) There are a number of vastly superior alternative solutions to the argument the WSJ article makes for reducing taxes on the wealthiest households. For now, I’ll just discuss two- the problem with states’ balanced budget requirements, and the need for states to build-up adequate rainy day funds that can be used in economic downturns to sustain the state government. 49 states have some form of balanced budget requirement. This means that in every single year expenditures cannot exceed revenues. Of course, economic downturns naturally increase expenditures and reduce revenues, which can make it very hard for states to instantaneously balance their budgets. For instance, in a downturn more people lose their jobs and health insurance, so they turn to Medicaid- a major component of state budgets. At the same time, incomes of many residents decline due to job losses and declines in the stock market for instance. Balanced budget requirements bind politician’s hands at the least-opportune time- in a recession! Eliminating balanced budget amendments would give states’ the flexibility to run the necessary deficits in an economic downturn and avoid the harmful policy changes a balanced budget requirement forces- making the volatility of state revenues a mute point.
I know how much some people LOVE these references, so here I’ll quote what over 100 New York state economists have to say about this issue (in a letter they sent in 2008 to Governor Patterson about New York’s budget). The letter was signed by three Hamilton economists, including Professors Erol Balkan, Jensen, and Georges: “We are concerned, however, that steep state budget cuts will exacerbate the economic downturn and harm vulnerable low- and moderate-income New Yorkers. Constrained by a balanced budget imperative, states face only difficult choices in balancing their budgets during recessions. Economic theory and historical experience gives a clear and unambiguous answer: it is economically preferable to raise taxes on those with high incomes than to cut state expenditures.The reasoning is straightforward: in a recession, you want to raise (or not decrease) the level of total spending—by households, businesses and government—in the economy. That keeps people employed and buying things, and makes it more likely that businesses will want to invest to serve that consumer demand. Budget cuts reduce the level of total spending. Raising taxes on high income households also will reduce spending, but by much less than the amount of the tax increase since those with plenty of income typically spend only a fraction of their income.By contrast, almost every dollar of state and local government spending on transfer payments to the needy and for the salaries of public servants providing vital services to our communities enters the local economy right away, generating a greater economic impact. The New York local spending impact difference is even greater when you consider that much of the higher state income tax will be deductible against federal income taxes, and that non-residents who commute to high-paying jobs in New York will pay much of the increase.Raising taxes and maintaining public expenditures and investments also helps New York and America in meeting its long run needs. America today faces two major problems— inadequate investments, especially in infrastructure, and growing inequality. The poor are particularly dependent on government expenditures, and cutbacks would hurt them the most.”Source: http://www.fiscalpolicy.org/Letter_EconomistsOnFiscalPolicy_December2008.pdf
Requiring balanced budgets every year is clearly bad policy. Why should states be instantaneously responsive to economic downturns? Do states have many functions logically related to the business cycle? Primary state functions measured as a % of spending devoted to them include k-12 education (the number of kids in school doesn’t decline during a recession- it’s possible that it could actually be increasing as a demographic trend), post-secondary education (which actually can see increased enrollment in a downturn because the labor market is so bad people go back to school), criminal justice (the relationship between recessions and increased crime is well established, Medicaid (more people lose employer-provided health insurance in a recession), and the safety-net (more people lose their jobs and qualify for assistance). There is no reason why states should be forced to balance budgets every year, just as there is actual strong evidence and theory that they at the very least should maintain their level of spending and services in a recession- even if revenues decline. Btw, this same argument applies to the federal government. This is why a 2003 survey of the American Economic Association found that almost 90% of its members agreed to the statement “If the federal budget is to be balanced, it should be done over the course of the business cycle, rather than yearly” (Source: http://www.jstor.org/pss/30042564 ). This belief in the automatic stabilizing effects of government expenditures and revenues is part of the reason why over 1,000 economists, including 11 Nobel laureates, signed a letter in 1997 opposing the federal Balanced Budget Amendment being considered then (the last time it was last seriously considered in Congress, source: http://www.ombwatch.org/files/bba/econ.html ). Even if you didn’t want to eliminate states’ balanced budget requirement, state governments could and should be forced to take stronger steps in an economic boom to build up their rainy-day funds (which they draw upon in a recession). This action would compensate for politicians’ tendency to enact spending increases and tax cuts in a boom, which add to state’s structural deficits that are exacerbated in an economic downturn by cyclical deficits. (for a good discussion of this phenomenon and related issues about state budgets, see: http://www.brookings.edu/~/media/Files/rc/papers/2011/0105_state_budgets/0105_state_budgets.pdf ) For instance, CBPP argues that states should build up at least 15% in those funds, as the WSJ article notes. Unfortunately the District of Columbia and 33 states, including California, actually cap (generally below 10%) how much of a rainy day fund they can build up below. Rainy-day funds allow states to moderate how much they have to fiscally adjust in a downturn, even when they have a balanced budget requirement.
In conclusion, states- like millions of Americans- are coming to terms with the impact of increasing inequality. Since wealthy Americans are accumulating so much of the nation’s income, their more volatile economic positions (largely because they are so heavily invested in financial markets) has made states’ revenue collections more volatile (responsive to the business cycle). The WSJ article was wrong when it suggested that an appropriate solution would be to reduce taxes on high-income households. That would just worsen the underlying problem of inequality. Instead states should make a number of alternative revenue collection and procedural changes, including ending balanced budget requirements and improving rainy-day fund financing, to address this problem. This way states can continue their historically consistent level of modest progressive income taxation. This way states don’t increase the pain and problems faced by the vast majority of Americans who have been struggling for decades with very modest income growth. P.S. The WSJ article also had one additional problem I wanted to comment on. Quote: “Tax experts say the problems at the state level could spread to Washington, as the highest earners gain a larger share of both national income and the tax burden. The top 1% paid 38% of federal income taxes in 2008, up from 25% in 1991, and they earned 20% of all national income in 2008, up from 13% in 1991, according to the Tax Foundation.” Once again, this argument is false. You can quickly do the math and see that income tax system’s progressivity has not noticeably changed over time- that changes in federal income collections have almost entirely been fueled by increasing inequality. In 1991 the top 1% of households paid income taxes per their share of income at a ratio of 1.92 (25/13), while in 2007 they paid at a ratio of 1.9 (38/20). By this measure, the progressivity of the federal income tax system has actually decline since 1991. Similarly, the CBO has found that while the federal income tax rate the top 1% faced was 20.6% in 1991, in 2007 it was down to 19%. The changes in taxes paid by the top 1% are entirely attributable to their increasing share of the nation’s income, not increasing progressivity. For the top 1%, the system has actually grown less progressive in the burden they face over time in tax rates. All of this while payroll taxes have increase as a source of federal revenues (even though they are quite regressive, with the bottom 20% paying them at a rate of 8.8% while the top 1% pays them at a rate of 1.6% in 2007 according to CBO). This trend is why the overall federal tax rate the top 1% of all households has faced has declined from 37% in 1979 to 29.5% in 2007. (the year 1979 is determined by this being the first year CBO has quality data sources for). Source: http://www.cbo.gov/publications/collections/collections.cfm?collect=13 Once again, inequality clearly explains the increasing tax collections from the wealthiest households. Yet conservatives want to reduce the tax responsibility, relative or absolute, on the wealthiest Americans who for decades have far outstripped the minimal economic success that the vast majority of American families have experienced. At the state level this would likely mean ending the progressive income tax system. Does it make sense to solve a problem by worsening the problem? Obviously, the answer of any rational person is a resounding NO!
1. Patrick, some states have increased taxes on highest income taxpayers:http://www.forbes.com/2009/05/26/income-tax-new-york-california-personal-finance-estimated-payments.html2. Although you and three of my distinguished colleagues (and CBPP?) may not like constitutional requirements for balanced budgets, these are not going away.
PS. to PAL:1. As a wyckoffian, can you provide us with data (which is greater than intuition) about how skillfully Congress and the President have employed countercyclical fiscal policy in the last fifty years? I2. Well managed states have rainy day funds to use during economic downturns.
I'm not sure if I'll get to the literature on countercyclical fiscal policy, or the Mises Institute article, by tonight. For now I'll just post my comments in response to the other points raised.1. I am well aware that some states have increased tax rates on a fraction of taxpayers. However, all of these provisions were specifically enacted at temporary tax levels in order to prevent massive cuts in services or implementation of broad-base tax increases while states and their residents were experiencing the worst economic downturn since the Great Depression. The NY economists’ letter specifically argued for such tax increases as a better response than shifting the burdens to low- and middle-income residents.Also, the WSJ article took 2007 as its baseline for almost every piece of state data it presented. I did the same thing- and since the temporary tax increases were not enacted then, my response never mentioned these temporary increases in the systems’ progressivity. Unfortunately, it will likely be several years before we will have enough data to quantify the progressivity of these temporary tax rate increases. I checked and I couldn’t find enough of the information necessary to recreate progressivity estimates for years in which the new tax brackets were in place. 2. I am well aware that constitutional requirements for balanced budgets are not going away (as is everyone who studies these issues), even though there is near-consensus among economists that they are a bad idea (for reasons beyond just their limitation of counter-cyclical economic activity). Luckily, rainy day funds can be used by states with balanced budget requirements. However, as I started to discuss near the end of my response- states need to make a lot of changes in their rainy day funds in order to improve their effectiveness. Very few, if any states had adequate rainy day-funds for this recession (though it is important to note that it’s been an unusually long and severe one, no thanks to the Bush administration’s failure to monitor the housing and financial sectors).
Speaking of failure to monitor, your next FBI Director?http://washingtonexaminer.com/opinion/editorials/2011/03/examiner-editorial-anybody-gorelick-fbi-director
A Cuomo rejects the robin hood principle:http://www.nytimes.com/2011/03/28/nyregion/28budget.html?_r=1&hp
I have a pretty interesting case study to demonstrate another way in which people with money get screwed. Not sure if it's relevant, but it certainly is interesting, and shows just how desperate state governments have become for money. The IRS went to my dad's company to perform a yearly audit. They found some minor problems (some things bought over the internet didn't get taxed- nothing serious). The IRS then discovered that the cleaning service my dad's company uses didn't charge for tax (and had not been paying its taxes for the entire year). They gave my dad two choices: pay the cleaning company's entire taxes for the year (they knew they wouldn't be able to get any money out of the cleaning service) OR cooperate with an IRS investigation looking back extensively at the companies' taxes for the past ten years (which would be more costly in both time and money). So the company paid an entire year of taxes because the cleaning lady didn't charge taxes. I just wonder how many other cases there are like this.
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