A common theory, embraced by the Romney campaign, argues that the economy is suffering due to an excess of policy uncertainty. Businesses, the theory goes, don’t know what government tax or regulatory policy is going to be, and so hold off on buying goods and hiring workers until they have more information. There’s not a whole lot of evidence that this is happening at the federal level. But a new paper suggests it could be an issue for states and, in particular, for state taxes.
The University of Michigan’s Nathan Seegert took a look at how state taxes and revenues have changed since the 1950s, and found that they’ve become much more volatile over time.* And because states are required to have balanced budgets, this has lead to a lot of volatility in state spending as well:
What’s causing this? Some of it, surely, is the natural variation in tax revenue between recessions and expansions. Tax revenue fell far below trend in 2001 and 2009, for instance, just as those years’ recessions started to hit. But Seegert found that only 28.95 percent of the increase in revenue volatility is explainable by economic factors.
The bigger problem is that states are messing around with their tax rates, and in particular their income and corporate tax rates, a whole lot, and have started to rely much more on income taxes than on sales taxes, which tend to be more volatile in terms of revenue. Seegert went state-by-state and estimated whether each was relying too much on their income taxes or too much on their sales taxes, relative to what they should be doing to keep revenue stable. Twenty six rely too much on their income tax, while only 10 rely too much on their sales tax:
By contrast, in 1965 only 14 states relied too much on their income tax. Seegert concludes that this shift toward taxing income rather than sales accounts for most of the increased variability in tax revenue, and thus in state spending. That should be concerning both to right-leaning folks who worry about uncertainty, as well as to Keynesians who worry that drops in revenue, and thus spending, during recessions can exacerbate the economic pain at the state level. If you want to keep state social spending relatively constant, then minimizing these fluctuations is key. And if Seegert is right, minimizing them means tamping back on the income tax.
* Hat-tip Tyler Cowen.