Last week I discussed the problem with periodical “under-funding” of schools in Arizona. I pointed to the obvious fact that tax revenue decline in recessions, and that it is meaningless to design school funding formulas that do not take recessions into account.
At the same time, it is also important to recognize that not all the fault lies with the funding formulas. The Arizona tax system also contributes to the cyclical variations in tax revenue, primarily because it directly and indirectly relies on personal income as its most important tax base.
The simple yet forceful fact is that the more a government depends on personal income for its tax revenue, the more volatile the tax revenue will be. In Arizona, taxes directly on personal income – the income tax – account for 27 percent of total state tax revenue. However, 61 percent of the state’s tax dollars come from sales and gross-receipts taxes, which essentially are taxes on select parts of household spending. Household spending depends directly on personal income, meaning that as much as 88 percent of Arizona state tax revenue depends on personal income.
When personal income changes, so do taxes based on that income.
So how can we minimize cyclical swings in tax revenue? In order to find a solution, let us look a bit more closely at the problem. In 2014 Arizona families paid the state more than $3.5 billion in personal income taxes. Those taxes were determined by five income tax brackets, which happen to raise the tax rate right in the “sweet spot” of middle-class family incomes.
This so-called progressive income tax system is a key contributor to tax revenue volatility. When families earn more money their tax liability goes up by more than their income; correspondingly, a drop in income reduces their tax burden by more than their income loss.
These variations in income tax revenue are so strong that they show up in total state and local income tax data. For every one percent of change in personal income, Arizona state and local tax revenues change by 1.54 percent. Almost all of this volatility is traceable back to the income tax.
This may sound like an insignificant technical detail, but it is quite a powerful little number. It means that if the income earned by individuals in Arizona is reduced by $100 million, the state, cities, counties and school districts will, on average over time, see their tax revenue drop by a total of $154 million.
Volatility in tax revenue gets really tough in recessions. In 2009, for example, for every $100 of income that individuals lost, state and local tax revenue declined by $548.
States without income tax tend to have much less fluctuations in their tax revenue. This is not a rock-solid correlation – Wyoming is a notable exception – but it holds for the most part. To illustrate, let us compare Arizona to Florida where property-based taxes are responsible for much more revenue than in Arizona. In fact, 98 percent of state revenue comes from motor-vehicle taxes, while personal property taxes account for 15 percent of all personal taxes in Florida. Compare that to less than seven percent in Arizona.
With their heavy focus on property, Florida governments can rely on a much more steady stream of tax revenue than their peers in Arizona. While the revenue volatility in Arizona is, as mentioned earlier, 1.54, it is only 0.06 in Florida. In other words: practically non-existent.
A telling example is, again, 2009 when the recession forced Arizona tax revenues into a virtual tailspin. In Florida, state and local tax revenue increased. For every $100 that Florida families lost in personal income, the collection of personal tax revenue went up by $42.
It makes sense, of course, that this would be the case under a system where taxes are independent of the individual taxpayer’s actual earnings. But it is nevertheless important for taxpayers and voters in Arizona to consider. As things are today, school districts complain about under-funding in a recession; at the same time households get a little bit of tax relief when a recession bites into their earnings. But the complaints from school districts are ultimately expressed by representatives of the very same taxpayers whose tax burdens are somewhat cushioned by a decline in income tax rates.
A tax base that is less prone to swings during recessions would certainly make it easier for the state and local governments to provide stable funding for their operations. This, of course, includes schools as well. It would mean that taxpayers would see less of a tax-burden relief in recessions. At the same time, their tax burden would not rise as closely with their earnings in good times either.
These are not simple matters. It boils down to the question: how important is it that government has a steady, predictable tax revenue?
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Sven Larson, Ph.D., is an economist and Member of the Council of Scholars of Compact for America. He is the author of Industrial Poverty (Gower Publishing) about the debt crisis in Europe. Find his daily blog articles at America’s Fiscal Future.