Report: Caution warranted despite robust income tax growth in the first quarter of 2017

Last week, we published an article that addressed South Dakota’s lawsuit over the state’s ability to tax internet sales made by vendors that lack a physical presence in the state. Whether states will finally be able to capture those otherwise lost tax revenues is now in the United States Supreme Court’s hands.

In addition to the dearth of sales tax revenues with which states are contending, our article also discussed the volatility of revenue streams that compounds already precarious fiscal situations. We pointed to an October 2014 Pew Charitable Trusts article, “Volatile Income Tax Revenue Stumps States,” which asserted that even though some states’ tax collections have recovered somewhat since the recession, and in fact are expected to rise, this growth “is anemic compared to years preceding the recession.”

Pew is not the only one to recognize the trend of hard-to-manage volatility despite increasing tax collections. A September 2017 Rockefeller Institute of Government state tax revenue report, Volatility in State Tax Revenues; Mounting Fiscal Uncertainties, concedes that “state and local government tax revenues showed relatively strong growth in the first quarter of 2017, compared to the recent past.” This trend is attributable to two things: first, the shifting of bonus payouts out of 2016 to 2017, and the second, which is of greater concern, is that income tax growth in just two states, California and New York, is partially behind the uptick.

In fact, the “changes in revenue growth underline increased volatility and uncertainty in revenue streams,” especially at the state level; local governments have been hit less hard. Even so, generally, governments that rely disproportionately on sales taxes or income taxes, and those in oil producing states, “are likely to be faring much worse than average.”

The more recent volatility in state tax revenues that the Rockefeller report describes underscores, in more detail, the trouble spots that we touched on last week. The report identified six specific causes:

• Substantial weakness in income taxes in 2016, followed by stronger growth in the first quarter of 2017. Most of the volatility in income tax revenues was caused by the inconsistency in estimated payments and final returns.
• Volatility in estimated and final payments in the most recent years, in turn, was caused by the unstable stock market, and taxpayer gaming in anticipation of federal income tax rate cuts.
• Continued weakness in sales tax collections, consistent with weak growth in taxable consumption. The report identifies sluggish nondurable goods consumption in 2015 and 2016, which recovered some in the first half of 2017. Sharp declines in oil and gas prices, which led to declines in spending on gasoline and other energy goods that do not appear to have been compensated for by increased consumption of other taxable items, account for this fragility.
• Outright declines in corporate income taxes since the Great Recession. In the 1980s, corporate income taxes accounted for 8.4 percent of total state tax revenues; in the 1990s, that figure was 6.8 percent. In the last five years, the number fell again to about 5.2 percent. Though there was a seemingly alarming drop of 26.9 percent in the first quarter of 2017, this is mostly a timing issue, stemming from the Internal Revenue Service’s change extension of the income tax return filing due date, for returns and final payments, from March 15th to April 15th for C-corporations. Data for the second quarter suggests that corporate income tax collections are recovering, also because of filing due date changes.
• Extreme weakness in oil-producing states. Although oil-related revenues grew in the first and second quarters of 2017, this is merely a reflection of an increase from the very low revenue levels of the previous two years, and is no cause for celebration.
• Natural disasters, like Hurricanes Harvey and Irma, which left Texas and Florida with significant fiscal damages, and 2005’s Hurricane Katrina, which did the same in Louisiana, have a years-long impact on tax collections in the states they affect.

Income tax collections

The Rockefeller report reveals that in the first quarter of 2017, personal income tax revenues grew 8.2 percent in nominal terms, and 6.2 percent in inflation-adjusted terms, relative to the same period in 2016. All of 2016 was relatively weak for states’ personal income tax revenues, so the growth in 2017 is not an indication of overall strength; as noted above, New York and California prop up those figures disproportionately. Excluding those two states, personal income tax collections grew at just 5.5 percent, though in the Southwest region, that rate was 16.7 percent. In New England, growth was only 1.1 percent.

In ten states, there were personal income tax collection declines. North Dakota fared the worse, with a 6.6 percent drop, due to two things: 1) income tax rate cuts; and 2) employment slow-downs in the oil production business.

As for corporate tax collections, the category is highly variable by its nature. Because many states collect so little corporate tax revenue, what appear to be significant fluctuations due to the percentage changes actually have only minor impact on state budgets.

Ultimately, tax revenue trends are accounted for by economic changes, which states weather in unique ways relative to each other and legislative actions, like modifications of tax rates, deduction amounts and consumption taxes of, for instance, cigarettes and fuel. Looking to these factors, the outlook for fiscal 2018 remains weak; median income tax and sales tax growth are projected to be 4.2 percent and 3.7 percent respectively. Low oil prices are not helping, nor is political uncertainty. “States will need to stay alert in the coming months and do their best to estimate the impact of potential and actual federal tax reform on state budgets,” concludes the report.