Conventional wisdom in public-finance circles for many years encouraged state governments to increase their reliance on personal income taxes. After all, the academic experts would point out, personal income is less volatile than corporate profits and tends to grow faster than retail sales. Besides, by injecting more "progressivity" into their tax codes, politicians could expand popular programs for the masses while passing on most of the costs to a relatively small number of high-income households.
Now, in the midst of an economic slowdown that has given rise to a fiscal Great Depression in most states, governors and legislatures are learning the pitfalls of progressivity.
While substantial deficits have cropped up all over the country during the past two years, by far the worst revenue declines have been in those states most heavily dependent on personal income taxes. This is no coincidence.
California, Connecticut, Massachusetts, New York and New Jersey all boast large concentrations of the sort of high-rolling investors, option-enriched corporate executives and dot-com pioneers who got rich in the boom of the late 1990s. Thanks to their income taxes, all five states effectively got drunk on the stock market's returns. And all are now experiencing severe fiscal hangovers in the aftermath of the market's decline, the recession and the 9/11 terrorist attacks.
Take New York. Starting in 1995, Gov. George Pataki cut state income taxes by an average of 25% -- and revenues over the next five years rose 63% anyway. The state became increasingly dependent on taxpayers near the top of the income scale. By 2000, the 3% of New York State taxpayers earning over $200,000 generated over half of state personal income-tax receipts. With a population approaching 19 million and the equivalent of the world's eighth-largest economy, the Empire State derived nearly one-third of its revenues from fewer taxpayers than live in a typical congressional district.
The distribution of the tax burden was even more skewed in California, which has the country's most steeply progressive income tax. Just 44,000 millionaires were paying more than one-third of the state income tax in 2000, right before the bubble burst.
While these were dream scenarios for progressive-taxation enthusiasts, they led to the fiscal nightmare these states are experiencing. In New York, revenue from capital gains dropped from roughly $3.7 billion to barely $1 billion in a couple of years. In California, taxes derived from capital gains and stock options plummeted from $18 billion to $8 billion in a single year. Connecticut and New Jersey experienced similar declines on a smaller scale. So did Massachusetts, although it has the group's only flat-rate income tax.
Now that these states have been reminded so pointedly of their dependence on the economic well-being of a relative handful of wealthy taxpayers, you might think they'd avoid giving these people an incentive to invest less, work less or move elsewhere. But you'd be reckoning without the baneful influence of "fairness" lobbies, led by politically influential unions and public educators intent on minimizing spending cuts.
Proponents of state income-tax increases make similar arguments everywhere the issue is debated. The rich can afford it, they say. And besides, the cost will be offset by the deductibility of state taxes on federal returns. (In fact, most of the targeted taxpayers are subject to caps on itemized deductions, and many are caught up in the federal alternative minimum tax, which excludes deductions for state and local taxes.)
Swayed by such interest groups, Connecticut legislators this year boosted that state's income tax rate from 4.5% to 5%, and they aren't done yet. Democrats in the lower house of the state Legislature are pushing for a "millionaire's tax" that would push the top rate to 5.9%. If it passes, despite the opposition of Gov. John Rowland, Connecticut will for the first time have a higher income tax than neighboring Massachusetts.
The Bay State, in turn, has canceled its scheduled elimination of taxes on long-term capital gains, which had been a major accomplishment of former Gov. William Weld. Now that they're near the vanishing point, all capital gains in Massachusetts will again be taxed at the same rate as other income.
In New York, Senate Republicans and Assembly Democrats joined to override Pataki's vetoes and pass a record tax increase that will, among other things, boost the 6.85% top tax rate back to 7.7% on taxable incomes over $500,000 (and to 7.5% on those starting as low as $100,000). Given continuing spending appetites and projected budget gaps for the foreseeable future, few believe the tax hike will expire, as scheduled, in three years.
The state increase could be compounded in New York City, where Mayor Michael Bloomberg has won the Legislature's permission to raise the city income tax at the income levels affected by the state hike. This would leave Gotham with a combined top rate of 12.15%, easily the highest in the country.
New Jersey enacted a massive business tax increase last year, and groups intent on preventing spending cuts are zeroing in on the upper brackets of the personal income tax, although Gov. Jim McGreevey so far is resisting.
In California, which began the year facing a deficit bigger than the entire budgets of most states, Gov. Gray Davis is seeking hikes that would raise the top income tax from an already sky-high 9.3% to 10.3%. This proposal faces strong opposition from legislative Republicans, but given the size of California's fiscal problems, the danger of income-tax increases will linger for years.
Recent history doesn't bode well for states that raise taxes in a recession. California, Connecticut, Massachusetts, New Jersey and New York all enacted significant increases from 1990 through 1992. During that span, they collectively lost 1.2 million jobs. Their job growth lagged far behind the national rate until they began rolling back taxes in the decade's latter half.
The potential negative consequences of bad state tax policies should be viewed with concern by the entire nation -- especially when such policies are on the table in California and New York, which together account for almost a quarter of the national economy. If these big states pummel investors with higher tax rates, they will undercut much of the economic benefits from President Bush's accelerated federal income-tax cuts.
In the short term, the best course for any state is to avoid tax increases, especially income-tax hikes.
In the long run, states saddled with progressive, soak-the-rich or investor-dependent income-tax codes should move toward a consumption-based system that exempts investment income. If such taxes had been in place in these states during the late 1990s, spending, by necessity, would have increased more slowly, and revenues would have decreased less sharply. These states would still have deficits, but they'd be much more manageable. And we'd all be better off.