August 14, 2003

State Sales Tax vs. State Income Tax

Chip Taylor comments on Rich Hailey's post below regarding Oregon's massive revenue shortfall vs. Tennessee's small revenue surplus - and what it says about Oregon's reliance on an income tax vs. Tennessee's reliance on a sales tax. And he notes a study, by none other than University of Tennessee economist Dr. Bill Fox, that says a sales tax is better during a sluggish economy than an income tax.

Huh? That's NOT what Fox was saying in Tennessee during the four-year debate over the proposed creation of a state income tax. Then, he was saying an income tax would be better for Tennessee. Perhaps he meant better for the University of Tennessee - which stood to gain a substantial increase in funding for, among other things, faculty pay, if an income tax passed.

Taylor summarizes a paper, authored by Fox, titled Three Characteristics of the Tax Structures have Contributed to the Current State Fiscal Crises:

Fox presents tax revenue elasticities for various types of state taxes for the nation as a whole. During the 1990s, personal income tax elasticity was 1.12, meaning that tax revenues grew faster than the base, personal income. Sales tax elasticity, on the other hand, was 0.96, which means that sales tax revenue grew slightly slower than personal income. In other words, a state that relied more on sales tax and less on personal income tax wasn't as likely to see the booming revenue growth experienced by a state that relied more on personal income tax and less on sales tax.

But, when the economy went into recession, the drop off in revenue wasn't likely to be as steep either. For example, Fox notes that from 2001 to 2002, personal income tax revenues fell by 10.2%; sales tax revenues by 0.9%.

The difference in taxes seems likely to affect fiscal policy decisions, too. States with slower growing revenue during the boom were probably less likely to increase spending by starting new and expensive programs. States that saw a boom in state revenue were more likely to find new ways to spend it. Those decisions served to magnify the pain of falling revenues.

So, yeah, I bet the differences in Oregon's and Tennessee's tax structures do have a lot to do with how they are recovering from the recession.

In short, the lesson of Oregon and Tennessee - backed up by Fox's calculations - is this:

1. During boom economies, sales taxes generate restrained revenue growth that prevents state governments from going hog wild on the spending, while income taxes generate surging revenues that encourage profligacy.
2. During sluggish economies, states that rely on income taxes get hammered from both sides, seeing massive revenue declines that can't possibly continue to fund their prior profligacy. States that rely on sales taxes face no such squeeze.

Of course, another way to fiscal discipline is to enforce it with something like Colorado's Taxpayers Bill of Rights, as I explain in this paper. A Taxpayers Bill of Rights, by limiting government to the amount of additional revenue it can keep and spend each year, prevents government from engaging in rapid expansion during boom years, thus lowering the base budget that must be funded in future lean years when revenue growth declines. Colorado is proof it works.

Also see this post from almost exactly one year ago.