Consumption Taxes, Income Taxes, and Revenue Stability - States and the Great Recession

This paper challenges the conventional wisdom that taxes on consumption are more stable through the business cycle than taxes on personal income, using the Great Recession as a test case. We first estimate the effect of tax shares from the personal income tax and taxes on consumption on the level and distribution of tax burdens across states, using Citizens for Tax Justice microsimulation estimates for all states. We find that while both higher income tax shares and higher consumption tax shares are associated with higher average tax burdens, a higher income tax share increases state progressivity, while a higher consumption tax share makes the tax burden more regressive. We then estimate a regression of tax change on tax burdens and AGI changes by income slice. We find that states with highly unequal income distributions and concentrations of capital gains had more volatile tax bases, but that this volatility did not systematically translate into more volatile tax revenues. We then use predicted tax burdens from the first stage to simulate the change in state taxes during the great recession. Finally, we simulate the effect of bring a state’s tax structure closer to national average income and consumption tax shares. Contrary to expectation, we find that states with the greatest reliance on the income tax would have experienced more volatility with a more balanced tax structure, while states with the least reliance would have experienced less volatility. Though there were a few states with higher income tax shares and greater volatility - e.g. California and New Jersey – some states with no income tax - e.g. Florida and Nevada - suffered the greatest hits from the recession. The conclusion is striking, and important for tax design. While policies which reduce the role of the personal income tax in state tax systems are likely to shrink the overall size of the public sector, in so doing they are also likely to shift the tax burden from the top 20 percent to the lowest 80 percent of the income distribution, and offer little or no gain in revenue stability.

Paper

Consumption Taxes, Income Taxes, and Revenue Stability: States and the Great Recession (as PDF, 688 KB)