Rising Income Inequality is Affecting State Tax Revenues, S&P Reports

Standard & Poor’s Ratings Services’ (S&P) recent report examined the effects of the widening income gap in the US and concluded that rising share of income to the wealthiest Americans has resulted in less tax revenue for the states. The implications of rising income inequality for the states vary.  

States generate a majority of their revenue from taxes levied on current economic activity, primarily income and consumption. Therefore, when the economy operates below its potential, state tax revenues tend to suffer. Insofar as income inequality contributes to economic output falling short of potential, it undermines the growth of states' tax bases, S&P reports. Consumer spending fuels about 70 percent of the economy.

S&P argues that rising income inequality is one factor contributing to slower economic growth and that this represents a structural rather than a cyclical change, making it harder for states to fund all their services. S&P found that wealthier Americans, who have seen the most income gains in recent years, also have higher savings rates than many other Americans, meaning they are likely to hold onto a larger share of their money and not spend it. That means a smaller portion of this money ends up as sales taxes collected by states.

According to the US Census Bureau data, state tax revenue grew an average of 9.97 percent a year from 1950 to 1979. That average steadily fell with each subsequent decade, dipping to 3.62 percent between 2000 and 2009. In addition, as measured by its standard deviation, tax revenue growth has turned more volatile, especially since 2000, S&P says.

S&P’s chart (below) marks the year of 1980 as an inflection point in the data, although many economists believe the wage gap began widening in the late 1970s and early 1980s. S&P states that in the 31-year span from 1980 through 2011, the portion of total income going to the top income percentile doubled to about 20% from roughly 10%. During the same span, the annual average rate of state tax revenue growth declined by half, to below 5% from nearly 10%.

Income inequality is not the only factor that affects state tax revenues. Online retailers in past years account for a rising chunk of consumer spending, yet they often can avoid sales taxes. As consumers have spent more online and on untaxed services, many states have tried to tax things such as Netflix subscriptions and iTunes downloads. Washington State now taxes services at dating centers, tanning salons, and Turkish baths. 

The following map measures Gini Coefficients, differences in national income equality, for each of the 50 states (includes margin of error). The coefficient is a number, between 0 and 1, where 0 implies perfect equality, i.e., every person has the same income, and 1 corresponds with perfect inequality.  As this map shows, states like New York and Connecticut have high levels of inequality, 0.5098 and 0.4994 respectively.  Wyoming and Alaska have low level of inequality and register Gini indices between 0.4083 and 0.4083.