Published in Public Finance Review, 2017
Howard Chernick, Hunter College and Graduate Center, CUNY; and Cordelia Reimers, Hunter College and Graduate Center, CUNY
The major sources of state tax revenue are personal income taxes and taxes on consumption – general sales and gross receipts taxes and excise taxes on tobacco, alcohol, and gasoline. Which source of tax revenue was more stable during the Great Recession? Contrary to conventional wisdom, we find that personal income taxes were a more stable source of revenue than consumption taxes during the Great Recession.
The conventional wisdom says that consumption taxes are more stable than taxes on income because the consumption tax base is less elastic than the income tax base with respect to changes in aggregate income (Tax Foundation 2013). We question the conventional wisdom that heavier state reliance on income taxation as opposed to consumption taxes increases the sensitivity of tax revenues to the business cycle. Our results show that for high income tax states, shifting to a more consumption-based tax structure would impose considerable reductions in tax progressivity, but would not have reduced the cyclical sensitivity of tax revenues during the Great Recession. If states with high income tax shares were to lower their reliance on the income tax, the revenue decline during the recession would have been greater; while states with high consumption-tax shares would have had smaller declines in tax revenue if they had higher income tax shares.
Using the Great Recession as a test case, we show that even controlling for policy responses, the shares of state taxes from the personal income tax and sales and excise taxes at the outset of the recession are unable to explain the variation in the change in tax revenue across states. By contrast, we find that an income distributional approach, in which the shock to different income classes is interacted with differences in effective tax burdens by income class, is able to explain a substantial portion of the variability of tax revenue changes during the Great Recession.
The interactions between tax burdens and recession-related shocks to the tax base by income class are key to our finding that states that rely heavily on income taxation were not more cyclically unstable than high consumption tax states. A second factor is that, among those states with highly unequal income distributions and heavy reliance on income taxation, there was a greater willingness to offset the recession shock by imposing income tax surcharges.
We emphasize that our study is based on a single, albeit important, episode – the change in state tax revenues from 2007 to 2009 induced by the Great Recession. We do not claim to have proved that the conventional wisdom – that consumption taxes are more stable than income taxes – is always incorrect. To be able to do so, our approach would have to be applied to a longer time period than just two years, in order to incorporate multiple downturns and recoveries.