Looking at Mid-Year Budgetary Shortfall and Income Tax Rates

The Center on Budget and Policy Priorities released a report last week about state budget shortfalls, “Recession Continues to Batter State Budgets; State Responses Could Slow Recovery.” (Link via an article on the Wall Street Journal: Real Time Economics blog).

This made me wonder the the following: Are income taxes correlated with a higher mid-year budget gap as a percent of the FY2010 General Fund Budget? Do states that have no income tax have a lower incidence of mid-year budgetary shortfall?

In an attempt to answer this, I took Table 1 from the CPP report, and added the states that do not have a budget shortfall (Alaska, Delaware, Michigan, North Carolina, Oregon, Texas, and Wisconsin) and those that have a surplus (Montana and North Dakota). I sorted this table by the percentage of budget gap over the 2010 general fund budget. Next, I added the top marginal tax rates for personal and corporate income for each state. The green cells indicate states that assess zero income tax, and the red cells indicate states that have income tax rates of  9.0 percent or greater.

Projected Mid-Year FY2010 Budget Gaps as a Percentage of FY2010 Fiscal Budget by State

(Modified to Include Income Tax Rates and States With Zero Shortfall)

* Washington is reflected low in the list because the amount shown is for the two-year budget, ending in FY2011.

The states that have no income tax are disproportionately aggregated at the top of the list. This graph indicates that states without an income tax may be better at predicting their revenues in the future. I can think of a few reasons why this is, and I invite our blog readers to suggest additional reasons in the comments.

• Sales taxes are a less volatile source of revenue than income taxes.
• Income taxes are closely tied to the job market, and sales taxes are not. When a person loses her job, she then has zero earned income, and therefore generates zero income tax revenue for the state. During this period of unemployment, however, she continues to make purchases and pay sales taxes (either by using personal financial reserves or unemployment compensation).
• Sales taxes are more effective than income taxes in addressing budget shortfalls more immediately, because they are collected at the point of transaction. Income taxes, in contrast, are collected only once per year. States do not have to wait until residents file their income taxes in order to collect revenue.

Notice that Missouri is ranked 37. This means that 36 other states were able to forecast their budgets better than Missouri. Perhaps if Missouri repealed its income tax in favor of a broad-based sales tax, it could predict its revenues better, and it wouldn’t face such a shortfall in the future.