Replacing Missouri’s Income Tax Would Reduce Revenue Volatility

As each month passes, Missouri’s fiscal outlook gets bleaker. The state started the fiscal year on July 1 with a balance of $833 million. As tax revenues plummet, however, the Office of Administration says it’s likely that the majority of that surplus will be gone by the start of fiscal year 2010. Incoming Gov.-elect Jay Nixon’s transition team anticipates a revenue shortfall this fiscal year of at least $340 million.

Some state lawmakers have responded by urging tax increases to fill the gaps, but that’s a dangerous course. Revenues are down because the economy is slumping, and an almost certain way to make things worse — not only for government, but for families and businesses — is to raise taxes.

There are better solutions for the state. Rather than a tax increase, these alternatives would require implementing wiser tax policies that provide revenue streams with less sensitivity to cyclical upturns and downturns. That means relying less on taxing individual income.

Nearly two thirds of Missouri revenue comes from the individual income tax. I would not be opposed to such a heavy reliance on the income tax if it made for sound fiscal policy, but it doesn’t. The income tax is highly sensitive to the overall economy, making it volatile. As a result, income tax revenues are subject to greater volatility during expansions and recessions. Public officials may value the extra income that this brings during expansions, but are forced to scramble for extra revenue during recessions. The bottom line is that the greater revenue volatility associated with income taxes makes it harder for state and local lawmakers to govern.

It’s one thing to point out a problem, but it’s also important to provide a long-term solution. Rather than raising taxes, I propose shifting to a less volatile tax. The best course would be to increase the state sales tax. I know that this runs counter to what many people believe, but my own analysis shows that from 1965 to 2006, annual income tax collections in the state of Missouri were 50 percent more volatile than sales tax collections.

It’s important to understand that my figures look at the average annual fluctuation over a 41-year period. In some individual years, the sales tax was more volatile than the income tax. Indeed, we’re going through a period now where the sales tax is hitting a deeper trough than the income tax. But, on average, sales tax collections have been subject to fewer cyclical fluctuations than have income tax collections. The point is that greater reliance on sales tax revenues would have resulted in less volatility over time than our current reliance on income tax revenues. Even in the face of income gyrations, people have needs — and those needs frequently take the form of consumption that is subject to the state sales tax. Although reducing revenue volatility is not the only mission of a state tax structure, it is an important hedge against business cycles, when states would otherwise face large spending cuts.

Missouri can also do more to make the sales tax even less volatile than it has been historically. Today, about 140 products and services are exempt from the sales tax. If that list were pared significantly, thus broadening the sales tax base, sales tax collections would be more stable, and the annual swings even smaller.

There is another economic argument for altering our state’s tax structure: By replacing the income tax with a sales tax, faster economic growth will follow. Income taxes act as a drag on growth because either businesses must pay higher wages to compensate, or employees will work fewer hours, cutting into productivity. Consider the nine states without an income tax. From August 1998 to August 2008, those states added more than 4 million jobs, a 16.3-percent increase that doubled the national job growth rate.

Business cycles will not disappear. When unexpected economic downturns occur, tax revenues fall. The question is: Which tax structure will best mitigate fluctuations in the state’s revenue collections? History and economics tells us that reliance on sales taxes will achieve this goal. With less revenue volatility, there will be correspondingly less pressure on lawmakers to enact short-term fixes that can produce long-term problems. That’s why I favor a long-term solution based on four decades of observation. If the people of Missouri value more stability in the state’s tax revenue streams, they should start by taking the income tax out of the equation.

Joseph Haslag is executive vice president of the Show-Me Institute and a professor in economics at the University of Missouri-Columbia.