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The Mysterious Boost in State Tax Revenues

In year-over-year terms, state tax revenues have been rising throughout 2010, reaching a high of 6.8 percent real growth in the fourth quarter. Given the dramatic impact of the recession on their budgets, state governments will certainly welcome this positive news. This is especially the case as federal aid to states is set to dry up at the end of August. There is reason to be cautious when evaluating these data, however, because it is unclear where the surge in revenue is coming from.

Figure 1. Four-Quarter Percentage Change in Tax Revenue

Although there is considerable variation across states in the composition of their revenue, on average states get most of their revenue from taxes. A substantial fraction of revenues comes from federal transfers, and a little less than 20 percent comes from fees and other miscellaneous items. With federal aid scheduled to be reduced in September of this year, the importance of taxes is going to rise.

Figure 2. Four-Quarter Percentage Change in Tax Revenue

Just as with the composition of revenue overall, the composition of state tax revenue differs widely across states. On average, however, about two-thirds of state tax revenue comes from two primary tax sources: personal income taxes and sales taxes. Both of these tax sources have been rising in the past four quarters relative to the year before.

Figure 3. Composition of State Tax Revenues (Average 1994 - 2010)

The rise in sales tax revenue is not surprising; consumption has been rising as well. The sharp increase in personal income tax revenue, however, is harder to explain. Breaking out the major taxable components of income (as defined by the Rockefeller Institute of Government) does not reveal the source of the increase. Real growth in wages and salaries, nonfarm proprietor’s income, and interest and dividend income have all remained below 2 percent.

Figure 4. Four Quarter Percent Change in Major Components of Taxable Income

What then can account for the rise in income tax revenues? One likely suspect is capital gains. Capital gains are realized only when assets are sold, and investors’ decisions to sell are influenced not just by the degree to which their assets have increased in value but also by concerns about the cut that taxes will take from those gains. Potential tax changes were being discussed in 2010 that could have raised capital gains taxes, and uncertainty about the future tax burden may have encouraged investors to take their capital gains before the start of the new year.

There are two reasons to suspect that such uncertainty caused capital gains to be especially high in 2010. First, there was uncertainty well into December of 2010 over whether federal tax rates on capital gains would rise back to their pre-2001 values. Faced with the possibility of tax rates rising steeply if tax law were allowed to sunset and no realistic chance of those tax rates declining, some individuals may have chosen to realize their capital gains before the end of 2010.

Second, a law removing income restrictions on the conversion of a traditional IRA to a Roth IRA went into effect in 2010. Making that conversion requires taxes to be paid on the amount converted. As a special one-time offer, the IRS did allow individuals to spread the capital gains from converting over 2011 and 2012, but some individuals, being uncertain about the future of capital gains tax rates, may have chosen to realize the gains in 2010.

Either of these factors would result in increased income taxes for states that tax capital gains. Unfortunately, it is nearly impossible to ascertain at this time whether those gains were the source of states’ surprise revenue boost. The states don’t report capital gains revenue consistently or in real time, if at all. So for now, we can only surmise. But this likely scenario suggests that the boost could be as transitory as it is mysterious.

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