As the Wall Street Journal reported in “The Price of Taxing the Rich ,” states heavily dependent upon income taxes have been hit especially hard in the economic downturn. For example, the top 1 percent of income earners in California paid almost half of the total income tax collected by the state. When you combine this with the fact that income taxes make up 43.9 percent of the state’s revenue, you have a recipe for a budget disaster in hard economic times. In 2009, states collectively overestimated their income tax revenues by $50 billion.
States with highly progressive income tax systems are especially susceptible to budget shortfalls because those who make the most income typically lose the most income during a recession. Between 2007 and 2008, top income earners saw their incomes fall by 16 percent while the U.S. average was only 4 percent.
From 2007 to 2009, Ohio adjusted gross income fell approximately 20 percent as did the total income tax liability for the state ($1.9 billion). This drop in part contributed to the $8 billion budget deficit considering that the income tax is the largest source of revenue for the state and comprises roughly 40 percent of the budget.
Because so many of Ohio’s top income earners actually earn substantial portions of their incomes out of state (think owners of large corporations) and thus pay income taxes in those states, Ohio is not overly dependent on income taxes from the wealthiest 1 percent of its citizens. The top 1 percent of income earners in Ohio (those who made over $300,000 in 2009) only pay 22 percent of the income tax liability. However, without the various tax credits, particularly the resident/non-resident credit for income earned out of state, the top 1 percent would pay 39 percent of all income taxes.
There are two lessons in all of this for states. First, to avoid budget crunches in economic downturns, states should not be overly dependent upon income tax revenues from their wealthiest citizens who have the most volatile incomes. Second, for the sake of stability, it would behoove states not to be overly dependent upon income taxes in general. Having an income tax isn’t necessarily a bad thing. However, income tax dependency is a definite problem for states such as New York, California, and Ohio that rely on this source of revenue to fund over 40 percent of state operations. These high tax states could all benefit from broad base tax reforms that diversify revenue sources and lower the overall tax burden.