U.S. Economy
Income Taxes and Fiscal Distress

Lori L. Taylor discusses the heightened economic vulnerability of states that rely on income taxes and the fiscal situation in Texas.

Many states have constitutional balanced-budget provisions. Such provisions can force state and local governments to raise taxes or cut spending during recessions or nascent recoveries. If too many states in fiscal distress adopt contractionary policies, the national recovery could be at risk.

Not all states are facing the same degree of fiscal distress, however. Because consumer spending has held up remarkably well in this recession, so too have sales tax revenues. Similarly, the strength of the housing sector has dampened the recession’s impact on property tax revenues. On the other hand, revenues from personal income taxes have plunged along with the stock market (Chart 1).

Chart 1

Given the pattern of tax receipts, state and local fiscal policy is likely to be much more contractionary in states that rely heavily on income taxes. As the map in Chart 2 shows, some states rely much more heavily on personal income taxes than others. Massachusetts and Maryland get 20 percent of their total revenues (and more than one-third of their tax revenues) from personal income taxes, while seven states (including Texas) get no revenue from personal income taxes. In general, the Northeast and the West Coast are more reliant on personal income taxes. By this measure, they are also more exposed to a fiscal shock than the rest of the nation.

Chart 2

The state of Texas is not in fiscal distress. Revenues exceeded expenditures during the 2002 fiscal year, allowing the state to add $80 million to its rainy-day fund and bringing the balance in the state’s saving account to just under $1 billion.

Press reports citing a budget shortfall refer to the upcoming two-year budget cycle. Spending requests for the 2004–05 fiscal biennium are running about 5 percent ($5 billion) ahead of revenue projections. However, because both spending and revenues are projected to be higher in the next budget cycle than they are now, the state is not facing the prospect of a fiscal contraction.

While the state is not in fiscal distress, local conditions are less favorable in some parts of the state. For example, the city of Dallas and a number of large Texas school districts have either increased taxes recently or indicated that they plan to do so this fall. In contrast, the city of Houston does not project any tax increases or service cuts this year. Scattered local tax increases may redistribute economic activity within Texas but are unlikely to be much of a drag on the state as a whole.

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