How rising income inequality affects state tax revenue

Standard & Poor’s made a big splash last month by releasing a report arguing that income inequality is reducing economic growth. But a report from the credit-rating agency released yesterday authored by its credit analysts—those responsible for determining credit ratings for state and local governments—might fly under your radar. It shouldn’t. The reason: the report provides a concrete example of how rising income inequality may pose an unexpected challenge for policy makers.

S&P’s job is to assess the risk of bonds or other fixed-income investments and the creditworthiness of the governments and corporations who issue them. In the United States, state and local governments can issue bonds whose interest is exempt from federal taxes. These “munis” are thus the central way our basic public infrastructure is funded. So analysts at the company have an interest in factors that affect the budgets of state governments.

According to the new report, rising income inequality is a factor that affects the creditworthiness of state governments, and thus their cost of borrowing and the tax revenue required to pay off their bonds. Over the past several decades, incomes have shifted upward while the tax code hasn’t responded. The result: states are collecting less tax revenue.

State tax systems have always been problematic when it comes to inequality. In fact, every single state tax system is regressive, putting more of a burden on medium- and low-income families. These tax regimes are highly dependent upon sales taxes, which are regressive, relative to income taxes, which tend to be progressive.

More progressive taxation would help alleviate the declining level of revenue, the S&P analysts point out, but it would make revenue more volatile. Top incomes are more volatile, especially now as those incomes have shifted away from labor income and toward capital gains on their investment income. So with the current high levels of income inequality, state governments may to have to choose between lower levels of revenue or more volatile revenue.

What’s also interesting about the new S&P report is the emphasis on bolstering the revenue side of state financial ledgers. For years, credit rating agencies have emphasized the importance of reining in costs and spending at the state and local level, particularly when it comes to the issues of public pensions.

The revenue situation is tricky because state governments have to run balanced budgets each year. If revenue is low, then governments will have to slowly pare back on spending, which could result in cuts to programs, such as higher education, that promote long-run economic growth. Or if revenue is volatile, then they have to sharply pull back on spending during recessions, which prolongs any economic downturn.

These spending cutbacks don’t just affect growth and stability. They also have implications for economic inequality. A paper by economists Laurence Ball, of Johns Hopkins University, and Davide Furceri, Daniel Leigh, and Prakash Loungani—all at the International Monetary Fund—finds that fiscal consolidation, or attempts to reduce budget deficits, ends up raising inequality. Particularly noteworthy is their conclusion that focusing primarily on cutting government spending results in larger increases in economic inequality.

This new S&P report is a reminder that fiscal policy doesn’t just affect inequality but also that high and rising levels of inequality can affect government levels of taxes and spending. Understanding the interplay between the two will be important as policy makers decide fiscal policy moving forward.