The Cyclical Volatility of Tax Revenues

[Section A, question 2]

Recent history suggests that countries, such as the UK and the USA, which rely heavily upon progressive income taxes and corporate profits taxes experience greater cyclical volatility of tax revenues than other countries.

What reasons might explain this outcome?

How might the overall structure of taxes and/or the management of fiscal policy be modified to take account of the cyclical volatility of tax revenues with respect to changes in GDP?

“California’s fiscal problems go well beyond the design of its tax system, but its tax system has certainly contributed to these problems.” remarks lan J. uerbach (2010, p. 1), professor of economics and law at University of California, Berkeley, in 2010. Before I address the implications of these fiscal problems, attempt to uncover their roots and explore just how much of a role the tax system does really play, I will briefly examine the structure of California’s tax system, as well as that of the United States in general and, for comparison, the tax structures of other selected OECD countries, namely the United Kingdom. It is these countries that seem to display the highest degree of cyclical volatility of tax revenues, and are therefore of interest. Please refer to the appendix for the tables.

1. Tax Data

Let’s begin with the corporate income tax rate. Table 1 displays the top marginal corporate income tax rates in the G7 countries. The US top the list with 35%, one of the highest rates in the world, while the rate in the UK is not quite as high¹, but still slightly above the OECD average, as one can derive from table 2. The same table also shows the top marginal personal income tax rates for most OECD countries, which are not significantly high in the US or the UK. More significant evidence of a strong reliance on personal income taxes is given in table 3, which displays the tax structures as a percentage of total tax receipts. It is plain to see that the income tax receipts in the two countries lie well above the average. Again, the US tops the list with over 36% of tax revenue coming from income taxes in 2006. Only three other countries have higher values.

Next, let’s examine the personal and corporate income tax rates and revenue distributions for individual US states². Table 4, which displays the state and local general revenue distribution for all the US states, provides evidence of a strong dependency on income tax, both individual and corporate, in California. Especially the revenue proportion of corporate tax is well above average with 3.6%, only behind seven other states. Another state with very high values in this area is New York, which generates even more of its total revenue through corporate taxes, and has the third highest revenue proportion of personal income taxes in the country, at 20%. The data on New York will be of substance later in the paper. Finally, observe the strong progressivity of California’s personal income tax structure in table 5, with six rates ranging from 1% to 9.3%, a range only larger in one state, Hawaii.

Figure 1 conclusively illustrates the overall heavy reliance of the US government on individual and corporate income taxes:

Figure 1: Sources of Federal Tax Revenue, USA, 2008

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Source: Williams (2009)

2. Evidence for Volatility

In this next step, I will examine the evidence for any high levels of cyclical volatility of tax revenues in regard to personal income and corporate income in the US and UK, as well as a selection of US states. Figure 2 (next page) depicts a diagram of corporate income tax as a share of GDP in the US since 1946.

Figure 2: Corporate Income Tax as a Share of GDP, USA, 1946-2009

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Source: Tax Policy Center (2010)

Notice the strong cyclical dynamism of the tax revenue from each recession to the next. The rate of revenue growth and subsequent fall from 2002 to 2009 is especially dramatic, with revenues growing from just over 1% to around roughly 2.7% within four years and then falling back down to 1% in just two, as the recession caused by the recent US subprime crisis reached its lowest point. Table 6 displays these revenue movements in numerical terms³, und to understand the impact of these (perhaps at first not strikingly dramatic) shifts, please refer to table 7, which places monetary values on the values in table 6. The severe impact of even modest personal and corporate income tax revenue movements becomes clearer when one considers, for example, that the recent financial crisis cost the federal government over 230,000 million dollars in corporate income tax revenue over two years, and even more in personal income tax revenue.

Moving on to tax revenue volatility in selected US states, examine figure 3 (next page), which outlines California’s total tax revenues against those raised by the personal income tax.

Figure 3: California State Tax Revenues, 1980-2003

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Source: Williams & Vasché (2005)

The strong volatility of personal income tax revenues has clearly determined much of the state’s overall revenue fluctuations. Moreover, this sort of volatility has actually increased in California over the last 30 years:

Figure 4: Personal Income Elasticity of Tax Revenue, California

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Source: Legislative Analyst's Office (2011)

Another state that has experienced strong volatility of the sort shown for California in figure 3 is Arizona. Figure 5 (next page) is the equivalent of figure 3, for the state of Arizona. We can draw similar conclusions as before.

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