State Tax Revenue in the Third District

Recently several state governments have announced that their tax collections have fallen short of expectations. In the Third District states—Pennsylvania, New Jersey, and Delaware—state tax collections announced reductions from budgeted spending. This report looks at the recent trend in state tax collections in the three states and reviews how state tax collections fared in past periods of economic weakness. The purpose is to understand how the current softening in national and regional economic conditions might affect state tax collections in the immediate future.¹ 

State Tax Revenue Is Very Sensitive to State Income

The amount of tax a state collects is very sensitive to the personal income of the state’s residents.² Total state tax collections vary with total personal income in the state, and the variation in the amount of tax collected tends to vary more than income. This relationship is as evident in the three states of the Third District as it is in all the states. The variance between income and tax collections is most pronounced around turning points in economic activity. While both tax collections and income accelerate and decelerate roughly in tandem, growth in tax collections slows more than income—or collected amounts actually fall—during recessions, and tax collections rise more than income in the early stages of expansions. Growth in state taxes fell below growth in income in the third quarter of 2000, before the onset of the 2001 recession, and the growth rate of tax collections remained below that of income until the fourth quarter of 2002, a year after the end of the 2001 recession. In the expansion following that recession, tax collection growth did not consistently exceed income growth until the third quarter of 2003. The growth rate of total state tax collections fell below the growth rate of income in the third quarter of 2006 and has remained below it since.

State tax collections vary more than state residents’ incomes for several reasons. Two important factors determining how tax collections respond to changes in income are the tax rate structure and the tax base (the economic activity to which the tax is applied). The two largest sources of state tax revenue are income taxes on individuals and sales and gross receipts taxes on the purchase of goods and services. The way in which these two activities—earning and spending—are taxed influences the variation observed in state tax collections.