Two years into the pandemic, states are flush with cash, a vastly different picture than the 20 percent revenue decline suffered by states in the early days of the pandemic. But today’s often double-digit revenue growth is not sustainable. Here are five reasons why state policymakers should proceed carefully despite the temptations of full coffers.
1. Inflation, inflation, inflation
Supply chain bottlenecks and unprecedented labor shortages drove annual inflation to 4.7 percent in 2021, a 30-year high. While high inflation hurts consumers, it increases state and local tax revenues. Among the winners: Those states with progressive income taxes that do not adjust their tax brackets for inflation. Higher wages and other income pushed taxpayers into higher income tax brackets, resulting in more revenue for these governments.
Inflation also increased sales tax collections because of higher prices. However, inflation-driven increases in sales tax revenues are likely to be short-lived. Supply chain bottlenecks are easing and the Federal Reserve has signaled it will begin raising interest rates as soon as March, likely slowing inflation. And even if prices continue to rise, effects on revenues could be short lived as consumers adjust by reducing their purchases or choosing cheaper products.
2. The Pandemic Increased Spending on Taxable Goods
The pandemic changed consumer spending patterns. Nationwide, lockdowns and health fears severely curtailed spending on services, which generally are exempt from sales tax, but elevated spending on goods, which are taxable in most states. This resulted in strong state sales tax revenues. Even better for states, the pandemic accelerated online sales that have been subject to sales tax since the Supreme Court’s Wayfair decision.
But many of those circumstances are changing. As Americans become accustomed to living with the pandemic and the virus threat eases, many will likely return to their pre-pandemic spending habits. Thus, consumption will shift back to often-untaxed services and sales tax revenues will return to their pre-pandemic trend. The unpredictable nature of changes in consumer behavior are certainly a cause of concern for state officials.
In addition, multiple federal responses to the pandemic resulted in stimulus payments, additional unemployment benefits, and – more recently – enhanced and advanced child tax credits. All these delivered trillions of dollars to households that translated into higher spending. But while millions of Americans have gone back to work, often at higher wages than before the pandemic, those big federal cash infusions have come to an end.
3. Robust Stock Market
The stock market’s performance was exceptional during most of the pandemic. In 2021, the S&P 500 stock index rose by 33 percent, the fastest annual rate in more than six decades. A strong stock market means larger capital gains realizations and increases in estimated income tax payments. Those payments rose by more than $35 billion, or nearly 50 percent in 2021. However, the stock market has been turbulent so far in 2022. And, as Nobel Prize economist Milton Friedman warned long ago, over the long run corporate profits will track the growth in the overall economy.
4. IPO Bonanza
US businesses raised a record nearly $300 billion from initial public offerings in 2021. And these IPOs generated significant revenues for states, especially California where firms are located and New York and Connecticut where deals were brokered.
However, it is hard to predict future IPO activity. And we are already seeing evidence that these offerings are slowing. Some companies recently pulled their US IPOs in the face of a volatile stock market and a likely rise in interest rates. The potential result: A decrease in state tax revenues from soaring 2021 levels.
5. Anticipation of Federal Tax Rate Hikes
While the Biden administration’s plans to hike tax rates on corporations and capital gains seem dead, the proposals themselves may have changed the timing of some taxpayer activities in 2021. For example, corporate and individual taxpayers may have shifted income and capital gains realizations from the tax year 2022 into tax year 2021 in anticipation of higher tax rates, also temporarily raising state and local tax revenues.
State Fiscal Outlook
With revenues soaring, many states are enacting big tax cuts. However, this year’s large surpluses can quickly turn to shortfalls in the wake of permanent tax cuts.
And states will continue to face long-run spending pressures due to an aging population, a continuing global pandemic, and the growing threats of climate change-induced natural disasters. As a result, they should exercise caution with big tax cuts, tempting as they are in a time of large fiscal surpluses.