State tax collections posted an startling 11.7 percent rise in year-on-year expansion in first quarter 2005, according to recent data from the Nelson A. Rockefeller Institute of Government. Increases in both personal and corporate income taxes fueled the higher revenues, with corporate income taxes jumping a stunning 61.1 percent during first quarter. Personal income taxes rose 11.2 percent for the period.

Employment, meanwhile, didn't rise that dramatically. "Companies have been posting fairly strong profits, but what's different in this recovery is that it hasn't spilled over into companies hiring a lot more people," says Tracy Clark, associate director of the Bank One Economic Outlook Center at the W. P. Carey School of Business. "We'll see two months up in employment nationally, and then a down month."

Payrolls won't account for the upswing in personal income tax, either. Wages and salaries grew 7.5 percent year on year, according to data from the Bureau of Economic Analysis.

Still, revenues are growing beyond belief, economists say. In Arizona, they're up "at a clip that I have not seen in 25 years of working here,'" says Dennis Hoffman, economics professor and associate dean for research at the W.P. Carey School of Business. "Arizona revenues have been growing faster than any models that I know of unless I add real estate to the picture. Then, I can explain our sales tax and personal income growth."

Hoffman admits he could have run his economic models last fall to project what the Rockefeller Institute reports as an astonishing 33 percent increase in Arizona's personal income taxes for this year's first quarter. "But candidly, I don't think I would have believed the results produced until I saw the revenue coming in this spring," he says. "Once I saw the revenue come in, there is no other logical place it could have come from other than capital gains."

Stock options and real estate

When the Wall Street Journal covered the rise in revenue, it credited "an unusual surge in bonuses or the huge Microsoft Corp. dividend payout" as possible factors for what may be an ephemeral boon to beleaguered state budgets. Sanjay Gupta, an accounting professor at the W.P. Carey school of Business, agrees that corporate bonuses may be at play.

"Recent years can be viewed as brewing a perfect storm for refiguring compensation," he says. He cites corporate scandals and the stock market plunge of 2000 as two reasons employees might be choosing cash-now bonuses over the iffy reward of company stock options.

Also, companies have less incentive to offer stock options these days. Previously, the options didn't show up as expenses on corporate income statements. However, the Financial Accounting Standards Board, which is the rulemaking body for accounting standards in the U.S., recently enacted a change that requires companies to recognize stock option expenses, Gupta says. "As a result, some companies have publicly acknowledged that they have changed their stock option policies," he adds.

As for the Microsoft dividend, Hoffman points out that much Microsoft stock is held in 401(k)s and other retirement accounts, so "not all of that income would have been taxable." Instead, Hoffman says the rise in tax revenue reflects increases in the foundations of basic capital gains: activity on Wall Street and the real estate market. "If you look at states that are booming," he says, "what you'll see is that they're either very active real estate markets or they're closely aligned with gains on Wall Street."

Good old-fashioned profit

 "No one thinks of the stock market as having gone up that much in recent years, but in 2002 it was at 800, and now it's about 1,200," says Clark. "That's enough to get people declaring capital gains on stocks."

And then, there's the housing market, which has been on fire in several U.S. states. According to figures released June 1 by the Office of Federal Housing Enterprise Oversight, housing appreciation averaged 12.50 percent during the 12-month period ending March 31, 2005.

Nevada is the state that saw the greatest housing appreciation -– 31.22 percent -– followed by California with 25.42 percent, Hawaii with 24.36 percent and the District of Columbia with a 22.21 percent rise in home values. No state in the top 10 experienced less than 15 percent rise in housing appreciation.

"Housing appreciation gets you capital gains revenue two ways," explains Clark. "First, if you sell a primary residence, any capital gains above the $250,000 exclusion get taxed. In some California communities, the median home price is over $600,000. Those people have a good shot of going over the $250,000 limit."

Investment activity in housing markets also is up, Clark notes, and it has been since the stock market tanked in 2000. Although real estate as an investment had been out of favor over the last two decades, Hoffman says, historically low interest rates combined with the stock market uncertainties have inspired people to look for more solid investments, and real estate fit the bill. The result: Real estate investing is hot, home sales are up, and so are tax collections driven by them.

The last Laffer?

According to a June 13 commentary in the Wall Street Journal, Stephen Moore, author of "Bullish on Bush: How the Ownership Society Will Make America Richer," sees the recent gains in state and federal revenue as "an eye-popping vindication of the Laffer Curve and the Bush tax cut's real economic value."

Invented by economist Arthur Laffer, the Laffer curve charts the relationship between tax rates and revenues collected. It suggests that beyond a certain tax threshold, high taxes thwart revenue collection efforts because they create a disincentive for people to earn money. The flip side of the Laffer equation is that lower taxes encourage moneymaking initiative. Moore believes that's exactly what's going on to produce today's remarkable rise in tax revenues.

Clark disagrees. "There is some evidence that the Laffer curve works on a federal level. You can at least make a case for it without crossing your eyes too hard," he says.

According to Clark, federal taxes are high enough that corporations pay attention to them and tax relief makes a difference. That is not the case with state taxes, he adds, and Gupta's research backs him up.

After reviewing corporate investment behavior between 1983 and 1997 in 44 states, Gupta found that changes in state corporate income tax "did not have any measurable effect on investments made."

Where tax breaks did have an effect, it was not always a positive one. Several states have tried encouraging corporate activity by super-weighting the sales portion of corporate income tax and downplaying taxes on property or payroll. When Illinois did this a few years ago, the state "experienced a $200 million loss in corporate income tax revenues as well as a decline in manufacturing jobs," Gupta says. "Similar stories have been documented in the literature for Ohio, Pennsylvania and Massachusetts."

Hoffman concedes that the Bush cuts in capital gains tax might encourage people to realize their capital gains rather than shelter them by rolling profits over into some non-taxable form. But, Hoffman also indicates that "over the last 25 years, the variation in national capital gains realization has been strongly associated with activity on Wall Street and changes in housing appreciation."

And as Wall Street has proven over the last few years, what goes up in the investment world also can come down.

"When you get money from a volatile source like capital gains, you have to keep in mind that once Wall Street activity falls off or the housing market cools, these revenues will decline," says Hoffman.

He adds that prudent policymakers won't pass permanent tax cuts or put ongoing spending programs in place as some states did during the 90s. "Fund something. Build something," he says. "A road. A research park. Something with expenses upfront that will yield benefits for years to come."

That may be a hard sell in the 31 states that, according to the National Conference of State Legislatures, have reported spending overruns for some portion of their 2005 budgets. "States are barely keeping their heads above the rising tide of new costs," says John Hurson, president delegate of the National Conference of State Legislatures.

Legislators in those states can take heart, though. According to Hoffman and Clark, 2005's strong revenues are in the bag, and 2006 looks good as well.

Maybe lawmakers can spend some of those "birthday bucks," after all. Hoffman offers this spending advice. "When you get windfall money like this, invest it in infrastructure."

Here's what you think...

Be the First to Comment on This Article.

 

Sign In to Join the Discussion

Email Address:
Password:
Not a member? Sign Up for Knowledge@W.P. Carey