Another Wall Street alarm: Income inequality hurting states’ bottom lines

Economic analysts at Standard & Poor’s sounded the alarm last month on how rising income inequality was putting a damper on U.S. economic growth. They’ve now followed up that finding with a report outlining its dampening effects on state tax revenues.

The bottom line, the S&P analysts say, is that as more income flows disproportionately to top earners, state tax collections fail to keep pace.

“From 1980 to 2011, average annual state tax revenues growth fell to 5% from 10%,” the analysts say in their draft report; “meanwhile, the share of total income for the top 1% of earners doubled” (to 20% from 10%).

Making state income tax more progressive by increasing marginal rates at the top can help, as California and numerous other states have found, but only to a limited extent. That change also comes at the expense of increasing revenue volatility (as California also has experienced). The reason is that incomes at the top are more dependent on capital gains, which are naturally more volatile than wage income.

That underscores that the answer lies in economics, not tax structure. Income inequality suppresses state revenue growth because it tamps down the rate of overall economic growth, S&P says.

That finding contradicts Laffer-style economic analysts who says that higher tax rates yield lower tax receipts -- not surprising, since the Laffer theory has been debunked repeatedly.

S&P came to this conclusion by comparing the effect of rising income inequality on states dependent on income-tax revenue versus those dependent on sales-tax revenues (including several without any income tax at all). The analysts found negative tax revenue growth in both categories, but a stronger effect in sales-tax states. That show that the problem is a lessening of overall economic growth, not lower tax collections from rich residents.

Standard & Poor’s is performing a real service by showing the effects of income inequality in the real fiscal world. This is a warning coming not from the ivory towers of academia or from political partisanship; it’s coming from deep in the heart of Wall Street, and policy-makers of all stripes should take notice.

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