Timothy Schiller

English

Research Papers in Economics

 
 
State Tax Revenue in the Third District
∗ 
Timothy Schiller 
Senior Economic Analyst  
November 2008 
 
 
  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  
in recent months have been below amounts anticipated in state budgets. The governors of these states have 
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. (See Chart 1.)  This relationship is as evident in the three states of 
the Third District as it is in all the states. (See Charts 2-4.) 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 
                                                      
∗ The views expressed here are those of the author and do not necessarily reflect the views of the Federal Reserve Bank 
of Philadelphia or the Federal Reserve System.  Timothy Schiller is a senior economic analyst in the Research 
Department and may be contacted at tim.schiller@phil.frb.org. 
1 Only state tax revenue is covered in this report. State governments also obtain revenue from other governmental units, 
mainly the federal government, from operating state-owned utilities, and from other sources. Revenue from these 
sources can vary, although this variation is not usually related as closely to the business cycle as tax revenue.  
  
  2
                                                                                                                                                                               
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. (See 
Table 1.) The way in which these two activities—earning and spending—are taxed influences the variation 
observed in state tax collections. 
In many states, individual income taxes are progressive, with higher tax rates for higher incomes. In 
the Third District, New Jersey’s individual income tax rates range from 1.4 to 8.97 percent; Delaware’s rates 
range from 2.2 to 5.95 percent. Pennsylvania has a flat rate of 3.07 percent. For states with progressive 
individual income tax rates, variations in income over time cause individual incomes to be taxed at different 
rates at different times. This magnifies the effect of variations in income on the amount of income tax 
collected, increasing it by more than the rise in income and decreasing it by more than the decline in income. 
This effect contributes to the pattern of variation in total state tax collections over the course of the business 
cycle described earlier. 
For sales and gross receipts taxes, variations in spending will cause variations in the amount of tax 
collected. Although sales taxes are not progressive, there are different rates for different classes of goods. In 
many states, food and clothing are exempt from sales taxes or taxed at lower rates than other goods. In 
several states, nonprescription drugs are also exempt from sales tax. In most states, prescription drugs are 
exempt. (Among Third District states, Pennsylvania and New Jersey have sales tax exemptions for most of 
the usually exempt goods. Delaware does not have a general sales tax.) The existence of different tax rates 
for different types of goods can cause sales tax collections to fluctuate more than income because of the way 
spending tends to vary as income varies. For example, as consumers’ incomes rise, they tend to spend 
relatively more on goods that are taxed (and on goods subject to higher tax rates) than on goods, such as 
food, that are not taxed (or subject to lower tax rates). This tendency results in sales tax collections that can 
rise or fall more than income or spending. Furthermore, large variations in spending can occur even when 
incomes are practically unchanged, resulting in greater variation in sales tax collections than in income. For 
example, during times of economic uncertainty, consumers might delay spending on goods for which they do 
not have an immediate need, especially big-ticket durable goods (e.g., automobiles, appliances, furniture, 
etc.)—as appears to be happening now—and then step up spending on these items as confidence is restored. 
  
 
 
2 State personal income data used in this report are from the U.S. Bureau of Economic Analysis. State tax data are from 
the U.S. Census Bureau survey of state government tax collections, unless otherwise noted.  
  3
                                                     
 
The Recent Trend and the Outlook for State Tax Collections 
  State tax collections were growing through the second quarter of this year, as the most recent census 
survey data indicate. However, the growth rate of collections has been slowing for the past two years. Recent 
data obtained directly from the states, although not complete, indicate that growth in state tax collections 
came to a halt in the third quarter.
3 For the total tax collections for all states for which data are available, 
collections in the third quarter of 2008 were up only 0.1 percent from the same quarter in 2007. A large 
decline in corporate income tax collections as well as a drop in sales tax collections negated nearly all of the 
gain in personal income tax collections. For total tax collections in the Third District states, Pennsylvania and 
New Jersey had decreases of 2.1 percent and 1.2 percent, respectively. There were declines in corporate 
income tax collections in Pennsylvania and personal income and sales tax collections in New Jersey. 
Delaware had an increase of 4.8 percent in total tax collections, on the strength of a large increase in 
corporate income tax collections. 
  Looking ahead, two factors suggest no growth or further declines in state tax collections in 2009. 
The first factor is the developing weakness in income. The rise in unemployment during 2008, with much of 
it occurring in the later part of the year, raises the likelihood that incomes will be lower during the fourth 
quarter of this year and into next year. This will probably result in lower personal income tax collections in 
the fourth quarter of this year. The weakness in personal income tax collections will probably persist through 
the first half of 2009,  a result of continued weakness in income if economic conditions do not improve 
speedily, and a result of lower tax collections in April 2009 based on 2008 income tax filings. Besides lower 
tax collections from earnings, the decline in financial asset values in 2008 will limit or reduce taxes collected 
on capital gains. The economic conditions that are reducing personal income tax collections are also reducing 
corporate income tax collections, which fell in total for all the states on a year-to-year basis in the second and 
third quarters. 
  The second factor limiting or reducing state tax collections is the current and prospective decline in 
consumption spending. Nominal retail sales fell 4 percent at an annual rate during the third quarter, the first 
quarterly decline since the 5.2 percent decrease in the first quarter of 2002. Sales of big-ticket durable goods 
were particularly weak; for example, sales of automobiles and light trucks fell 19 percent from the second 
quarter to the third quarter. As noted earlier, state sales tax collections for all the states as a whole have been 
falling, and if consumer spending declines further, sales tax collections will also fall. In the Third District, 
this factor is not relevant in Delaware, which does not have a general sales tax, but it is a factor in 
Pennsylvania and New Jersey, where the latest monthly data indicate that sales tax collections have slipped. 
 
3 Donald J. Boyd and Lucy Dadayan, “State Tax Revenue Now Flat, for the First Time Since 2002 Recession: After 
Weak Third Quarter, Further Declines Likely Lie Ahead,” Nelson A. Rockefeller Institute of Government State 
Revenue Flash Report, November 6, 2008. www.rockinst.org/government_finance/.  
  4
                                                     
  The current weakening in economic activity has been particularly serious in the financial services 
industry, including the real estate sector. For states where the finance-insurance-real estate (FIRE) industry 
accounts for a large share of economic activity, tax revenues from this source are at risk. There are three 
readily available measures of the importance of the FIRE industry in a state: state gross domestic product, 
employment, and earnings. By each of these measures, the FIRE industry is somewhat more important in 
New Jersey and significantly more important in Delaware than it is nationally. (See Table 2.) Of course, all 
types of FIRE businesses are not affected equally, and the exact types that make up the FIRE industry in each 
state will have an important influence on how the industry performs in each state. Nevertheless, a broad 
scaling back in financial activity—which is evidently under way—has negative implications for the overall 
economies and potential tax revenues of states with significant FIRE industries. 
 
Coping with Variations in State Tax Revenues 
  States are vulnerable to variations in tax collections, especially declines in tax revenue that can 
necessitate reductions in expenditures from budgeted amounts, such as the recent spending cuts noted at the 
beginning of this report. Most of the states have limited flexibility in coping with negative variations in tax 
revenue because they are legally bound to balance expenditure and revenue in their annual budgets. States 
attempt to compensate for variations in tax collections with budget stabilization funds, also known as rainy 
day funds. The legal discretion that states have with respect to adding to or withdrawing from rainy day 
funds varies from state to state. In some states there are limits on the amount of revenue that can be placed in 
the funds, and legislative action is required to use the funds. In many cases, the amount of the funds (whether 
limited by law or not) has not been adequate to cover the shortfall in tax collections when economic 
conditions have deteriorated. For example, in the 2001 recession, state deficits in total were five times greater 
than state rainy day funds in total.
4 
As currently structured, the size and use of rainy day funds might be sufficient to deal with 
unforeseen short-term declines in state revenue. However, to be sufficient to compensate for the variation in 
tax collections that is typical over the course of a business cycle, rainy day funds need to be larger in relation 
to average annual tax collections. If the objective of a budget stabilization fund is to be able to maintain 
steady spending over the course of a revenue cycle, then such a fund must have certain key features. First, it 
must be large enough to cover the cyclical decline in revenue. Second, each state’s buildup of a rainy day 
fund should be continuous during the expansion phase of its own cycle of revenue growth and decline, which 
is not always synchronous with the national business cycle.
5 Third, the fund should be a regular part of the 
budget and not based on fortuitous surpluses (as is the case in many states). Fourth, both additions to the fund 
 
4 Elaine Maag and Alison McCarthy, “State Rainy Day Funds,” Tax Notes, October 2, 2006, p. 79. 
5 For estimates of required rainy day funds and annual savings rates for the states, see Gary A. Wagner and Erick M. 
Elder, “Revenue Cycles and the Distribution of Shortfalls in U.S. States: Implication of an ‘Optimal’ Rainy Day Fund,”  
  5
                                                                                                                                                                               
and disbursements from it should be automatic according to procedures established beforehand, not decided 
ad hoc when state tax collections are either rising above or declining below amounts anticipated in the 
budget.  
 
 
 
 
 
 
 
 
 
National Tax Journal, 60 (December 2007), pp. 727-42. 
 
 
  
 6
Chart 1
Personal Income and State Tax Collections
All States
-15
-10
-5
0
5
10
15
20
Q1/1998 Q1/1999 Q1/2000 Q1/2001 Q1/2002 Q1/2003 Q1/2004 Q1/2005 Q1/2006 Q1/2007 Q1/2008
Percent Change, Year-Year
Taxes
Income
Source: U. S. Census Bureau and Bureau of Economic Analysis
 
Chart 2
Personal Income and State Tax Collections
Delaware
-20
-15
-10
-5
0
5
10
15
20
25
30
Q1/1998 Q1/1999 Q1/2000 Q1/2001 Q1/2002 Q1/2003 Q1/2004 Q1/2005 Q1/2006 Q1/2007 Q1/2008
Percent Change, Year-Year
Taxes
Income
Source: U. S. Census Bureau and Bureau of Economic Analysis
  
 7
Chart 3
Personal Income and State Tax Collections
New Jersey
-10
-5
0
5
10
15
20
25
Q1/1998 Q1/1999 Q1/2000 Q1/2001 Q1/2002 Q1/2003 Q1/2004 Q1/2005 Q1/2006 Q1/2007 Q1/2008
Percent Change, Year-Year
Taxes
Income
Source: U. S. Census Bureau and Bureau of Economic Analysis
 
Chart 4
Personal Income and State Tax Collections
Pennsylvania
-10
-5
0
5
10
15
20
Q1/1998 Q1/1999 Q1/2000 Q1/2001 Q1/2002 Q1/2003 Q1/2004 Q1/2005 Q1/2006 Q1/2007 Q1/2008
Percent Change, Year-Year
Taxes
Income
Source: U. S. Census Bureau and Bureau of Economic Analysis
  
 8
Tax Category* PA NJ DE All States Total
Individual Income Taxes 32.4 40.9 32.7 36.3
Sales and Gross Receipts Taxes 27.6 29.0 0.0 31.1
Corporation Net Income Taxes 6.8 9.8 10.0 6.5
Motor Fuel Sales Taxes 6.5 1.8 3.8 4.9
Corporation Franchise Taxes & Fees 2.5 1.1 24.9 1.3
Occupation and Business Licenses 2.2 1.8 7.9 1.7
Source: U.S. Census Bureau, Quarterly State Tax Collections, 2007Q3 - 2008Q4
Major Taxes in Third District States
Percent of Total Taxes
*Includes only those taxes that account for 5 
percent or more of total taxes in at least one of the 
three states.
Table 1
 
 
 
 
PA NJ DE US
Gross Domestic Product 18.6 24.9 44.7 20.8
Employment 5.7 6.7 10.4 6.0
6.6 8.2 13.0 7.6
Source: U.S. Bureau of Labor Statistics and Bureau of Economic Analysis
Earnings of State Residents Employed in 
the Industry as a Share of Total State 
Personal Income
Table 2
Finance-Insurance-Real Estate Industry Measures
2007
Percent of Total
 

State tax revenue in the Third District

http://www.philadelphiafed.org/research-and-data/publications/research-rap/2008/state-tax-revenue-in-third-district.pdf

State tax revenue in the Third District

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