William McEachern

English

Research Papers in Economics

By William A. McEachern
As the 1990s began, the sales tax was the biggest fiscal horse in the barn,
accounting for about half of all state tax revenue.  That changed in 1991 when
the new broad-based income tax was introduced.  For better or worse, state
government in Connecticut has hitched its wagon to the new income tax.  As a
result, the 1990s could be called the decade of the income tax.  What’s more,
the new tax will likely dominate state finances in the next century.  What does
this horse-trade mean for Connecticut’s future? 
Profile of the 1990s
The accompanying bar chart shows the composition of state taxes in
Connecticut by fiscal year during the 1990s.  Since the state broadened the
base of the income tax, that tax has captured a growing share of tax revenue,
increasing from 33.3% in 1992 to 41.2% in 1998.  Meanwhile, the sales tax
share dropped from 35.1% in 1992 to 31.8% in 1998.  
The share of other taxes as a group dwindled from 31.6% of the total in
1992 to 27.0% in 1998.  These other taxes declined because of some tax cuts
and some unresponsive tax bases.  For example, to promote a more competi-
tive, business-friendly climate, lawmakers cut corporate tax rates from 11.5%
in 1994 to 7.5% by 2000.  And to discourage retirees from moving out of
state, lawmakers are phasing out the inheritance tax. Finally, revenues from
taxes on cigarettes and motor fuels lag growth in the economy. 
What about non-tax sources of revenue?  Gambling revenue increased dur-
ing the 1990s, but only because of the slot-machine agreement with the casi-
nos.  Other gambling revenues, such as lottery receipts, have been virtually
flat for the last dozen years.  Despite the growth of slot revenues, this source
still accounts for less than 3% of all state revenue and can hardly be viewed
as a revenue engine for the new century.  One month’s data may not mean
much, but slot receipts from Foxwoods in March were virtually unchanged
from March 1998, suggesting a possible slowing of this cash machine. 
How Does Connecticut Fare?
The estimated model fits the data well and pro-
vides a useful way to assess each state’s tendency
to spend more or less than predicted, based on
their particular characteristics.  Substituting each
state’s population, average income, and land area
into the estimated model provides a predicted level
of state and local spending.  A state with actual
spending above the level predicted for such a state
could be wasteful or might simply have special
features not accounted for by the model.
Similarly, a state that spends less than predicted
could be unusually efficient or possess features
that the model omits.  The graph summarizes this
comparison of actual and predicted levels of total
state and local government spending in each state. 
Alaska’s state and local public spending is
almost 53% above the amount predicted for a state
with its population, average income, and area.  At
the other extreme, New Hampshire spends about
23% less than the model predicts for such a state.
The Granite State is one of only ten states that
seem to be relatively more frugal than Connecticut.
Our state and local spending in 1995-96 was 9.3%
less than predicted for a state with almost 3.3 mil-
lion residents, a 1995 per capita personal income
of nearly $32,000, and 4,845 square miles of rocky
turf.  This translates into a total annual estimated
“savings” of $2.03 billion, or about $620 per per-
son.  This outcome is all the more striking in the
context of neighboring states’ performance.  New
York, Rhode Island, and Massachusetts exceeded
their predicted levels of public spending by about
36%, 20%, and 6%, respectively.
Some Caution
The ranking in the graph—from “overspenders”
to “underspenders”—provides only a relative indi-
cator of performance.  Slack could remain in even
the thriftiest public sector, but the ranking tells us
nothing about that.  Also, as noted before, a state
with unique features that are omitted from the
estimated model could be inaccurately ranked.
Finally, dollar-based comparisons offer no direct
information about the physical quantity and quali-
ty of public services—such comparisons would
require much more information than is currently
available.  Yet, despite these and other more tech-
nical limitations, the model offers a better way of
evaluating popular claims of government waste
than simply looking at spending levels.  
Criticizing Connecticut’s state and local spend-
ing of $6,047 per person, more than 15% above
the national average, may seem warranted until
someone points out that the bulk of government
spending involves direct or indirect payments for
labor services, and per capita personal income in
Connecticut exceeds the national average by more
than 42%.  Controlling for income, population
size, and land area, Connecticut state and local
government looks pretty lean and may be a con-
tributor to the state’s economic dominance rather
than an economic burden.
5 The Connecticut Economy Spring 1999
State Income Tax Now
Biggest Fiscal Horse
% Other
Tax
% Personal
Income Tax
% Sales Tax
Composition of State Taxes in Connecticut 
By Fiscal Year
Source: Developed by The Connecticut Economy based on data from the Connecticut General
Assembly’s Office of Fiscal Analysis.E-Commerce and the Sales Tax  
The sales tax, or more officially, the “sales and
use tax,” will diminish in importance in the new
century as e-commerce grows.  The U.S. Supreme
Court has ruled that sellers do not have to collect
the tax if they do not have a significant “physical
presence” in the state.  Thus most who sell via
mail-order catalogs, telephones, or the Internet are
not obliged to collect taxes for the state. 
Catalog sales have nagged tax officials for
decades, but e-commerce is the real threat to the
sales tax base.  On-line sellers escape the overhead
involved with a physical presence and thus have a
competitive price advantage over local merchants
from the get-go.  The absence of a sales tax boosts
this advantage.  For example, a Connecticut mer-
chant who sells the video Titanic for the list price
of $29.99 will charge $31.78 after the sales tax.  In
contrast, Amazon.com sells the video over the
Internet for $17.99 plus $3.95 shipping, for a total
of $21.94, or about one-third below the in-store list
price.  A University of Chicago economist argues
that the absence of a sales tax accounts for at least
one quarter of Internet sales.
Connecticut residents who purchase on-line are
still liable for Connecticut’s 6% sales and use tax.
Revenue officials try to collect the tax through the
only direct contact they have with most state resi-
dents—the state income tax return.  As you may
have noticed, that return includes an “Individual
Use Tax Worksheet” warning residents: “If you
purchased taxable goods or services for use in
Connecticut during the calendar year and a
Connecticut or out-of-state merchant failed to col-
lect Connecticut sales tax, you must pay the
Connecticut use tax.”  Despite the worksheet and
the warning, the state collected under $1 million
from the use tax in 1997, implying that residents
spent only $15.4 million on goods subject to the
use tax, or just $12 per filer.  In contrast, actual
sales tax receipts imply that filers that year spent
an average of about $36,000 per return on taxable
items.  The tiny use tax number combined with
the ubiquity of UPS trucks in the state suggest that
many residents are not “‘fess’n up” to their share
of the use tax.  
The exploding on-line commerce will erode the
sales tax base for years to come, especially in
Connecticut, one of the most “wired” states in the
country.  Residents here have the income and the
computer links to lead the nation in on-line shop-
ping.  On-line sellers such as eBay and
Amazon.com have huge stock market values based
on the promise of this sales channel.  Ebay, an on-
line auction house, has a capitalized value of about
$23 billion—three times the value of K-mart.
Amazon.com is also worth $23 billion—more than
ten times that of Barnes & Noble.  Granted, most
Internet stocks seem to be encased in a speculative
stock market bubble, but nobody doubts that on-
line sales are going nowhere but up. 
Married to the Income Tax 
For better or worse, Connecticut has married its
public finances to the state income tax.  But that
tax base has been narrowed by recent legislation.
Because of generous exemptions for low income
filers combined with property tax credits, especial-
ly for low and middle income groups, a growing
share of all filers escape the tax altogether. 
Exemptions and credits at the lower end of the
income distribution combined with the bull run on
Wall Street have boosted the share of the tax paid
by the high end.  For example, the number of
Connecticut filers reporting an adjusted gross
income in excess of $2 million increased from 802
in 1992 to 1,945 in 1997, a jump of 143%.  State
income taxes paid by this top group climbed from
$144.9 million in 1992 to $401.9 million in 1997, a
growth of 177%.  These high rollers, who account
for only 1 of every 657 filers, paid more state
income taxes in 1997 than the bottom two thirds of
all tax filers combined.  Thus high-income filers
pay the overwhelming share of the tax.  (For more
on the distribution of the tax burden, see my
“Straws in the Wind” on page 18.)
Although most low-income filers pay little or no
state income tax, The Connecticut Economy’s April
poll found the least support for the tax among this
low-income group.  Among those with incomes
below $30,000, 41% favor the current income tax
and 49% oppose it.  Among those reporting
income above $100,000, 64% favor the tax and
33% oppose it. 
Overall, 46% of the 500 residents polled favor
the income tax and 48% oppose it.  Time has soft-
ened opposition to the tax, however.  In 1992, the
year when Connecticut residents filed their first
state income tax return, 31% of the 500 state resi-
dents polled favored the tax and 66% opposed it.
So back then, the opposition held a two-to-one
edge.  Now it’s a toss-up. 
Path of Least Resistance
Since 1992 income taxes have grown at an annu-
al rate of 10.5%—more than twice the 4.9% rate
for the sales tax and the 3.9% rate for other taxes.
If this growth continued, the income tax would
account for about 70% of all tax revenue by 2018.  
Since the income tax was first introduced, law-
makers have exempted a growing fraction of lower
income filers from the tax through a combination
of lower rates, broadened exemptions, and proper-
ty tax credits.  There are plans to expand the
exemptions and credits.  The bottom half of filers
based on adjusted gross income paid only 5.8% of
all state income taxes collected in 1997 (down
from 7.6% in 1995).  They will pay even less of
this tax in the future.  
Given the growing importance of the income tax
in the fiscal system, what are the implications of
having that tax paid primarily by a small subset of
the population?  Will voters eventually realize this
and be more inclined to support increases in state
spending because the burden falls primarily on
others?  Also, it’s great fun cutting taxes during
good times, but will the resulting erosion of the tax
base come back to haunt us when the music stops
and Wall Street turns bearish?
6 The Connecticut Economy Spring 1999

State Income Tax Now Biggest Fiscal Horse

http://cteconomy.uconn.edu/articles/WM_Sp1999.pdf

State Income Tax Now Biggest Fiscal Horse

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Research Papers in Economics