Revenue Volatility in New Jersey: Causes, Consequences, and Options

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1 Revenue Volatility in New Jersey: Causes, Consequences, and Options A report prepared by Capitol Matrix Consulting for the New Jersey Chamber of Commerce Capitol Matrix Consulting May, 2012

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3 Revenue Volatility in New Jersey: Causes, Consequences, and Options Table of Contents Executive Summary...1 Revenue Volatility in New Jersey...2 New Jersey s Revenue System...4 Statistical Estimates of Revenue Volatility...5 Why Has Volatility Increased?...8 Consequences of Volatility for Budgeting and the Economy...16 Options for Dealing with Volatility...18 Conclusion...22 Appendix...23 Highlights Statistical Measures Used in Our Analysis...3 New Jersey s Big Three State Revenue Sources...5

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5 Revenue Volatility in New Jersey: Causes, Consequences, and Options Executive Summary New Jersey has been coping with the negative effects of revenue volatility on its budget and economy for many years. The report addresses several aspects of this volatility problem. Our main findings are: Volatility is a large and growing problem. Over the 24-year period from to , major New Jersey state taxes grew at an average rate of about 4 percent per year, but the average variation around that trend was over 6 percent, and over the past fifteen years, the variation was nearly 8 percent. Revenues have been more than twice as cyclical as the New Jersey economy since the late 1980s, and three times as cyclical since the late 1990s. While the problem is not unique to New Jersey, the magnitude of its revenue volatility is greater than the majority of other states. Economic and policy factors are responsible. The rising amount of volatility is partly due to New Jersey s increased reliance on its gross income tax, which itself has become more volatile over time. The greater variation in this tax is related to two economic factors: (1) the increased concentration of earnings at the top end of the income distribution; and (2) large fluctuations in investment and business income received by these top earners. These factors have been magnified by policy changes enacted over the past two decades that have made the gross income tax more progressive. The upward adjustment of the top rates, in particular, has made the state more reliant on the volatile incomes of a relatively small number of high-income taxpayers. Consequences have been severe. The large revenue declines and had particularly harsh effects in New Jersey, contributing to major structural budget deficits, rapid increases in state debt, credit downgrades, and general budget and economic uncertainty in the state. Both budget and tax reforms needed. Budget options, such as a more robust reserve requirement, are valuable tools that can help cushion budgets against some volatility. However, they alone cannot be expected to protect New Jersey against the full degree of volatility inherent in its present tax system. Addressing the full problem would also require tax revisions focused on reducing progressivity of the gross income tax, or otherwise lessening the impacts of dramatic fluctuations in investment earnings and other forms of volatile income on annual tax receipts. 1

6 Capitol Matrix Consulting Revenue Volatility in New Jersey Revenue volatility has been a challenge in New Jersey for many years, and a particularly major problem during the past decade. Some degree of revenue volatility is expected in any tax system that is tied to consumer spending, profits, income, and other economic measures that fluctuate over the course of a business cycle. However, the level of revenue volatility in New Jersey cannot be explained solely by the economy. As shown in Figure 1, in the past fifteen years, New Jersey has experienced revenue increases exceeding 10 percent and declines of more than 17 percent per year revenue swings that were much more extreme than changes in state personal income. When compared to other states over this period, New Jersey has experienced a higher-thanaverage level of revenue volatility, ranking in the top 15 states overall, and the top 10 states when Alaska and other less-populated states relying primarily on resource-based taxes are excluded. 1 Figure 1 Revenue Volatility in New Jersey 15.0% Annual Percent Change 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% -20.0% Tax data adjusted to remove effects of tax law changes New Jersey State Tax Revenues New Jersey Personal Income This report examines various aspects of New Jersey s revenue volatility problem. First, we statistically quantify the degree of volatility and how it has changed over time. We then discuss key factors behind the volatility, focusing on the relative contributions made by economic factors (over which policymakers have little immediate control) and characteristics of the state s tax system (over which policymakers have considerable control). We also discuss the consequences of volatility for New Jersey s government, taxpayers, and economy. Finally, we highlight options for dealing with the volatility problem in the future. 1 Source: Authors calculations based on state-level tax data for through published in State Government Tax Collections, U.S. Census Bureau. The data also show that the recent recession had a greater-than-average effect on New Jersey s major tax revenues in , causing them to fall by over one-quarter more in percentage terms than the 50-state average. 2

7 Revenue Volatility in New Jersey: Causes, Consequences, and Options Statistical Measures Used in Our Analysis Our analysis focuses on two types of statistical measures. The first set of computations, shown in Figure 3, focuses on the gross amount of revenue volatility. This includes the annual average percent changes for the each tax source, as well as two measures of variation around the longterm growth averages. These measures of variation are: Standard deviation, or the average difference around the mean growth rate. As an illustration, consider a tax that grows at an average annual rate of 4 percent and has a calculated standard deviation of 6 percent. Assuming the growth rates are normally distributed, one can conclude that the annual growth rates will fall between -2 percent and +10 percent roughly two-thirds of the time. Likewise, the rates will lie outside this range that is, be less than -2 percent or more than +10 percent one third of the time. Thus, the greater the standard deviation, the more volatile is revenue performance. Coefficient of variation, which is the standard deviation divided by the arithmetic mean growth rate. This measure is often used by statisticians to measure the relative amount of variation of two sets of data. Consider two taxes, the first having an average annual growth rate of 6 percent and second having an average growth rate of 3 percent. Assume that both have the same 6 percent standard deviation around their respective average growth rates. The first tax would have a coefficient of variation of 1.0, and the second would have a coefficient of variation of 2.0. In this example, both taxes have the same standard deviations around their average growth rates, but the relative volatility of the second tax (as measured by the coefficient of variation) would be double that of the first tax. Short-Term Elasticity Short-term elasticity is a measure of how sensitive a tax is to changes in the underlying economy during a business cycle. This statistical measure addresses two related questions: (1) is there a systematic relationship between revenues from the tax and the underlying economy, and (2) if there is, how do the fluctuations in the growth rate of the tax compare to that of the economy over a business cycle? The elasticity estimate is developed using a regression-based estimate of the relationship between the change in personal income and the corresponding change in the tax source. 2 As an example of how to interpret a short-term elasticity estimate, consider the case where both revenue from a tax source and personal income have an average long-term growth rate of 4 percent. Also, assume that during the expansion phase of a business cycle, personal income grows 6 percent (2 percent above its long-term growth rate) but that a revenue source grows by 8 percent (4 percent above the long-term trend). Conversely, during the downside of a business cycle, personal income grows by only 2 percent (2 percent below its long-term trend) but revenue growth falls to zero (4 percent below the long-term trend). In this case, the revenue source would have a short-term elasticity of about 2, meaning that, over an economic cycle, fluctuations in the tax around its long-term growth trend will be roughly twice the magnitude of personal income fluctuations around its long-term growth trend. Such a result would imply a tax has a relatively high degree of sensitivity to changes in the economy. 2 Specifically, our elasticity estimates are based on a regression analysis using an error- correction model of the following form: ΔLog T = β! + β! ΔLog Y + β! (Log(T!!) ) δlog(y!! )) + E where T = Tax. Y = Personal income. δlog Y!! = predicted level of T!! based on long term elasticity of T with respect to Y. E = error term. 3

8 Capitol Matrix Consulting New Jersey s State Revenue System New Jersey relies on a large number of revenue sources to finance its governmental operations. As indicated in Figure 2, however, nearly three-quarters of the total $29 billion collected in was from three major taxes the Gross Income Tax (GIT), the Sales and Use Tax (SUT), and the Corporation Business Tax (CBT). We outline the key provisions of these taxes in the accompanying box. The remaining one-quarter of revenue consists of other major taxes including levies on cigarettes, insurance premiums, inheritances, property transfers, and motor vehicle fuels. It also includes an array of minor taxes, licenses, departmental fees, lottery revenues, casino revenues, and investment earnings. Figure 2 New Jersey State Revenues ( , Amounts in Billions) Minor Taxes, Charges, and Fees $6.0 21% 36% Gross Income Tax $10.6 Other Major Taxes $2.3 8% Corporation Business Tax $2.3 8% 27% Sales and Use Tax $8.1 Source: State Budget, Summary of Revenues, Expenditures and Fund Balances New Jersey Office of Management and Budget. Much of the year-to-year changes in the minor taxes, charges and fees category are due to policy-related changes and other factors unrelated to the economy. For this reason, our volatility analysis will focus on major taxes and in particular, the big three : GIT, SUT, and CBT. 4

9 Revenue Volatility in New Jersey: Causes, Consequences, and Options New Jersey s Big Three State Revenue Sources The largest of the big three taxes is the Gross Income Tax. Under the New Jersey Constitution, all revenues collected from this tax are deposited in the property tax fund, and are used exclusively for reducing or offsetting property taxes (mostly through payments for K-12 education). 3 The GIT has a progressive tax rate structure, with marginal rates currently ranging from 1.4 percent to 8.97 percent. The rates are imposed on gross income less personal exemptions and deductions for certain medical expenses, property taxes, and a few other specific expenditures. The second largest source is the sales and use tax, which is imposed on a variety of goods and selected services. Specifically, the tax is imposed on: the retail sale, rental, and repair of tangible personal property; telecommunications; certain advertising services; restaurant meals; rental of hotel and motel rooms; certain admission charges; alcoholic beverages; cigarettes; disposable paper products; and non-prescription drugs. Sales of food, clothing, and most personal and business services not enumerated are exempt from the tax. The current state rate is 7 percent, of which 6.5 percent goes to the General Fund, and 0.5 percent is dedicated to property tax relief. 4 The corporation business tax is the third largest tax. It is imposed on corporations located or doing business in the state. The general rate is 9 percent for companies with combined earnings exceeding $100,000, 7.5 percent for companies with combined earnings between $50,000 and $100,000, and 6.5 percent for companies with combined earnings of less than $50,000. For multi-state companies, the tax is applied to the net income that is apportioned to the state. Historically, the apportionment has been based on the share of the company s combined property, payroll, and sales occurring in New Jersey. However, legislation passed in 2011 shifts the formula (over a three year period) to a single sales method, whereby income is apportioned solely on the percentage of the company s combined sales occurring in the state. Exceptions from the business income tax are provided for agricultural cooperative associations, as well as certain non-profit entities, railroads, sewerage, and water corporations. Statistical Estimates of Revenue Volatility Our statistical analysis focuses on two key aspects of revenue volatility (1) the gross amount of annual revenue fluctuations, and (2) the cyclicality of revenues that is, their degree of sensitivity to business cycles. Specifically, we analyzed the year-to-year changes in New Jersey revenues for the period through , a period encompassing three major business cycles. For this analysis, we adjusted each of the state s major revenue sources to remove the effects of significant law changes, accounting shifts, amnesty programs, and other policy-related factors on year-toyear changes in revenues 5. This allows us to isolate the underlying volatility of the revenue system. We then calculated, for the major taxes: (1) the average percentage growth rates, (2) the standard deviations around the averages, and (3) the coefficient of variation, and (4) the short-term 3 Despite the dedication of its proceeds to K-12 education and property tax relief, fluctuations in the GIT have implications for New Jersey s overall budget. This is because state assistance for education is supported by both the GIT and the state s general fund. Consequently, shortfalls in GIT revenues create additional pressures on the general fund for support of these programs. 4 Under the New Jersey Urban Enterprise Zone Act, first approved in 1983, businesses operating in designated economically distressed urban centers and meeting certain criteria are authorized to impose a sales tax at 50 percent of the regular rate. 5 Our estimates of legislative and other changes are based on information from a variety of sources. These include historical editions of the New Jersey Division of Taxation Annual Report, the State Budget and the Budget Summary documents from the Office of Management and Budget, and Fiscal Notes maintained by the Office of Legislative Services (OLS). For some major rate changes we developed retrospective estimates using current historical data on income and tax revenues. For earlier years, we also utilized historical estimates of underlying revenue changes that were published by the OLS in the 1990s. 5

10 Capitol Matrix Consulting elasticity with respect to changes in New Jersey s personal income. These statistical measures are described in the nearby box, and the results of our calculations are shown in Figure 3 and Figure 4. Figure 3 Statistical Measures of Volatility: Tax Revenues and the Economy Combined Taxes: Full Period Through New Jersey State Taxes Sub-periods Through Through Average Growth 4.1% 4.4% 4.0% Standard Deviation 6.3% 3.7% 7.8% Coefficient of Variation Three Major Taxes: Gross Income Tax Average Growth 6.3% 7.2% 5.6% Standard Deviation\a 9.2% 4.2% 11.6% Coefficient of Variation Sales and Use Tax: Average Growth 3.0% 2.7% 3.2% Standard Deviation 4.7% 5.1% 4.7% Coefficient of Variation Corporation Tax: Average Growth 2.9% 3.7% 2.3% Standard Deviation 11.4% 8.7% 13.2% Coefficient of Variation Gross State Product Through New Jersey Economic Measures Through Through Average Growth 4.7% 5.8% 3.9% Standard Deviation 2.5% 2.7% 2.2% Coefficient of Variation Personal Income Average Growth 4.9% 5.8% 4.3% Standard Deviation 2.6% 2.0% 2.9% Coefficient of Variation Note: Tax data adjusted to remove effects of law changes. 6

11 Revenue Volatility in New Jersey: Causes, Consequences, and Options Our main findings are: 1. Volatility has been present in the New Jersey revenue system for the past quarter century. As shown in Figure 3, average growth in the state s major taxes (adjusted for law changes) has been 4.1 percent per year, but the standard deviation (that is, the average variation around the long term growth trend) has been 6.3 percent, or one and one-half times the long-term average growth rate. Regarding individual sources, the corporation business tax shows the highest volatility, followed by the gross income tax. The sales tax has been the most stable, with a standard deviation around its long-term growth trend that is about one-half that of the gross income tax, and about 40 percent of the corporation business tax. 2. Volatility increased substantially during the more recent sub-period. Average annual growth in the major taxes fell modestly from 4.4 percent in the through sub-period to 4.0 percent in the through sub-period. At the same time, the standard deviation more than doubled from 3.7 percent to 7.8 percent. This resulted in a sharp increase in the coefficient of variation from 0.86 to Main source of increase the Gross Income Tax. The central reason for the increase in overall volatility has been the dramatic jump in volatility of the largest state revenue source, the GIT. As shown in Figure 2, the standard deviation around its trend growth rate jumped from 4.2 percent during the through sub-period, to 11.6 percent in the through sub-period. In contrast, the second largest tax the sales tax showed a modest decline in volatility between the two periods. The corporation business tax showed a substantial increase in volatility both in absolute terms and relative to the economy. However, given that it is much smaller revenue source than the sales and gross income taxes, its contribution to the overall change is less significant that the GIT. 4. New Jersey revenues have been more volatile than its economy. This is demonstrated in Figure 3, which shows that that the standard deviation in revenue growth has been more than twice that of New Jersey personal income or gross state product. It is also evident from the short-term elasticity estimates shown in Figure 4. Specifically, the 2.55 short-term elasticity estimate for the three taxes combined implies that each one percent variation in statewide personal income growth relative to its long term trend translates into an over two and one-half percent variation in revenue from the big three taxes relative to their combined long-term growth trend. Since , the elasticity has been even higher slightly over 3. The high elasticity, which is attributable to the GIT and corporation taxes, implies a high degree of sensitivity of revenues to the economy. Even modest increases or decreases in economic growth can translate into substantial changes in the trajectory of New Jersey state revenues. Figure 4 Historical Effects of Economic Cycles on Key State Revenues Short Term Elasticity with Respect to Personal Income Full Historical During Recent Two Period Boom-Bust Cycles Through Through Gross Income Tax Sales and Use Tax Corporation Business Tax Three Major Taxes Combined

12 Capitol Matrix Consulting In summary, the statistical calculations confirm what is graphically displayed in Figure 1 that the New Jersey revenue system is volatile, and has become more so over the past 15 years. In the following section we examine factors behind the growing volatility problem. Why Has Volatility Increased? The two main factors are (1) the rising share of total New Jersey revenues coming from the inherently volatile GIT over time, and (2) a substantial increase in the volatility of the GIT itself. Increased Reliance on GIT The first development is highlighted in Figure 5, which shows the increased dominance of the GIT during the past quarter century. Over this period, the GIT was the only major revenue source to grow at a faster rate than the economy. The relatively high growth reflects both policy related factors namely, decisions to raise GIT tax rates over the years and the interaction of income growth with the progressive tax rate structure. Increases in income tend to push taxpayers into higher marginal tax brackets over time, thereby raising their average tax rates. Figure 5 Gross Income Tax Has Become Dominant Revenue Source (Fiscal Year Revenues) Source: Various editions of State Budget and the New Jersey Comprehensive Annual Financial Report, New Jersey Office of Management and Budget. As a result of this relatively faster growth rate, the GIT share of total major tax collections rose from 30 percent in the late 1980s to 45 percent in (see Figure 6). This development is important because the GIT is considerably more volatile than the sales tax, which it has eclipsed over the last 25 years as the state s dominant revenue source. 8

13 Revenue Volatility in New Jersey: Causes, Consequences, and Options Figure 6 GIT's Growing Share of New Jersey Taxes Corporation Business 14% 21% % Gross Income Tax Corporation Business Other Major Taxes 10% % Gross Income Tax 45% 35% Sales and Use Sales and Use 35% Increased Volatility within the GIT As noted earlier, the GIT has experienced a significant increase in volatility in recent years as measured either by the standard deviation around its long-term growth trend or by its estimated short-term elasticity with respect to personal income. This increase can be linked to two related factors: 1) Increased concentration of income and taxes at the top end. Income and, especially, tax payments have become much more concentrated at the top end of the income distribution over time. As shown in Figure 7, the share of total gross income received by the top 10 percent of filers rose from 41 percent in 1991 to a peak of 51 percent in 2007, and taxes paid by this group climbed from 58 percent to 73 percent over this same period. Even at the bottom of the recent steep financial and economic downturn in 2009, the concentration of income and taxes attributable to the top 10 percent of filers remained well above where they were nearly two decades earlier. The increased concentration at the top 1 percent of taxpayers was even more dramatic, with its share of taxes rising from 26 percent in 1991 to 38 percent in (See the Appendix Table for more detail on the historical distribution of GIT income and taxes paid.) 9

14 Capitol Matrix Consulting Figure 7 Income and Taxes Have Become More Concentrated at Upper End (New Jersey Gross Income Tax) Top 10% of Filers (Income Above $150,000 in 2009) 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Share of Gross Income Share of Taxes Paid Top 1% of Filers (Income Above $499,000 in 2009) 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Share of Gross Income Share of Taxes Paid Source: New Jersey Division of Taxation 10

15 Revenue Volatility in New Jersey: Causes, Consequences, and Options 2) Dramatic fluctuations in earnings of high-income taxpayers. The increased income concentration is important because income earned by those at the top of the distribution has historically exhibited much greater volatility than income earned in the lower and middle ranges. As indicated in Figure 8, income accruing to the top 10 percent of filers expanded at a faster rate than the income of their lower- and middle-income counterparts during the upsides of both recent economic cycles. However, on the downsides of these cycles, the income to this top group plunged much more dramatically than did the income in the lower and middle ranges. Figure 8 Earnings of High Income Filers Are Cyclical (Average Annual Percent Change In Gross Income) Capital gains and partnership income are key culprits The principal reason for the greater income fluctuation at the top is that the type of income accruing to these filers is inherently quite volatile. As indicated in Figure 9, over 80 percent of capital gains and over 90 percent of partnership income accrued to the top 10 percent of New Jersey tax filers in 2009, compared to less than 50 percent of compensation and 20 percent of pension income. Figure 10 shows the volatile nature of these income sources. The fluctuations in capital gains have been particularly large in recent years, with net gains rising by as much as 40 percent and plunging by as much as 60 percent in a single year. In contrast, annual changes in compensation stayed within a narrower range between minus 5 percent and plus 8 percent. The volatility in capital gains and partnership income is not surprising given the inherently volatile nature of profits, stock values, real estate values, and other assets that form the basis for these categories of income. Over the long term, capital gains and partnership income have taken on an increasing share of overall income, meaning that their fluctuations have greater effects on overall revenue volatility today than in the past. 11

16 Capitol Matrix Consulting Figure 9 Profits and Capital Gains Accrue to Upper End of Distribution (Percent of Income Source Received By Top 10% of Gross Income Tax Filers) Figure 10 Profits and Capital Gains Are Extremely Volatile Income Sources (Annual Percent Change In Income, By Source). But past policy choices have also played a major role Absent any changes in tax policy, the developments highlighted above increased concentration of income in the hands of high-income taxpayers, and increased volatility of income accruing to the upper end would have made New Jersey s tax system more volatile. However, policy decisions have magnified these effects by increasing the state s relative dependence on volatile income sources. These include provisions such as the adoption and subsequent expansion of 12

17 Revenue Volatility in New Jersey: Causes, Consequences, and Options the earned income tax credit that lowered or eliminated income taxes paid on the relatively stable income earned by lower income taxpayers. But more significantly, they include policies that have increased dependence on those at the top end of the income scale. One example is that, unlike the federal government and some other states, New Jersey fully taxes capital gains. This means that fluctuations in this income source have a larger impact on GIT tax liabilities than would be the case if some of the gains were excluded from tax calculations. Another example is the successive changes made to the income tax rates over the past two decades that have made the tax schedules more progressive. As shown in Figure 11, prior to 1991, the GIT was a relatively flat tax, having just two rates 2 percent on taxable income up to $20,000, and 3.5 percent for income above that amount. To fund an increase in state aid for K- 12 education, New Jersey raised income taxes in 1991 by imposing several higher rates, topping out at 7 percent for income in excess of $150,000. The tax increase was partly reversed through tax cuts in 1994, 1995, and 1996, with most of the rate reductions directed at rates applying to lower income levels. The cumulative effect of these changes was that the tax rate schedule in effect from 1996 to 2003 was considerably more progressive than the pre-1991 schedule. It had marginal rates that were about 30 percent lower then the pre-1991 schedules for incomes of up to $70,000, but more than 80 percent higher for incomes above $150,000. The top rate was raised further in 2004, to 8.97 percent for incomes exceeding $500,000. In 2009, the state temporarily added three new rates 8 percent for incomes above $400,000, percent for incomes exceeding $500,000, and percent for incomes exceeding $1 million. The rate schedule reverted to the pre-2009 levels in 2010 where it has since remained. 6 Figure 11 New Jersey Marginal Tax Rate Have Increased Over Time (Joint and Head of Household Returns) Taxable Income Marginal Tax Rates From To Pre and 2010 Onward , % 1.40% 1.40% 1.40% 20,000 50, % 1.75% 1.75% 1.75% 50,000 70, % 2.45% 2.45% 2.45% 70,000 80, % 3.50% 3.50% 3.50% 80, , % 5.53% 5.53% 5.53% 150, , % 6.37% 6.37% 6.37% 400, , % 6.37% 6.37% 8.00% 500,000 1,000, % 6.37% 8.97% 10.25% 1,000,000 And Above 3.50% 6.37% 8.97% 10.75%. The series of rate changes raised the amount of revenue volatility relative to what would have occurred if the state had either left the income tax rates unchanged, or had accomplished its revenue-raising objectives by simply increasing the pre-1991 rates in a proportional manner. By reducing the effective rates on lower-income taxpayers and raising rates on the high end, the 6 Governor Christie s Budget proposes a 10 percent reduction in GIT rates, phased in over three years. 13

18 Capitol Matrix Consulting state created a greater dependency on the inherently volatile income streams of a relatively few high-earners. As shown in Figure 12, as a result of these changes, the average rate paid by taxpayers in in the top 1 percent of the distribution is currently about triple the average paid by those in the middle of the distribution. In terms of an additional dollar earned, the marginal rate on such income would be nearly 9 percent if it were earned by someone in the top 1 percent of the distribution, compared to 4 percent for someone in the middle part of the distribution. Figure 12 Comparison of Rates Paid on Earnings Received by Taxpayers with Different Income Levels (New Jersey Gross Income Percentiles) Note: In 2009 the 20 th percentile was $9,532, the 40 th was $26,407, the 60 th was $51,775, the 80 th was $100,392, the 90 th was $150,129, the 95 th was $209,703, and the 99 th was $499,015. Impact of Historical Changes to Tax Rate Schedules on Recent Volatility To illustrate the extent to which the increasing progressivity of the tax rate structure has affected the cyclicality and volatility of the GIT, we applied three different tax rate schedules to the actual distribution of taxpayer incomes in New Jersey from 2002 through Specifically, we applied (1) the relatively flat schedule in effect prior to 1991, (2) the more-progressive schedules in effect from 1996 to 2004, and (3) the current schedule, with the still-higher top marginal tax rate on high- income earners. 14

19 Revenue Volatility in New Jersey: Causes, Consequences, and Options Figure 13 Estimated Effects of Alternative Tax Rate Schedules on GIT Liabilities During Recent Business Cycle (Average Annual Growth Rates) Added progressivity boosted revenues during the expansion 14.0% Expansion 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Pre-1991 Schedule Schedule Current Schedule But at the expense of punishing declines in the Great Recession 0.0% Recession -2.0% -4.0% -6.0% -8.0% -10.0% -12.0% -14.0% Pre-1991 Schedule Schedule Current Schedule Figure 13 shows that the increases in progressivity have had substantial effects on revenues during both the upside and downside of the recent business cycle. We estimate that, during the 2003 to 2007 expansion, average annual growth under the present system was 50 percent greater than it would have been under the pre-1991 rate schedules, and nearly 20 percent greater than it would have been under the schedule in effect from 1996 through

20 Capitol Matrix Consulting However, on the downside, the more progressive schedules resulted in a much deeper plunge in revenues during the 2008 to 2009 period than would have occurred under the previous tax rate schedules. As indicated in Figure 13, the present schedule results in decline of 11.5 percent per year, compared to about 10 percent per year under the schedule in effect from 1996 to 2003, and 6 percent under the pre-1991 schedule. We note that the simulation results for the pre-1991 tax structure are similar to what would have occurred if the state had raised the pre-1991 rates in a proportional manner thereby maintaining a relatively flat rate structure to achieve its revenue raising goals over the years. While these simulations cover an unusual boom and bust period that was of historic proportions, they do illustrate the consequences of a progressive tax system for volatility. While a progressive system provides a bounty of revenues during economic expansions, it also produces much steeper revenue declines than its less-progressive counterparts during recessions. Consequences of Volatility for Budgeting and the Economy Revenue volatility makes effective budget planning and management extremely difficult. On the upside of business cycles, strong revenue growth can create unrealistic expectations about the amount of public spending that can be sustained over time. When the subsequent downturn inevitably occurs, it may be not be politically feasible to adjust program expenditures and taxes adequately to offset the extremely large budget shortfalls that can emerge. This leads to negative consequences over the longer term, including structural budget shortfalls, rising debt, and credit downgrades. This has been the experience of New Jersey during the past two decades. As shown in Figure 14, revenue collections in the late 1990s and mid-2000s expansions outpaced budget forecasts by significant margins. However, when the expansions ended, subsequent shortfalls were steep, exceeding 10 percent in both and These boom-bust cycles and in particular the major revenue shortfalls that occurred during the economic downturns contributed to major budget problems in New Jersey. During the second half of the 1990s, the above-average revenue growth enabled the state to both reduce taxes and expand budget commitments in public safety, health care, and other areas. 7 But when the downturn hit, the sharply diminished amount of revenues were no longer able to support the expanded commitments, and major budget shortfalls ensued. The Budget projected an (at the time) unprecedented gap between expenditure commitments and revenues of over $5 billion, or 22 percent of the budget. 7 Budget expenditure data during the late 1990s and early 2000s can be found in New Jersey Comprehensive Annual Report, Statistical Information, For a discussion of budget actions taken in the 1990s and early 2000s, see Randall R. Bovbjerg, State Responses to Budget Crises in 2004: New Jersey, The Urban Institute, February Another factor contributing to New Jersey s structural budget problem was the state s redirection of surplus earnings from its pension fund to other programs in the late 1990s, and subsequent pension enhancements enacted in

21 Revenue Volatility in New Jersey: Causes, Consequences, and Options Figure 14 Difference Between Forecasted and Actual Receipts 8 (Combined Gross Income, Sales and Use, and Corporation Business Taxes) 10.0% Percent of Forecast Amount 5.0% 0.0% -5.0% -10.0% -15.0% The Legislature responded with some cuts to programs and, eventually, tax increases. But these actions were insufficient to close the full gap. To cover the remainder, the Legislature adopted numerous non-recurring budget solutions. These included: the issuance of bonds secured by tobacco settlements and certain motor vehicle taxes; borrowing from special funds; requiring prepayments of tax liabilities; and deferring payments to pension funds. Between and , these non-recurring solutions ranged from slightly under $1 billion to nearly $4 billion annually. 9 These solutions temporarily covered annual budget shortfalls, but they did nothing to address the state s ongoing structural imbalance. In fact, in many instances they aggravated the structural problem by creating future repayment obligations. Partly because of the reliance on one-time solutions, New Jersey has faced structural budget deficits almost continuously since The annual shortfalls diminished as the economy grew through , but then ramped back up again when revenues plunged in , peaking at nearly $11 billion by Though the state has made considerable progress in the past two years, current projections continue to indicate that the state faces a widening budget shortfall absent corrective actions. 10 The extensive use of borrowing and pension deferrals has also contributed to a major increase in the state s long-term debt. As indicated in Figure 15, this debt which includes both bond and non-bond sources grew from $16 billion in to $65 billion by This rapid growth in debt was a key factor behind the state s downgrade by all three major ratings agencies in Forecasted amounts are based on the certified revenue estimates accompanying the enacted budgets. 9 Listings of non-recurring budget actions are included in various editions of The Budget In Brief, New Jersey Office of Management and Budget. See, for example, table entitled Use of Non-Recurring Resources on page 59 of the edition of The Budget in Brief. 10 See, for example, Facing our Future, Updated Report With Options Analysis, Council of New Jersey Grantmakers. February In the report, the Council asserts that, despite meaningful reductions and long term reforms to pension and other post-employment benefit programs, New Jersey state government continues to face a widening gap between revenues current-service expenditures, rising to over $8 billion by absent corrective actions. 11 Consists of bonded debt, including tobacco-backed and other revenue bonds that were used to balance past budgets. Also includes non-bonded debt, such as net pension and retiree health care obligations. Source: through editions of the New Jersey Comprehensive Financial Report, New Jersey Office of Management and Budget. 12 The state s general obligation debt rating was reduced by Standard and Poors from AA to AA- in February 2011, by Moody s Investor Service from Aa3 to Aa2 in April 2011, and by Fitch Ratings from AA- to A+ in August Other factors behind the 17

22 Capitol Matrix Consulting Figure 15 Indirect Consequence of Volatility Rising Long-Term Debt (Sum of bonded and non-bonded debt outstanding, in billions) $70 $60 Billions of Dollars $50 $40 $30 $20 $10 $0 Options for Dealing with Volatility The extreme volatility surrounding the two most recent boom-bust periods may or may not turn out to be an historical anomaly. However, the other factors contributing to volatility in the past the increased reliance on the GIT, increased concentrations of income at the upper end of the income distribution, and the inherently volatile nature of capital gains, business profits and partnership distributions are unlikely to subside in the future. As a result, it is highly likely that revenue volatility will continue to be a problem unless the system is reformed. Given the magnitude of the volatility in New Jersey, stabilizing future budgets in New Jersey will likely require a combination of budget and tax reform strategies. In this section we highlight options in both of these areas. Budget Options The most effective budget option is the creation and maintenance of more expansive budget reserves, along with meaningful requirements relating to annual appropriations to the reserve and controls on spending from the reserve. Revenues set aside into such reserves during revenue expansions would be available to cushion the budget during downturns. Also, requiring the allocation of a significant portion of above-average revenue growth to reserves reduces the risk of committing one-time revenue surges for ongoing purposes. 13 ratings downgrades included concerns that the 2012 budget was based on optimistic assumptions about revenues and budget reductions, and the budget s reliance on non-recurring revenues and one-time savings. (See, for example, Global Credit Portal, New Jersey Transportation Trust Fund Authority. New Jersey: Appropriations: General Obligation; Joint Criteria. Standard & Poors. November 9, 2011). 13 New Jersey has various financial management provisions in law aimed at maintaining a balanced budget and restricting appropriations of unanticipated funds, but they are far from comprehensive and have not prevented significant deficits from occurring. The State Constitution requires that appropriations not exceed anticipated resources. State law also limits the growth in the state operations portion of the budget to a three-year average growth rate in per-capita personal income, though the Legislature 18

23 Revenue Volatility in New Jersey: Causes, Consequences, and Options A second budget-related option is adoption of a requirement that proceeds from above-average revenue growth be dedicated only to one-time purposes such as payoffs of deferred pension obligations or buy-downs of outstanding debt. This would also avoid the commitment of onetime resources to ongoing purposes and reduce the state s debt. Though both these options could be effective, it is unlikely that these types of budget strategies, used alone, would be adequate to fully stabilize New Jersey s budgets. Set-asides may be able to cushion the state against moderate-sized shortfalls and perhaps buy the state time to deal with steeper declines. However, it may not be politically feasible to set aside enough funds to protect the budget against the steeper declines that can occur under New Jersey s current volatile revenue system. We estimate that the state would need to build a reserve equal to one-quarter or more of its annual budgets to protect against the larger revenue declines that have occurred during the past quarter century. In the current tough budget environment, in particular, major set-asides would have to be weighed against other budget priorities. For these reasons, stabilization of New Jersey s budget will most likely require a combination of budget- and tax-reforms. Tax Reform Options Figure 16 outlines several tax revisions that would specifically reduce the magnitude of revenue volatility. We also discuss some of the key policy trade-offs that would be involved with each option. may exceed this limit if the bill making the appropriation receives two-thirds vote in both houses. The state also has a Surplus Revenue Fund, which receives 50 percent of the revenues exceeding certified projections made at the beginning of the year, and requires that expenditures from the fund only be made to cover fiscal emergencies or upon a finding that revenues are below certified estimates. However, the state s largest and most volatile tax the GIT is excluded from this reserve. 19

24 Capitol Matrix Consulting Figure 16 Tax Reform Options for Dealing with Volatility Option Reduction In Volatility Other Benefits and Policy Trade-Offs 1. Reduce progressivity of GIT. Potentially substantial. Going to flat tax would reduce GIT volatility by 30 percent or more. Increased competitiveness of tax system. Shift in tax burden among income groups. Reduction in long-term revenue growth. 2. Reduce GIT rates on capital gains. 3. Rebalance taxes away from the GIT and toward less volatile sales and use tax. 5. Eliminate corporation business tax. Replace with tax on gross receipts attributable to New Jersey. Moderate to substantial reduction, depending on rate reduction. Modest reduction. Modest reduction, given relatively small share this tax contributes to total collections. Increased competitiveness of tax system. Potentially increase returns on investments in the state. Shift in tax burdens among income groups and among taxpayers with different types of income. Could result in broader based revenue system if rebalancing involves expansion of sales tax base. Modest to moderate shift in tax burdens toward lower income groups, depending on how structured. Shift in tax burdens among corporations. Would reduce conformity with most other states. 6. Income averaging. Moderate reduction. Non-conformity with federal government and other states. Reduce Progressivity of the GIT The most direct way to lower revenue volatility in New Jersey would be to reduce the progressivity of its GIT tax rate structure. This could be done in a revenue neutral way by combining reduced rates at the top end with higher rates at the low end. Or alternatively, a reduction in top rates could be replaced through tax increases from other sources. The flatter rate structure would reduce volatility by lessening the state s relative dependence on capital gains, business income, and other volatile income sources that flow to high-income taxpayers. If the state were to adopt a flat tax on all income, the GIT volatility would be reduced by about one-third. A reduction in top rates would have the additional benefit of making the New Jersey tax system more competitive with neighboring states. This is especially true given New Jersey s high combined state and local tax burden, its proximity to New York and other out-of-state urban centers, and the amount of cross-border commuting for work and other purposes. While recent migration studies focusing on New Jersey have reached varying conclusions about the magnitude 20

25 Revenue Volatility in New Jersey: Causes, Consequences, and Options of such tax-related effects on migration patterns and the economy, a reduction would clearly have some positive effects on the state s business climate and overall economic competitiveness. 14 A key policy tradeoff of this approach is that a flattening of the tax rate structure would result in a significant shift in tax burden from high-income to moderate-income and low-income taxpayers. An offsetting increase in virtually any alternative tax source would also likely result in a shift in burdens down the income scale, since virtually all other taxes are less progressive than the GIT. The countervailing argument is that some increase in the bottom rates is consistent with the principal that government services for education, health care, public safety and other purposes benefit citizens of all income levels, and everyone should have a stake in controlling the cost of government. Under the current progressive GIT rate structure, nearly one-third of taxpayers with positive incomes of less than $50,000 pay no income tax. For those with positive incomes less than $25,000, the share paying no income taxes is 57 percent. 15 The other trade-off is that reducing the progressivity of the GIT would tend to lower its long-term growth rate. As noted earlier, the GIT has been the state s fastest-growing revenue source. This is partly due to its progressive tax rate structure, under which taxpayers experiencing rising income levels are subjected to higher marginal tax rates over time. A flatter tax rate structure would reduce this effect. Reduce Rate on Capital Gains Another direct way to lower volatility is to reduce the state s dependence on the most volatile income source capital gains either by reducing the rate or excluding a portion of the gains from taxation. Like most other states, New Jersey taxes most capital gains as ordinary income. This is in contrast to the federal government, which taxes long-term gains at a reduced rate. Cutting the maximum rate on capital gains by half (from 8.97 to about 4.49 percent) would reduce average GIT volatility by about 25 percent. It would also make New Jersey s tax code more competitive relative to surrounding states, which do not provide preferential rates. As with the first option, the main policy trade-off is that a reduction in the dependence on capital gains will shift the tax burden away from the top end of the distribution, since, as noted earlier, over 80 percent of the gains are received by the top 10 percent of income tax filers. The revenue reductions could be offset through broad-based increases from other tax sources, but since no other tax is as progressive as the GIT, any reduction in capital gains taxes will likely result in a shift in tax burdens toward lower income taxpayers. The state could also raise the top rate for non-capital gains earnings to compensate for the revenue loss. However, that would have negative consequences for business owners, which would face higher tax rates on proprietor income, S-corporations, and partnership distributions. Increase Reliance on Alternative Taxes Under this option, the state could implement an across-the-board reduction to the GIT and simultaneously increase reliance on alternative taxes. Such a change could be made in a revenueneutral fashion through, for example, a corresponding increase in the relatively stable sales and use tax either through a tax rate increase or a broadening of the sales tax base to include additional services. The trade-off, again, would be that, compared to the income tax, the sales tax is more regressive. Thus, there would be a shift in tax burden from the high end to those in the lower and middle parts of the income distribution. 14 For a review of recent studies on the relationship between New Jersey tax policies and out-migration of high wealth individuals, see pages A-11 through A-17 of Analysis of the New Jersey Budget, Tax and Revenue Outlook, Office of Legislative Services, New Jersey Legislature. 15 Source: Statistics of Income, 2009 New Jersey Division of Taxation. 21