Governments Can Diversify Risk Too

A basic economic rule of income taxation is that revenues are relative to the overall economy. When the economy is good, so are income tax receipts. When the economy contracts so do income tax revenues.

There is no big mystery in this rule. Logically, it is in government’s interest to work for a robust economy. The better the economy does, in essence, the more the government has to spend. Or at least it would work that way if the amount our politicians allocate had more than just a passing connection to government revenues.

I noted a few months ago that the amount of taxes actually paid by Americans has in effect become much more progressive during the Bush years. The rates haven’t become more progressive, but actual payments have. Nearly half of all “taxpayers” pay no federal income tax at all.

This creates a perverse incentive for the half that pays little or nothing to clamor for expansion of government services at the expense of the other half. In effect, they vote themselves benefits from their neighbors’ bank accounts. Although they pay disguised taxes in the form of reduced opportunity and productivity, the lack of a direct cost causes them to want more of what they don’t expressly pay for.

The effectual progressive tax has yet another problem; a problem that is exacerbated when heavier taxes are levied on specific sectors or when an economy relies too much on a given sector. Government revenues become increasingly dependent on the performance of a decreasing number of taxpayers. Any economic effect that more strongly impacts those that pay a higher percentage of the taxes has an outsized impact on government revenues.

This works in general. If those that typically pay capital gains taxes — usually the wealthier people — suddenly have no capital gains (as in our current downturn), the capital gains revenues government has been used to receiving go away also. If capital gains have made up a hefty portion of tax revenues, government revenues will be disproportionately impacted.

The principle also works in relation to specific sectors. An economy that is heavily skewed to a given sector puts government at excessive risk should that sector go south. Both New York City and the State of New York are discovering this problem right now, as explained by the WSJ Editors.

Financial sector income increased from 2% to 20% of total income in New York over a 30-year period. Government revenues became tightly tied to this source. Now that the sector has fallen flat, both the city and state are scrambling trying to figure out how to deal with the massive decrease in tax revenues.

States like Michigan and Ohio that spent decades courting, developing, and kowtowing to specific industries now find their fates inseparably tied to those industries. So tightly linked are they that they are incapable of breaking out of policies that doom them even decades after it has become clear that the heyday of those industries is permanently gone. Instead of adjusting, they’d rather look to federal taxpayers to help fund their rut.

When it comes to income taxation, it is best to follow the advice mutual fund brokers have repeatedly pushed (often to deaf ears) over the years. Diversify your portfolio to reduce risk. Instead of relying on a steadily decreasing number of “rich” taxpayers, governments can hedge against hard times with flatter tax systems that more evenly spread the burden throughout the economy.

Of course, this creates a situation politicians wish to avoid. It is in the blood of Americans (one of our nation’s founding principles) to stand against general tax increases. Americans don’t get too upset about tax increases on the other guy — the guy that supposedly “can afford to pay more.” But they get downright testy when their own taxes are directly increased. Politicians that raise taxes in flatter tax systems end up enduring the wrath of the taxpayers.

There are those that love to sing the praises of progressive taxation and there are those that like to listen to those songs. But the fact is that when it comes to government revenues, the path of progressive taxation is progressively risky.