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Tax VOX

Surprise! Tax revenues up, but should we celebrate?

California reported that its April income tax revenues were higher than expected. But where did the money come from?

By Kim RuebenGuest blogger / May 25, 2011

A teacher holds up a sign during a protest against education budget cuts in Los Angeles, Friday, May 13, 2011. California's budget is coming closer to being balanced. How?

Jae C. Hong / AP

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As I noted a couple of weeks ago, California’s April income tax revenues were well above forecast levels. Many other states, especially those reliant on somewhat progressive income taxes have also reported higher than expected revenues. Goldman Sachs reports first quarter state revenues were up 9 percent year over year with April alone up 12 percent. Last week, Governor Brown’s May Revise (the update to his January budget) anticipated an additional $3.5 billion in revenues for the current fiscal year, and a combined two-year gain of $6.6 billion. Coupled with budget actions adopted in March (about $13 billion) this brings California’s budget closer to balance from an estimated $25 billion in the red to a $9.6 billion budget gap. So what’s happening here?

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Before we pop the champagne, let’s look at both where the money is coming from and what that source means to the budget process. Federal and state personal income tax revenues are up nationwide even though in some places corporate taxes are down. The revenue gain may reflect stronger ongoing economic activity, but it could also represent a one-time revenue boost due to taxpayer actions. I already blogged about potential revenue gains from IRA conversions. Conversations with others over the last week have suggested other possible explanations. Although the two-year extension of the Bush tax cuts kept capital gains tax rates low, that didn’t happen until mid-December. I’m guessing at least some high-wealth households decided to realize some capital gains to lock in the 2010 rates and avoid the uncertainty of potentially higher future rates. After all, it was pretty clear that tax rates on long term capital gains wouldn’t go down come 2011 and investment advisors seemed to think that realizing gains was worth considering. In 1986 when taxpayers knew for certain that tax rates were increasing in the following year, realizations spiked to 7 percent of GDP before falling back down in 1987. Thus, uncertainty in federal tax policy may have led to a boom in this year’s revenues that might not last.

Why does this matter? For starters, states still need to deal with ongoing structural deficits. If states think the higher revenues will be permanent, they may postpone hard decisions. As Billy Hamilton (a former deputy state controller in Texas) said in a recent Pew Center for the States and the Rockefeller Institute report, “One of the rules of revenue estimating is ‘It’s the turns that kill you’”.