Why states should have expected tax payments to fall

In recent months, several governors have complained about the April, 2014, surprise in state tax revenues. They say they were shocked when personal income tax payments fell far below expectations. They shouldn’t have been.

What happened? In part, in an effort to beat an upcoming increase in capital gains taxes, investors accelerated realizations into tax year 2012, artificially increasing their tax payments in April, 2013. Most state revenue estimators recognized the bump but a few used the high base and forecast continued high payments again in 2014. That windfall did not happen and those states were faced with embarrassing shortfalls.

There are some surprises every April 15, as taxpayers settle up with both the IRS and those states with a personal income tax. Sometimes the surprise is pleasant, like last year, and sometimes ugly, like this year.

But it should not have been so shocking. Investors timing asset sales in response to changes in capital gains tax rates is hardly new. And they often exacerbate swings caused by a changing stock market.

First a little background. In 2012, federal tax law was filled with temporary extensions from 2010 expirations of tax cuts including a preferential capital gains tax rate. In addition, the 2010 Affordable Care Act also raised taxes on capital gains for some investors. As a result, taxpayers shifted capital gains realizations into 2012 to avoid higher federal taxes. If this sounds familiar, it happened in 1986.

Add to that a strong stock market rebound and those April 2013 returns reported a lot more capital gains than anyone expected. The Congressional Budget Office reported that federal income tax collections were 20 percent higher in April, 2013 than April, 2012.

The same thing happened in the states, where individual income tax revenue in the second quarter of 2013 was 18.4 percent higher than the same period in 2012. (California alone was responsible for about 2 percentage points of the growth –not only did it raise its top tax rates in 2012 but it also raked in a pile of tax as residents took profits from Facebook’s initial public offering).

The real surprise came this past April when income tax revenues tanked as final payments came in well below forecast.  A few states got it right. Ohio projected a loss of about 17 percent (because of tax cuts in addition to the capital gains shift) and was pretty happy when income tax only fell 15 percent.  Same with California where the underestimate of income tax led to the first year end surplus since 2007.  But a lot of states projected income tax growth and came up empty. Some, like New Jersey, were way off the mark.

For the estimate of capital gains, the strong market in 2013 (the SP500 was up 19 percent) was the main reason for optimism.  For example, Arizona’s estimators recognized the shift in capital gains, reducing revenue by $52 million over three years but added revenue because of the strong 2013 market performance. Maryland’s Board of Revenue Estimates told a similar story: a strong stock market and rebounding housing market offset the shift in capital gains. Both states ended up with much less income tax than they had planned for.

Fortunately, Congress isn’t making any big tax changes this year so state economists can take the opportunity to improve their models.  But the feds have not eschewed short term tax gimmicks –pension smoothing anyone? So state revenue forecasters will still need to understand how taxpayers react to uncertain tax rules, both federal and state.