July 2017
April income tax returns brought bad news for state budgets. Payments with tax returns usually arrive in April and early May, and often they are surprising. By mid-to-late May, states know whether those payments were surprisingly good or surprisingly bad. The news often comes as states are finalizing the budget for the new fiscal year, complicating this already challenging task.
To learn how states did this year, we collected data from forty-one states with broad-based income taxes. This April, total state income tax revenue was down 4 percent compared to the previous year, driven by declines of 7.3 percent in final returns and 4.3 percent in estimated payments, more than offsetting 5.3 percent growth in withholding tax collections. April income tax revenue fell in twenty-four of forty-one states for which we have data. The declines were largest in the New England and Mid-Atlantic states, followed by Southern states. April revenue was up in the Great Lakes and Rocky Mountain states.
Although many states had forecasted declines in April and May, they were worse than expected. Nineteen out of twenty-one states that publish monthly cash flow forecasts fell short in April and May. The median shortfall was 6.4 percent in the months of April and May. Many states that do not publish their monthly cash flows probably also fell short.
Forecasters are working to learn why tax revenue fell short, and what it means for the future. Fortunately, the revenue declines and shortfalls were not as large as some states have witnessed in recent years.
An April shortfall generally means that taxable income in the prior tax year, which is only an estimate at this point, was lower than estimated. This overestimation could occur in two ways: (1) taxable income may have diverged from economic measures of income in ways that aren’t reflected in published data; or (2) the underlying economy in the prior year may have been weaker than preliminary data suggested.
We believe the first explanation — taxable income diverged from economic measures of income — is at least partly to blame. Taxpayers probably shifted taxable income out of 2016 into 2017 or beyond in the hope of benefiting from promised federal tax cuts — a “Trump Effect.” Taxpayers may have shifted capital gains on stocks, which are relatively easy to defer and are not included in economic measures of income. They may also have shifted other income, such as interest, dividends, and IRA distributions, albeit to a lesser extent. Some states anticipated these moves, revising their forecasts downward to project declines in estimated and final payments. Even so, actual personal income tax (PIT) revenue collections in April were significantly below state forecasts. To the extent that a Trump Effect was the cause, states may see strong revenue growth next April from this year’s depressed April, if income shifted out of 2016 is taxed on 2017 returns.
The second explanation — a weaker-than-estimated economy — also could play a role. If preliminary economic statistics for 2016, which at this point in the federal government’s reporting are based on partial data, overstated last year’s income, then revenue forecasters may have expected stronger final returns than perfect data would have warranted. Economic data are revised, sometimes substantially, as new data become available. If some of last year’s income growth is revised away, economic forecasters may revise their assessment of current economic conditions downward and lower their expectations for growth over the year ahead. In this case, the implication for revenue forecasters could be the opposite of the Trump Effect: slower growth ahead, rather than a bump in next April’s tax returns.
The Trump Effect or a weak economy may be to blame, or both could be at work at the same time. Data released in coming months will begin to unravel the mystery, but it could be a year or more before forecasters really understand what happened and why. Until then, we and state revenue forecasters will have little hard data to go on.
We begin with the gloomy news, and then discuss possible causes and implications.
