Taxing the rich makes state revenue stream more volatile

Advocates for a more progressive state income tax won key battles in 2009 and again this spring as new top rates place even higher burdens on Connecticut’s wealthiest households.

But that came with a price: Nearly 40 percent of the state’s chief revenue source now stems from a quarterly payment system that largely reflects the volatile conditions of Wall Street. During the recent recession, turmoil in the financial markets yanked more than $1.4 billion out of the state’s coffers.

“There is a price to pay from over reliance on revenues derived from taxing the incomes of wealthy people,” Sen. Andrew W. Roraback of Goshen, ranking GOP senator on the Finance, Revenue and Bonding Committee, said. “It’s a dangerous game, and we’ve amplified it.”

According to the latest report from the state Department of Revenue Services, nearly $2.7 billion of Connecticut’s income tax revenues last fiscal year, 39.2 percent, came from quarterly payments rather than paycheck withholding. Those quarterly payments, though they also come from the self-employed at many income levels, primarily represent earnings tied to capital gains, dividends and other investment income generated by Connecticut’s richest households.

In 1995, just before the legislature first modified the income tax to make it more progressive, this source provided just 26 percent of total income tax receipts.

Receipts from capital gains and dividends tends to peak during boom times, drop during  economic downswings, and then rebound faster than receipts from paycheck withholding, just as Wall Street typically recovers faster than the job market.

But while the state income tax reflects these cycles, Connecticut’s reliance on Wall Street earnings has become a little greater each time around.

The share of income tax receipts from quarterly payments remained in the high 20s and low 30s until 2001–just before the economy slumped into recession–when it hit 37 percent. Coming out of that downswing in 2004, it climbed to 32 percent.

Just before the most recent recession began in 2008, capital gains and other investment earnings provided almost 42 percent of all income taxes. And within two years of that peak, after the recession had bottomed out, the ratio was back to 39 percent.

But the biggest problem with relying on this revenue source, critics note, is that when times are bad, it shrinks rapidly, sending the state budget into violent fiscal contractions.

Taxes from quarterly payments shot up 18 percent in 2008, topping $3.1 billion. One year later they fell 27 percent, losing $900 million of their value. They would have fallen another 21 percent, or nearly $500 million more, in 2010, had Rell and the legislature not raised income tax rates on the wealthy.

“The system sets us up to spend way too much money when times are good, and then get clobbered when times are bad,” Peter Gioia, chief economist for the Connecticut Business and Industry Association, said. “This is nuts.”

Both Gov. Dannel P. Malloy’s budget chief and the House chairwoman of the finance committee said they struggled with this problem during the last legislative session as they closed a record-setting $3.67 billion hole built into the 2011-12 budget.

“We understand that we are very dependent on a very small segment of the state for a lot of our revenue stream,” said Rep. Patricia Widlitz, D-Guilford. “We tried very hard to look at spreading out the burden to make sure it didn’t fall too heavily in any one place.”

But Widlitz noted the tax also had long been criticized for not placing a fair burden on the wealthy.

“There’s been a massive run-up of inequality in Connecticut,” said Wade Gibson, senior policy fellow for Connecticut Voices for Children, a New Haven-based public policy research and social services advocacy group.

Buoyed by a five-year stretch during which their collected adjusted gross income shot upward by more than 230 percent–a growth spike unmatched in the 19-year history of the state income tax–filers earning more than $1 million reported a total adjusted gross income for 2008 more than double that of 2002, according to Department of Revenue Services records.

Even after the worst year of the recession in 2009, those households’ incomes still stood at nearly 140 percent above 2002 levels.

In a simple comparison, for those who didn’t top the $1 million mark, 2002 through 2008 offered more modest growth of 21 percent.

When the 1991 legislature and then-Gov. Lowell P. Weicker Jr. launched the state income tax, it largely was a flat levy with a 4.5 percent tax on all wages. At the same time the capital gains tax, with a top rate of 14 percent, was abolished.

Within the first five years lawmakers also had adopted small personal credits and exemptions, a 3 percent rate on the first $10,000 taxed on individuals and the first $20,000 on couples, and a property tax credit.

But most of those changes were aimed at ensuring low-income households paid no taxes and didn’t do much to separate the effective rates charged to middle-income and wealthy earners. And when the income tax faced its first increase in 2003, the principal 4.5 percent rate was increased to 5 percent for nearly all households.

It wasn’t until 2009 that then-Gov. M. Jodi Rell, a Republican, helped end a seven-month budget standoff with the Democrat-controlled legislature and agreed to support a new top rate of 6.5 percent on earnings above $500,000 for singles and $1 million for couples.

Malloy followed that up this year by creating several new rates, including a new top level of 6.7 percent on income above $250,000 for individuals and $500,000 for couples. The governor and legislature also added a “recapture” provision that effectively taxes most of the wealthiest households’ earnings at top rates.

Office of Policy and Management Secretary Benjamin Barnes, Malloy’s budget chief, said “I am happy that we have some people in Connecticut who are doing so well, but I am troubled that we are getting almost 40 percent” of the income tax from quarterly payments.

Barnes acknowledged that the tax has been made more progressive in recent years, but he said Connecticut’s high unemployment rate of 9.1 percent also has played a role in expanding this portion of the income tax stream.

“As some people lose their jobs, they don’t become unemployed,” he said. Depending on the skills they possess, “many become self-employed” and then pay their taxes quarterly rather than through paycheck withholding.

The volatile nature of the income tax was one of the reasons the administration opposed certain groups’ calls for a top rate of 9 or 10 percent on top earners.

But Barnes also said the administration built large surpluses into the new budgets for this fiscal year and next, and wants to rebuild the state’s emergency reserve to help guard against future economic downswings.

Still, Rep. Sean Williams of Watertown, the top House Republican on the finance committee, said he fears that Connecticut’s fiscal roller-coaster ride on the income tax is likely to accelerate with steeper highs and deeper lows.

And Williams added that a new fiscal plunge may not be far away in Connecticut’s future, given that the new $20.14 billion budget approved for this fiscal year increases spending nearly 5 percent over 2010-11.

“This administration has doubled down on the hope that the economy is going to improve,” Williams said. “But if it doesn’t’ we’re could be looking at more budget deficits.”

And if Wall Street’s performance over the last two weeks is any indication, Williams could be right.

The Dow Jones Industrial Average, one of the leading indicators of blue chip stock health, has lost over 1,340 points since reaching 12,724 on July 21.

“It’s hard not to be fearful of what lies ahead,” Roraback said. “Wall Street has really taken it on the chin.”