After flatlining for the past year, US income tax receipts – both at the federal government and on a state and local level – have been disappointing, and have posted a sharp drop since the start of the year, which is “sounding an alarm about the health of the US economy” in BofA’s words (in addition to the countless other alarms about the health of the economy, which however are ignored due to the record stock market).
As Bank of America highlights something we warned about last September, according to the Rockefeller Institute and CBO, US federal income tax receipts have come in about 3% below expectations this year.
Digging deeper, the disappointment was largely in personal current tax receipts, with withheld tax receipts showing little growth over the prior two quarters. The story is a bit different for state and local governments where personal tax receipts were fairly stable, but there was a significant decline in tax receipts for corporate income.
In fact, corporate income tax receipts fell a sharp $7bn in 1Q, the biggest drop since the recession. Since corporate income tax receipts only make up about 14% of the total, there was still a modest gain in overall state and local tax receipts. While there has been particular weakness of late, the trend through last year was weak; according to the Rockefeller Institute, total state tax collections grew only 1.2% in FY16 (declined in real terms), the weakest performance since 2010.
In an attempt to explain away this otherwise troubling development, the CBO has proposed that the weakness in tax receipts may reflect the shift of taxpayer income into later years on the anticipation of legislation to reduce tax rates, which however is looking increasingly unlikely. Presumably this would have the biggest effect on high income and high net-worth individuals. And this will matter for the aggregate figures as the top 1% of earners account for almost 40% of federal personal income tax receipts.
If, indeed, it is the case that high-net worth individuals and smaller corporations are delaying payments, there would be pent-up tax receipts. As such, tax receipts should jump if and when tax reform is passed or it becomes clear it will fail. Either way, behavior should shift, leading to an increase in declarations of income. The question is over timing
A more likely explanation is that state tax collections continue to be strain from the energy sector, which pays taxes based not on non-GAAP imaginare “wishful earnings”, but on hard cash, which for most companies, is still a trickle. This is confirmed by a map of tax receipts on a geographical basis which isolates the energy-patch states. There is a clear pattern of weakness in energy states like Wyoming, West Virginia, Texas, Oklahoma, and North Dakota. Alaska is also heavily oil-dependent and while growth in tax receipts increased sharply, it is coming from a subdued base.
While a modest recovery in oil prices earlier in the year may have helped, the recent decline will undoubtedly add to further pressure on state corporate tax receipts.
Why does this sharp drop in tax revenues matter? Simple: tax receipts are tracked for varioous reasons, most directly they influence the forecast for government spending. As BofA notes, “a slowdown in tax receipts could lead state and local governments to reduce spending or increase taxes to make ends meet.”
According to the Rockefeller Institute, uncertainty surrounding federal tax reforms “leaves the states in the dark as they are finalizing state budgets for the fiscal year 2018.” It would seem the combination of potential policy changes on the horizon and the weakening in tax collections results in weak state and local spending. And the data already show hesitance on the part of state and local governments, with state and local government expenditure slicing an average of 0.06ppt from GDP growth over the past four quarters (Chart 3).
On a federal level, it will impact the amount the government has to borrow to fund its deficit, therefore determining when the government will hit the debt ceiling. This is quite relevant today since the debt ceiling was officially reached on 17 March and has been extended using extraordinary measures. However, the weakness in tax receipts could create challenges, pulling forward the date that the debt ceiling is hit. This was likely a motivating factor for Treasury Secretary Mnuchin to ask Congress to raise the debt ceiling before the Congressional summer recess begins on 28 July. In our view it is possible this becomes another point of conflict in Washington in coming weeks.
But most importantly, economists care about tax receipts because it is one of the few unvarnished, unadjusted, and realistic data points regarding the health of the overall economy. Tax receipts are a function of income creation in the economy: a slow-down in tax receipts indicates a slowing in income creation and therefore overall economic performance. Growth in federal tax receipts trends with the growth in aggregate payrolls (aggregate hours worked x earnings), which is why the recent deterioration in federal tax receipted is especially troubling.