Volatility of the Personal Income Tax Base

Volatility of the Personal Income Tax Base MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • FEBRUARY 2017 Summary This brief provides some perspectives on the volatility of California’s personal income tax (PIT) base. California’s Income Tax Base Much More Volatile Than Statewide “Personal Income.” Personal income is a widely used measure of the size of California’s economy, as reported quarterly by the U.S. Bureau of Economic Analysis (BEA). From 1990 to 2014, California personal income grew fairly consistently, with only a limited degree of volatility. On the other hand, the state’s PIT tax base was much more volatile than personal income. This is because (1) some of the more stable pieces of personal income are not taxed under California’s PIT and (2) the PIT tax base includes capital gains (gains on sales of stock, bonds, certain homes, and other assets), which are extremely volatile from year to year and are not counted by BEA in personal income. In an effort to protect the state budget from some of the volatility of capital gains, California has adopted a constitutional provision requiring PIT deposits into a state rainy-day fund in years when capital gains are plentiful. This Brief Discusses Part of the Picture . . . Not the Whole Picture. This brief examines the volatility of the PIT tax base—one important element of the PIT’s overall volatility—but this does not provide the whole picture. Specifically, this brief does not consider how the state’s progressive PIT rate structure (in which high-income Californians pay a bigger fraction of their income than lower- and middle-income Californians), deductions, exemptions, and credits affect the volatility of PIT revenues paid to the state. We anticipate discussing the volatility resulting from some of these other choices—choices the state has made about how to tax its PIT tax base—in future analyses. AN LAO BRIEF Introduction PIT structure is progressive (meaning that higher- income people pay a bigger fraction of their income In this brief, we provide perspectives on the in income taxes than lower-income people do), volatility of California’s personal income tax (PIT) some elements of this PIT base are effectively taxed base. The PIT is state government’s most important at higher rates than other elements. This brief does revenue source, making up about two thirds not consider directly how tax rate progressivity, of the state General Fund. This fund supports deductions, exemptions, or credits affect volatility schools, universities, major health and social of PIT revenues paid to the state. We anticipate services programs, prisons, and other state-funded discussing the volatility resulting from some of programs. In this brief, we compare the PIT tax these other choices—choices the state has made base to personal income, a broad measure of the about how to tax its PIT tax base—in future state’s economy produced by the U.S. Bureau of analyses. Economic Analysis (BEA), and examine how these two factors change from year to year (that is, the The BEA Personal Income Measure volatility of both PIT and BEA’s personal income Personal income is measured quarterly by measure). Specifically, this brief discusses: BEA, and it is a key economic statistic that we • BEA’s personal income measure. track to measure the rate of growth of the state and • How BEA’s personal income measure national economies. As shown in Figure 1, wages compares to the tax base of California’s PIT. and salaries make up nearly half of BEA personal income for California. Below, we describe what is • A measure of the year-to-year volatility of included in this personal income measure, starting income and taxes: “average deviation” (AD). with the biggest component of personal income: wages and salaries. • The AD of major elements of California’s Figure 1 PIT base, such as wages Wages and Salaries Make Up and capital gains. This Nearly Half of Personal Income will help illustrate what LAO Estimates, 2016 drives the volatility of Transfer Payments the tax base. • Some brief perspectives on the implications of PIT tax base volatility. Wages and Dividends, Interest, Salariesa Part of the Picture . . . and Rent Not the Whole Picture. This brief examines the volatility of the PIT tax base. This is one Proprietor and Partnership Income important element of the PIT’s overall volatility, but does not Employer-Paid Benefits provide the whole picture. In a Net of social insurance contributions. particular, since the state’s 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF Wages and Salaries. BEA measures wages and for about 5 percent of this category’s total in salaries before deductions (such as payroll taxes California. and employees’ 401[k] contributions). Wages and Employer-Paid Benefits. This includes the salaries include commissions, tips, bonuses, and value of employer contributions to employee gains from exercising stock options. pension and insurance plans including health, life, Dividends, Interest, and Rent. BEA’s personal workers’ compensation, and unemployment. (The income measure includes cash payments of employer portion of the payroll taxes for Social dividends, interest, and rent. It also includes two Security and Medicare is listed under “benefits” categories of income—called imputed rent and in BEA’s data tables but is omitted from tables in imputed interest—that do not directly give people this brief because it has no net effect on personal more cash to spend. Imputed rent is the estimated income.) amount that homeowners would have to spend if, California’s PIT Tax Base instead of owning, they rented their own homes. The idea of imputed rent is that not having to pay The tax base used by California for its personal rent effectively gives homeowners more income. income tax is similar to the federal government’s, Imputed interest includes investment income but is set in state law. Figure 2 summarizes the earned on insurance policies, the value of implicit major components of the state’s PIT tax base as services provided by banks and other lenders, and reported on federal and state tax forms. It shows interest earned on employee pension plans. that well over half of the base consists of wages and Transfer Payments. Transfer payments consist salaries. A comparison of Figure 1 and Figure 2 mainly of government payments to and for the reveals some of the differences between BEA benefit of individuals, such as Social Security, personal income and the state’s PIT tax base. In this disability payments, Medicare and Medicaid payments, Figure 2 unemployment insurance Wages and Salaries Make Up benefits, and veterans’ Well Over Half of Personal Income Tax Base benefits. The only private LAO Estimates, 2016 transfer payments are personal Retirement injury liability payments and (Pension/IRA) Distributions Other corporate gifts to nonprofits. Proprietors’ and Capital Gains Partnership Income. This Dividends, Interest, category in the BEA personal and Rent income measure refers to the net business income from Proprietor and Partnership proprietorships (typically small Income businesses with a single owner) Wages and Salariesa and partnerships (a form of small business organization with multiple owners). Farm a Net of deferrals such as employee contributions to retirement plans, including 401(k) plans. IRA = Individual Retirement Account. income typically accounts www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO BRIEF section, we will describe some of these differences. made. For example, California does not tax In general, California chooses to tax most, but not pension contributions when they are made all, elements of BEA personal income, and it also but rather taxes pension income employees chooses to tax some types of income not included receive in retirement. Similarly, essentially in the BEA personal income measure. none of the items classified as transfer PIT Does Not Tax Some Elements of Personal payments are taxable under the state PIT. Income. For each piece of personal income Some Social Security payments, however, measured by BEA, the taxable component (that is, are taxable at the federal level. the part of personal income taxed by California’s • Most Dividends, Interest, and Rent in PIT) is smaller than the total income in that BEA Measure Not Taxed. Only a small category. There are various reasons for these fraction of income from dividends, interest, differences: and rent is taxable at the state level. The • Non-Reporting or No Requirement to state does not tax imputed rent. Dividends Report Certain Income on Tax Returns. and interest received by pension and life In the cases of wage and salary income and insurance plans are not counted as income business income from proprietorships and for tax purposes in the year the plans’ partnerships, the discrepancies likely stem investments generate that income. from taxpayers not reporting (or not being PIT Taxes Some Dollars Not Included in BEA required to report) all of their income on Personal Income. Two significant pieces of the PIT PIT tax returns. This occurs for various base—capital gains and retirement distributions— reasons. For example, residents with total are not defined as being part of personal income. income low enough to have a state tax A capital gain is the difference between the selling liability of zero are not required to file, price of an asset (stock, bond, building, etc.) and although many indeed file state returns. the asset’s original purchase price. Asset sales For purposes of this brief, we exclude the are not included in BEA’s estimates of personal non-filers’ income from the PIT tax base income or output. Distributions from pensions and as we have no data on their income and individual retirement accounts often are taxable would not be able to estimate it with any in the year that they are withdrawn, but BEA has precision. In addition, underreporting already counted them as personal income once of business income on tax returns is a when the initial contributions were made. In other longstanding issue at both the federal and words, in the year the withdrawals happen, this state levels. income is counted in the PIT base, but not in BEA • Some Elements Generally Excluded From personal income. PIT Base. PIT wages and salaries deduct Summary. Figure 3 summarizes what is employee retirement contributions (such counted in BEA personal income versus the as those to 401[k] plans) and other elective categories of income in California’s PIT base, using deferrals. In addition, under federal and our office’s most recent estimates for 2016. (Figure 4 state tax laws, essentially none of the items [see page 6] displays the same data graphically.) classified as employer-paid benefits are As shown, $1.15 billion of the state’s $2.2 billion taxable at the time the contribution is in BEA personal income is included in the PIT 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF tax base. In addition, Figure 3 around $240 billion of Comparing BEA Personal Income and additional income—from California’s PIT Tax Base capital gains, as well LAO Estimates, 2016 (In Billions) as distributions from Amount in BEA Amount in pensions and other Type of Income Personal Income PIT Tax Base retirement accounts—is Wages and salaries $1,030a $955 taxed by California, Employer-paid benefits 192 — but not counted in the Proprietor and partnership income 208 138 Dividends, interest, and rent 426 61 BEA personal income Transfer payments 329 — measure for 2016. Wages Items in BEA Personal Income $2,185 $1,153 and salaries make up Capital gains — $128 the largest portion—by Retirement (pension/IRA) distributions — 108 Other — 7 far—of both California’s Items Not in BEA Personal Income — $243 BEA personal income Totals $2,185 $1,396 tax base and its PIT tax a Net of social insurance contributions. base. Capital gains and BEA = U.S. Bureau of Economic Analysis; PIT = personal income tax; and IRA = Individual Retirement Account. retirement distributions are a small part of the 2011 is 1.6. (Because the sum of positive and PIT tax base and are not a part of BEA’s annual negative deviations is approximately zero, the AD personal income calculation at all. calculation has to use the absolute value [always a positive number] of each annual deviation.) In 2013 Measuring Volatility the growth rate was 1.3 percent, or about 3.9 points In assessing the state’s revenue situation, it is below the 5.2 percent average annual growth important to look at the year-to-year changes in rate, so the annual deviation is positive 3.9. The various data series, such as personal income and average of all four annual deviations in Figure 2 the PIT base. When data show more variability in (1.6, 1.2, 3.9, and 1.0) is 1.9 percentage points, annual changes, they are said to be more volatile. which produces an AD of 1.9. This means that if There are many ways to measure volatility. One the pattern that held from 2010 to 2014 continues such measure is AD. AD summarizes—for a given into the future, personal income growth would, time period—how many percentage points the on average, deviate from its average growth rate data deviate from the average annual compounded by plus or minus 1.9 percentage points each year. growth rate. The higher the AD of an income or tax, the more Figure 5 (see page 7) illustrates AD for volatile it is—tending to move more up or down California’s BEA personal income growth between each year, compared to the average annual growth 2010 and 2014. Personal income’s compound rate over time. annual growth rate over this specific four-year period was 5.2 percent, as shown on the red line. AD of Personal Income and PIT Tax Base The growth rate in 2011 was 6.8 percent, which Figure 6 (see page 7) summarizes the AD of is 1.6 percentage points above the compound each major element of California’s personal income annual growth rate, so the annual deviation for and PIT tax base over the period from 1990 to www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO BRIEF volatile—level of personal Figure 4 income growth from year Comparing BEA Personal Income and to year. Personal income California's PIT Tax Base consists largely of wages and LAO Estimates, 2016 (In Billions) salaries, as discussed earlier, Items in BEA Personal Income and the AD of wages and Wages and salaries included in BEA Salaries a personal income was 2.8 over Dividends, the period. Other components Interests, of BEA personal income are and Rent Amount in BEA Personal Income somewhat more volatile, with Transfer Amount in PIT Tax Base Payments both the dividends, interest, Proprietor/ and rent category and the Partnership proprietor and partnership Income income category having ADs Employer-Paid Benefits of over 4.0 during this period. BEA Personal Income Items Not in BEA Personal Income Elements Not in PIT Tax Base. Figure 6 also shows Capital Gains that the AD for elements of the PIT base counted in BEA Pension/IRA Distributions personal income is 4.0— almost twice the 2.3 AD of 200 400 600 800 1,000 $1,200 BEA personal income. There a Net of social insurance contributions, for BEA personal income. are two main reasons for the BEA = Bureau of Economic Analysis; PIT = personal income tax; and IRA = Individual Retirement Account. difference: • Not Taxing Some 2014. In this section, we discuss these measures of Stable Categories of Personal Income. volatility. California’s PIT generally does not tax two BEA Personal Income Not Very Volatile. As fairly stable parts of BEA personal income: shown in Figure 6, the AD of California’s BEA transfer payments and employer-paid personal income was 2.3 over the 1990 to 2014 benefits. period. For that 24-year period, the average annual growth rate of personal income was 4.8 percent. • Not Taxing Relatively Stable Subcategories Therefore, the AD of personal income was less than of Personal Income. In addition, half of the average annual growth rate. To put it California’s PIT does not tax certain parts another way, personal income in California grew of three other categories of BEA personal by somewhere between 2.5 percent and 7.1 percent income: wages and salaries; proprietor (that is, 4.8 percent plus-or-minus the AD of and partnership income; and dividends, 2.3 percentage points) in 15 of those 24 years. interest, and rent. In each case, the volatility This represents a fairly reliable—not terribly of the overall category of BEA personal 6 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF income is Figure 5 less than the California Personal Income Growth Annual Deviations, 2011-2014 volatility of the part of 8% that category 7 Each Year’s Annual Growth taxed by California. In 6 1.6 1.2 Average Annual Growth = 5.2% 1.0 other words, 5 California 4 does not 3.9 3 tax some relatively 2 stable 1 subcategories in these 2011 2012 2013 2014 three major Note: The average deviation of California personal income in the example above was 1.9, which is the buckets of absolute value of the average of the annual deviations from the 5.2 percent average annual compound growth rate over the period (1.6, 1.2, 3.9, and 1.0). BEA personal income. retirement accounts were much less volatile, with PIT Tax Base Elements Not in Personal an AD of 3.7. Combined, capital gains and these Income. Figure 3 also shows two income retirement distributions had an AD of 18.5 over the categories taxed by California but excluded from 1990 to 2014 period. BEA’s personal income measure: capital gains Figure 6 and distributions from Volatility of California Personal Income Tax and the pension and individual Personal Income Tax Base retirement accounts. Average Deviation in Percentage Points, 1990-2014 While these income Average Deviation of Amounts: categories are relatively In BEA In PIT small compared to wages Type of Income Personal Income Tax Base and salaries, capital gains Wages and salaries 2.8 3.4 are by far the most volatile Employer-paid benefits 3.4 — part of the California PIT Proprietor and partnership income 4.7 6.4 Dividends, interest, and rent 4.6 12.5 tax base. Over the 1990 Transfer payments 3.0 — to 2014 period, capital Items in BEA Personal Income 2.3 4.0 gains’ AD was 35.3. This Capital gains — 35.3 makes capital gains over Retirement (pension/IRA) distributions — 3.7 ten times as volatile as Items Not in BEA Personal Income — 18.5 the part of salaries and Overall 2.3 6.3 wages in the PIT tax BEA = Bureau of Economic Analysis; PIT = personal income tax; and IRA = Individual Retirement Account. base. Distributions from www.lao.ca.gov Legislative Analyst’s Office 7 AN LAO BRIEF PIT Tax Base Almost Three Times More California’s PIT, as these changes in the AD of Volatile Than Personal Income. As noted above, the tax base over time do not account for changes the parts of the California PIT tax base that are in in PIT policy, such as the approval of higher BEA’s personal income measure had a collective tax rates on the highest-income earners under AD of 4.0 over the 1990 to 2014 period. The two Proposition 30 [2012] and Proposition 55 [2016].) components of the PIT tax base excluded from LAO Comments each year’s BEA personal income measure—capital gains and certain retirement distributions—have a Tax Choices Contribute to Volatility. combined AD of 18.5, but these two elements are California’s progressive tax rate structure and other relatively small parts of the PIT tax base. Overall, tax policy choices contribute to the volatility of the entire California PIT tax base—the income its PIT revenues, but a significant element of this taxed each year by the state from 1990 to 2014— tax’s volatility results from the volatility of the PIT had an AD of 6.3, or almost three times as volatile tax base itself. This brief has focused on that tax as BEA’s measure of personal income. This is a base volatility. While state personal income, as relatively volatile tax base, with both fairly stable measured by BEA, is not very volatile, California elements (wages and salaries, with an AD of 3.4) has made choices about what to include in its tax and smaller, but very volatile, elements (capital base and what to exclude. These choices make gains, with an AD of 35.3). the PIT tax base more volatile than state personal Changing AD Over Time. The personal income income. In particular, including capital gains in the of Californians, as measured by BEA, has become taxable PIT base adds significantly to the PIT base’s slightly more volatile over time, as shown by volatility. comparing the AD during the 1990-2002 period State’s Management of Volatility. Over much with that from the 2002-2014 period. Overall BEA of the last two decades, the state has debated personal income for California had an AD of 2.0 how to manage its budgetary volatility. In 2014, from 1990 to 2002, which increased somewhat to the Legislature proposed and voters passed 2.5 over the 2002 to 2014 period. Among those PIT Proposition 2, a measure that sets aside revenues tax base items outside of BEA personal income, during good budget years in order to help stabilize capital gains became more volatile over the period, the budget during bad budget years. Specifically, with its AD of 29.0 over the 1990-2002 time Proposition 2 captures a base amount of state frame jumping to 41.6 in the 2002-2014 period. In revenues plus a portion of capital gains-related PIT contrast, taxable retirement income became less revenues during good budget years. Proposition 2 volatile over time. requires these revenues to be used to build budget Taking all PIT tax base elements together, the reserves and make one-time debt payments. This AD of the California PIT tax base fell somewhat helps keep spending at more sustainable levels, as from 6.5 during the 1990-2002 period to 5.9 during well as building reserves that can be used during the 2002-2014 period. While capital gains became bad budget times. While Proposition 2 did not much more volatile, other elements—especially change the state’s PIT tax base (or the volatility wages and salaries—became less volatile, more figures cited in this brief), this constitutional than making up for the increased volatility of stock provision aims to reduce the volatility of state and other asset gains. (As noted earlier, however, revenues available for spending by “taking money this is not the whole story about the volatility of off the table” in good budget years when capital 8 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF gains typically are elevated and by “putting to tax high-income Californians—who receive a more money on the table” in bad budget years by disproportionate share of total capital gains and allowing for use of accumulated reserves in periods proprietor and partnership income—at higher when capital gains often are depressed. marginal tax rates also affects the volatility of There’s More to the Volatility Story. The the state’s revenues. We anticipate discussing state’s chosen PIT tax base is relatively volatile. the volatility resulting from some of these other But this is not the whole story. The decisions the choices—choices the state has made about how to state makes about how to tax that base also affect tax its PIT tax base—in future analyses. tax revenue volatility. For example, the decision www.lao.ca.gov Legislative Analyst’s Office 9 AN LAO BRIEF 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO BRIEF www.lao.ca.gov Legislative Analyst’s Office 11 AN LAO B R I E F LAO Publications This brief was prepared by Justin Garosi and reviewed by Ryan Miller and Jason Sisney. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This brief and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 12 Legislative Analyst’s Office www.lao.ca.gov