Predictable policy outcomes

From One Top Taxpayer Moved, and New Jersey Shuddered by Robert Frank.

The situation is not as dire as the headline indicates and yet, from another perspective, more so. The circumstances are that a number of high spending states, New York, Connecticut, California, and Illinois come to mind, have high spending, high degrees of crony capitalism, highly progressive income tax rates and very high levels of state personal income tax. Frank is covering the consequences when, in the state of New Jersey, the resident who pays the highest amount of income tax, takes up residence in another state.

The article is interesting for three reasons - from a policy perspective, as evidence of poor reportorial skills, and as evidence of reportorial ideological blinders.

From a policy perspective there is the intersection of three different issues - variability, dependency, and fragility. High income individuals tend to have very high variability in their income. Progressive tax structures are politically expedient but financially fragile.

It is well known in economic circles that most people with very high levels of income show a great deal of variability in their income year-to-year. A fact obliquely supported in the article.

Mr. Tepper regularly topped state wealth rankings as New Jersey’s richest resident. He also has homes in Miami Beach and the Hamptons. In 2012 and 2013, he also topped Alpha’s list of the highest-earning hedge fund managers, with estimated earnings of $2.2 billion in 2012 and $3.5 billion in 2013. His earnings fell to $400 million in 2014.

His year-to-year income variability is huge. A more than 50% increase in income from 2012 to 2013 and then a nearly 90% plunge from 2013 to 2014. If you are a state with a highly progressive state income tax as in New Jersey, that means that the state's income tax revenue from that high variance income stream will also be highly variable. State budgets typically cover a lot of big ticket, long term commitments such as education, transportation, etc. where you want some steady predictability.

States mitigate this individual income variability to some degree by have larger pools of high income tax payers. If they are all earning their high incomes from many sources and many industries, then there should be some smoothing out of revenue variability across the pool of individuals. That will work in bigger states with heterogeneous economies such as Texas or California. But in New Jersey, virtually all your high income earners are going to be from the financial sector with all its dramatic ebbs and flows.

The more progressive the state's income tax structure, the more dependent the state is on a select group of high tax payers. Again, from the article.

In California, 5,745 taxpayers earning $5 million or more generated more than $10 billion of income taxes in 2013, or about 19 percent of the state’s total, according to state officials.

I have read elsewhere that the top 1% of California taxpayers generate greater than 50% of the income tax revenue to the state. So not only do you have variability risk, but you have dependency risk. States that are highly dependent on a few tax payers to fund state operations open themselves up to excessive degrees of co-dependency and corruption arising from rent seeking and regulatory capture. A whiff of that dynamic is offered in the article based on Connecticut's experience.

Connecticut, home to several hedge fund billionaires, now tracks the quarterly estimated payments of 100 of its top earners. Kevin B. Sullivan, commissioner of the Connecticut Department of Revenue Services, said about five or six of the highest earners could have a “measurable impact on the revenue stream.”

Mr. Sullivan said that when one of the state’s rich hedge fund executives planned to move his family and company to a lower-tax state, state officials met with him and persuaded him to leave some of his work force in Connecticut.

“We knew we were going to lose him,” Mr. Sullivan said. “But we wanted to keep some of the higher-paying jobs.” He said the state worked out a deal to keep the jobs in exchange for an agreement about the owner’s regular visits to family and friends in Connecticut. (Homeowners who spend more than 183 days in the state are considered residents for tax purposes.) He said the state was holding discussions with other top earners in hopes of keeping them.

“I’m not saying we’re sending fruit baskets and get-well cards,” said Mr. Sullivan, a former Democratic legislator. “But we’re trying to send a more welcoming message to the high earners as a group.”

You don't have to be a class warrior to be alarmed by this degree of incestuous co-dependency and intimacy between the political power of the state and the highest income earners in the state. We want all citizens to be equal in the democratic process but that is not what is being cultivated in these high progressive income tax structured states. State backing/funding of white elephant infrastructure and vanity projects (tram lines and mass transit rail in cities, long distance passenger rails, football and baseball stadiums, neighborhood redevelopment programs) suddenly can be seen in a different light when there are such discussions between the taxing authorities and the high income taxpayers.

On top of variability and dependency, there is the consequence of these two issues - fragility. If your income tax is so progressive that the movement of a single taxpayer or class of taxpayers can undermine your budget, then you have both corrupted the political system (citizens see the incestuous self-dealing between the political elite and the wealthy elite) and made the state financial system more volatile. It does no one any good to have wild swings in funding from year-to-year.

What started as an ill-considered but logically motivated strategy (make the rich pay the most) ends up undermining the whole system.

Separate from the policy angle of the article, there is the reportorial ignorance. It is common that reporters bungle reporting on anything to do with numbers or finance. In this case what is on display is a lack of awareness about the distinction between income and wealth. Income is a financial flow and wealth is a stock. People with high flow don't necessarily have high stock and vice versa.

The article focuses on the consequences to the states' income tax from losing high flow individuals (high income individuals). But the reporter then derives comfort by conflating wealth and income without seeming to recognize the distinction.

While some high earners may be moving for tax reasons, New Jersey, New York, California and other states are replacing rich people faster than they are losing them. New Jersey had 237,000 millionaires in 2015, compared with 207,200 in 2006, according to Phoenix Marketing International, a research firm. New York added 69,500 millionaires from 2006 to 2015, to 437,900, while California added over 100,000 millionaires, to 772,600.

"Rich" people can be rich because of their high incomes or they can be "rich" because they have a high stock of wealth, but they are not the same thing. Take this scenario: A young couple moves to Menlo Park, California in 1970. He's a teacher and she is a homemaker. They make a down payment on a $50,000 home, the very maximum they can afford. 45 years later they are retired living on a combined social security and pension income of $50,000 per year. That is close to the national household median income. They are doing alright. In terms of income, they are comfortable but not notable. If they retired to Arizona, taking their income with them, it would scarcely register on California's income tax receipts.

Despite that, they are also millionaires. Their home was paid off long ago. What was a $50,000 home and piece of land in 1970 is now worth $1.5 million. Because of Silicon Valley and the massive inflation of land prices there and in San Francisco, California is minting thousands of new millionaires each year. Lots of new wealth millionaires (from land inflation) has no impact on income taxes paid. Replacing departing "rich" income people with "rich" wealth people does nothing to repair the state budget. A fact of which the reporter appears to be unaware.

Finally, the article is interesting for the unstated reporter priors. The reporter is sort of reporting facts but through a very definite ideological lens. A lens of which there is a good probability the reporter is unaware. Frank reports the phenomenon of variability, dependency and fragility as arising from income inequality.

Our top-heavy economy has come to this: One man can move out of New Jersey and put the entire state budget at risk. Other states are facing similar situations as a greater share of income — and tax revenue — becomes concentrated in the hands of a few.

Last month, during a routine review of New Jersey’s finances, one could sense the alarm. The state’s wealthiest resident had reportedly “shifted his personal and business domicile to another state,” Frank W. Haines III, New Jersey’s legislative budget and finance officer, told a State Senate committee. If the news were true, New Jersey would lose so much in tax revenue that “we may be facing an unusual degree of income tax forecast risk,” Mr. Haines said.

Frank never seems to recognize that there is a multi-variable process.

It is relatively clear that as a factual matter, the US and all other OECD countries are seeing increases in income inequality. That is a matter of empirical record. There are two unknowns. One is what are the root causes of increasing income inequality? Lots of candidate root causes ranging from globalization of trade to tax dodging elite. Lots of candidates but relatively little consensus as to what are the real root causes to rising income inequality across all such countries.

The second unknown is whether rising income inequality matters for reasons other than aesthetic or normative. If everyone's boat is rising on the same tide, just some faster than others, does that matter? Empirically there is little correlation between degree of inequality and rate of economic growth, innovation, life outcomes or any other significant measure. Within bounds of course. The observation does not apply to kleptocracies such as Russia or extreme inequality as exists in some South American and African countries.

Frank, as is common among reporters, accepts as a predicate that income inequality is inherently bad. He therefore elides the causal mechanisms and leaps straight to the unstated conclusion that increasing state financial fragility must arise from increasing income inequality. That assumption is not supported by the evidence.

All states are experiencing rising income inequality but not all states are experiencing rising state financial variability, dependency and fragility. Variability, dependency and fragility arise, not from increasing income inequality, but from increasing dependency on a particular public financial policy. Different states have different funding policies. Some, such as Florida, have no income tax at all. Most states have an income tax but it is low and relatively flat. Yet others, such as California, Illinois, Connecticut, New York and New Jersey, have elected to have very high and very progressive income tax rate.

All states are experiencing high and rising income inequality. Only those states with very high and very progressive income tax rates are also experiencing increasing state financial variability, dependency and fragility. Frank's priors lead him to misattribute that outcome to increasing inequality when it is in fact a predictable outcome arising from specific policy choices.