The Fiscal Cliff

What happens to state revenue when its three foundations shift simultaneously

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TAM-RWR.4-01 · The Reshaped World, Arc 4: The Renegotiated Contract · The Approximate Mind

Sandra has run the projection seventeen times.

She arrives at the same place every time. Income tax receipts flattening despite nominal wage growth, because the growth is concentrated in a fraction of earners employing the most sophisticated minimization strategies available. Corporate tax declining, because the most profitable companies have become the most effective at jurisdictional arbitrage, booking revenue in places it was not produced. Property tax following commercial real estate down in the jurisdictions that depend on it, and the commercial market is not in a slump that will correct. It is in a structural reorganization that will not.

Safety net requirements expanding.

She does not need to run the projection again. She has run it seventeen times because she keeps hoping the number changes. The number does not change. The number is the same number it was a year ago, the same direction, moving faster than last year.

On her windowsill, a cactus she has kept alive for nine years. She waters it once a month. It has never flowered. She considers this a form of solidarity.

The Three Foundations

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State and local governments in the United States fund their operations primarily through three revenue streams, each built to capture value from the mid-twentieth century economy.

The income tax was designed for an economy where income was distributed broadly enough that taxing a significant fraction of it produced meaningful revenue. The progressivity of the federal income tax, and the flat or mildly progressive rates of most state income taxes, were calibrated for an economy where the top decile earned something like twice what the median earner made. In such an economy, a flat rate produces adequate revenue because the middle is large and the top is not so far above it that minimization is worth the investment. When the top decile earns ten times the median, the income tax faces a different problem: the revenue base is the middle, which is growing slowly or not at all, while the taxable income is at the top, where sophisticated minimization strategies are available and where the returns to minimization are high enough to justify the investment.

The corporate tax was built on the assumption that profitable corporations operate primarily within the taxing jurisdiction. This assumption was reasonable when a manufacturer who sold in Ohio employed primarily in Ohio, bought inputs primarily in Ohio, and had its headquarters in Ohio. The corporation’s economic activity and its geographic location coincided closely enough that a state corporate tax captured something real about the value created in the state. The corporation that designs its products in California, manufactures them in Vietnam, books its intellectual property in Ireland, and sells worldwide has no simple relationship between economic activity and geographic location. It optimizes its tax position across jurisdictions the way it optimizes any other cost. The state corporate tax captures what the corporation fails to move offshore.

The property tax was designed for an economy where commercial real estate values reflected economic activity in the taxing jurisdiction: factories that employed local workers, office buildings that housed local businesses, retail that served local consumers. Commercial property value tracked economic activity reasonably well. When economic activity concentrates in a smaller number of jurisdictions and economic actors’ physical presence requirements decline, commercial real estate values diverge from economic activity in ways the property tax was not designed to handle.

Each of the three foundations is shifting, and the shifts are structural rather than cyclical.

The Interaction Effects

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The three shifts would be manageable if they occurred independently. They are not occurring independently.

The income tax base’s weakening increases the pressure on the corporate tax. State budgets that relied on a certain blend of income and corporate tax revenue must now get more from corporate sources when income sources weaken, precisely as corporations are optimizing their corporate tax positions more aggressively. The corporate tax base’s weakening increases the pressure on the property tax. But commercial real estate follows the economic activity that the corporate and income bases were taxing, and when that activity migrates or concentrates or goes offshore, the commercial property values that supported the property tax follow.

The three foundations are not independent revenue streams. They are three measurements of the same underlying economic activity, each capturing a different aspect of it. When the economic activity restructures, all three measurements shift in the same direction.

Sandra’s projection shows not three separate trends but a single trend viewed from three angles. The single trend: the state’s claim on the economic activity occurring within its borders is weakening, because the economic activity is reorganizing in ways that make the state’s claim harder to enforce.

At the same time, the claims on the state are expanding.

The populations that need public services most, people whose incomes are insufficient for private market alternatives, people whose health requires ongoing public support, people whose housing is affordable only because of public subsidy, people whose children depend on adequately funded public schools, are precisely the populations whose economic circumstances are most affected by the restructuring that is weakening the tax base. The automation that reduces corporate payroll also reduces the income-tax-paying workforce and expands the population requiring assistance. These effects are not coincidental. They are mechanically linked.

The safety net expands as the revenue base that funds it contracts.

The Wealth Tax Problem

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The structural response to this is legible. If the income tax is failing to capture value concentrated at the top, and the corporate tax is failing to capture value that migrates offshore, and the property tax is following commercial real estate down, then the alternative is to tax wealth directly: the accumulated assets held by the fraction of the population whose income and corporate and property tax positions have been most successfully optimized.

The wealth tax faces a political problem that is not incidental to its economics. Wealth concentration produces political influence, and political influence is deployed, through mechanisms that are legal and effective and fully documented in the academic literature on political economy, to protect the concentration. The mechanisms are not primarily corrupt in the legal sense. They are the ordinary functioning of a political system that processes influence the way the economic system processes efficiency: whoever can invest in the outcome receives returns proportional to the investment.

The wealth tax’s highest-profile proponents have proposed it repeatedly. Its highest-profile opponents have defeated it repeatedly. The pattern is not random. The pattern reflects the structural advantage that concentrated wealth has in political systems that process influence through the mechanisms of campaign finance, lobbying, regulatory comment, media ownership, and the revolving door between government and the sectors it regulates.

I wonder whether democratic governance can restructure its revenue architecture before the degradation of services produces the political crisis that the restructuring was supposed to prevent, or whether the degradation is a necessary precondition for the political will, and what is lost in the interim.

The interim is not abstract. The interim is the school that reduced its counseling staff. The interim is the road that is not repaired. The interim is the public health department that could not maintain the capacity it had built. The interim is the accumulation of deferred maintenance and deferred service that falls most heavily on the populations the state was built to protect.

What “Noted” Means

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Sandra has submitted her projection to the committee. She has submitted it to the commission. She has briefed the governor’s office, twice. She has testified before the relevant legislative subcommittee. The response, from every level of governance she has access to, has been: noted.

She does not know what “noted” means in this context. She suspects it means: we see what you are describing, we understand that it is structural rather than cyclical, and we are unable to change course, not because we lack the knowledge or the will in the abstract, but because the specific course change required would impose costs on the constituency whose support we need to remain in the position from which we could impose the course change.

The structural incapacity of the democratic system to impose costs on the coalition that sustains it is Part 4-02’s territory. Sandra has arrived at its edge. She backs away from it, because her job is the revenue projection, not the political science.

The projection is the same number it was a year ago.

She waters the cactus. Once a month. It has never flowered. It survives on what it gets. She is not sure the same can be said for the systems she serves, but the cactus does not know this, and surviving on what you get, for as long as the conditions hold, is not nothing.

The projection will be submitted again next quarter. The number will be the same direction.

References

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State and Local Revenue Architecture

Brunori, David. State Tax Policy: A Political Perspective. 4th ed., Urban Institute Press, 2016.

Fox, William F., and LeAnn Luna. “State Corporate Tax Revenue Trends: Causes and Possible Solutions.” National Tax Journal, vol. 55, no. 3, 2002, pp. 491–508.

National Conference of State Legislatures. State Budget Update. NCSL, 2024. ncsl.org.

Income Concentration and the Tax Base

Piketty, Thomas, and Emmanuel Saez. “Income Inequality in the United States, 1913-1998.” Quarterly Journal of Economics, vol. 118, no. 1, 2003, pp. 1–41.

Saez, Emmanuel, and Gabriel Zucman. The Triumph of Injustice: How the Rich Dodge Taxes and How to Make Them Pay. W. W. Norton, 2019.

Corporate Tax Avoidance

Clausing, Kimberly A. Open: The Progressive Case for Free Trade, Immigration, and Global Capital. Harvard University Press, 2019.

Zucman, Gabriel. The Hidden Wealth of Nations: The Scourge of Tax Havens. Translated by Teresa Lavender Fagan, University of Chicago Press, 2015.

Wealth Tax: Arguments and Politics

Summers, Lawrence H., and Natasha Sarin. “A ‘Wealth Tax’ Presents Formidable Implementation Challenges.” Washington Post, June 2019.

Warren, Elizabeth. “Ending the Two-Tiered Tax System.” White paper, Warren for President campaign, 2019. elizabethwarren.com.

Political Economy of Tax Reform

Mian, Atif, et al. “Indebted Demand.” Quarterly Journal of Economics, vol. 136, no. 4, 2021, pp. 2309–2373.

Stigler, George J. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science, vol. 2, no. 1, 1971, pp. 3–21.

Winters, Jeffrey A. Oligarchy. Cambridge University Press, 2011.