Revenue Above Estimates Not a Sure Sign of Economic Health

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The total tax revenue that the State of Rhode Island has received for the fiscal year continued to beat estimates in January, by $57 million (3.6%), but it would be premature to infer either strong economic growth or the disappearance of the deficit expected for fiscal 2013. The reason, as confirmed with Office of Revenue Analysis Chief Paul Dion, has largely to do with changes in the state’s tax structure made back in the spring of 2010.

“We were being a little cautious at the revenue conference to account for the change in the income tax,” Dion told me. “We’re going to enter an interesting test shortly.”

At the end of January, the excess revenue was distributed across the various categories as follows:

Actual Revenue Exceeding Estimates by Category, January 2012

To put these receipts in perspective, it is necessary to understand how the monthly estimates are calculated.  Twice a year (once in May and once in November) the relevant officials hold an Estimating Conference to determine some number that the state can reasonably expect to collect for the total fiscal year.  They then plug the annual totals into a month-by-month model based on past experience.  So, for example, the model may show that the state has typically collected 57% of the total business corporations tax that it expects for the year by the end of January.

To track how the state is doing as the year goes by, Dion applies the monthly percentage to the total predicted by the Estimating Conference and compares it with actual revenue received.  That methodology can distort some of the smaller categories considerably.  This year, the excess in the “other tax” category may be entirely attributable to a very substantial inheritance tax payment in the past that threw off the model, according to Dion.

This year is also the one in which the tax reforms of 2010 will show up in the numbers.

Because the state changed its calculation for taxes so dramatically (mainly by eliminating itemized deductions), the Division of Taxation changed its withholding tables (PDF) to make sure that taxpayers paid more than enough of their taxes up front and wouldn’t owe large payments at the end of the year.  While each exemption used to reduce employees’ income by $3,650 for the purpose of calculating the amount to withhold from their paychecks, for 2011, that reduction changed to $1,000.

Unless the supposedly “revenue neutral” tax reform was in actuality a massive tax increase, the likelihood is that the state will pay out more in refunds overall.  And because the fiscal year and the tax year are out of line by six months, the bulk of those checks will go out toward the end of the fiscal year, as a line chart of a “normal” year illustrates:

Percentage of Total Estimated Income Tax Refunds Paid by Month, 2010

Paul Dion still believes that the estimate for total refunds is correct.  However, the change in withholding distorts the month-by-month model, so the $10.8 million that the state has “saved” in refunds through January can also be removed from the excess pie above.  The fact that wealthier taxpayers more often seek extensions — thus pushing their final tax payments and refunds into the next fiscal year — may also affect the model.  Dion has “cautioned everybody who would listen to me to be careful of the refunds” when reviewing these numbers.

The changes in tax structure are also hitting during an unusual economic time.  With economic growth not matched in overall employment numbers, tax revenue is shifting from one category to another, and predictions are difficult to make.

Taking all of the trends into account, Dion still sees evidence of real economic growth, but when it comes to the state’s looming deficit, we’ll have to check back in two months.  One thing that is certain, though, is that extra tax money in the state’s coffers is extra spending money taken out of the state’s private economy.