Why income inequality puts state budgets on a roller coaster course
By Chris Stiffler
CFI Economist
Income inequality, or the growing gap between the rich and poor, has become a fairly hot topic, and a lot of that has to do with the growing recognition that income inequality is bad for the entire economy, not just some people.
The biggest reason that inequality is an economy-wide problem is that the middle class, faced with stagnating wages, doesn’t have the disposable income to support the consumer spending that has historically been a driver of the economy. Working families have less to invest in their future, which means fewer opportunities for investments in education and fewer opportunities to start businesses, which has long-term effects on the economy’s potential.
But there are also other harmful side effects of income inequality, and some of them are a bit less apparent. For example, economists and policy wonks are now beginning to link income inequality to increased volatility in tax revenue collections.
Now, most people don’t lose sleep because our state economists are having a harder time predicting how much revenue Colorado will collect each year, but it is something that should cause some concern.
Let me show you why.
Inequality is linked to more frequent boom-and-bust cycles that make our economy more volatile. Even the International Monetary Fund has noted the relationship between inequality and economic instability. And in a recent study, Standard & Poor’s warned that income inequality contributes to greater booms and busts in the economy because the lower and middle classes, faced with declining or stagnating wages, have had to rely on increased debt to maintain their living standards.
A side effect of this volatile economy means unstable and unpredictable tax revenue collections. A new report from the Nelson A. Rockefeller Institute of Government shows how forecasting errors have increased over the past decade which means that tax revenue is more unpredictable.
As anyone who has prepared a household budget knows, if you don’t know how much income you will have next month, it makes it especially difficult to know what you can and can’t afford. It also makes it really difficult to plan for the future or it forces you to make unnecessary cutbacks.
The same is true with government. If policy makers can’t count on revenue next year, it makes it extremely risky to hire new teachers, make the kinds of long-term commitments needed to build roads and infrastructure, or give more state aid for higher education. Consider also the impact of cuts in state programs that occur because of volatile revenue streams.
In a political environment like Colorado, where our elected officials already lack the flexibility to adapt to changing economic conditions, it is important that we remove as much uncertainty from the budgeting process as possible. Not only would addressing the growing gap between the rich and the poor improve the entire economy, it would also make it less vulnerable to booms and busts while simultaneously reducing revenue uncertainty. With greater certainty, policy makers can more effectively and efficiently plan our state budget that funds policy priorities like Medicaid, transportation and education. This is another reason why addressing income inequality would be good for the entire economy, and it reaffirms that the economy does better when everyone does better.
