Another peak year in Alabama’s tax revenue, but inflation will take a bite

Alabama tax revenue grew at a staggering rate in fiscal 2022, with particularly strong growth in income tax revenue (up 27% from 2021) and online sales (up more than 20%). The strong collections resulted in surpluses in both of the primary government accounts: the Education Trust Fund and the General Fund.

While growth fuels talks of rebates and tax cuts, inflation will increase state government operating costs. At the same time, rising interest rates and decreasing federal tax relief are likely to slow growth in the future.

Alabama has endured a record number of tax collection years with no discernible strain from the pandemic shutdown and subsequent recovery. Before the pandemic, Alabama had historically low unemployment and began increasing the labor force participation rate, pulling discouraged workers off the sidelines and contributing to income increases.

While the pandemic sent a sudden jolt through the economy, federal relief ensured many paychecks and also made stimulus money available to households. Alabama’s slump in the second quarter of 2020 wasn’t as severe as some states, and the economy reopened faster than some others. In fiscal 2021, ongoing government stimulus and the recovering labor market led to record tax revenue growth. And in fiscal 2022, total collections grew even faster, 18% across both funds, with the strongest growth at the Education Trust Fund.

Government revenues have increased in recent years despite the pandemic. (Public Affairs Research Council of Alabama)

Education Trust Fund

Income and sales tax collections increase with a growing economy and can decrease when the economy contracts and enters a recession. Inflation, which has averaged below 3% over the past 20 years, averaged over 7% in 2022. As people spend more, sales taxes increase and tax revenues also increase.

At the same time, fiscal year 2022 saw strong demand for labor with historically low unemployment. In order to attract and retain employees, employers raised wages. Alabama’s labor force returned to and exceeded pre-pandemic numbers in fiscal 2022. Alabama’s labor force participation rate is still 5% lower than the US, but the strong labor market has lured more people back into the workforce.

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In fiscal 2022, the number of people working in Alabama surpassed pre-pandemic peaks, although it didn’t do so until July.

With more workers earning higher wages comes higher income tax revenues. Income tax revenue increased 27% in fiscal 2022, contributing a total of $7.2 billion to the Education Trust Fund, up $1.5 billion from 2021. And 2021 wasn’t a bad year; Income tax collections increased by 21% in 2021. Even in fiscal 2020, the year the pandemic receded, income tax collections rose nearly 7%.

Income taxes are the largest source of education funds. (Public Affairs Research Council of Alabama)

In addition to rising wages, which contribute to higher income tax revenues, Alabama’s corporate income tax revenue increased 33% in 2022, an increase of $325 million from fiscal 2021. Another likely contributor to 2022’s withdrawals were stock market gains in 2021, a year in which the S&P 500 rose 27%. Taxes on these profits would have accrued in the 2022 financial year. Another factor is the government’s return to normal levels of testing after pandemic-related restrictions; Some gains can be attributed to comparisons from previous years and increased compliance.

value added tax

Meanwhile, state sales tax revenue rose 7.66% — almost in line with the 7.7% inflation rate during the period. The state is making some sales tax adjustments before making a final contribution to the Education Trust Fund, slightly reducing the percentage gain for the fund. Ultimately, sales tax revenue going to the Education Trust Fund increased 6.8%, or $159 million. The use tax, a supplement to the sales tax but levied on out-of-state purchases of goods and machinery, rose 18% and contributed an additional $35 million. The government’s share of the Simplified Sellers Use Tax (SSUT), a tax on online purchases, increased by 21%, indicating an ongoing migration to online shopping. Overall, SSUT raised $311 million, with 75% of the proceeds going to the General Fund. Overall, the Education Trust Fund grew 21%, up $1.78 billion, with total revenues of $10.42 billion.

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Tax revenue from online purchases has risen sharply in recent years. (Public Affairs Research Council of Alabama)

Due to the State Rolling Reserve Act, the Education Trust Fund is budgeted conservatively, with spending limited by a formula. This formula calculates a historical growth rate for the fund, keeps lawmakers from overspending during periods of high growth, and conserves funds for lean times. It more than did its job in fiscal 2022, with the Education Trust Fund raising $2.75 billion more than the state budgeted for education spending. Lawmakers will determine what to do with the surplus at next year’s session.

The massive federal grant to education, totaling more than $3 billion over three years, will expire in 2024. Irrespective of this, the state has healthy reserves and has continued to budget conservatively with state funds. The Education Trust Fund budgeted for fiscal 2023 to spend $8.3 billion, down $2 billion from fiscal 2022 income.

The General Fund

The General Fund also grew, but not to the same extent, which is typical. The Education Trust Fund grows quickly when the economy grows, while the General Fund has a slower growth rate. The General Fund consists of a hodgepodge of revenue streams. It supports the operations of all non-educational government agencies, including Medicaid and the state prison system.

Lawmakers have made several adjustments in recent years to increase the growth of the general fund. The most successful have been the establishment of the simplified seller use tax and the transfer of 75% of Internet sales revenue to the General Fund. The shift towards digital commerce will continue, but sales increases are unlikely to be as rapid in the future.

The General Fund receives its income from several sources. (Public Affairs Research Council of Alabama)

Insurance company taxes also gave the General Fund a big boost in 2022, up 13%, or $65 million. The tax is assessed on the value of the insurance premiums issued. Insurance tax is the largest source of taxes in the General Fund at $554 million in fiscal 2022.

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The consumption tax was the second largest contributor to the General Fund at $272 million. This is a tax on the purchase of cars, machinery, boats, RVs, or other goods in other states for use in Alabama. In 2022, use tax revenue increased 18% and provided an additional $35 million to the General Fund than in 2021.

Rising interest rates boosted interest earned on government deposits, increasing revenue by $20 million to $40 million. Higher energy prices increased tax revenue from oil and gas exploration taxes by 80%, an increase of $17 million.

Overall growth for the general fund rose 8.4%, a slightly faster rate than inflation. Total revenue increased to $2.87 billion from $2.56 billion. By the end of 2022, revenue to the General Funds exceeded projected expenditure for fiscal 2022 by $351 million. Legislators anticipated the excess and applied it to the 2023 budget.

The big picture

In addition to the taxes earmarked for the Education Trust Fund and the General Fund, other sources of government revenue flow directly to the agencies. For example, highway fuel taxes go to the Alabama Department of Transportation. State colleges and universities charge tuition fees. Federal funds help pay for highways, Medicaid, education, and community services. About half of Alabama’s public spending is on education and the other half is on non-educational institutions.

When a recession leads to a drop in revenue, Alabama is in a better position to weather a downturn than it has in the past. According to a recent analysis by the Pew Charitable Trust, Alabama has the 20th strongest reserves, with $1.4 billion stashed away in bad day funds. According to Pew, Alabama could run 49 days with the amount it has in reserve.

This article originally appeared on the Public Affairs Research Council of Alabama website.

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