Compared with local governments, which rely to a greater extent on property taxes, states generate the bulk of their revenue from taxes levied on current economic activity, namely personal income and consumption. Therefore, when the economy operates below its potential, state tax revenues tend to suffer. Insofar as income inequality contributes to economic output falling short of potential, it undermines the growth of states’ tax bases.
Our analysis found a negative relationship between income inequality and state tax revenue tends. When we tested the relationship by tax structure, we found the negative effect was stronger and only statistically significant in the sales tax-reliant states. The findings support our view that rising income inequality contributes to weaker tax revenue growth by undermining the rate of overall economic expansion.