Elasticity, more than just keeping your socks up

Elasticity - probably not something that you think of every day, but, it is a concept often used in economics and tax policy.  Unfortunately, the nuances of elasticity can be somewhat confusing.  To the best of my ability, I will try to make it a little more comprehendible.

Elasticity is a measure of how a tax system keeps up with changes in the economy.  It shows how tax revenues compare with the economy in good times, bad times, and over the long run.  An ideal tax system will keep pace with the economy and remain as steady as possible in both good times and bad.  If a tax system keeps pace with changes in the economy, then it is said to have good elasticity. Elasticity, or Short Run Elasticity (SRE) (as the 2002 Washington State Tax Structure Study calls it), measures the relationship between two economic factors.  More precisely, elasticity measures the percent change in one economic variable in relation to the changes in another economic variable.  Still with me? 

The goal of a well-designed tax structure is to have a 1 to 1 ratio in SRE. When one factor goes up, the other follows relatively closely, the same is true when one of the factors goes down.  Tax structures that are able to weather economic and business cycles without any drastic disproportionate changes in revenue are said to have good elasticity.   A tax system with a SRE ratio greater than one is volatile, subject to compounded fiscal crises.  In periods of economic expansion, tax revenues grow faster than the economy; in times of recession tax revenues shrink faster than the economy.

To try and put this in perspective, think of a roller coaster (I know, not the most comforting tax policy analogy, but it works).  A roller coaster has a number of cars to hold passengers.  Ideally, you want your economic activity (measured by personal or corporate income) and your revenue collections in the same car, so that when one goes up the other is right beside it.  If these two riders are generally instep, it is said that the system has good stability or elasticity.

Unfortunately, in Washington those two thrill seeking roller coaster riders are not in the same car, they are not even on the same ride.  In both the short and long term view, state revenue is not keeping pace with personal or corporate income.  This creates BIG problems when trying to plan and develop solid public programs like education, environmental protection, and infrastructure maintenance and development. 

http://www.eoionline.org/

One way to add elasticity to our tax code in Washington is to connect revenue collections to the major economic driver of the state—this has been done before in Washington.  The first time was before Washington’s statehood through the 1930s when Washington was a property tax state, and the economy was driven by agriculture.  The second time this was done was the shift to a consumption-driven sales tax that reflected Washington’s transition to a manufacturing economy.

As we transition further away from a consumption driven economy to an innovation driven economy we should make appropriate changes in our tax code to increase the elasticity and stability of funding streams used to fund core public programs and resources.  An introduction of an income tax would be one step towards greater stability and elasticity in Washington’s tax code.