More Evidence of a Flat Economy

One of the more important indicators of Rhode Island's economic performance is income tax withholding. Part of the reason for its importance is that it is not a survey-based indicator, so we don't have to worry about the possibility of survey error and subsequent revision. Furthermore, income tax withholding is real-time data. But it is not what economists refer to as a "leading economic indicator," which is the best type of indicator to use when attempting to predict the future. To the contrary, income tax withholding is a "lagging indicator" which reflects economic activity in past months.

In using income tax withholding as the basis for attempting to understanding Rhode Island's current economic performance, three things must be taken into account. First, income tax withholding is a nominal value, meaning that it does not take inflation into account. Therefore, inflation can distort this indicator, making its performance appear to be better than it really is. Second, there are seasonal variations in the amount of withholding collected throughout the year. To account for this, it is necessary to perform seasonal adjustment. After both of these adjustments have been made, it is possible to meaningfully compare any particular month to any other month. The result, after both of these corrections have been made, is called seasonally adjusted real income tax withholding. To simplify this and what follows, I will simply refer to it as real withholding. Finally, it is critical to remember that, as stated above, withholding is a lagging economic indicator.

First, let's take a look at income tax withholding using seasonal adjustment, but not adjusting for inflation. The chart below shows this (click to enlarge). Its performance of late looks very impressive. Someone using this chart as the basis for determining how well Rhode Island's economy is performing would almost certainly give a very positive vote -- the line of late is clearly sloping upward with a respectable slope.

Now for a more detailed look -- place the above chart in the context of the longer-term trend in withholding, as shown in the next chart (click to enlarge):

While the recent trend still seems promising, in a longer-term context it is apparent that since 2008, income tax withholding in Rhode Island has remained below its longer-term trend. But can't that just be evidence that this recovery has been relatively slow compared to past recoveries? The answer is yes it can. But since neither of the above charts takes inflation into account, we need to view real income tax withholding before making any final determination on current economic performance based on withholding.

The final chart takes inflation into account, showing real income tax withholding (click to enlarge). I have made the base period the purchasing power of September of 2011 (the most recently available data). Notice how real withholding has failed to break above its recent highs of around $75 million, and that it has remained range bound between $70 and $75 million throughout this entire recovery. I labelled these as "support" and "resistance," respectively, terminology from the technical analysis of markets. So, it is not in any way a stretch to state that during this entire recovery, Rhode Island's real income tax revenue has displayed a flat (horizontal) trend. So, while current dollar income tax withholding has been rising, as the above two charts show, its relatively static real value reflects the fact that current dollar growth has only matched, and failed to exceed, the rate of inflation.

However, that's not necessarily bad news. State budgets are run based on nominal values, and nominal withholding growth appears to be strong up to this point. And therein lies the true caveat: what happens from this time forward?


The answer to this question cannot be adequately determined based solely on the past behavior of any single indicator like income tax withholding, whether nominal or real values are considered. As I have indicated numerous times on this Blog, it is necessary to "hedge" one's bets by using a set of indicators to arrive at a far more educated answer to this question. And that is precisely why I formulated and publish my Current Conditions Index each month (http://www.llardaro.com/current.htm ).

The CCI value for August indicated a contraction value (of 42). If we were to observe a string of several consecutive contraction values, it would then be appropriate to conclude that Rhode Island would indeed have begun a double-dip recession. But we are not there yet. And at this point, I am not willing to make that call.