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How To Address Rising Volatility in State Tax Systems April 2011

How To Address Rising Volatility in State Tax Systems

By Donald J. Boyd and Robert B. Ward

Donald BoydRobert Ward

As we noted in a recent Observation, even relatively small errors in states’ revenue forecasts can make a substantial difference for their budgets and the services that tax dollars support. When tax collections come in lower than expected, policymakers often must make midyear cuts in programs. The widespread budget crises of the last three years are extreme examples of that problem. And even when revenues are higher than expected, results may include spending increases or tax reductions that later prove unsustainable.



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Donald J. Boyd, a senior fellow at the Institute, has written or co-authored many of the Institute’s reports on the fiscal climate in the 50 states. Robert B. Ward is the Institute’s deputy director. Boyd and Ward are part of the project team that produced a recent report on states’ revenue estimating errors, published in conjunction with the Pew Center on the States. In a previous commentary, they discussed the rise in volatility in states’ tax systems.

These errors have grown larger in recent decades. Recognizing that forecasting tax revenues is an inexact science, what can state policymakers do to minimize errors, and deal with such issues when they arise?

As elsewhere, learning from inevitable mistakes is a good starting point. The Congressional Budget Office regularly reviews its forecasts to identify potential improvements, and many states do as well. All states should consider this a best practice well worth emulating.

For many states, more frequent updates may be helpful. For example, Vermont traditionally issued revenue estimates twice a year, but moved to quarterly forecasts during the Great Recession. And states that do not already take advantage of outside expertise — such as asking independent experts to review economic projections — may find that kind of assistance invaluable.

Still, no forecasting system can eliminate errors. During tough economic times, elected officials find it much easier to deal with unexpected shortfalls if there is enough cash on hand to compensate for mistakes in revenue estimates. Given the increasing volatility of state revenue systems, establishing adequate reserves is more important than ever.

In states that rely heavily on taxes from capital gains, fiscal analysts know they must expect particularly volatile revenue streams. Massachusetts saw capital gains-related revenue jump to $2.1 billion in 2008 and then fall to $500 million a year later — creating big gaps in a budget that did not account for such swings. The Bay State, like New York and some others, had experienced similar ups and downs in previous recessions but taken few steps to guard against a repeat of the problem. In 2010, though, Massachusetts leaders enacted a law limiting to $1 billion the amount of capital gains revenue that could be used in any year’s operating budget. Any amount above that must go to the state’s rainy day fund, where it can cushion any sharp declines.

Another fiscal device worth consideration is adoption of spending rules that limit appropriations to some level below expected revenues. Delaware, Rhode Island, Oklahoma, Iowa and Mississippi have such constitutional or statutory provisions, with limits that range from 95 to 99 percent of projected collections.

And states may wish to look at the structure of their tax systems. Economists commonly say the features of a good tax system include a broad base, relatively low rates, adequacy, predictability, equity and simplicity. If, for example, policymakers wish to exempt food from sales tax — as most states do in an effort to counteract the regressive nature of the sales tax — there should be an understanding that narrowing the base of the tax in this way may make revenue declines during recessions somewhat sharper than they otherwise would be. Understanding that can lead to other policy alternatives — for example, including food in the sales tax base, but enacting an income tax credit designed to offset its regressive effects. States that choose to have relatively high taxes on personal income, and depend heavily on capital gains and bonuses, should be prepared for heightened volatility and a greater possibility of significant budget gaps if steps are not taken to smooth expenditures over the business cycle.

Whatever the nature of the tax system, being able to match expenditures and revenues is the bottom line. Changes in the economy and in state tax systems make that job tougher than ever. One way or another, however, policymakers must address this new reality.


ABOUT THE ROCKEFELLER INSTITUTE OF GOVERNMENT

The Nelson A. Rockefeller Institute of Government, the public policy research arm of the State University of New York, conducts fiscal and programmatic research on American state and local governments. It works closely with federal, state, and local government agencies nationally and in New York, and draws on the State University’s rich intellectual resources and on networks of public policy academic experts throughout the country.