Finance

Staying Stable

We'd always take a tax cut, of course," says David Johnson, the former chairman of the Ohio Manufacturers' Association. Nothing surprising in those words, but...
by | December 31, 2007
 

We'd always take a tax cut, of course," says David Johnson, the former chairman of the Ohio Manufacturers' Association. Nothing surprising in those words, but the businessman -- he heads a mid-sized tile company in Summitville, Ohio -- doesn't stop there. Of even greater importance, he says, "is having a fixed code. If it's going to change every two years -- even if it's a change for the better -- it's confounding to business plans."

Johnson was deeply involved in a tax reform in Ohio in 2005. A major accomplishment was to replace the state's tangible personal property tax and corporate franchise tax -- both of which were perceived as anti-business -- with a broad-based, low-rate corporate activity tax, levied on taxable gross receipts from most business activities. Throughout the debate, one focus was on keeping that state's tax system as stable as it has been.

But not all states have been able to keep their focus on stability. The most significant concern for many corporations is the tendency for state legislatures, moved by a variety of causes, to alter their tax policies on a regular basis.

"People who run businesses successfully need to know what the variables are," says Bill Blazar, senior vice president for the Minnesota Chamber of Commerce. If a company wants to expand its factory in Minnesota, its planners would factor into that decision how much more the company would have to pay, say, in property taxes and sales taxes on equipment. "They want to write an equation that leads to profitability," Blazar says. "They have to have certainty that the equation will be true."

Meanwhile, a volatile revenue stream is a problem for governments. It makes it hard to maintain programs and invest for future growth. And that is a concern for taxpayers and the business community as well. "Instability in the revenue base obviously leads to difficult budgeting at certain times," says Michael Allen, director of economic research for Maine Revenue Services. "Government programs that businesses may depend on, such as job training or other economic development programs, can be susceptible to cuts."

Volatility is a close cousin of unpredictability. The distinction is that a highly volatile tax structure -- one in which revenues bounce around a great deal from year to year -- might be predictable if the factors driving those swings are well understood and are themselves predictable. For example, income taxes are driven in part by stock market capital gains, making them very volatile. They are not very predictable, though, because the market itself isn't and because taxpayers choose when to sell their stocks and realize gains.

One problem with reducing volatility is that the economy gets in the way. A downturn in the business cycle has a negative effect on receipts but rarely reduces the need or demand for government services and programs; an uptick opens the fiscal spigots. Some states are more affected by these cycles than others.

But the economy is just the beginning of the story. As Alison J. Grinnell and Robert B. Ward point out in one of their reports for the Fiscal Studies Program at the Neslson A. Rockefeller Institute of Government, "Even if growth affected all regions and states to exactly the same degree and at exactly the same time, the effect on state revenue would vary because the tax systems used by the states react differently to similar economic situations."

Whatever the cause, the bottom line is the same. "Volatility," says Don Boyd, an independent consultant affiliated with the Rockefeller Institute, "has negative effects, whether they're caused by underlying economic fluctuations or by a volatile tax structure."

TAMING THE WILD RIDE

States have tools available to tamp down tax revenue volatility and to ease its impact. They can reduce the overall revenue ups and downs by building a diversified portfolio of taxes, relying not just on a single tax or on a single industry but instead using several taxes, such as an income tax, a sales tax and selective excise taxes. Such a diversified base can sometimes draw a large portion of its revenues from sales taxes, which are themselves diversified among various areas of consumption. Individual taxes imposed on different bases almost never move in lockstep, even in recessions and booms, so their instabilities tend to offset each other partially, reducing the volatility of total tax collections.

In the last recession, many states were clobbered by the sudden downward swing in personal income tax receipts. As the stock market and other investments declined, income tax collections collapsed much faster than the economy, creating large holes in the budget of almost every state with an income tax -- even in states such as New York and Colorado that have had moderate tax volatility on average over the long term. Colorado's real per-capita state government tax revenue fell by 12.1 percent in 2002 and by another 7.6 percent in 2003. New York's fell by 5.7 percent and 4.7 percent in these years -- despite a tax increase. "Both states rely on very high-income taxpayers for a disproportionate share of their income tax revenue, with highly variable capital gains income and other forms of non-wage income," Boyd points out. "With the right kind of economic conditions, these states have extremely volatile revenue."

The design of individual taxes matters, too. A broad-based tax usually is more stable than one that is narrowly based, and progressive tax rate structures tend to be more volatile than flatter taxes. Choices such as these, made in the interest of tax stability, often conflict with other tax policy goals. One way to stabilize revenue from the income tax, for instance, is to broaden its base and make it less progressive. A flat tax tends to ease volatility. But that stability comes at a cost to low-income taxpayers. With flat-tax proposals, notes Ray Nelson of Brigham Young University in his paper, "State Income Tax Revenue Volatility Causes and Effects," revenue volatility is largely dependent on the definition of taxable income while progressive taxes are dependent on many factors that lead to volatility, such as exemptions, deductions and phase-outs, to say nothing of broader tax brackets.

States have other ways to manage revenue volatility that need not conflict with other tax policy goals, but those, too, have shortcomings. Take rainy-day funds, which are supposed to help states weather the swings in the business cycle. States can withdraw money from the funds during a downturn to help stabilize services and allow orderly policy changes. During recoveries, they can replenish the fund. But several studies have shown that rainy-day funds rarely are large enough to fully stabilize spending during even a modest recession, and establishing funds large enough to achieve this goal would create a new set of political and financial issues.

"Rainy-day funds are great in concept," says Scott Pattison, executive director of the National Association of State Budget Officers, "but rarely are they funded adequately to make a material difference beyond a few projects in any given year." That was certainly the case in Maine during the 2000-01 downturn. The state burned right through its $140 million fund, says Michael Allen, director of economic research for Maine Revenue Services. As to the current fund, Allen says he doesn't "envision that it would be able to solve the problem entirely. It might lessen it."

There's one other problem with a robust rainy-day fund. "Tax collections high enough to allow states to build rainy-day funds large enough to address the falling revenues experienced in the last recession," says Ron Snell of the National Conference of State Legislatures, "would lead to demands for substantial tax cuts."

Someday, states may be able to use pure financial instruments to hedge revenue volatility related to economic volatility, much as businesses now hedge risk related to exchange rates, interest rates and the prices of specific commodities. The advantage of these instruments, if they become available, is that they would not require states to skew their tax policies to achieve stability goals. This benefit, however, would come at the price of, in essence, purchasing a revenue insurance policy. Then if revenue (or the underlying economy) performed as expected, the money paid for the equivalent of premiums would be gone forever.

Swinging Revenues

RATING THE STATES

Volatility results in large part from state policy choices. Since sharp shifts in policy can be a deterrent to economic activity, they have been included in the volatility index for assessing the states on the stability of their revenue.

Researchers generally have used several broad approaches to defining and measuring volatility, such as large or frequent year-to-year changes in tax revenue, large and persistent deviations in revenue from long-term trends, tax revenue that changes rapidly in response to economic changes and tax revenue that deviates substantially from the amount predicted.

Overall, the assessment found that almost every state had at least a 15 percent reduction in volatility due to diversification of its taxes -- the portfolio effect -- and that three-quarters of them had a benefit of 26 percent or more. In Arizona, for example, the tax-by-tax volatility indices for the individual taxes were 6.8 for income tax, 3.3 for sales tax, 5.7 for nonproperty taxes. Yet, the state's overall tax volatility measure of 2.8 was about 50 percent lower than the tax-share weighted average -- a nearly 50 percent reduction in volatility due to diversification.

A state such as Oregon, on the other hand, relied on the individual income tax for about 67 percent of its tax revenue over the time period examined -- more than any other state. And it had the 7th most volatile state tax system with a volatility index of 7.0 compared with the median of 4.3. Washington, meanwhile, relied on the sales tax for 60 percent of its tax revenue -- more than any other state -- compared with 32 percent for the median state. Yet over the 20-year period examined, Washington's state tax revenue was the least volatile in the nation. So despite the general rule that relying on a single tax can lead to great volatility, for this period, when income taxes were particularly volatile, Washington's sales tax-dependent revenue was relatively stable.

The general rule remains, however: A diversified tax base generally is more stable than a non-diversified base. In the wrong kind of recession, a state like Washington's revenue could be hit especially hard. Still, three of the other four states that relied on the sales tax for more than 50 percent of their tax revenue -- Florida, Tennessee and South Dakota -- had below-average tax volatility over the 1986 to 2005 period. Only Nevada, among the states heavily reliant on sales tax, had above-average volatility.

Even states with "low" volatility are likely to find in the next recession that they have far too much of it. The goal in crafting a tax structure is to put together one that works in tandem with other counter-cyclical fiscal devices. That will help a state weather broad economic downturns and take advantage of upswings. It will also help taxpayers, particularly business taxpayers, rely on the tax structure to plan for the future.

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