State Revenue Volatility: An Inevitable Challenge With a Workable Solution

Opinion September 11, 2017 By: Mary Murphy & Steve Bailey Read time:

Projects: State Fiscal Health

In Alaska, 2012 was a very good year. The state is heavily dependent on severance taxes, which are levied on extraction of natural resources. And Alaska has one natural resource in abundance: oil. With the price of oil on the rise, total revenue grew by 27 percent that year—which helped the state increase its rainy day fund to an amount more than double the state's annual budget, making it the largest such fund in the nation at the time, both in total dollars and relative to spending . But in 2015, state tax collections declined 75 percent when oil prices dropped, and the state had to rely on the same rainy day fund to help close a multibillion-dollar budget gap.

This is an extreme example of revenue volatility. But it illustrates a challenge faced by every state: how to manage the ups and downs of tax revenue so that budgeting can be predictable and policy goals can be achieved.

Each state's volatility depends on its unique mix of taxes, and swings in revenue are often influenced by factors beyond policymakers' control. For example, volatility in tax collections can be attributed to economic factors—such as the mix of industry, natural resources, workforce, and population growth—and to federal budget changes and unforeseen events such as natural disasters.

Common Revenue Stream Volatility

Four of the most common revenue streams are personal income, sales, corporate income, and severance taxes. Each has a different level of volatility. Personal income and sales taxes—levied in 41 and 45 states, respectively—form the largest share of most states' tax collections and typically display relatively low fluctuations. Corporate income and severance taxes are significantly more volatile and unpredictable.

Volatility is not always a problem, especially when it leads to unexpected revenue. States can use a spike to make one-time investments in programs, temporarily reduce taxes, increase savings, and invest in infrastructure, among other things. But when revenue suddenly declines, states can be left with large budget deficits and limited options to fill those gaps.

For some states, such as Alaska, the impact of volatility is readily apparent. But all states must manage revenue fluctuations. As Fitch Ratings—a credit rating agency that assesses the strength of state and local government finances—noted in its recent downgrade of Oklahoma's general rating, “volatility related to the energy industry is an inherent part of the state's economy.” Oil and gas production tax revenue in Oklahoma is earmarked by statute to various funds; once the earmarks are fulfilled, additional revenue goes toward the general fund. Depending on whether severance tax revenue is spiking or declining, the state's general fund has fluctuated between being flush and falling short of projections: After contributing nearly $250 million to the state's general fund in 2000, oil production taxes didn't even meet the minimum earmark requirement to allocate funds toward the budget account from 2001 to 2004. Similarly, gas production taxes contributed almost $700 million to the general fund in 2008 but less than $100 million in 2015.

Promising Practices to Manage Volatility

States base tax policy on a number of economic and social considerations, as well as policy goals; volatility, although partly a consequence of a state's tax structure, should not necessarily dictate tax policy. States are better off studying their revenue fluctuations and developing policies to manage their impact. In Oklahoma, for example, lawmakers enacted legislation in 2016 to prevent a repeat of the revenue shortfalls caused by previous periods of volatility. When revenue recovers, the state will begin setting aside above-average collections of the oil production tax, gas production tax, and corporate income tax into a new revenue smoothing account called the Revenue Stabilization Fund, allowing the state to save more when funds are available and set aside less—or make withdrawals from the fund—in leaner years to ensure that the general fund receives more predictable revenue each year.

In 2016, Maryland's Department of Budget and Management, Department of Legislative Services, and comptroller examined fluctuations in the state's revenue structure. They concluded that personal income tax collections tied to non-withholding income, such as capital gains and dividends, significantly contributed to the unpredictability of tax revenue. In response, this year the General Assembly passed, and Governor Larry Hogan signed, House Bill 503, which will limit the amount of non-withholding income that flows to the general fund. If this income exceeds the previous 10-year average, the excess amount will be put into the state's rainy day fund.

Next Steps for All States

Whether tax fluctuations are large or small, every state can benefit from a comprehensive and regular examination of volatility. For example, Utah's Legislative Fiscal Analyst and Office of Management and Budget are required to produce a volatility study every three years to measure the changes in all major revenue streams, identify the key factors influencing fluctuations, and present clear policy recommendations to mitigate future risk. The study helps lawmakers set an optimal size target for the rainy day fund, determine when revenue growth is unsustainable, and consider rules for when to save.

Understanding volatility gives states the ability to more effectively manage revenue throughout economic cycles, allowing them to increase their rainy day funds when revenue is above normal or direct more money toward nonrecurring priorities—so that they have the resources they need from year to year and over the long run. As policymakers in Alaska, Maryland, and Oklahoma know, revenue volatility is inevitable, but that does not mean they—or any other state—are at the mercy of uncertainty.