States Face Increasingly Uncertain Revenue Forecasts

The tough tasks of state revenue forecasting and budgeting have always been complicated, but increasing volatility in tax streams—caused by swings in personal income, slowing consumer spending, and uncertainty about marijuana markets and other so-called sin taxes—could be even more pronounced when the next downturn hits.

States must balance their budgets each year and accurate revenue projections help achieve that goal without significant changes in services or tax policy during the fiscal year. The greater the volatility, however, the more difficult that forecasting becomes.

Although volatility complicates forecasting and budgeting, it is not inherently bad. When receipts are higher than anticipated, states can allocate more resources to improve roads and bridges, pay down debt, or build up reserves. But periods of unexpectedly high revenue may just as easily be followed by years of unanticipated declines that prompt spending cuts or tax increases.

Revenue volatility differs across states because each relies on a unique mix of tax streams. Four of the most common are taxes on personal income, sales, corporate income, and natural resource extraction (known as severance taxes). But each of these taxes exhibits its own level of volatility. Personal income and sales taxes—levied in 41 and 45 states, respectively—form the largest share of state tax collections.

Factors that influence volatility

In general, two factors work in tandem to influence a state’s overall revenue volatility: how dramatically each tax stream changes from year to year and how heavily a state relies on each source. Smaller tax streams can be highly volatile, but the more minor the source, the less of an impact it has on overall volatility.

Two states with large natural resource economies—Alaska and Texas—illustrate how these factors come together. In Alaska, a highly volatile severance tax on oil and gas production has been the state’s primary source of revenue over the past two decades, although its share of total tax revenue peaked at 82 percent in 2012. As a result, Alaska has by far the highest revenue volatility in the country. By contrast, severance revenue accounted for an average of only 7 percent of Texas’s overall revenue over the past decade, and the state ranks near the middle in terms of total revenue volatility, according to Pew’s Fiscal 50 Revenue Volatility Indicator.

Although states can raise or lower tax revenue by changing tax policies, the underlying volatility of individual tax streams is driven by various factors, many outside policymakers’ control. These include the mix of industry, natural resources, workforce, and population growth, for example, as well as federal budget changes and unforeseen events, such as natural disasters.

Most state revenue increases in recent years have been driven by a surge in personal income tax collections. According to Pew analysis of state-level data from the U.S. Census Bureau, such taxes averaged just over half of total revenue gains from fiscal 2012 through 2018 for the 41 states that collect it as a major source.

As shown in the Fiscal 50 Revenue Volatility Indicator, personal income tax collections tend to experience more fluctuations than the other major source, sales taxes. This means that personal income taxes see greater swings over the course of the economic cycle.

Following the economic downturn that began in the fourth quarter of 2007,  personal income grew slowly in most states. The National Association of State Budget Officers’ 2019 spring survey showed that a large portion of revenue increases from personal income taxes came from the most unpredictable sources, including interest, dividends, partnerships, self-employment taxes, and—critically—capital gains. These sources are notably subject to big swings in the stock market, which can often occur during periods of economic distress.

Even though total state tax revenue recovered nearly six years ago from its losses in the downturn, policymakers in many states are still dealing with fallout from the tough choices they had to make to fill budget holes during the recession. Various states have faced strikes by teachers who went years without pay raises, the need for higher tuition at public universities, pressure from local governments living with less state aid, mounting repair bills for public infrastructure, and smaller state workforces.

In addition, income inequality, a measure of the economic gap between the rich and poor, has risen steadily in the United States since the 1970s. For those states that count on personal income tax, that means they now rely on fewer people for a greater share of revenue. This concentration adds to volatility; any changes in income driven by rises and falls in stock and other asset prices among this increasingly small group can significantly affect revenues at any time.

The downside of the cycle may be coming soon. In September Moody’s Analytics chief economist Mark Zandi estimated that the chances of recession in the year ahead were as high as 67 percent. He warned that, based on economic indicators ranging from the bond market to job creation, states need to prepare now for the national economy to stall and start contracting in the second quarter of 2020.

Uncertainty over new sources

Uncertainties, including long-term consumption trends and new revenue sources from what had once been an underground economy, can also make returns difficult to forecast. As with tobacco, alcohol, and gambling taxes, new levies on marijuana and e-cigarettes may provide short-term revenue gains, but their ability to be sustainable long-term revenue sources capable of funding ongoing expenditures is unclear.

Officials in 11 states and the District of Columbia are grappling with how to project revenue from taxes on recreational marijuana. Forecasting revenue from a product that was illegal just a few years ago—and that remains so under federal law and in most states—presents a difficult challenge for state budget planners. For example, in Nevada’s first six months of collecting marijuana taxes, revenue came in 40 percent higher than budget officials expected; in neighboring California, however, it was 45 percent below projections for the first six months of collecting marijuana taxes.

Together these factors provide an important reminder that revenue growth in many states increasingly relies on more volatile sources, so policymakers may need to plan for steeper declines by accruing more reserves. They also reinforce the reality that every state can benefit from a comprehensive and regular examination of revenue volatility.

Kil Huh is a vice president at The Pew Charitable Trusts leading the work on government fiscal and economic policy.