Volatile State Tax Collections Make Budgeting Difficult

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Volatile State Tax Collections Make Budgeting Difficult

The pandemic-induced recession drove historic tax revenue declines during the first half of 2020, confounding state lawmakers’ efforts to balance budgets. Such unexpected swings in tax collections present challenges even under less extreme economic conditions, with some states more prone to higher tax revenue volatility than others. During the 20 years ending in fiscal 2020, Alaska recorded the greatest volatility and South Dakota the least, after removing the effects of state tax policy changes.

In this analysis, The Pew Charitable Trusts removes the estimated effect of state tax policy changes, which state lawmakers control, to calculate a volatility score for the underlying trends in each state’s overall tax revenue and major taxes—those that account for at least 5% of its tax revenue on average over the past decade.

Revenue volatility differs across states because each relies on a unique mix of tax streams. Individual tax streams experience different fluctuations from year to year, contributing to a state’s overall revenue volatility. Between fiscal years 2001 and 2020, severance taxes on oil and minerals and corporate income taxes were consistently more volatile than other major state taxes, such as those on personal income and sales of goods and services.

Although states can raise or lower tax revenue by changing tax policies, the underlying volatility of individual tax streams is often driven by a variety of factors, many outside policymakers’ control. These include economic factors—such as the mix of industry, natural resources, workforce, and population growth—as well as changes to federal budget and tax policy and unforeseen events, such as natural disasters. In early 2020, the coronavirus pandemic introduced a new dose of volatility. Tax revenue took its steepest plunge during a single quarter in at least 25 years, leaving no major sources unscathed as the public health crisis brought an abrupt end to the longest economic expansion in U.S. history. Even sources that are relatively less volatile, such as broad-based personal income taxes and general sales tax revenue, steeply declined as restaurants, bars, retail stores, and other businesses were shuttered, unemployment rates spiked, and consumer spending fell sharply.

However, much of the tax revenue drop in the second quarter of 2020—the final quarter of the fiscal year for most states—was offset by gains made in the first eight months of fiscal 2020, before the pandemic struck. So, the percentage decline in annual revenue wasn’t large enough to significantly affect 20-year volatility scores.

Volatility scores measure the variation in year-over-year percent changes between fiscal 2001 and 2020, based on a calculation of standard deviation. A low score means that revenue levels were similar from year to year, and a high score indicates that revenue grew or declined more dramatically.

Overall, 50-state tax revenue had a volatility score of 4.99 for the 20 years ending in fiscal 2020, slightly lower than last year’s score of 5.01 because one of the most volatile revenue years in recent memory—2000—was removed from the study period. The results mean that from 2001 to 2020 total tax revenue across the states typically fluctuated 4.99 percentage points above or below its overall growth trend. Tax revenue was more volatile than the national benchmark in 30 states and less so in 20.

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Source: Volatility scores for each state’s overall tax revenue and specific tax sources were calculated using the U.S. Census Bureau’s State Government Tax Collections historical data series from fiscal 2000 to 2020. Data were adjusted to control for the effects of tax policy changes using the National Conference of State Legislatures’ State Tax Actions reports for fiscal 2000 to 2020.

State highlights

  • The highest volatility occurred in Alaska (35.5 percentage points), North Dakota (17.2), and Wyoming (13.2), all natural resource-dependent economies that rely heavily on severance tax revenue.
  • The lowest ranked states for volatility were South Dakota (2.8) and Kentucky and Arkansas (both 2.9). Each of these states relies on relatively stable tax streams for over half of its revenue—sales for South Dakota, and sales and personal income for Arkansas and Kentucky.
  • Volatility scores rose in 29 states for the 20-year period through fiscal 2020, compared with scores based on the period from fiscal 2000 to 2019, though many of the increases were small enough to be obscured by rounding. New Mexico and Utah experienced the greatest increases. New Mexico’s increase was driven by a recent drop in personal income tax revenue, and Utah’s by recent declines in personal income and motor fuels tax collections.
  • Severance tax, which is highly dependent on global energy prices, was the most volatile revenue source in eight of the nine states where it accounted for enough revenue over the past decade to be considered a major tax. The exception was Alaska, where corporate income tax revenue was most volatile. Volatility scores for severance tax ranged from 19.2 in Louisiana to 46.1 in Alaska.
  • Corporate income tax revenue seesawed more than any other tax stream in 18 of the 21 states where it was a major tax. Volatility scores for this tax ranged from 13.3 in New Hampshire to 49.7 in Alaska.
  • Broad-based personal income tax, collected in 41 states, and sales tax, collected in 45 states, were relatively less volatile revenue sources. Volatility scores for personal income tax ranged from 4.7 in Kentucky to 17 in North Dakota, and for sales tax from 2.8 in Wisconsin to 14.5 in Wyoming.

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 revenue source. Smaller tax streams can be highly volatile. But the more minor the tax source, the less of an impact it has on a state’s overall revenue volatility.

For example, the three states with the highest overall scores—energy-rich Alaska, North Dakota, and Wyoming—collected the greatest share of their tax dollars over the past 10 years from highly volatile severance taxes. Yet Texas, the largest oil producer in the nation, ranked close to the middle of states for overall revenue volatility even though its severance tax revenue was more volatile than any but Alaska’s. The crucial difference is that severance tax accounted for 7.7% of Texas’ total tax collections over the past decade, compared with 59.5% of tax revenue in Alaska, 46.2% in North Dakota, and 34.9% in Wyoming.

Similarly, in the 21 states where corporate income tax was a major source of tax revenue, it was the most volatile major source in all but three. However, its average share of total tax revenue was under 10% in all but three of these states.

Changes to federal budget and tax policy are among the factors that can affect the underlying volatility of state tax streams. In 2018, states experienced their largest annual swing in tax collections since the depths of the Great Recession in 2009, as collections climbed and states and taxpayers began adjusting to passage of the federal Tax Cuts and Jobs Act (TCJA). Because of the way in which state and federal tax codes are linked, the TCJA’s federal tax code changes automatically led to higher state tax bills for some residents and businesses, unless states counteracted them. This upswing did not affect most states’ 20-year revenue volatility scores, however.

Although volatility complicates the already difficult tasks of revenue forecasting and budgeting, it is not inherently bad. When receipts are higher than anticipated, states can pay down debt, make one-time investments such as in infrastructure projects, or build up reserves. But times of unexpectedly high revenue may just as easily be followed by periods of unanticipated low revenue that may prompt spending cuts, tax increases, or withdrawals from dedicated savings accounts to make ends meet.

By studying volatility, policymakers can better determine their own budgetary risk and put in place evidence-based savings strategies that harness tax growth in good years to cushion the lean years. These strategies include depositing one-time or above-average revenue into a rainy day fund and dedicating these balances to explicit, narrowly defined spending purposes. States can also reduce fiscal uncertainty by restricting spending from particularly volatile tax streams. Revenue from these streams could instead be deposited in longer-term savings accounts or sovereign wealth funds, as several natural resource-rich states do. These policies and related fiscal management tools can help stabilize budgets and aid policymakers in planning for the long term.

Download the data to see individual state trends. Visit Pew’s interactive resource Fiscal 50: State Trends and Analysis to sort and analyze data for other indicators of state fiscal health.

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Data Visualization

Fiscal 50

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Data Visualization

Fiscal 50: State Trends and Analysis, an interactive resource from The Pew Charitable Trusts, allows you to sort and analyze data on key fiscal, economic, and demographic trends in the 50 states and understand their impact on states’ fiscal health.

Fact Sheet

How to Study Volatility

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Fact Sheet

Across the country, state revenue has become increasingly volatile, confounding the best efforts of officials and policymakers to make forecasts and keep budgets in balance. To help states better manage this uncertainty, The Pew Charitable Trusts recommends that policymakers periodically study their states’ economic and revenue volatility. Such analyses can help states develop policies for rainy day funds that smooth budgets throughout the business cycle and align with each state’s objectives and characteristics.


Economic Downturns: Protecting State and Local Budgets

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In particularly challenging times, when revenue is volatile and priorities may need to be reassessed, it is important that lawmakers manage budgets effectively to mitigate fiscal stress.