How Revenue Volatility Informs State Savings Targets

Pew offers guidance to Colorado lawmakers

How Revenue Volatility Informs State Savings Targets

In a memo, sent March 12, 2021, to Colorado’s Office of State Planning and Budgeting, experts from The Pew Charitable Trusts provide information on how measuring revenue volatility can help state officials determine how much they need to save in reserves.

When economic downturns strike, tax collections often decline while certain spending demands increase—in these situations, reserves are states’ best line of defense. But to determine how much to save, states need informed estimates of the size of the budget shortfalls they are likely to face. The most important factor in calculating such estimates is revenue volatility. States with relatively stable revenue sources require lower reserve levels than states with more volatile revenue sources.

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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.

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In a series of reports, The Pew Charitable Trusts has identified several best practices for building better rainy day funds. The reports emphasize that states should study how sensitive their tax systems are to economic volatility; identify concrete objectives and an appropriate savings target; link deposits to economic or revenue growth; and establish withdrawal conditions that encourage use during periods of fiscal stress.

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States' Tax Portfolios Drive Differences in Revenue Volatility

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Volatility in state tax collections can pose challenges for policymakers, making it difficult to forecast revenue, craft a budget, and manage long-term priorities. Just as individual tax streams account for varying shares of revenue in each state, collections from these taxes fluctuate to differing degrees. For example, a state may experience relatively low overall tax volatility even as certain tax streams are highly volatile. Policy decisions and shifts in the economy affect these streams in different ways.

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