State Budgets and Taxes during Business Cycles Pavel Yakovlev, Ph.D. Professor of Economics

1. State Budgets and Taxes during Business Cycles Pavel Yakovlev, Ph.D. Professor of Economics Duquesne University Capital Campus Pennsylvania January 26, 2009

2. Every state except Vermont has a balanced budget requirement (BBR). 2/3 of the states have ex-post BBR. 1/3 of the states have ex-ante BBR. Balanced Budget Requirement

3. State revenues are small during economic contractions and large during expansions. State welfare spending rises in economic downturns putting additional pressure on budgets. BBR reduces state spending during economic downturns. State Budgets Are Pro-cyclical

4. The largest revenue sources such as property, sales, and income taxes shrink during recessions. Increasing tax rates during recessions is unpopular and may hurt state economy even further. States Have Limited Options

5. State tax revenues are mainly determined by personal income and tax portfolio composition. Tax portfolio composition is crucial to smoothing the volatility of state tax revenues over business cycles. Some tax instruments are more stable than others during economic booms and busts. How to Stabilize Tax Revenue?

6. Sales taxes are less volatile than personal income, corporate income, and severance taxes (Felix 2008, Sobel and Holcombe, 1996). Selective sales taxes on tobacco, alcohol, and gasoline are the least volatile because they are levied on item quantity rather than value. Tax Revenue Volatility

7. Food and medical care consumption is least volatile, while corporate income is most volatile. By choosing the right taxes, states can reduce the volatility of their tax revenues without giving up the long term growth in revenues. Tax Revenue Volatility

8. States should rely more on taxing food, tobacco, alcohol, gasoline, and medical care during recessions. However, these taxes might be regressive, unpopular, and uncompetitive compared to neighboring states. What to Tax in Recessions?

9. 2006 State & Local Tax Collections by Source (% of Total Revenue) Source: Federation of Tax Administrators

10. Tax capacity refers to the potential amount of revenue that could be collected Tax effort refers to how much of the tax capacity is being utilized Tax capacity is measured by total taxable resources (TTR) Tax effort is measured as actual tax collections divided by TTR Tax Capacity and Effort

11. 2004 Tax Capacity and Effort Source: Mikesell (2007)

12. Pennsylvania can raise more revenue during economic downturns by increasing the general sales tax and specific taxes on food, gasoline, alcohol, tobacco, and medical care. Even though these taxes can provide much needed revenue during recessions, they are also regressive and unpopular. Conclusion

13. Federation of Tax Administrators, http://www.taxadmin.org/. Mikesell, John. 2007. “Changing State Fiscal Capacity and Tax Effort in an Era of Devolving Government, 1981–2003” Publius: The Journal of Federalism Sobel, Russell S. and Randall G. Holcombe. 1996. “Measuring the Growth and Variability of Tax Bases Over the Business Cycle.” National Tax Journal 49, No. 4, pp. 535-552. Felix, Alison. 2008. “The growth and volatility of state tax revenue sources in the Tenth District.” Economic Review, Issue Q III, pp. 63-88. References