Volatile States: Institutions, Policy, and the Performance of American State Economies

6. Reliability of Revenues from Alternative Tax Instruments

Chapter 6 Reliability of Revenues from Alternative Tax Instruments More than 200 years ago Adam Smith maintained that reliability is one of the most important attributes of a good tax system. Economists have since formalized this concept into a basic principle of public Anance, and most policymakers quickly discover its verity through practical experience.1 Governments beneAt from a reliable revenue stream for the obvious reason that spending commitments must be made before revenues are actually in hand. When revenues fall short of budgetary commitments, elected ofAcials And themselves in a politically precarious position. They face a limited set of possible Ascal policy responses, and none is pleasant: renege on spending commitments , raise taxes, print money, issue debt, or some combination of the four. In years when actual revenues exceed budgetary commitments, elected ofAcials sometimes respond gleefully; yet a revenue windfall that results in an unanticipated budget surplus is not costless. Policy options were forgone or at least delayed. Some desired programs went unfunded for the Ascal year, or an opportunity to enact a tax cut was missed or delayed. In the event of either a revenue shortfall or a windfall , policymakers face inferior policy options relative to those that are available when actual revenues meet budgetary expectations.2 Various constraints limit the options available to policymakers in the American states to deal with revenue shortfalls, and these make the predictability of revenue Bows particularly important. Foremost among these, the U.S. Constitution prohibits American state governments from raising public revenue through money creation. In addition , a mix of state constitutional provisions, statutory budget rules, and a competitive bond market constrains the ability of states to issue debt in response to revenue shortfalls. Given these constraints, American state governments for the most part achieve Ascal balance through adjustments in spending and taxes. The need to adjust taxes in response to cyclical revenue Buctuations distorts resource mobilization and thereby creates a source of 73 inefAciency that impairs economic activity. This follows because the deadweight cost (or excess burden) of taxation depends on the square of the tax rate. Classic works in public Anance such as those by Barro (1979), Kydland and Prescott (1980), and Lucas and Stokey (1983) use this standard proposition to formalize the tax-smoothing thesis as a way to minimize the excess burden of taxation over the business cycle. This thesis, in brief, argues that to promote economic development governments should shun cyclical changes in taxes. Constraints on the use of debt Anancing by state governments to achieve tax smoothing mean that the reliability of revenue Bows represents a crucial factor in the evaluation of alternative tax instruments.3 This chapter analyzes the reliability of state revenues from sales taxes and individual income taxes, the two largest sources of state tax revenues, as discussed in detail in chapter 4.The initial task is to construct an indicator of revenue volatility, which of course reBects the opposite of revenue reliability. This metric is then used to compare the volatility of sales tax revenues and individual income tax revenues for each state. Finally, the analysis examines the related issue of tax structure diversiAcation and its impact on revenue volatility in the states. The Measurement of Tax Revenue Volatility The Arst order of business is to compute a relevant measure of tax revenue volatility. Generally the procedure entails estimating the revenue volatility for each tax type (sales and individual income), given the existing tax structure in a state, and then standardizing this volatility measure by its share of total revenues raised.The basic measure of revenue volatility is the standard deviation of the deviation in revenue from its long-run trend line.4 The deviation in revenue from its long-run trend is estimated with the following regression equation: ln (Tax Revenuet / Incomet) ⫽ ␣ + ␤(Yeart) + εt , (6.1) where ln (Tax Revenuet / Incomet) is the natural log of revenue from a speciAc tax instrument (here, the sales tax or the individual income tax) as a share of state personal income in year t. This speciAcation of the dependent variable thus measures tax revenue Buctuations in relation to a state’s economic Buctuations. In other words, state economic conditions naturally inBuence state tax revenues, but here the analysis seeks to focus on how much more (or less) revenues Buctuate compared to the state’s economy.Yeart is a linear time trend vari74 Volatile States able (from 1968 to 1998). Its coefAcient...