State Tax Revenues over the Business Cycle: Patterns and Policy Responses

By McGranahan, Leslie; Mattoon, Richard H. | Chicago Fed Letter, June 2012 | Go to article overview

State Tax Revenues over the Business Cycle: Patterns and Policy Responses


McGranahan, Leslie, Mattoon, Richard H., Chicago Fed Letter


State tax revenues have become far more sensitive to changing economic conditions since the turn of the century. The authors document this increasing volatility and offer suggestions for what state governments might do to better manage their tax revenues to avoid or minimize dramatic fiscal downturns.

State tax revenues have historically been procyclical (i.e., rising when economic times are good and falling when they are bad). However, the magnitude of this response since 2000 has been much larger than in the 1980s and 1990s. The behavior of the state individual income tax is a key underlying factor behind this increased responsiveness to national business cycle fluctuations. Changes in both income tax rates and personal income dynamics have contributed to increased volatility in individual income tax revenues. On average, income tax rate policy across states has transitioned since 2000 from being countercyclical (i.e., raising tax rates when economic times are bad and lowering rates when times are good) to being largely independent of the business cycle. Since 2000, individual income growth-especially from investment income (i.e., income from capital gains, interest, and dividends)-has become more sensitive to changing economic conditions.

In this Chicago Fed Letter, we document the changing cyclical behavior of state tax revenues and discuss some of its causes. We then offer some suggestions for what state governments might do to avoid the negative consequences of the boom-bust cycles in state tax revenues observed over the past decade.

Evidence for increased volatility

To examine tax revenue performance over the business cycle, we compare a measure of state tax revenues (summed across the 50 states) with a measure of national business cycles (figure 1). For our measure of state tax revenues, we use the year-over-year growth rate of quarterly aggregate real state tax revenues per capita (e.g., 2011:Q1 relative to 2010:Q1), as reported by the U.S. Census Bureau.1 For our measure of business cycle conditions, we use the growth rate of the Federal Reserve Bank of Philadelphia's coincident index for the United States. This coincident index combines four indicators at the national level to generate a single measure of economic conditions.2 (The Philadelphia Fed also creates a measure for each of the 50 states in a similar manner.)

In the first two decades depicted in figure 1, state tax revenue growth and economic growth track each other closely. Starting around 2000, however, the swings in state tax revenues become more dramatic relative to the swings in economic conditions. While this new pattern is most pronounced during the downturns in 2001 and 2008-09, we also note relatively large positive swings in revenues in the middle years of the 2000s. In our recent research,3 we date this change in the state tax revenue-business cycle pattern to 2000 and note that it occurred in many of the 50 states.

In figure 2, we separately depict changes in the two most important sources of state tax revenues-the individual income tax and general sales tax. Combined, these two types of taxes represented about two-thirds of state tax revenues across all 50 states in 2010.4 As shown in the figure, the increased volatility of state tax revenues over the business cycle is primarily due to the dramatic swings in the individual income tax.

Individual income tax

Changes in individual income tax revenues can arise from two sources: changes in the amount or type of income that is taxed and changes in the tax rates that apply to the various forms of income.

Thus, a higher volatility of individual income tax revenues could emerge if incomes rose and fell more dramatically with changing economic times or if the income tax rate policy became less countercyclical than it had been historically. (Countercyclical tax policy would typically offset some of the business cycle impact.)

We first investigate changes in the dynamics of income. …

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