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

Pavel Yakovlev/Duquesne University 1

State Budgets and Taxes during Business Cycles

Pavel Yakovlev, Ph.D.Professor of Economics

Duquesne University

Capital Campus PennsylvaniaJanuary 26, 2009

Pavel Yakovlev/Duquesne University

Balanced Budget Requirement

• 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.


State Budgets Are Pro-cyclical

• 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.


States Have Limited Options

• 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.


How to Stabilize Tax Revenue?• 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.


Tax Revenue Volatility

• 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

• 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.


What to Tax in Recessions?

• 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.


2006 State & Local Tax Collections by Source (% of Total Revenue)

Property Sales Income Corporate

United States 30 23.6 22.5 4.4

Pennsylvania 29 17.5 25.1 4.3

Ohio 29.1 21.3 31.8 2.6

New York 29.5 17.6 31.2 7.3

Maryland 23.1 13.1 38.2 3.3

New Jersey 43.4 14.5 22.2 5.3

West Virginia 18 19.1 22.1 9.1

Source: Federation of Tax Administrators


Tax Capacity and Effort• 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


2004 Tax Capacity and Effort

Tax Capacity ($) Tax Effort

United States 44,067 7.8%

West Virginia 31,353 8.7%

Ohio 40,642 8.4%

Pennsylvania 42,073 8.2%

New York 52,101 10.1%

Maryland 52,128 7.7%

New Jersey 56,380 8.1%

Source: Mikesell (2007)


Conclusion

• 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.


References• 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.

Documents

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