Source: LAO Report on Revenue Volatility

Revenue Volatility In California

January 2005

Following the boom-bust revenue cycle in recent years, concerns have developed about volatility in California's General Fund revenues. This brief quantifies the amount of revenue volatility experienced in California during the past quarter century, identifies the main causes of the volatility, and discusses the outlook for volatility in the future. We also highlight some options for reducing future impacts of volatility�both those involving changes to the tax system and budgetary changes�and discuss the trade-offs inherent in each of the alternatives.

Introduction

California's system of taxes that supports the General Fund has been in place for many years. Its main elements�the personal income tax (PIT), sales and use tax (SUT), and corporation tax (CT)�were established over half a century ago. The system has performed relatively well through most of the intervening period and has generally received good marks from economists and public finance experts. For example, it is diversified and relatively broad-based, thereby ensuring that all types of individuals, businesses, income, and economic activity contribute to the financing of public services. It also provides revenues that increase over time in response to growth in the state's population and economy, thus helping ensure that the state can fund the public services that demographic growth requires, such as education and infrastructure.

Despite its generally positive features, there are certain areas where California's tax system could benefit from reforms, such as those making it more reflective of the state's modern economy and more neutral with respect to its effects on economic decision-making. One particular concern which has emerged in recent years is the current system's relatively high degree of volatility. Annual fluctuations in General Fund taxes have been quite significant. These fluctuations have been considerably more pronounced than the volatility in California's overall economy, and more substantial than the revenue fluctuations experienced in other states. This revenue volatility has contributed to major problems for state policymakers attempting to manage and balance California's state government budget. This has been particularly true during the past five years, when General Fund revenues increased by as much as 20 percent in 1999-00 but then plunged by a dramatic 17 percent in 2001-02.

What Exactly Is Meant by Revenue Volatility?

As noted above, revenue volatility in broad terms refers to fluctuations over time in tax receipts. Actually, however, there are a number of different characteristics and dimensions that such revenue fluctuations can have, which in turn can determine both the challenges volatility poses for policymakers and the best options for dealing with it. These factors include:

Amount and Frequency of Variability. There can be year-to-year growth fluctuations that are frequent but of modest size, fluctuations that are infrequent but of more dramatic magnitude, or any number of other possible patterns. (There can also be dramatic revenue fluctuations within fiscal years, which can have significant implications for cash-flow and intra-year borrowing needs.)

Varying Underlying Causes. Some fluctuations are closely related to business cycles and their impacts on such variables as personal income and employment. In other cases, however, fluctuations can be primarily caused by changes in such factors as capital gains and stock options, which may be only loosely related to the general business cycle.

Given the above, revenue volatility�though perhaps simple in concept�is in reality a multi-dimensional and often complex phenomenon.

Implications Of Revenue Volatility

Given California's significant revenue volatility experiences over the past two decades, a natural next question to ask is: What are the adverse consequences of such revenue volatility? Understanding this is particularly important in considering whether and what steps should be taken to lessen volatility since, as we discuss further below, reducing volatility can itself involve trade-offs. These include reducing the rate at which revenues may grow and changing how the tax burden itself is distributed.

Large Dollar Variations Occur in Revenues

The first and most obvious impact of revenue volatility involves the large dollar variations in state revenues that it can produce. To provide an indication of what the above-discussed percentage estimates of volatility imply in dollar terms, consider that 2004-05 General Fund revenues (excluding transfers and loans) are currently expected to be roughly $78 billion. If revenues were to grow from that level in 2005-06 at the long-term underlying average growth rate of 6.1 percent, the resulting revenue total would be roughly $83 billion. However, an 8 percent standard deviation implies that the actual level of revenues could differ from that amount by an average plus-or-minus margin of $6 billion, resulting in a revenue range from $77 billion to $89 billion.

These are extremely large dollar margins. Admittedly, they are probably somewhat skewed by the extraordinary large volatility of the late 1990s and early 2000s. However, even after excluding the "outliers" (that is, the years in which the most extreme fluctuations occurred), the year-to-year variation in past revenue growth has been considerable and suggests that multibillion-dollar single-year future revenue swings are more likely than not.

Less Stable and Predictable Program Funding Results

Even if revenue volatility could be accurately predicted, year-to-year revenue fluctuations of this magnitude make it difficult to provide stable funding for state programs, and thus complicate budgeting. Compounding this, of course, is the fact that to date it has not proved possible to accurately predict volatility itself. The forecasting procedures used by both the Department of Finance and our office do attempt to forecast year-to-year revenue fluctuations by taking into account the impacts of general economic cycles and specific economic factors such as consumer and business spending, housing starts, employment, profits, and changes in income distributions. These methodologies have been successful in predicting a significant portion of the revenue fluctuations that have occurred in most years. However, since revenue volatility is related at least in part to particularly hard-to-predict factors such as changing stock market values and business profits, it is often associated with increased forecasting discrepancies.

Volatility of the Property Tax

Although the property tax in California is a local revenue source, fluctuations in revenue growth from this source nevertheless can have significant impacts on the state's budget. This is because under the minimum funding guarantee for K-14 education under Proposition 98, General Fund expenditures are equal to the total guarantee minus the portion of the guarantee that can be funded from local property taxes. Thus, increases (or reductions) in property tax revenues reduce (or increase), dollar for dollar, General Fund financial obligations for schools.

Local property taxes have exhibited less volatility than the state's General Fund tax sources�both over the full 24-year period we have examined and during its two individual subperiods. The average growth rate for this tax has been 7.5 percent, while the standard deviation has been 3.5 percent.

Characteristics of the Tax System

As noted previously, California's revenue growth has fluctuated by considerably more than statewide personal income growth during the past couple of decades. California's tax system has several key features which have contributed to this above-average volatility.

In particular, California has become highly dependent on the PIT. Specifically, the PIT's share of total revenues rose from 37 percent in 1979-80 to a peak of 57 percent in 2000-01, before retreating some to 48 percent in 2003-04. The increased dependence on the PIT over time is significant because this tax has two features that have contributed to above-average volatility:

First, it has a highly progressive tax rate structure, with marginal tax rates ranging from 1 percent to 9.3 percent. Many view this as a positive attribute from a policy perspective, in that it links tax burdens more strongly to the ability to pay. However, this progressive structure also magnifies the effects on revenues of the earnings volatility of higher income households.

Second, California, unlike the federal government and most other states, does not provide preferential tax rates on capital gains. Full taxation of capital gains has increased California's dependence on this volatile revenue source relative to most other states.

Who Pays Taxes - 2006 from California Budget Project

To a lesser extent, some other features of California's tax structure have also resulted in increased volatility. As noted earlier, its SUT is largely applied to the exchange of only tangible personal property, and California has not extended the SUT to many services. As a result, the tax is primarily influenced by the more cyclical categories of spending, such as for automobiles, residential and nonresidential construction, computers, and other "big ticket" items.

The Bottom Line on Revising the Revenue System

The state could reduce revenue volatility through making a number of different changes to its basic tax structure. Some of these changes, such as those which broaden tax bases and reduce overall tax rates, would result in other positive benefits to the state's tax system. However, the options that would have the greatest impact on lessening volatility would come with significant policy trade-offs, such as changing the distribution of the tax burden and lowering underlying revenue growth rates.

In any case, the dynamic and often volatile nature of California's economy implies that even with substantial structural tax changes, the state would still likely be left with significant revenue volatility in the future. Any revenue system that is responsive to economic growth over the long term will inevitability be influenced by the ups and downs of economic cycles in the shorter and medium term. Consequently, even if California were to modify its tax structure, it would be important to also consider budgetary tools as an important option for dealing with revenue volatility in the future.

Conclusion

Revenue volatility has long been present in California's tax system, but it became dramatic in recent years. We believe that the extreme volatility associated with the recent stock market boom and bust will likely prove to be an historical anomaly. However, several other factors�in particular, California's dynamic economy and the state's current heavy reliance on a highly progressive PIT�mean that revenue volatility will remain a feature of California's current-law tax system in the future. We have identified several options involving changes to the state's tax structure that could lessen future revenue volatility. Some of the options would both reduce volatility and achieve other objectives of state tax policy. However, certain other options�including those that would have the greatest impact on lessening volatility�would involve significant policy trade-offs that would need to be considered. Among these trade-offs would be redistributions of tax burdens and possible effects on future revenue growth.

Even with tax reforms, it is likely that California would continue to face significant volatility in the future. Thus, we believe that any strategy to deal with future volatility should include reliance on budget management options. The most effective of these options is a large reserve, in line with the targets established by Proposition 58.

Reference Documents from CA Legislative Analyst Office

TOP

Comments. Questions. Broken links? Bad spelling! Incorrect Grammar? Let me know at webmaster.
Last modified: , 2005

Disclaimer: This website is the sole responsibility of Mike McMahon. It does not represent any official opinions, statement of facts or positions of the Alameda Unified School District. Its sole purpose is to disseminate information to interested individuals in the Alameda community.