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Lawmakers hear how and why to better plan for revenue volatility

by Tim Anderson~ 2014 MLC Annual Meeting Edition ~ Stateline Midwest »
When the Great Recession began to hit states, they had a total of $59.9 billion in reserves. A year later, total budget gaps were nearly double that figure, $117.3 billion.
“States found themselves woefully short in terms of the amount of savings they had to offset the budget shortfalls created by the crisis,” Robert Zahradnik of The Pew Charitable Trusts told lawmakers at the Midwestern Legislative Conference Annual Meeting. “A lot of that is because savings is not the highest priority when it comes to making state budgets.”
The fiscal crisis is over, but it has opened new questions about budget planning and management. Prior to the Great Recession, for example, a fiscal reserve of 5 percent of the total budget was considered a sound target. Now, Zahradnik said, the preferred goal tends to be between 8 and 10 percent.
Part of the reason is that state revenue sources have simply become more volatile, thus the need to better plan for more-extreme “rainy days.”
“You’re very dependent as states on your wealthiest people; it’s more pronounced than even five or 10 years ago,” Scott Pattison, executive director of the National Association of State Budget Officers, said, noting that the personal income tax accounts for close to 44 percent of state general-fund revenue.
“[Wealthy individuals’] income is much more volatile today based on capital assets and because of changes in how they are compensated [bonuses and stock options, for example].”
At the moment, Pattison said, states as a whole are “slogging through” a fiscal period marked by stable but below-average revenue growth. And though another recession does not appear on the horizon, Robin Prunty of Standard & Poor’s Ratings Services had this warning for lawmakers: Economic downturns occur, on average, once every 6.6 years, and it has been five years since the last one.
Pattison said, too, that policymakers should plan for changes in the federal-state fiscal relationship; right now, nearly one-third of total state spending comes from the federal government (see pie chart).
“Over the next five years, I believe you will see dramatic declines in growth or outright cuts from the federal government, except for Medicaid,” he said.
Zahradnik provided a three-step outline for how states can plan for revenue volatility. First, conduct a study that focuses on historical patterns of volatility in tax collections. Second, tie the deposits made into budget stabilization funds to the study’s findings. Third, set targets for the size of these funds based on the state’s experience with volatility. Indiana and Michigan already link their rules on budget savings to one measure of volatility — fluctuations in personal income.
This year, the Illinois legislature passed a bill (SB 274) calling for a study of the volatility of its revenue sources, and Minnesota lawmakers will now require annual evaluations of the state’s budget reserves (HF 1777) that are based on revenue volatility.