CHICAGO —  States should consider adapting their tax and budget practices to avoid the deep bruising of downturns as their fortunes over the last decade have grown increasingly tied to economic cycles, the Federal Reserve Bank of Chicago recommends in a new report.

“State governments are facing a period of fiscal turbulence. To get through these stressful times, states must understand the dynamics influencing their tax revenue collections,” writes Leslie McGranahan, senior economist, and Richard H. Mattoon, senior economist and economic advisor. “If this trend persists, states should consider ways of adapting their budgeting practices to ensure that necessary services can be maintained.”

State tax collections have long been in tandem with economic cycles, but since 2000 the swing has grown more pronounced, and was especially evident during downturns in 2001, in 2008-2009, and during the strong growth p in the mid-2000s. The Fed data showed that the more magnified swings occurred in many states.

The underlying cause of the volatile pattern is individual income-tax collections and changes that have intensified the impact of economic conditions on collections. The report’s authors attribute the growing volatility to a number of factors. Since 2000, economic shifts have had less influence on state tax rates.

The analysis indicated that during recessions in the early 1980s and early 1990s, states increased their tax rates, easing the impact of economic conditions on overall collections while many states responded to more flush times by lowering their rates. 

“By contrast, since the mid-1990s, tax rates have been essentially unchanged in the face of economic fluctuations. Because of political constraints or other forces, policymakers began to make a different set of decisions concerning tax rate policy,” the authors write.

And while wage and salary track the economic climate, fluctuations in investment income have grown more dramatically since 2000, depending on the economic climate. Those swings were less dramatic during the 1990s, the report notes.

The report attributes the more pronounced swings of investment income on income tax collections to the periods in which there was a big drop in stock market returns. It suggests a change in capital gains tax policy in 2003 “may have influenced investors’ decisions concerning when to take gains and in which amount.”

Individual income taxes, along with general sales taxes, made up about two-thirds of state revenues across all states in 2010, but the volatility of sales taxes pales in comparison as their rise and fall lacks the dramatic up-and-down spikes of income tax collections.

The report notes that the primary ways states can deal with changing fiscal tides include relying on federal help, adjusting spending habits, policy changes on taxes and revenues, and asset management.

Policymakers over the last several years have adjusted tax and revenue policies. “Going back to the historical practice of increasing tax rates during bad economic times and decreasing them during good economic times would be one way that states could reduce state tax revenue volatility,” the report suggests.

But the authors also offer other alternatives. States could focus their tax rates more on wage and salary income and less on more volatile investment income. To reduce volatility in sales taxes, states could broaden the tax base to include more foods and services that are less vulnerable to the economic climate. “Higher sales taxes on foods and services would reduce states’ reliance on tax revenues generated from less frequently purchased big-ticket goods, like furniture and cars,” the report reads.

State assets could also help manage through a downturn. States could establish rainy-day funds, perhaps funneling strong capital gains during strong growth periods to the fund for use during downturns.

The report comes as recent analysis has shown that state taxes rebounded last year. State tax revenues at the end of last year rose for the first time above the peak levels at the beginning of the Great Recession after two straight years of growth, the Rockefeller Institute said in a report issued last month.

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