Revenue bubbles and structural deficits: What's a state to do?

Abstract

The 2001 recession proved alarming to state government finances. A relatively shallow national recession led to a severe downturn in state revenues that took three years to unwind. In the current economic downturn, early signs of fiscal stress are already apparent. This raises several fundamental questions: - Since the mid-1980s the U.S. macroeconomy entered into a period dubbed the 'Great Moderation' in which economic volatility was reduced. Has state revenue volatility relative to the business cycle increased during this period? - Has the composition of state revenues and expenditures made states more susceptible to economic downturns and less likely to rebound in recovery? - Do states have the appropriate tools to address structural deficits or are they using budgeting techniques designed to address cyclical downturns to fix structural gaps? - Do the states have appropriate early warning mechanisms to anticipate fiscal stress? In this paper we will use state specific indicators of economic conditions to examine fiscal performance and budgeting practice over the economic cycle. In particular we will examine the interaction of policy choices in the states of Illinois and Iowa to see how these choices have impacted revenue collections and revenue productivity. Illinois and Iowa have significantly different economic structures and tax structures that should help illuminate what factors affect fiscal conditions. Finally we will offer some observations on how revenue and expenditure structures may need to change if states are going to avoid (or minimize) fiscal downturns.