Tax Revenue Volatility

Abstract

State governments experienced unprecedented fiscal crises in the 2000s precipitated by an extraordinary increase in the volatility of their tax revenues. Between 1970-2001 and 2001-2014 tax revenue volatility increased from 1.23 percent of revenues to 10.36 percent. To understand the factors that led to the increase in tax revenue volatility, I develop a novel application of decomposition methods. I find that tax policy differences explain 58.9 percent of the increase in tax revenue volatility and differences in economic uncertainty and tax base changes explain 22.3 and 18.8 percent respectively. To understand how governments should tax different revenue sources in the face of uncertainty, I derive an updated Ramsey rule that characterizes the optimal tax policy. I use the updated Ramsey rule to assess how well state governments are setting tax policy and find that the number of states that exposed themselves to excessive risk increased from 26 in 1975 to 36 in 2005.