Planning for Next Rainy Day, States Look at Revenue Volatility to Guide Savings Strategies

It was no small adjustment. In late January, North Dakota legislative staff issued a revised oil and gas tax forecast for the state that lowered revenue estimates from the prior month by about $4 billion.

Estimates from last December pegged oil and gas tax revenues for North Dakota's 2015-2017 budget cycle at $8,322,330,000. The January forecast was just $4,268,140,000. Falling oil prices prompted the revised forecast. During the six-month period beginning in August 2014 and ending in January, the average price for a barrel of North Dakota crude dropped from $87.66 to $37.54, according to U.S. Energy Information Administration figures.

In the preceding years, the state’s oil and gas sector had experienced a boom, driven largely by the rise of hydraulic fracturing, commonly known as fracking.

While only a relatively small percentage of oil and gas taxes go to the North Dakota’s general fund, they do provide an important source of revenue for other accounts, such as education-related funds, and a resources fund, which helps cover the cost of water projects. Sizable chunks of the money are also allocated to counties, cities and tribes.

About a year before the revised oil and gas revenue forecast was issued, North Dakota state Sen. Mac Schneider attended a National Conference of State Legislatures event in Chicago.

There he learned about research from the Pew Charitable Trusts that ranked North Dakota  as one of the top U.S. states in terms of tax revenue volatility. In other words, the state had some of the highest levels of year-to-year variability in the amount of tax dollars it collected.

(via Pew Charitable Trusts)

For Schneider, the lowered revenue projections drove home Pew’s findings. “It became something other than an academic issue,” the state senator said in a recent interview.

Tax revenue volatility is not only an issue in North Dakota. As states emerge from the Great Recession, lawmakers and public officials around the U.S. are looking more closely at how volatile tax streams should guide decisions about budgeting and the amount of money that gets saved in reserve accounts, also called “rainy day funds.”

Some of these efforts are playing out legislatively. In late February, Schneider introduced a concurrent resolution that called for North Dakota to study how vulnerable it is to volatile tax streams. The resolution was shot down on March 13 during a Senate verification vote.

But similar measures have had more traction in other states.

On April 7, Nebraska’s legislature approved a bill requiring the state’s legislative fiscal analyst to issue a “revenue volatility report” every two years beginning in 2016. The report will look not only at the variability in tax streams, but also at federal funding sources that could change, and assess the adequacy of current and projected reserve fund balances given these factors.

A bill is also under consideration in the Oregon state legislature that would create a new task force on reserve funds, consisting of lawmakers from the state’s House and Senate.

And in Utah, the Governor’s Office of Management and Budget plans to run a series of new “stress tests” to see how different revenue scenarios would affect the state’s finances.

Pew’s policy director for state fiscal health and economic growth, Robert Zahradnik, notes that states looking at previous revenue trends is not a new phenomenon. But more recently, he said, they’ve begun to do so in a new context.

One key difference is that states are increasingly trying to use more of what they’ve learned from those past trends to inform decisions about reserve accounts.

“It’s been rare that that look-back has been tied, sort of explicitly, to what their savings policy is going to be going forward,” he said. “I think there’s more interest in it,” Zahradnik added, “because the Great Recession was so difficult on states.”

Analyzing revenue trends can help show whether an uptick in one type of tax collections is in line with previous growth rates, or if it is an anomaly. It can also offer insight into whether a certain source of revenue—a state’s corporate tax for instance—is historically erratic. Additionally, trends can show if a state’s overall tax revenue tracks with broader economic ups and downs, or moves to its own localized rhythm.

All of this information can prove useful for budget and reserve fund planning. But using past revenue trends to draw conclusions about where a state’s finances are headed can also be tricky.

“I think it’s part of the answer, but not the whole answer,” said Kristen Cox, the executive director of the Utah Governor’s Office of Management and Budget.

Beginning in 2009, the office began working with the state’s Office of the Legislative Fiscal Analyst to assess revenue volatility and to provide recommendations for managing Utah’s rainy day fund balance. And last year, for the first time, a report the two offices co-produced compared revenue estimates for each tax the state collects against 15-year trends.

Cox said this type of analysis can be helpful in some ways, but warns that basing estimates of future revenue on past trends alone can be problematic for a number of reasons. For starters, it’s possible to analyze trends in different ways, using linear or nonlinear techniques. Trends are also complicated by year-to-year policy changes, and structural economic shifts.

A trend analysis by itself, Cox said, is akin to a family planning their household budget by looking at 15 years of income without considering factors like savings, debt or raises.

This is where a stress test can help, she said. The testing method her office is working on will involve first determining the probability that various fiscal scenarios could unfold. These scenarios might involve different streams of tax revenue rising or falling.

It will then be possible to run models to look at what would happen if the most likely scenarios actually took place. How would they affect Utah’s finances? Would the state have enough reserve funds on hand based on those predictions to withstand each scenario?

“We think budget stress-testing will give us a forward-looking view, trend gives us a historical looking view, and between the two we hope to get a more robust picture of what’s happening,” Cox said. But still she cautioned: “We never think we’ll be able to perfectly predict.”