1. Tax Base Volatility Thomas Stinson Matthew Schoeppner June 24, 2008

2. Tax Base Volatility What is volatility? – A measure of the variation between normal (trend) growth and actual changes How do we measure volatility? – The standard deviation ( σ ) is the standard measure of volatility

3. What is a Standard Deviation? A measure of dispersion or central tendency In a normal distribution 68.2 percent of the values will fall within one σ of the mean and 95.4 percent of the values will fall within 2 σ’s of the mean A distribution with σ = 1 will have a narrower concentration of values than a distribution with σ = 2

4. Why Is Volatility Important? More volatile (higher σ) tax systems will have larger surpluses and deficits The volatility of a tax system helps determine how large a reserve is needed Tax system volatility can be adjusted by changing either the proportion of revenue derived from each tax or the volatility of the individual taxes

5. Questions How volatile is Minnesota’s tax system? Has its volatility changed over time? Is Minnesota’s tax base more volatile than the economy? How large a budget reserve is needed? Could we produce the same revenue with less volatility?

6. How We Measure Volatility Focus first on tax base, not revenues Analyze growth rates, not dollar amounts Find annual growth rates for detailed items in the tax base Find yearly deviations from trend growth Convert tax base to revenues Combine volatilities of each separate segment of the tax base to produce an estimate of the system-wide volatility

7. Volatility Is the Variation Around the Trend Rate of Growth

8. Sometimes Shocks Move Series in Different Directions

9. U.S. Capital Gains 1960-2006 (Annual Percent Change)

10. Hodrick Prescott Filter uses a trend component and a cyclical component to obtain a smoothed non-linear representation of the long term trend growth rate of a data-series.

13. Volatility Calculation Summary Method – Hodrick-Prescott filter gives trend growth rate – ARCH, GARCH, and EGARCH models used to estimate volatility (σ) from trend growth rate over time Data – National data from SOI, NIPA accounts – Income tax: 7 income types – Sales tax: 19 purchase categories – Corporate tax: domestic profits – Other tax and non tax revenue

14. Questions How volatile is Minnesota’s revenue system? Has the volatility changed over time? Are Minnesota’s revenues more volatile than the economy? Could Minnesota’s tax system produce the same revenue with less volatility? How large a reserve should we have?

15. Minnesota’s Individual Income Tax Base Percent of Federal Gross Income 1960-19652000-2005Change Salaries and wages79.3%71.8% ↓ Taxable Interest2.1%2.5% ↑ Ordinary Dividends3.0%2.0% ↓ Net Capital Gains4.0%6.6% ↑ Taxable Pensions, Annuities, and IRAs0.7%7.1% ↑ Business, Partner, S-Corp, and Farm9.4%7.5% ↓ All Other Income1.6%2.6% ↑ Total:100.0% Data Source: IRS, Statistics of Income (SOI)

16. 3.7% 1.3%

17. 3.7% 1.3% 2.3% 0.9%

18. 16.9% 19.2%

19. 27.3% 16.9% 19.2% 21.8%

20. 2.3% 0.6% 3.3% 6.0% 12.3% 15.2% 27.3%

21. Wages Are Largest Portion of Tax Base and Least Volatile

22. Estimating the Volatility of a System of Taxes Markowitz’s modern portfolio theory used as a guide: – The expected growth rate in revenues is the weighted sum of the individual growth rates – Portfolio volatility is the square root of the weighted sum of the variances and covariances of the individual components

23. 3.0% 5.4%

24. 3.1% 3.0% 5.4% 1.4%

25. General Sales Tax Base Results 2006-2007 Estimated Current Law Proportion of General Sales Tax Base 2006-2007 Investment in Equipment17.7% Non-Auto Durables15.1% Other Non-Durables10.2% Construction Materials9.9% Prepared / Purchased Meals and Beverages9.8% Telephone5.6% Gas and Electricity5.5% Recreation3.7% State and Local Government Consumption3.6% Auto Parts3.5% Alcoholic Beverages3.2% Candy, Gum, and Soft Drinks2.6% Motor vehicle rental, leasing, washing, parking, and other2.5% Hotels and Motels2.4% Other Household Operation1.7% Investment in Software1.6% Personal Care/Other Services0.9% Fuel Oil and Lubricants0.3% Tobacco0.2% TOTAL100.0% Data Source: BEA, National Income and Product Accounts (NIPA)

26. 2.7% 5.2%

27. 2.1% 2.7% 5.2% 2.2%

28. Corporate Income Tax Base Results Data Source: BEA, National Income and Product Accounts (NIPA)

29. 12.3% 14.9%

30. 12.1% 12.3% 14.9% 7.4%

31. Other Minnesota Tax Revenues - Motor Fuels Excise Tax (Non-General Fund Revenue) - State General Property Tax - Motor Vehicle Sales Tax (Phasing-out of General Fund) - Motor Vehicle License Fee (Non-General Fund Revenue) - MinnesotaCare Tax (Non-General Fund Revenue) - Insurance Premiums Tax - Deed and Mortgage Tax - Health Care Provider Surcharge - Cigarette/Tobacco Tax - Liquor/Wine/Beer Tax - Estate Tax

32. Other Tax Revenue 2006 Trend Growth Rate Comparison (Nominal) Other General Fund Total Tax Revenue 7.7% Other General Fund Total Tax Revenue - Post MVST Phase-out 11.1% Inflation 2.6% 5.9% 10.9% 3.7%

33. Total Minnesota Tax Base Portfolio Results General Fund Tax Base Sources Portfolio 1. Pre MVST Phase-Out 2. Post MVST Phase-Out

34. Total General Fund Tax Base Portfolio (Pre MVST Phase-out) Proportion of Total General Fund Tax Revenue 1970-752000-06Change General Sales Tax22.6%30.4%↑ Corporate Income Tax10.6%5.7%↓ Individual Income Tax42.6%44.9%↑ Other General Fund Taxes24.2%19.0%↓ TOTAL:100.0% Data Source: U.S. Census, State Government Finances

35. 2.4% 2.1% 5.9% 12.1% 3.1% 2005-2007 Trend Growth Rate of General Fund Tax Base Corporate IncomeTax Base 14.9% Individual Income Tax Base 5.4% MN Sales Tax Base 5.2% Other Revenue Tax Base 7.6% Total Portfolio 6.2% Inflation 2.6% 2.0%

36. 2.4% 2.0% 2.9% in 1983 1.9% in 1996 2.7% in 2002

37. Total MN General Fund (Post MVST Phase-out) Proportion of General Fund Tax Revenue With / Without MVST 2000-06 (w/MVST) 2000-06 (w/No MVST )Change General Sales Tax30.4%31.8%↑ Corporate Income Tax5.7%6.0%↑ Individual Income Tax44.9%47.0%↑ Other General Fund Taxes19.0%15.2%↓ TOTAL:100.0% Data Source: U.S. Census, State Government Finances

38. 2.6% 2.1% 10.9% 12.1% 3.1% 2.0% 2005-2007 Trend Growth Rate of General Fund Tax Base Corporate Income Tax Base 14.9% Individual Income Tax Base 5.4% MN Sales Tax Base 5.2% Other Revenue Tax Base 11.0% Total Portfolio 6.5% Inflation 2.6%

39. 2.0% 2.2% in 1987 2.1% in 1996 2.8% in 2002 2.5% in 1991 2.5% in 1983

40. Questions How volatile is Minnesota’s revenue system? Has the volatility changed over time? Are Minnesota’s revenues more volatile than the U.S. economy? How large a reserve should we have? Could Minnesota’s tax system produce the same revenue with less volatility?

41. How Does the Volatility of MN’s Tax Base Compare with the National Economy? Measure the “income elasticity of taxes” Provides information concerning: – How MN’s Tax Base grows relative to GDP Long Run Elasticity: ln(TAX t ) = α + β ln(GDP t ) + ε t – How MN’s major Tax Base fluctuates over the business cycle Short Run Elasticity: Δln(TAX t ) = α + β Δln(GDP t ) + ε t

42. Over the long run (1970-2005) MN’s tax base growth was statistically the same as nominal GDP growth – Personal Income Tax Base -- same as GDP – Corporate Income Tax Base -- 92% of the rate of GDP – Sales Tax Base -- 10% faster than the rate of GDP* – “Other” Taxes -- 82% of the rate of GDP Over the business cycle there is no statistically significant difference between MN’s tax base volatility and nominal GDP – Personal Income Tax Base -- same as GDP – Corporate Income Tax Base -- more volatile – Sales Tax Base -- nearly the same as GDP – “Other” Taxes -- volatility not statistically different from zero, (unaffected by the business cycle) How Does the Volatility of MN’s Tax Base Compare with the National Economy? * MN’s Sales Tax Base growth has slowed to below the rate of GDP since 2002

43. Questions How volatile is Minnesota’s revenue system? Has the volatility changed over time? Are Minnesota’s revenues more volatile than the economy? How large a reserve should we have? Could Minnesota’s tax system produce the same revenue with less volatility?

44. Calculating the Appropriate Size for Minnesota’s Budget Reserve Convert estimated tax base volatility to total GF revenue volatility (3.03% post MVST) Choose how often it is acceptable for the budget shortfall to exceed the budget reserve (1 in 20, 5%) Multiply the revenue volatility estimate by the critical failure rate value to obtain the percent shortfall exceeded 1 in every 20 times (3.03*1.645 = 4.98%) (critical value for a 5% one tail z test = 1.645)

45. Appropriate Budget Reserve for General Fund Post-MVST Phase-Out Tax Source FY 2005-2007 Share of GF Total Revenue Trend Growth Rate Volatility (σ) General Sales 28.64%5.23%2.06% Corporate Income 6.83%14.94%12.03% Individual Income 44.25%7.25%3.88% Other Revenues 20.29%8.55%5.24% Total GF Portfolio100.00% 7.46%3.03% Final Results : With 95% Confidence (one tail or z = 1.645) an appropriate... One-Year Budget Reserve: 5.0% (of Year 1 Current Resources) Two-Year Budget Reserve: 7.1% (of Year 1 Current Resources) Biennium Budget Reserve: 3.7% (of Biennial Current Resources) For Example, in FY06-07 (Thousands $) FY06 Resources FY07 Resources FY06-07 Resources $17,355,445$18,192,177$33,734,477 With 95% Confidence an appropriate FY06-07... One Year Budget Reserve:$868,000 Two Year Budget Reserve:$1,232,000 Biennium Budget Reserve:$1,248,000 Actual FY06-07 Budget Reserve:$653,000 Cash Flow Account:$350,000

46. Appropriate Budget Reserve for General Fund Pre-MVST Phase-Out Tax Source FY 2005-2007 Share of GF Total Revenue Trend Growth Rate Volatility (σ) General Sales 28.17%5.23%2.06% Corporate Income 6.72%14.94%12.03% Individual Income 43.53%7.25%3.88% Other Revenues 21.58%6.75%3.61% Total GF Portfolio100.00% 7.09%2.83% Final Results : With 95% Confidence (one tail or z = 1.645) an appropriate... One-Year Budget Reserve: 4.7% (of Year 1 Current Resources) Two-Year Budget Reserve: 6.6% (of Year 1 Current Resources) Biennium Budget Reserve: 3.4% (of Biennial Current Resources) For Example, in FY06-07 (Thousands $) FY06 Resources FY07 Resources FY06-07 Resources $17,355,445$18,192,177$33,734,477 With 95% Confidence an appropriate FY06-07... One Year Budget Reserve:$809,000 Two Year Budget Reserve:$1,144,000 Biennium Budget Reserve:$1,147,000 Actual FY06-07 Budget Reserve:$653,000 Cash Flow Account:$350,000

47. Questions How volatile is Minnesota’s revenue system? Has the volatility changed over time? Are Minnesota’s revenues more volatile than the economy? How large a reserve should we have? Could Minnesota’s tax system produce the same revenue with less volatility?

48. Portfolio Theory Suggests Using a Tax System that Minimizes Volatility for a Given Growth Rate Given the trend growth rate, variance and covariance of each major tax, an Efficiency Frontier Line (EFL) can be estimated – The EFL shows combinations of taxes that provide the lowest volatility for each growth rate – Points below the frontier are suboptimal. The EFL is determined using quadratic programming to minimize state tax revenue volatility, σ 2 T, given growth rates g T – Minimize – Subject to: and and where ω is the weight of each t ax.

50. Actual FY 2005-2007 Portfolio Efficient Tax Mix Portfolio Difference: (Efficient Less Actual) Trend Growth Rate7.70% 0.00% Volatility (Standard Deviation) 3.26%3.09%-0.17% Share of Total Tax Revenue General Sales 31.2%60.3%+29.2% Corporate Income 7.4%13.1%+5.6% Individual Income 48.1%9.2%-39.0% Other Revenues 13.3%17.4%+4.2% Total 100.0% Actual vs. Efficient MN One-Year Tax-Mix Given the Current Trend Growth Rate

51. Summary Minnesota’s tax base has grown more volatile The volatility of MN’s current tax base appears to increase during recessions MN’s tax base is about as volatile as the national economy (measured by GDP) At current levels of volatility MN’s biennial budget reserve should equal approximately 3.7 percent of biennial revenues The necessary budget reserve can be reduced by relying more on less volatile revenue sources

52. Other Considerations Volatility is not the only criterion that should be used in determining a state revenue system Good tax systems are also – Equitable – Efficient – Simple – Administratively convenient

53. Thank You