Revenue Bubbles and Structural Deficits: What’s a State to Do? (REVISED April 2012)

The past two recessions have both proved alarming to state government finances. In 2001, a relatively shallow national recession led to a severe downturn in state revenues that took three years to unwind. In the wake of the recent economic downturn, signs of fiscal stress are readily apparent. In this paper, we investigate whether the revenue patterns surrounding these two recessions are the result of state government revenues having grown more sensitive to economic conditions. We find that the responsiveness of revenues to measures of business cycle conditions has grown since the 1990s. We use data on state government revenues, state specific information on economic conditions, and measures of state policy to examine fiscal performance and budgeting practice over the economic cycle. Our findings suggest that increasing income cyclicality, in particular of capital gains, have made state revenues more responsive to the business cycle since the mid-1990s. We also find that changes in policy making have served to increase revenue cyclicality.