Arizona Fiscal Issues
The Effects of the Economic Cycle on Government Revenue
By Marshall J. Vest
Director, Economic and Business Research Center
November , 2009
Key Points
Economic Cycle in Arizona Relative to the Nation
Cyclicality of Government Revenue in Arizona
Income Tax
Sales and Use Tax
Noncyclicality of Government Spending Needs
References
Key Points
• Arizona’s economy is one of the most volatile in the nation. Arizona grows much faster than the nation during expansions, but suffers equally with the nation during recessions. General fund revenues are far more volatile than the economy itself. Inflation-adjusted revenues can grow by more than 20% during strong expansions and decline by a similar amount during recessions.
• Arizona’s general fund revenue structure is extremely cyclical. The three major revenue sources—sales and use taxes, individual income tax, and corporate income tax—each decline much more than the general economy during economic downturns and rise considerably more during economic expansions.
• Income tax collections, especially from the corporate tax, are particularly volatile, but collections from the sales and use tax also have been quite cyclical in recent years.
• While government revenues rise and fall during the economic cycle, demand for government services as a whole grows at a relatively steady pace throughout the business cycle.
• The demand for some government services is countercyclical, rising more during recessions when people lose their jobs and qualify for government-provided healthcare benefits and various welfare programs. Government safety net programs were established for that very purpose—to aid individuals and families in times of need.
• The key to responsible management of the state’s finances is an adequately funded budget stabilization fund.
The Economic Cycle in Arizona Relative to the Nation
Economic growth around the globe and over time has been cyclical. The typical cycle consists of a period of rapid economic growth and a shorter period during which the size of the economy contracts (after adjustment for inflation). In the United States, the typical economic cycle through the 1950s had a length of only about four years. Since then, some cycles have been longer, up to 10 years in length.
The economy of each state is cyclical, though not all state economic cycles coincide with the national cycle 1. The timing of Arizona’s economic cycle usually is quite similar to the national average, but the difference in growth rates from the cyclical peak to trough are unusually large. In fact, Arizona has long had one of the most volatile state economies in the country.
An index based on quarterly personal income shows that Arizona is second only to Nevada for economic volatility over the period stretching from 1950 through the first quarter of 2009. All of the states with the most volatile economies are in the South or West (see Exhibit 1). The common link between these states is their rapid population growth. Nationwide, the construction and real estate sectors experience substantial cyclicality. In fast-growing states in which these sectors account for an above-average share of economic activity, the overall economy tends to be relatively more cyclical.
Exhibit 1
Volatility Index, 10 Most Volatile State Economies
| Rank | State | Index* |
| 1 | Nevada | 130.6 |
| 2 | Arizona | 119.5 |
| 3 | Florida | 113.7 |
| 4 | Colorado | 112.2 |
| 5 | Utah | 111.1 |
| 6 | Georgia | 110.8 |
| 7 | Texas | 110.5 |
| 8 | Washington | 107.8 |
| 9 | Idaho | 107.6 |
| 10 | North Carolina | 107.5 |
* U.S. average = 100.
Source: Economic and Business Research Center, Eller College of Management, the University of Arizona.
Exhibit 2 compares annual rates of growth in quarterly inflation-adjusted personal income for Arizona and the nation. This graph clearly shows that the reason why Arizona’s economy is so volatile relative to the national average is that it grows very rapidly during business expansions, while it suffers equally during recessions. During expansions, Arizona’s much more rapid economic growth results mostly from its much greater population growth rate. During recessions, despite still experiencing more rapid population growth, the state’s personal income growth falls at about the same rate as the national average. During the last five recessions, the decline in personal income in Arizona was worse than the U.S. average in three and about the same in one. In the other recession, personal income never decreased in Arizona.
Exhibit 2Annual Real Percentage Change in Personal Income Based on Quarterly Data
Arizona and United States, 1951 Through 2008
United States Arizona Source: U.S. Department of Commerce, Bureau of Economic Analysis.
For example, during the early 1970s, Arizona’s annual growth rate in real personal income peaked at 12.1%, compared to the national average of 7.2%. During the ensuing recession, national personal income fell as much as 1.8% on an annual basis while the annual rate of decline in Arizona exceeded 3%. More recently, personal income during the year ending in third quarter 2005 expanded 8.2% in Arizona compared to only 1.9% nationally, though the national rate reached 4.2% in 2006. During the four quarters through first quarter of 2009, the most recent data available, the economy contracted 1.3% nationwide, while the decrease in Arizona was larger at 2.7%.
Cyclicality of Government Revenue in Arizona
The state of Arizona’s general fund ongoing revenue stream is much more volatile than the economy itself. Exhibit 3 displays inflation-adjusted annual growth rates based on quarterly data from 1988 through early 2009. General fund revenue collections have fluctuated far more wildly than personal income. In addition to containing more quarter-to-quarter variability, rates of growth in revenue collections are much higher during business expansions and much lower in recessions than growth rates in personal income. For example, during the third quarter of 2005 when the economy was soaring, revenues surged 24.2% compared to the prior year, while growth in personal income registered 8.2%. Between the first quarters of 2008 and 2009, revenues fell 26.0% while personal income declined 2.7%.
The overall revenue line in Exhibit 3 reflects tax code changes in addition to cyclical swings in collections. However, the Arizona Joint Legislative Budget Committee has since 1989 made estimates of the effects of tax code changes. Using these estimates to adjust actual annual revenue collections, it is possible to estimate what revenues would have looked like without the tax changes, as shown in Exhibit 4. The lines in this chart are adjusted for both inflation and population growth. In each recessionary period, real per capita revenue decreased considerably more than did real per capita personal income. In other years, revenue growth has ranged from similar to, to much higher than, economic growth.
Exhibit 3
Annual Real Percentage Change in Arizona State Government General Fund Revenue and Arizona Personal Income, Based on Quarterly Data From 1988 Through Early 2009
Source: U.S. Department of Commerce, Bureau of Economic Analysis
Exhibit 4
Estimated Annual Real Per Capita Percentage Change in Arizona State Government Ongoing General Fund Revenue and Arizona Personal Income, Fiscal Years 1989 Through 2009
Source Exhibits 3 and 4: Arizona Joint Legislative Budget Committee (revenues) and U.S. Department of Commerce, Bureau of Economic Analysis (personal income,population, and GDP implicit price deflator). Exhibit 3 presents actual data and does not adjust for population growth while Exhibit 4 adjusts actual revenues for changes in the tax code and includes an adjustment for population growth.
Analysis (personal income, population, and GDP implicit price deflator). Figure 10.2 presents actual data and does not adjust for population growth while Figure 10.3 adjusts actual revenues for changes in the tax code and includes an adjustment for population growth.
In each of the last five recessions, annual average real per capita personal income has dropped in one or two fiscal years; another year of slow or no growth has resulted in a total of two-to-three years of subpar economic performance. In contrast, the period of weakness in real per capita government revenue growth in each down cycle has lasted at least a year longer.
Growth in real per capita personal income and real per capita revenue (after adjusting for tax law changes) peaked in fiscal years 2005 and 2006, with the revenue gains unusually strong at more than 10% in each year. Growth slowed sharply in fiscal year 2007, with the revenue measure decreasing slightly. In fiscal year 2008, the revenue measure fell nearly 10%, compared to a 1% drop in the economic measure. The revenue measure fell again in fiscal year 2009, by an unprecedented 18%, while the economic measure dropped only slightly.
Using the JLBC estimates of the effects of tax code changes to individual revenue sources, the fluctuations in the income and sales and use taxes are presented in Exhibit 5. (Since the state portion of the property tax was eliminated, it was not possible to estimate this tax source.) The lines in this chart are adjusted for both inflation and population growth.
Income Tax
Income tax revenues are considerably more volatile than sales and use taxes, as shown in Exhibit 5. Collections from the corporate income tax have been more volatile than from the individual income tax, but the volatility of the latter has increased since the mid-1990s. During this period, percentage changes in adjusted real per capita individual income tax revenues varied from 13% in 1998 to -12% in 2002 to 18% in 2005 to -20% in 2009. The range in growth rates in real per capita personal income was only from 4.1% to -1.1%.
Another way of looking at the individual income tax is to examine taxable income 2. This series, representing the tax base, is computed before any tax rates (or tax cuts) are applied.
Exhibit 5
Estimated Annual Real Per Capita Percentage Change in Major Sources of Arizona State Government General Fund Revenue and Arizona Personal Income,
Fiscal Years 1989 Through 2009
Source: Arizona Joint Legislative Budget Committee (revenues adjusted for changes in the tax code) and U.S. Department of Commerce, Bureau of Economic Analysis (personal income, population, and GDP implicit price deflator).
Though the annual pattern is somewhat different in Exhibit 6 than in Exhibit 5, the conclusion is the same in terms of the high volatility of the individual income tax relative to economic performance. (Exhibit 6 adjusts for inflation but not for population growth.)
Much of the volatility in taxable income during this period is due to realized capital gains. According to the Federation of Tax Administrators and reported by the National Association of State Budget Officers 3, realized capital gains increased by more than 300% between 1994 and 2000 and state treasuries reaped windfall gains. Unfortunately, these one-time realized capital gains were interpreted as a trend line and permanent tax cuts were made. After plummeting around the 2001 recession, capital gains again soared (see Exhibit 7). Taxes again were permanently cut. The tax reductions during the 1990s and again more recently are contributing to the current fiscal condition of Arizona. Capital gains almost certainly have again plunged since 2007, the latest data available.
Corporate income tax revenues are the most volatile of the three major revenue sources to the general fund. Annual changes in corporate income tax revenue frequently have exceeded 20% in both directions, even after adjustment for inflation and population growth.
Sales and Use Tax
Until recent years, sales and use tax collections were more cyclical than personal income but much less volatile than the income taxes. After an unusually high peak in 2006, sales and use tax collections have fallen sharply, though still not as much as income tax collections.
Exhibit 6
Annual Real Percentage Changes in Taxable Income and Personal Income, Arizona, 1985 Through 2008
Source: Arizona Department of Revenue (taxable income) and U.S. Department of Commerce, Bureau of Economic Analysis (personal income and GDP implicit price deflator). Taxable income is estimated for 2008 and not shown for 1990 due to changes to the tax structure.
Exhibit 7
Capital Gains as a Percentage of Personal Income, Arizona, 1988 Through 2007
Sources: Internal Revenue Service (capital gains) and U.S. Department of Commerce, Bureau of Economic Analysis (personal income).
Relative to personal income, sales tax collections fell during the 1990-91 recession, then rebounded in 1993-94. Otherwise, the growth rates were similar during the 1990s expansion. As in the prior economic cycle, sales tax collections fell (from 2001-03), then rebounded (2006). The current recession officially began in December 2007, but Arizona’s economy was already slowing substantially by July 2007. The real per capita sales and use tax growth rate fell from more than 8% in 2006 to -1.8% in 2007, -6.6% in 2008, and -13.5% in 2009. Arizona’s real per capita personal income growth fell much less, from 3.4% in 2005 to -1.1% in 2008. Among the largest components of Arizona’s sales tax base, retailing and utilities are the least volatile, while contracting sales and use tax sales are the most volatile.
Noncyclicality of Government Spending Needs
While government revenues rise and fall during the economic cycle, demand for government services as a whole grows at a relatively steady pace throughout the business cycle. Demand for most services rises fastest during expansions when population growth is the most rapid. Demand for most of these services—for example, elementary and secondary education—continues to rise during recessions, though at a lesser pace. In contrast, the demand for some government services is countercyclical, rising more during recessions when people lose their jobs and qualify for government-provided healthcare benefits and various welfare programs. Government safety net programs were established for that very purpose—to aid individuals and families in times of need. During long and deep recessions, even enrollment at institutions of higher education goes up at an unusual rate, as those who otherwise would be employed choose to enhance their educations while unemployed or underemployed.
Actual spending is one measure of the demand for services, but since state and local governments must produce a balanced budget each year, spending is constrained by available revenues. Expenditures often are reduced during recessions. For this reason, as well as the addition and deletion of government programs for other reasons, a time series of government spending does not adequately illustrate the cyclical pattern of public demand.
Caseloads also provide an indication of the demand for public services, but changes in eligibility requirements can affect these figures as well. Typically, caseloads begin to rise a little before the official beginning of a recession, then rise rapidly through the recession. In the current recession, for example, 16% more people were enrolled in the Arizona Health Care Cost Containment System on August 1, 2009 compared to August 1, 2008. The number of recipients of nutrition assistance (previously called food stamps) surged 36% from July 2008 to July 2009.
During the last two economic cycles, caseloads continued to rise at a rapid pace for about two years after the official end of the recession. In each case, the two years were marked by slow economic growth in which unemployment continued to rise. The total increase in caseloads from the trough shortly before the recession to the peak two years after the end of the recession may exceed 100%. Once caseloads peak, they fall steadily throughout the expansionary period. The total decline may be on the order of 50%.
This mismatch between available revenue and spending needs during recessionary periods is at the core of public finance issues. Diversification will do little to reduce the cyclicality of the Arizona economy. Moreover, modifying the revenue system to eliminate the most volatile components will reduce the severe cyclicality in government revenue flows, but at the expense of other guiding principles, such as fairness and equity. The key to responsible management of the state's finances is an adequately funded budget stabilization fund.References
1. For a recent review of the business cycle in states and a bibliography see Michael T. Owyang, Jeremy Piger, and Howard J. Wall, “Business Cycle Phases in U.S. States,” The Review of Economics and Statistics 87, No. 4 (November 2005): 604-616.
This analysis was first published as part of the background report for the 95th Annual Arizona Townhall - Riding the Fiscal Roller Coster: Government Revenues in Arizona. For further information on these issues, please refer to this full report.
2. Arizona Department of Revenue. Figures for 2008 are estimated.
3. National Association of State Budget Officers, Budgeting Amid Fiscal Uncertainty: Ensuring Budget Stability by Focusing on the Long Term (2004)
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