IMPACTS OF REVENUE DIVERSIFICATION AND REVENUE ELASTICITY ON STATE FISCAL HEALTH.

Author:Yan, Wenli
 
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  1. INTRODUCTION

    Beginning in 2007, the US experienced its greatest economic recession since the Great Depression in the 1930s. States experienced an extended decline in revenues and oftentimes were forced to cut public services or resort to emergency actions. Nevertheless, some states have been better shielded against the recession than have others. A very important and yet unanswered question is what characteristics of a revenue structure contribute to government's fiscal health? More specifically, what helps some states weather a downturn better than others and what features contribute to a state's fiscal resilience? In this context, fiscal resilience is defined as the ability of a state to shield itself against general declines and rebound to its fiscal position prior to a downturn.

    One of the great challenges for fiscal administration is planning for revenue and expenditure before it is realized. Budget preparation and implementation become even more difficult when there is an unexpected change in the general economy and fiscal environment. For example, revenues can fall short of projections, and the demands for public services might surge beyond normal levels. To cope with fiscal stress, the immediate options that are available to state and local governments are quite limited and often include raising one time revenue; cutting non-essential spending; tapping into reserves; or short-term borrowing. Subnational governments even resort to certain non-conventional practices such as either drawing down net assets through debt issuance, or one-time sales (Ross, Yan, & Johnson, 2015). These short-term options will change the financial outlook of these public entities.

    As a long-term strategy that is embraced by most scholars and practitioners, revenue diversification has been well debated and adopted in the field of public finance. The fundamental idea behind revenue diversification is utilizing a mix of revenue sources to smooth out the revenue streams. As long as all these revenue sources are not highly correlated with each other, the fluctuations of some revenues can be offset by the opposite movements of other revenues. However, the appeal of revenue diversification has also been questioned by some recent research as the effect of revenue diversification can vary significantly depending on the way revenue is diversified and the nature of the economic base (Carroll, 2009; Yan, 2012).

    Revenue portfolio elasticity has emerged from the public finance literature, providing a compelling perspective distinct from revenue diversification. The elasticity of revenue sources in a government's revenue portfolio is used to explain revenue volatility; if a government uses a set of more elastic revenue sources, the overall revenues tend to experience more volatility. Such fluctuations can impact public service delivery and overall government fiscal health unless sufficient financial reserves are available.

    The concept of fiscal health has been defined in a variety of ways, and there is no consensus as to how it should be best measured. Prior studies have tried to develop a certain index or set of measures that help to gauge the fiscal health of individual governments. Even though there are pros and cons associated with each set of measures, a series of fiscal health measures from Brown (1993) and Kloha, Weissert, and Kleine (2005) provide a solid foundation for our research. We further refine these fiscal health measures and propose a revised set of fiscal health indices, providing a new lens through which to look into the relative fiscal strength of individual states. We then use this framework to analyze the effects of revenue diversification and revenue elasticity on state fiscal health.

    The primary objective of this research is to disentangle the corresponding impacts of the two distinct characteristics of state revenue structure--revenue diversification and overall elasticity of the revenue portfolio--on state fiscal health, controlling for other influencing factors. Findings from this study provide important guidance for states in designing a sound tax structure that enables adequate revenue to pay for public services while being resilient to withstand significant stress from business cycles. This analysis also provides a unique and important perspective in our understanding of the fiscal side of statewide economic development strategies.

    In the following section, we provide a review of the literature on fiscal health, revenue diversification and revenue elasticity. The third and fourth sections of this paper outline the conceptual framework and the data and estimation methodology of this study. The fifth section of the paper summarizes the empirical results. The last section of the paper concludes the discussion with policy implications and directions of future research.

  2. OVERVIEW OF THE LITERATURE

    2.1. FISCAL HEALTH AND ITS MEASURES

    The term fiscal health has been used interchangeably with fiscal condition and fiscal position, although there are subtle different connotations attached to each (Honadle, Cigler, & Costa, 2003). Berry (1994) defined an agency's fiscal health as the "extent to which its financial resources exceed its spending obligations." However, the work of Ladd and Yinger (1989) defines the fiscal health of a city from the perspective of its actual capacity to service its citizens instead of the raw budgetary decisions emerging from the government. In a similar vein, Hendrick (2004) defined local financial condition as the ability of a government to meet its financial and service obligations. As such, neither is there a consensus on the precise definition of this term, nor does it have an agreed upon best measure.

    As highlighted in Kloha et al. (2005), one of the earliest influential studies assessing the fiscal health of local governments is the Advisory Commission on Intergovernmental Relations (ACIR) report on thirty cities that experienced significant financial problems (ACIR,1973). The analysis identified six early warning indicators of local financial emergency which encompass the areas of negative operating position; high property tax delinquency; and decreases in assessed values.

    Subsequent studies have proposed practitioner-based measures focusing on solvency and service level, including the Brookings Institute (Dommel & Nathan, 1978) and the International City/County Management Association (ICMA). Several other professional associations, along with some government entities, have also proposed of practitioner-based measures, including the financial trends monitoring system (FTMS) framework (Groves & Valente 1986, 1994; Nollenberger, Groves, & Valente 2003). This line of research defines fiscal health in terms of four types of solvency: cash, budget, long-run, and service level. The fiscal health literature has also proposed theoretically-grounded measures of fiscal health, such as the "need-capacity gap" approach put forward by Ladd and Yinger (1989). The theoretical frameworks emerging from the academic literature have been applied to localities; for example, see Skidmore and Scorsone (2011), Coe (2007), Crosby and Robbins (2013), and Stone, Singla, Comeaux, and Kirschner (2015).

    Fiscal health by-and-large encompasses four components: the balance between revenues and expenditures; taxation levels; expenditure levels; and debt utilization (Arnett, 2012). Since the adoption of the Governmental Accounting Standards Board (GASB) 34 in 1999, the literature has explored measurement of fiscal condition from the perspective of financial reporting; for example, see Chaney (2005), Chaney, Mead, and Schermann (2002), Wang, Dennis, and Tu (2007), and Rivenbark, Roenigk, and Allison (2010).

    Although an extensive literature assessing financial condition and fiscal health has developed, measurement issues are yet to be resolved. As pointed out by Jacob and Hendrick (2013) and Jimenez (2009), there is neither a single measure that can best capture financial condition, nor any single composite index that exists to capture all dimensions. Since a series of scholarly works already provide a comprehensive review on the concept and measurement of financial condition--(for example, see Skidmore and Scorsone 2011; Gorina, Maher and Joffe 2017; Arnett 2012; Lincoln Institute of Land Policy,2013)--this paper does not attempt to canvas the entire discussion in the literature regarding the subject. Overall, there is no single set of measurement that is free from criticism. Also, given the caution of Clark (2015) about either reliance on a single composite index, or arbitrarily selected indicators to evaluate fiscal condition, there is a growing understanding that indicators of fiscal condition need to be validated against the reality of a government. The choice of the measure should be centered on which approach incorporates the information most relevant to the needs of the users. Indices are typically developed containing individual metrics that address the main components of fiscal health.

    Fiscal health can be defined using either an absolute or a relative metric. Honadle et al. (2003) point out fiscal health is a relative concept, arguing the most intuitive approach of measuring fiscal health should be a comparative analysis between governments or over time. The fundamental gist of this approach is to "identify the 'outlier' without establishing any absolute norms" (Bahl, 1982). Brown (1993) takes this approach, for example using quartiles to identify relative fiscal health for most metrics. However, there are also drawbacks to a relative definition of fiscal health (Kloha et al., 2005; Honadle et al., 2003). A relative measure by definition is reliant on the overall health of the comparison governments (Honadle et al., 2003). Non-normal distributions can skew the mean and standard deviation, hindering benchmarking. Also, some governments will always be identified as having poor fiscal health...

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