1. Tax Base Volatility(Update) Thomas Stinson Matthew Schoeppner July 22, 2008

2. Summary • Minnesota’s tax base has grown more volatile • The volatility of MN’s current tax base appears to increase during recessions • The volatility of the tax system can be reduced by relying more on less volatile revenue sources or by changing the volatility of existing revenue sources • At current levels of volatility MN’s biennial budget reserve should equal approximately 4.1% (or $1.4B in FY06-07) of biennial revenues

3. Measuring a Growth & Volatility Example: Wages and Salaries Trend Growth Rate (Hodrick Prescott Filter)

4. Measuring a Trend Growth Rate Example: Wages and Salaries Trend Growth Rate (Hodrick Prescott Filter) 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.

5. Measuring Volatility Example: Wages and Salaries Trend Growth Rate (Hodrick Prescott Filter) 2.3% Volatility Measure (GARCH σ) 0.9% GARCH Model is a time variant measure of statistical dispersion (σ) based on the assumption that volatility changes over time. The model captures both short-term high-frequency volatility as well as long-term influences.

6. Volatility Calculation Summary • Method • Hodrick-Prescott filter estimates a trend growth rate • GARCH model estimates volatility (σ) from trend growth rate over time • Markowitz’s modern portfolio theory (MPT) is used to estimate the volatility of 4 major revenue sources of MN’s tax system: • Portfolio trend growth rate: weighted sum of the individual component’s growth rates • Portfolio volatility: weighted sum of the variances and covariances of the individual components • Volatility of MN’s total tax system estimated using MPT model and volatilities of 4 major revenues

7. Data Summary • MN Tax Portfolio: 4 Major Revenue Types • Individual Income Tax: 7 income types (Source: IRS SOI) • General Sales Tax: 19 purchase categories (Source: BEA NIPA tables) • Corporate Franchise Tax: domestic profits (Source: BEA NIPA tables) • Other Taxes and Non-Tax Revenue (Source: U.S. Census)

8. 27.3% 15.2% Taxable Interest 12.3% 6.0% 3.3% 2.3% Salaries & Wages

9. 27.3% 15.2% Taxable Interest 12.3% 6.0% 3.3% 3.1% 2.3% Salaries & Wages

10. 12.1% 10.3% 10.9% 3.8% 3.1% 2.4% 2.6% 2.0% 2.1% 2.1%

11. 2.8% in 2002 2.5% in 1983 2.6% 2.5% in 1991 2.2% in 1987 2.1% in 1996 2.0%

12. 3.0%-3.1% in ‘99, ‘01 & ‘02 3.0% in '83 2.7% in ‘97 2.6% in ‘91 2.6% in ‘87

13. Summary • Minnesota’s tax base has grown more volatile • The volatility of MN’s current tax base appears to increase during recessions • The volatility of the tax system can be reduced by relying more on less volatile revenue sources or by changing the volatility of existing revenue sources • At current levels of volatility MN’s biennial budget reserve should equal approximately 4.1% (or $1.4B in FY06-07) of biennial revenues

14. 27.3% 12.1% 2.6% 2.4% 1.9% 1.5%

15. 2.6% 2.4% 1.9% 1.5%

16. Summary • Minnesota’s tax base has grown more volatile • The volatility of MN’s current tax base appears to increase during recessions • The volatility of the tax system can be reduced by relying more on less volatile revenue sources or by changing the volatility of existing revenue sources • At current levels of volatility MN’s biennial budget reserve should equal approximately 4.1% (or $1.4B in FY06-07) of biennial revenues

17. Calculating the Appropriate Size for Minnesota’s Budget Reserve • Convert annual estimated tax base volatility to 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 annual revenue volatility estimate by the critical failure rate value to obtain the % shortfall exceeded 1 in every 20 times (3.03*1.645 = 4.98%) (critical value for a 5% one tail z test = 1.645) • MN budgets on a 2 year basis. Biennial reserve found using the same procedure but for two years.

18. Appropriate Budget Reserve for Post-MVST General Fund 2-Year Portfolio Method

20. Appropriate 2nd Year Budget Reserve for Post-MVST General Fund 1-Year Portfolio Method

22. Thank You