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Tax Base Volatility (Update)

Tax Base Volatility (Update). Thomas Stinson Matthew Schoeppner July 22, 2008. Summary. Minnesota’s tax base has grown more volatile The volatility of MN’s current tax base appears to increase during recessions

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Tax Base Volatility (Update)

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  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

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

  20. Thank You

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