Managing State Tax Revenue Volatility in California and Oregon

While the impact of tax revenue volatility in energy dependent states has been evident since the precipitous drop in oil prices in 2015, states reliant on receipts from personal income taxes are also subject to revenue volatility. Moody’s Analytics has pointed out that increased reliance on personal income taxes has also led to steeper state revenue declines in recent economic downturns. The largest drop in cumulative state tax revenue occurred during the Great Recession, and though before the 2001 recession there had been declines in revenue growth, there was never an actual annual decline in cumulative state tax revenues.

Although there are some states that do not levy income taxes, including Florida, Texas and Washington, reliance on income taxes in those states that do has increased. California and Oregon are two states where this is evident. About 68% of California’s general fund revenues are derived from the income tax, far exceeding the second largest source, sales taxes at 20%. As Oregon does not levy a sales tax, its tax base is even more concentrated, with income taxes generating about 85% of general fund revenues.

California’s tax structure also adds to its revenue volatility. Its income tax rates have been highly progressive and even more so with the extension of temporary income tax rates adopted in 2012. As tax rates have increased, the tax base has narrowed to higher-income taxpayers who have wider swings in income due to capital gains from investments. As a result, the state’s revenue growth has become more correlated with growth in the financial markets. Oregon’s top income tax rates are similar to California’s, but California’s highest tax rate is now over 3% higher than Oregon’s due to the extension of the temporary tax rates.

Both California and Oregon have benefitted from the performance of the financial markets, but that has also made them more susceptible to market fluctuations. The impact on California was devastating in prior economic downturns because the state had not adequately recognized its revenue volatility, and had increased its budget base with revenues that had spiked from increased taxes generated from capital gains. When those revenues retreated in the downturns, the state was forced to make drastic cuts and increase its budget liabilities.

California has taken steps to mitigate the impact of income tax revenue volatility. In addition to increasing contributions to reserves, excess capital gains taxes are now required to fund reserves or pay down liabilities instead of increasing the budget base. While California may still have some impediments to its fiscal flexibility, the addition of tools to manage its tax revenue volatility should increase credit stability through the economic cycle.

While California now restricts its use of excess capital gains, Oregon’s ability to utilize spikes in income tax revenue for reserves or to pay down liabilities is restricted. Oregon’s “kicker” provision requires the state to refund excess revenues to taxpayers. Oregon has been able to build up reserves to reduce the impact of revenue volatility, but Standard & Poor’s has noted that recent tax rebates from the Oregon kicker “inhibits the state’s ability to take advantage of favorable revenue growth to build additional budgetary flexibility.”  Despite the impediment, Oregon’s General Obligation bonds are rated Aa1 by Moody’s, and AA+ by S&P and Fitch, two notches above California State GO ratings, Aa3/AA-/AA-. California’s lower ratings reflect lower levels of reserves and fiscal flexibility compared to Oregon, but its ability to more effectively manage its revenue volatility is a credit positive. 

Source: California Legislative Analyst Office, Fitch Ratings, Moody’s Analytics, Standard & Poor’s