Association for Public Policy Analysis & Management

Policy makers want to structure revenues to grow in a predictable and stable manner. Revenue portfolio diversification is viewed as a means to smooth revenue volatility, thereby ending up with more flexibility in financial management. Despite the positive aspects of revenue diversity, the way in which a state diversifies its revenue portfolio is influenced by institutional conditions. Many state governments have fiscal limits on the ability to raise taxes and/or expenditures. To the extent that the limits are effective, they will curb states’ ability to diversify revenue structures and, accordingly, affect revenue volatility. The existing literature on such fiscal rules focuses on their average effectiveness in decreasing revenues and expenditures; it has not explored their impact on the revenue-stabilizing effect associated with a diversified revenue structure.

The American states can be a great laboratory in which to test the hypothesis that TELs decrease the desirable revenue-stabilizing effect from revenue diversification. Approximately half of the states have stringent tax and expenditure limits that require the supermajority vote for a tax/spending increase, or growth cap tied to inflation and/or population rates. The relevant studies demonstrated that such stringent restrictions motivate states to rely more on income-elastic user charges or income taxes and would make revenue portfolio complex. Thus, it might be plausible to assume that the greater reliance on income-elastic sources will increase revenue volatility although the movement toward income taxes or charges can increase revenue diversification in states having stringent TELs.  

Using the panel data of 47 states from 1980 to 2012 and fixed-effects regressions, this work assesses how the strictness of TELs and revenue diversification jointly affect revenue volatility. When the regression employs the aggregate variable of TELs restrictiveness developed by Deller, Stallmann and Amiel (2012), the preliminary findings show its weak moderating effect on the relationship between revenue diversification and revenue volatility. However, when the different breadth of limit coverage is considered, the empirical results are inconsistent with the hypothesis: states with stricter limits imposed only on taxing authority tend to increase the revenue-stabilizing effect associated with revenue diversification while no significant effect is found in states with stricter limits imposed only on expenditure as well as both on revenues and expenditures. The further research exhibits that stringent revenue-based limits are likely to increase user charges, whereas decrease income taxes as a share of state-own revenues. Taken together, the findings imply that states with more binding revenue-limits can stabilize their revenue streams by replacing high income-elastic income taxes with relatively high (or moderate) income-elastic charges in their revenue portfolios, leading to small changes in revenues over years.

This research will contribute to the fields of public policy and financial management in several ways, expanding our understanding of TELs, revenue diversification and revenue volatility. It empirically shows that the desirable negative impact of revenue diversification on revenue volatility changes to the different type and strict levels of TELs and also provides practical implications to state governments that have concerned fluctuations in their revenue streams.