Predicting Revenue in Unpredictable Times: The Outlook of Major Revenue Sources

October 2008

By John Rees, Director of Research, and Leigh Schroeder, Business Development Manager

AngelouEconomics

As the country teeters towards a recession, states and other municipalities are already facing significant budgetary shortfalls. Across nearly every tax category in most jurisdictions—city, state, and national—incoming revenue is falling below expectations.  The Fiscal Survey of States, released in June by the National Association of State Budget Officers, reports that the budget offices of 20 states expected overall budget deficits due to disappointing tax revenues. With the country’s economy weakening significantly in the past few months, it is likely that a majority of states will face fiscal difficulty by the year’s end. Cities and counties, particularly those hardest hit by the housing market crisis, may face an even greater challenge in budgeting as the property tax base will inevitably decline. Strategic economic development has never been more important to ensuring the financial viability of communities across the United States.

Sales Tax

Even before the true depth of the current financial crisis began to emerge in recent months, most states were already reporting lower than expected sales tax revenues. Of the forty-five states that levy a sales tax, 28 suffered less than expected sales tax receipts. Not surprisingly, states at the epicenter of the subprime housing crisis are suffering the most severe declines; Florida, Arizona, and Nevada all reported shortfalls in projected sales tax receipts in excess of 7%.

Most worrisome is the fact that retail sales will almost certainly suffer further declines throughout the rest of the year. This week alone, dozens of stores reported disheartening financial figures for September. Sales at stores open for one year or more, the most widely accepted measure of retail strength, fell across all niche sectors. Stein Mart, JcPenney’s, Dillard’s, Neiman Marcus, and Saks’ all experienced double digit declines. Only value-oriented stores such as Wal-Mart and Costco escaped unscathed.

Due to the recent disappointing earnings among the country’s leading retailers, analysts are forecasting the worst potential Christmas shopping season in a quarter century. As described by the New York Times, “it might be a holiday of movie tickets and board games, not of big-screen televisions and vacations.”

Ultimately, declining retail sales will depress sales tax receipts further, posing a continued threat to state tax coffers. Unfortunately, falling sales tax levels are just one of the many burdens facing state government budgets.

Income Tax

Many states rely on personal income or payroll taxes as a primary source of revenue.  Of the 41 states that tax personal income, 12 have reported lower than projected personal income receipts. 

As the recession progresses and industries begin to tighten budgets and lay off employees, the tax base will inevitably shrink. States with a large finance industry have already realized a decline in employment. The Bureau of Labor Statistics reported in September that employment in financial activities fell by 17,000, with nearly half of the decline occurring in securities and investment firms. Since its employment peak in December 2006, the financial activities industry has lost 172,000 jobs.  However, the greatest losses in employment were in the leisure and hospitality industry, followed by professional and business services, and then by the financial activities industry.

Over the past year, the number of unemployed persons has increased by 2.2 million and the unemployment rate has risen by 1.4 percentage points. The number of persons who worked part time for economic reasons rose by 337,000 to 6.1 million in September, an increase of 1.6 million over the past 12 months.  The increase in unemployed persons and the move of the full time employed to part time work is indicative of a decrease in the income tax base.

Unfortunately, this downward trend in employment is expected to continue in many industries with an increase in only a few industries such as healthcare, energy, and mining.  Cities and states with diversified economies will inevitably weather the economic times far better that those with industries who are quickly and deeply impacted by the recession.

Property Tax

Property taxes are an important revenue source for many city and county municipalities.  The Office of Federal Housing Enterprise Oversight released their Second Quarter Report in June and described a significant depreciation of housing prices in many areas.  The hardest hit areas with the sharpest depreciation over the year included California (-15.8%), Nevada (-14.1%), and Florida (-12.4%).  Oklahoma faired the best with an appreciation rate of 4.9%.  Of the 20 MSAs with the greatest price decline over the past year, 19 were located in Florida or California. The chart to the left graphically illustrates the depreciation of housing prices nationwide.

Local leaders across the nation must surely have concerns about how the depreciation of home values may threaten their city or county’s ability to fund basic services that are essential to citizens’ lives. In spite of the clear evidence of housing price depreciation, it is important to remember that housing prices are not necessarily related to the appraised housing value.  Many municipalities re-appraise property value on a five year cycle meaning that the shift in housing values will not be noticed in property tax revenue for several years.  This also means a plethora of citizens will be taxed for a house value that has not declined with the shift in the market.

Some municipalities have begun to take steps to offset a decrease in valuation.  For example, Fairfax, Virginia raised property taxes approximately 9% to make up for the 3% decline in housing values.  Not all municipalities will have the flexibility to adjust property taxes to match the fall in value due to tax caps and regulations affecting the percentage increase from year to year.  Most municipalities will be forced to slim down already tight budgets this year and in the future. The areas that will feel the greatest impact will be those with recent high residential growth and areas that do not have the ability to compensate for lower valuations with higher rates.

Analysis of Revenue Impact and Positioning of Industry Base

Cities and states must identify their own industry mix to determine what effect the pending recession will have on their collected revenue and when the effect will be realized. Efforts can be made at both the local and state level to balance the portfolio of companies in a city, county or state. The goal of any diversification strategy is to balance high growth, high risk with low growth, low risk; to target and grow industries which move counter to each other in economic cycles; and finally to give ample employment opportunities across a spectrum of skill sets and salary levels.

Municipalities must set their economic health as a priority.  Given that some of the effects of the downturn in the economy may not be realized for several years, there is still the opportunity to create an economic plan which promotes strategic growth.  Municipalities should re-evaluate their incentive programs for those industries expected to successfully weather the recession as competition for those companies is sure to increase. It is essential to have an economic plan which factors in recent trends and future economic developments. Even the best five-year-old plan would benefit from an update to ensure its ability successfully adapt in an ever changing, competitive economy.

Please contact the authors, John Rees and Leigh Schroeder, for more information.

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