Does Tax Revenue Diversification Help States Weather Economic Downturns? Evidence from the Great Recession

This capstone seeks to build on previous research to assess the validity of the claim that revenue diversification is an effective policy tool for states to use during recessions in order to stabilize their revenue flow. Revenue diversification is defined as the degree to which states take advantage of various tax sources, rather than reliance on a few or one in particular. Previous research, especially by Carroll (2005) and Suyderhound (1994), has shown that states with higher revenue diversification rates experience lower revenue shortfalls during recessions and other economic downturns on average. This paper will reassess these claims in terms of the most recent Great Recession to see if the findings are supported, or if the Great Recession’s severity nullified the benefits diversification has provided in the past. A model of diversification is built using the Herfindahl–Hirschman Index, (HHI). The index measures the proportional use by states of the six major tax revenue categories as reported by the United States Census Bureau - property tax, sales tax, personal income tax, corporate income tax, license tax, and an “other” category that includes severance and other miscellaneous smaller taxes. This model finds little support for the claim that diversification (a higher HHI score) would lead to better fiscal performance during the recession (less revenue decline from 2008-2010). The model did show that states that collect personal income taxes, all else equal, lead to better fiscal performance. Conversely, states that use a corporate income tax actually experienced a larger decline in revenue than those that did not. The Great Recession had a profound impact on state governments and their budgets. Because economic downturns are recurring events, it is therefore prudent for jurisdictions of all shapes and sizes to plan ahead for them. This research adds to the existing literature on possible strategies for states to employ in order to better weather future economic downturns