Rainy Day FundsOctober 30, 2014

NTA Session ICounterCyclical Fiscal Policies for States and

Localities

NTA Session IIVolatility in States: Are Rainy Day Funds Up to the

Task?

Current Utah Proposal

• Budget grows at the long run rate rather than forecasted revenues

• Surplus years accrue into a rainy day fund• Deficit years are financed by the previous surpluses

accumulated in the rainy day fund• Separates the debate of government size from tax policy

Two Year State Budgeting Cycle

First Forecast

Budget Guidancefor Agencies

November

Second Forecast

Initial Budget

February

Third Forecast

November

Fourth Forecast

Supplementals

February

Balanced Budget

June 30

Budgeting Time Line

Alternative Objectives

• Long term saving plan with expenditure smoothing

• Forecaster indemnity fund

Revenue and Expenditure Smoothing

First Forecast

Budget Guidancefor Agencies

November

Second Forecast

Initial Budget

February

Third Forecast

November

Fourth Forecast

Supplementals

February

Balanced Budget

June 30

Budgeting Time Line

Cycle and Trend

Unobserved Components ModelsHodrick-Prescott

1

22

1 11 2t

T T

t t t t t ts

t t

Min y s s s s s

The l values gives the relative importance of smoothing and controls the degree of smoothness. The larger values for l give more smoothness.

Hodrick and Prescott suggest the following values for l.

100 Annual data

1,600 Quarterly data

14,400 Monthly data

Cyclical Component of Total State Tax Revenue

Proposed Saving Plan Won’t Work for Tax Revenue

Coincident Indicators

• Nonagricultural employment• Unemployment rate• Average hours worked in manufacturing• Real wage and salary disbursements

Would Budgeting Plan Work for US Economy?

Rainy Day Funds would need an initial endowment.

Probability Distributions of State Growth Rates

• Absolute• Location: Mean and median• Scale: Standard deviation and interquartile range• Symmetry: Skewness• Outliers: Kurtosis

• Relative• Inherent Growth Rate• Cyclical Growth Volatility• Systematic and Unsystematic Risk• Standard Error of Regression

• Dynamic• Growth• Volatility

• Switching Regression• Probability of Staying in Expansion• Probability of Staying in Recession

Mean Growth RateState Economy 1992-2013

Standard Deviation of Growth RateState Economy 1992-2013

Equity Market Growth and Risk

it i i mt tr r

State Growth and Volatility Relative to US

, , ,i t i i us t i tr r

Systematic Risk (R-Squared)State Economy 1992-2013

Nonsystematic Growth Rate (Alpha)State Economy 1992-2013

Systematic Volatility (Beta)State Economy 1992-2013

Adaptive Expectations (Exponential Smoothing)

New Information Observation

Measurement Equation

Transition Equation

New Information+

Estimate of Level+

Estimate of Slope

Revisionof

Level and Slope

Adaptive Expectations Growth RateState Economy 1992-2013

Adaptive Expectations Forecasting Error

State Economy 1992-2013

Switching Regression

The switching model assumes that there is a different regression model associated with each regime. We assume that we have regressors then the conditional mean of is given by

𝜇𝑡 (𝑚)=𝑋 ′𝑡 𝛽𝑚+𝑍 ′

𝑡𝛾

where are vectors of coefficients. The coefficients associated with are regime invariant.

Transition Probabilities

FutureExpansion Recession

Current Expansion 0.904 0.096Recession 0.245 0.755

Ability to Replicate the Business Cycle

Revenue and Expenditure Smoothing

First Forecast

Budget Guidancefor Agencies

November

Second Forecast

Initial Budget

February

Third Forecast

November

Fourth Forecast

Supplementals

February

Balanced Budget

June 30

Budgeting Time Line

State Tax Revenue During an Expansion

Out[5]=

min

max

c

Expenditures and the Budget

Out[10]=

min

max

c

State Tax Revenues

State Expenditures

Surpluses and Deficits

0.5 0.5

Billions of Dollars

Rainy Day Fund

0.5 0.0 0.5

Surplus Defic it Probability Distribution