A recent evaluation of Oklahoma’s state government debt by Standard & Poor’s (S&P) downgraded Oklahoma’s general obligation debt one rating rank, to AA from AA+. Although this decision warrants skepticism, S&P is right to raise concern about one factor influencing Oklahoma’s recent fiscal shortfall: tax volatility.

Tax volatility is not about changes in tax rates, but rather changes in the revenue base against which taxes are levied. Imagine an Oklahoman who makes $60,000 per year. This person will owe roughly $2,545 annually in state income tax. But if the following year this individual’s earnings rise or fall by $5,000, his or her revenue burden will likewise rise or fall by about $262 dollars. This is an 11% change in the revenue, or a volatility value of 11.

Volatility is a problem because budgets usually assume slow and steady revenue growth. Writing a budget is easy when you assume the growth patterns typical for blue chip stocks, but it doesn’t work out so well if you wind up with the volatility of small companies in emerging markets. When tax revenues are heavily dependent on a fluctuating market (such as the oil and natural gas industry), booms and busts alter the revenue base and cause excessive volatility.

During the oil boom of 2009, Oklahoma’s severance tax (a tax levied on the gross production of natural resources) yielded $722 million, which was 13% of the state’s general revenue. Eight years later, with a sluggish energy market and reduced new drilling in Oklahoma, severance revenue dropped to only $128 million, or 3% of total general revenue.

Since the energy industry dominates the state economy, this recession and revenue volatility extends to Oklahoma’s individual and corporate income taxes. Together, these three revenue sources combined make up 45-55% of the state’s general revenue. In the past eight years, revenue from these three taxes has decreased to $2.3 billion from a high of almost $3 billion. Most of this decrease is entirely the result of changes in the energy market (rather than changes in tax rates).

In an analysis of this data by Pew Charitable Trusts, Oklahoma’s tax system ranks as the eleventh most volatile revenue system in the nation over the past twenty years. After factoring in all major revenue policy changes between 1997 and 2016, Oklahoma received an overall volatility score of 7.1, thanks in large part to the severance tax’s volatility score of 39.0.

It was this tax volatility that contributed to Oklahoma’s recent revenue decline. The unusually high oil prices of a few years ago led state revenues higher than prediction or expected. Rather than saving those funds or constraining them to one-time projects, legislators spent the windfall to expand ongoing government programs. This increased the continuing cost of government, creating tough choices when oil prices declined. The political response to such revenue drops can make things worse. If politicians raise taxes on cash-strapped businesses during a recession they may raise some additional revenue but are also likely to make the recession worse.

Instead of harmful, short-term solutions, state legislators should look for tax and budgeting reforms that insulate the state from inevitable swings in volatile commodities markets. A possible first step is to capitalize on the next uptick in oil prices to build a stronger Rainy Day Fund and confine funding increases to one-time projects. Emergency reserves are crucial insurance against the next recession. Pew’s data revealed that in 2016, Oklahoma’s Rainy Day Fund had only enough money to sustain governmental operations for two weeks.

A longer-term fix is for Oklahoma to increase significantly its efforts toward greater economic diversity, reducing dependency on the energy sector. In the past thirty years, Oklahoma has seen over 1,000 new, small businesses emerge across the state and explosive growth in the technology sector. Oklahoma’s dependency on energy companies has already decreased by half over those three decades, and continued emphasis on growing business will further expand Oklahoma’s economic diversity and stabilize the volatile revenue base.

Sources:
Oklahoma Legislative Appropriations Report, FY2009-2017
Pew Charitable Trusts, State Tax Revenue Volatility