Introduction
Economic and Fiscal Performance in a
Mean-Variance Perspective
American states ended the twentieth century on a winning streak.
Most had participated in an uninterrupted eight-year economic ex-
pansion that lifted living standards to record levels and reduced un-
employment rates to thirty-Ave-year lows. This string of favorable
economic events, coupled with a progressive tax structure, caused a
surge in state government coffers. State legislators and governors
wrestled over what to do with this Bood of new revenues, relishing
the choice between cutting taxes and expanding their favorite pro-
jects. The forces favoring new spending basically won that contest.
The typical state budget in the 1990s outpaced state income growth
by nearly 1 percentage point annually. At the same time, federal gov-
ernment spending declined as a share of national income, effectively
shifting power from Washington to the states.
Those were heady days in the state capitals. Thousands of state
politicians had never shared responsibility for a revenue shortfall.
Fewer than half of elected state lawmakers had held ofAce long
enough to experience hard Ascal times.
The economic winning streak ended early in the new millennium,
and the Ascal tide began to turn. In 2001 many state economies began
to sputter even before the terrorists attacked the World Trade Center
and the Pentagon and new risks to homeland security became a real-
ity. In that year, 44 states reported revenue collections that were
below expectations, requiring unpleasant choices not confronted for
a decade: spending cuts, tax increases, increasing debt, and dips into
rainy-day funds.
Looking back at the 1970 99 period, one Ands recurring episodes
of major economic stress that squeezed state revenues: 1990 91,
1982, and 1975. Even in these earlier periods of national recession, we
discover vast differences in how the individual states fared, how each
reacted to changing economic circumstances, and how their econo-
mies and budgets bounded and rebounded. As a general matter, few
2 Volatile States
states mirror the national economy. Yet the notion of a U.S. econ-
omy routinely dominates the way we encapsulate, aggregate, and
characterize economic conditions that are actually quite unalike at
the state level.
In the Anal three decades of the twentieth century, living standards
in the United States increased by 50 percent, or by about $11,500 per
person (in 2000 dollars). In North Carolina, the state growth cham-
pion, real income rose by nearly $13,000 per person, a 64 percent rise.
In Alaska, the state laggard, income grew by 28 percent, less than half
the rate in North Carolina. Of course, one might write off Alaska s
poor showing to the vicissitudes of oil prices. But what about Cali-
fornia s relatively anemic 37 percent growth or Ohio s below-average
42 percent growth? Economic performance in these and other states
paled in comparison to the 60 percent plus real growth in states such
as Colorado, Massachusetts, and Virginia.
Why do the American state economies grow at such vastly differ-
ent rates and manifest wide differences in living standards? This
question rightfully occupies a prominent place in the history of eco-
nomic analysis. Few issues in social science are more worthwhile than
the sources of rising living standards.This study joins the discourse by
examining the economic and Ascal history of the American states in
the last three decades of the twentieth century. It dives deeply into
these historical data in search of new insights about the factors that
stand behind state economic success.
The Role of Volatility in State Economies and
Fiscal Policy
The central point of departure is the elevated role of volatility. This
departure from traditional analyses of economic performance tracks
the perspective in modern Anancial theory that emphasizes a two-
dimensional, or mean-variance, criterion for evaluating portfolios.
Just as rates of return alone provide an incomplete basis for gauging
portfolio performance, the level or growth in state economies reveals
an incomplete and perhaps distorted picture of performance. Taking
the volatility of state economies explicitly into account reAnes the
whole notion of economic success.
This book explores and illustrates the considerable promise of a
two-dimensional or mean-variance criterion for assessing state eco-
nomic performance. For example, the empirical analysis Ands that
high-income states tend to be signiAcantly more volatile than low-
income states, which raises a host of doubts about the adequacy of tra-
Introduction 3
ditional models of economic development. Some citizens may simply
prefer a low volatility to a high volatility environment, even though
this choice requires some sacriAce in the form of residing in a state
with below-average income. The mean-variance perspective amends
applications of growth models that rely on the mobility of productive
factors keyed to income levels alone.The elevated importance of state
economic volatility also ushers in novel questions about the determi-
nants of volatility and the interplay between the volatility and the
level of state income.
In addition to economic volatility, the book explores and accents
the importance of the volatility dimension in state Ascal policy. For
example, the analysis of state revenues considers the reliability of al-
ternative tax instruments by computing and comparing the volatility
in revenue Bows from speciAc tax sources. Regarding expenditures,
the analysis discovers a systematic trade-off between the volatility of
state budgets and the efAciency of public sector operations.
Overview of Chapters
The book is organized into 10 chapters. Chapter 1 begins with a re-
view of state economic performance, detailing the variation in living
standards and economic growth rates among states. Chapter 2 inves-
tigates the pat explanation for the state growth process from neo-
classical economics, the convergence thesis, which posits that low-
income regions will outperform and therefore catch up with the
living standards in high-income regions. The appealing simplicity of
the neoclassical convergence thesis fails to explain the state experi-
ence for at least 25 years; income convergence among the American
states ended in the mid-1970s.
Chapter 3 introduces the mean-variance perspective as a positive
framework for analyzing state economic performance.Two techniques
for computing state economic volatility are developed, and these mea-
sures are used to rank and exposit the extent of volatility among
states. The chapter surveys alternative theories for an underlying rela-
tionship between the level and volatility of state income and probes
this relationship empirically. As previewed in the preceding discus-
sion, the statistical models reveal a signiAcant and positive correlation
between income and volatility, consistent with the risk-return rela-
tionship observed in standard portfolio analysis.
Chapter 4 moves the analysis into the realm of state Ascal policy,
speciAcally beginning with an overview of the evolution of state tax
structures. States relied on sales taxes as the predominant revenue
4 Volatile States
source in the 1960s but steadily replaced it with the individual income
tax in the succeeding three decades. By the late 1990s, collections
from the state income tax were nearly on a par with collections from
the sales tax in the typical state. Chapter 5 and chapter 6 proceed to
related issues: the progressivity of state tax structures, the impact of
income versus sales taxes on economic performance, and the reliabil-
ity of these alternative revenue sources. The analysis of revenue reli-
ability again brings the role of volatility to the front burner. The re-
sults from these analyses help to explain the demise of the state sales
tax and its replacement by the income tax. The state sales tax deters
economic performance and, contrary to conventional wisdom, pro-
vides a less reliable revenue source than the state income tax in al-
most two-thirds of the states that levy both types of taxes.
Chapter 7 takes up the spending side of Ascal policy, highlighting
the wide variation among states over the 1970 through 2000 period.
Chapter 8 returns to the mean-variance perspective, in this case ap-
plying it to state budget processes. The analysis demonstrates that un-
certainty is the enemy of efAciency in public as well as private enter-
prise. If public budgets are volatile and therefore difAcult to predict,
agencies incur higher operating costs than if budgets are stable and
predictable. State Ascal volatility creates uncertainty that limits the
efAciency of agency planning and thereby tends to increase state
spending. In light of the elevated importance of Ascal volatility, chap-
ter 8 examines the role of Ascal institutions in a mean-variance per-
spective. Institutions such as balanced budget requirements, tax and
expenditure limitations, biennial budgeting, and the item veto affect
Ascal volatility and through this channel have indirect as well as direct
effects on the size of government. In essence, Ascal institutions take on
a more subtle and signiAcant role in state budgetary processes than
previous analyses have appreciated.
Chapter 9 examines the composition of state budgets and the rel-
ative inBuence of various forces in determining spending priorities.
The inBuence of political ideology matters, but not nearly as much as
Ascal volatility and Ascal institutions. Chapter 10 reiterates the major
results and summarizes the lessons in state political economy that
emerge from the study.
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