U.S. states see rising volatility in tax revenues

May 2 (Reuters) - Forget the best of times and worst of times. For U.S. states' tax revenues, it could be the times of greatest volatility.

The Federal Reserve Bank of Chicago, in a report released on Wednesday, said that while state tax revenues have historically risen when times are good and fallen when they are bad, "this response since 2000 has been much larger than in the 1980s and 1990s."

Most of the trend of higher peaks and deeper troughs comes from a reliance on income taxes. Investment income experienced "dramatic swings throughout the 2000s," and states have grown more reluctant to change tax rates "in the face of economic fluctuations," the report said.

"On average, income tax rate policy across states has transitioned since 2000 ... to being largely independent of the business cycle," wrote Leslie McGranahan and Richard Mattoon, senior economists at the Chicago Fed. "Since 2000, individual income growth - especially from investment income - has become more sensitive to changing economic conditions."

The volatility left states with four options to manage their budgets: change tax policies, rely on federal aid, change spending, or store up assets to have on hand during recessions.

Although the recession began in late 2007, the effects on state revenues did not materialize until the end of 2008. Then, revenues dropped for five straight quarters from record highs to more than 20-year lows. Because all states except Vermont must balance their budgets, they slashed spending, raised taxes, borrowed and turned to the federal government for help.

The temporary tax hikes and extraordinary federal aid that came through the stimulus plan have recently expired.

Revenue is improving, and earlier this month the New York-based Rockefeller Institute reported that total state revenue has returned to the highs reached before the recession.

"Going back to the historical practice of increasing tax rates during bad economic times and decreasing them during good economic times would be one way that states could reduce state tax revenue volatility," the Chicago Fed paper suggested.

But it added that relying on other revenue sources, such as taxing wages and salaries more than investment income, could reduce volatility.

Cutting spending during recessions creates a problem: demands for state programs such as health care "increase or stay constant when the economy worsens," the paper said.

Meanwhile, reliance on federal aid would make the U.S. government more responsible for state policymaking.

States relied on reserves at the beginning of the recession to close budget gaps, and the Chicago Fed suggested states build up "dedicated rainy day funds explicity connected to tax revenues generated by capital gains."