FY 2016 Budget Outlook: Surprisingly Fragile

Distribution of Virginia Retirement System portfolio, March 2015. Image credit: VRS.

The stock market correction has frightened the bejeebers out of investors large and small — and it ought to frighten the bejeebers out of state and local governments, too. As John Rubino, publisher of DollarCollapse.com, noted yesterday, falling stock prices will reduce the capital gains that have been fueling rising income tax revenues for state and federal governments. Writes Rubino:

A bear market-related sell-off in capital gains would cause a double crisis, cutting pension fund investment returns (and thus raising the level of underfunding) and cutting tax revenues, diminishing states’ ability to even keep up with their current pension funding schedule.

Progressive income tax rates are fun when asset prices are rising, as the Federal Reserve Board has engineered them to do with its near-zero rate interest policies: States reap an income tax bonanza in capital gains taxes. But they are a disaster when assets prices tumble and capital gains take a dive.

Virginia isn’t as vulnerable as some states, which rely more heavily upon income tax receipts. But the individual income tax is the largest single source of revenue for the General Fund. The commonwealth closed fiscal year 2015 in June with a $553 million surplus, which Governor Terry McAuliffe attributed mainly to a surge in individual income tax revenue, which increased 8.1%, ahead of the 4.7% forecast. Most of that increase came from people cashing in capital gains from the stock and bond markets, not from rising wages and salaries. With the stock selloff, a repeat of that performance is highly unlikely. Fortunately, the budget assumes only a modest increase in individual income taxes this year, so the exposure is modest.

Less visible is the Virginia Retirement System’s exposure to falling equity prices. As of March 31, 2015, 21.4% of the VRS investment portfolio consisted of domestic equities. Another 16.5% consisted of non-U.S. equities — it would be interesting to know how much of that was invested in China, whose stock market meltdown has been cataclysmic. Another 3.6% was in emerging market debt, which is looking shakier and shakier as developing-nation economies take a beating from falling commodity prices, while another 4.8% was held in unspecified “emerging markets” assets.

In 2014, the VRS generated a 15.7% return on its investment portfolio, driven mainly by strong performance in its equity investments — and far above the 7% annualized return the VRS is aiming for. Given the state of U.S. and global financing markets today, it will take a minor miracle to meet that 7% goal this year. Of course, that’s only one year. Stock prices go up, stock prices go down, then they go back up again.

But Virginia faces another round of sequestration-driven cuts to the federal government, and the state economy will struggle to grow. Given the fact that we’re in the sixth straight year of a national economic expansion, our economic and budgetary outlook is surprisingly fragile.


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  1. LarrytheG Avatar

    some interesting things –

    South Dakota

    these are states without an income tax

    Kansas – a state that is trying to do what the 7 states
    are doing – and encountering difficulty.

    what might be worth knowing more about –

    is how the taxes are structured in these other states and how well their pension funds are doing.

    Kansas is proceeding in part on the theory behind the Laffer Curver – that if you cut income taxes , cut State spending – that you’ll get an increase in other tax revenues.

    the thing is – when you cut govt spending -you’re also cutting jobs..

    so you cut a teacher or policeman and the savings go to taxpayers who will spend it on something else that creates a job.

    but have you really created a new net job or have you merely traded a teacher for a private sector employee?

    that’s sort of off a different subject than a State depending on income taxes but it’s related to Kansas attempt to transition to a non-income-tax state.

  2. Steve Haner Avatar
    Steve Haner

    You used the word “correction” to describe the recent drop in the U.S. market, and so far the indications are it is just that – a typical (and overdue) correction that will be followed by a return to growth. There might actually be a surge of tax revenue following that kind of sell-off, as you don’t owe any capital gains tax until you sell something and reap a profit. So I wouldn’t start to cringe over revenue impacts just yet.

    Likewise VRS. The books don’t close today. The picture could (will likely) look very different in 30, 60, 90 days, by year’s end. As the TD recently reported, they have a long list of highly-compensated financial industry pros on the payroll — the kind of pros you expect to produce “beat the market” results when chaos presents opportunity. Let’s hope they’ve been earning those high salaries in the last few days! A wise fellow taught me long ago that the way to look at this situation is — stocks are on sale!

    1. LarrytheG Avatar

      I’m with Steve on this. I don’t think most folks with 401K much less the VRS are going to get spooked enough to bail out of their long-held investments.

      and yes.. a bunch of folks got spooked and lost their butts and a bunch of others got bargains…

      however.. the gloom and doomers will find a way to weave this into the “govt is bad and we’re all gonna die” parable…. I’m sure

    2. Cville Resident Avatar
      Cville Resident

      Winner. This is much more about a correction in equity prices than a full-scale panic. It’s also true that corrections usually result in rebalancing of portfolios which could, theoretically, lead to greater capital gains tax returns in a fiscal year. If a lot of the China narrative is correct…you may see a lot of rebalancing by selling international equity funds and reinvesting in domestic equities or bonds.

  3. JOHN BR Avatar

    You mention the budget only assumes a modest increase over last year’s income taxes as being a good thing.
    A “modest increase” over a record-setting year implies that this year must also be record-setting to merely avoid a deficit in the budget.
    A “modest decrease” in anticipated income tax revenues would be more prudent. Otherwise, you are assuming the good times will roll on forever. we’ve seen that scenario before.

  4. LarrytheG Avatar

    always curious about what a state budget without income tax revenues would look like.. how it would perform… if depending on sales and property taxes would be more volatile… and be more influence by economic and consumer spending swings…

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