The purpose of this study is to examine how cyclical fluctuations in tax revenue affect state fiscal policies, using a state panel data set. In particular, the study develops a measure of revenue gap—the cyclical component of tax revenue—by calculating the orthogonal deviations of tax bases from the trend, and then analyzes its effects on the level of spending and taxation—as measured by expenditure gap and overall tax rate—using a dynamic panel-data model. The analyses reveal that revenue gap is positively related to expenditure gap and negatively to overall tax rate. These results clearly show the procyclical patterns of state fiscal policies and further suggest the association between revenue volatility and fiscal instability. Based on the results, the study discusses the spending stabilization rules as a policy solution to the recurring state fiscal crises.
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