Chapter7CarlE.VanHorn.docx

The United States is a federal system of government in which the responsibility for providing and financing public services is shared among three levels of government. The 87,576 units of government in the U.S. federal sys- tem include the federal government, 50 state governments, and more than 87,500 local units of government.1 Each of these jurisdictions provides public services to its citizens and raises revenue to support those services. Economists define fiscal capacity as a jurisdiction’s revenue-raising ability relative to the spending needs that it faces. A jurisdiction’s fiscal capacity is influenced by many factors. The state’s economy and tax system affect its ability to raise revenues. Its income, population, and demographic mix influence public service demand. Where a jurisdiction’s spending needs outstrip its revenue-raising ability, a fiscal crisis looms.
The system of federalism in the United States is both diverse and dynamic. At any point in time, fiscal capacity may differ significantly among units of government. It is dynamic in that considerable changes in fiscal capacity are often evident over time, both within and among units of government.
Within the U.S. federal system, the national government often seems to dominate in regard to the level of spending and taxation, and its ability to influence fiscal activities at other levels of government. Local governments are highly visible due to the sheer number of units and to the widely held view that they are the level of government closest to the people. However, state government finances play an important role in the U.S. federal system, al- though they may be the least visible entities within the federal system. For several reasons, state governments are likely to face an even more expanded role in providing domestic services in the future.
First, in a trend that started during the Reagan administration and was heightened in the aftermath of September 11, the national government is increasingly focused on national defense and homeland security. As such, more traditional domestic service responsibilities will rest with state and local governments.2 However, the future role of local government is itself in doubt, as some scholars hold that local governments need a primary own-source of tax revenue, such as the property tax, to remain viable.3 Other analysts note that the property tax is being undermined as a major revenue source for local governments through tax revolts, tax incentives, tax exemptions, and many school financing controversies around the country.4 So serious concerns have been raised about the extent to which local government can step in to fill the void left by the federal government in providing domestic services. As such, whether through the devolution of responsibilities from the federal government or by default through limitations on local governments, states may be forced to assume more importance within the federal system. This expanded role for state government should not obscure the fact that significant differences in taxing and spending patterns among individual states may exist.
Whether state governments rise to the occasion is a function of their collective willingness and ability to assume an expanded role.5 Throughout much of the current decade, state governments in aggregate have experienced a fiscal crisis, which may greatly affect their ability to assume a larger role within the federal system. The fiscal crisis confronting states has been sustained and significant, with estimates of the deficits totaling nearly $200 billion for fiscal years 2002–2004. Initial state budget projections for fiscal year 2005 showed that $40 billion in shortfalls had to be addressed.6
It has also been argued that the current fiscal crisis (fiscal years 2002–2005) has been both more sustained and more severe than the previous crisis of the early 1990s, which lasted for only three years. Moreover, states have been much more reluctant to raise taxes, and much more inclined to cut services, in responding to the current crisis. Even though state revenues have recently shown signs of renewed growth, they are still well below the level necessary to restore services to the level that prevailed at the start of the 1990s.
The nature of the fiscal crisis facing states varies by cause, severity, and ap- propriate policy responses. For example, the deficit confronting a particular state may be caused by downturns in the overall economy, which is called a cyclical deficit, or by more chronic long-term disparities between revenues and spending, which is referred to as a structural deficit. In other words, a cyclical budget shortfall occurs when, during an economic downturn, state revenues fall while spending pressures increase. Revenues decline because personal income decreases, consumption by individuals and businesses decreases, and business profits decline, thus reducing the revenue yield from the state’s personal income tax, general and selective sales taxes, and corporate income taxes, respectively. Spending increases because poverty and unemployment increase, which leads to increased demand for public assistance, housing assistance, health care assis- tance, and so forth? Because most states are required to spend no more than they raise in revenues—to balance their budget—these cyclical imbalances are a cause for concern. However, cyclical deficits are generally temporary and will likely be reduced or eliminated as the economic recovery occurs.
Structural deficits are said to exist when recurring revenues are not adequate to cover recurring spending needs. These deficits are considered chronic, or long-term, and often indicate that the state’s revenue system is not responsive to the need for more revenues as the costs of providing needed public ser- vices increase. Perhaps more important, structural deficits are believed to result because the tax system for many states has not adapted to reflect evolving economic, demographic, or technological conditions.
Coleman Of course, a state may suffer from any one or combination of these bud- get deficits. Because of their chronic nature, structural deficits are considered to represent the most serious threat to the ability of state government to play an expanded role in the U.S. federal system. A summary of several recent studies suggests that between twenty-seven and forty-four states were experiencing significant structural gaps in their budgets.8
The remaining sections of this chapter present a brief discussion of state budget processes, a review of state government spending and revenue-raising activities, and an examination of the major fiscal policy issues confronting state finances at the beginning of the twenty-first century.
Overview of Budget Processes
Budgets are important because they describe the context in which state spending and revenue decisions are made and any limitations imposed on policymakers in making changes to state tax or spending policies.9 Several aspects of state government budget processes will be discussed, including balanced- budget requirements; limitations on taxes, spending, and indebtedness; and reserves available to help deal with unexpected economic downturns or other emergencies.
Balanced-Budget Requirements
Most states operate on a fiscal year that runs from July 1 to June 30.10 Twenty-nine states operate on an annual budget cycle and twenty-one on a biennial budget cycle.11 Within the prevailing budget cycle, states are required to balance spending and revenues, although the nature of the balanced-budget requirement varies significantly.12 The economists Brian Knight, Andrea Kusko, and Laura Rubin have observed the following:
While all states except Vermont have some form of balanced budget requirement, the manner in which state governments must correct shortfalls in operating budgets depends on the requirements’ details, which vary substantially across states. These rules are either stated explicitly in the state’s constitution or are part of the laws of the state, and some states have multiple provisions that require a balanced budget. Balanced budget requirements can be placed into the following five categories, according to the state’s most stringent provision:
1. Governor must submit a balanced budget—that is, one that contains no projected shortfall (1 state);
2. Legislature must pass a balanced budget (5 states);
3. State must correct any shortfall in the next fiscal year (7 states);
4. No carryover of shortfall into the next biennial budget cycle (7 states); and
5. No carryover of shortfall into the next fiscal year (29 states).13
These authors further note that other factors, such as bond ratings and public expectations, may also contribute to fiscal discipline within a state. For example, bond-rating agencies often take a skeptical view of fiscal “gimmicks”— such as deferring expenditures, accelerating tax payments, selling assets, or one-shot revenues—and respond to such proposals by downgrading the state’s bond rating. This increases the costs of borrowing for the state. Thus, the threat of having its bond rating downgraded helps to instill fiscal discipline. Similarly, the fear that tax and spending policies may be seen as radical and generate an adverse public response—as reflected in opinion polls, unfavorable editorials, or public demonstrations—also prompts adherence to more main- stream policies, which contributes to fiscal discipline.
Tax and Expenditure Limitations
Many states impose some type of restriction on spending or revenue raising. Indeed, thirty states have some type of tax or expenditure limitation, or both. Two-thirds of those states restrict spending growth to some index of inflation. In addition, twelve states require approval by a supermajority (such as two-thirds majority vote margin) in the state legislature for an increase in taxes or fees, and another three states require voter approval.
Debt Limits
In financing many capital activities, states can choose a pay-as-you-go system or the issuance of debt. Two types of debt issues are generally avail- able—revenue bonds or general obligation bonds. With revenue bonds, the re- payment of the principal and interest is contingent on the successful completion of the project. The full taxing authority of the issuing jurisdiction is pledged to the repayment of the principal and interest of general obligation debt, which is also called full faith and credit debt. Several states do not issue general obligation debt, and other states that issue general obligation debt do not limit the amount.14 Each of the remaining states has some type of limitation on the amount of general obligation debt, with the limitation generally based on a formulaic relationship with either the general revenues or appropriations of the state. Alternatively, some debt limits are stated as fixed dollar amounts.
Budget Reserves
The effects of recessions on state budgets were noted earlier. Although the onset of a cyclical downturn is often difficult to predict with any precision, states also have to deal on occasion with unforeseen emergencies due to natural or man-made disasters. To help in dealing with the financial impacts of unexpected emergencies or downturns in the economy, states maintain contingency and stabilization funds. Budget stabilization funds—so-called Rainy Day Funds—allow states to spend during an economic downturn without having to resort to raising existing taxes or introducing new ones.
Some forty-five states (all but Arkansas, Kansas, Montana, Oregon, and Utah) now have such funds. Although these instruments have been helpful in staving off more drastic adjustments during short-term crises, they are seldom capitalized sufficiently to withstand a significant and sustained economic downturn. Among the fifty states all but two (Michigan and Mississippi) have contingency funds—reserves set aside for unexpected emergencies, such as natural disasters.
Again, these budget processes help to provide a context for the adjustments that state governments must make in response to problems brought on by a fiscal crisis. This is an important, but only partial, part of the story. In to get a more complete picture, information on how states raise and spend money is needed. The following sections shed further light on these aspects of state finances.
How Do States Spend Money?
State governments are major players in the federal system. Total general expenditures for state governments in 2001 were $1.045 trillion, up significantly from the 1990 total of $508 billion. Per capita state general spending grew from $2,048 in 1990 to $3,671 in 2001. Per capita state general expenditures varied significantly among states, with the top states being Alaska ($13,232), Vermont ($5,221), Hawaii ($5,008), Delaware ($4,959), and Wyoming ($4,718). The lowest per capita spending states were Texas ($2,723), Nevada ($2,798), Florida ($2,846), Arizona ($2,926), and Tennessee ($2,981).1
Within the state budget, spending takes place via several funds. Fund ac- counting is used by nonprofit organizations that receive funds whose use is restricted to a specific purpose. The accounting system is organized so that the use of the dedicated funds is separately identified and monitored.16
Although it varies somewhat from state to state, four types of funds are used in state budgeting. The “general fund” is the largest and most flexible fund, and the one generally considered to most closely reflect state preferences and priorities. “Federal funds” are funds received from the federal government, generally in the form of grants-in-aid. “Bond funds” are established with the proceeds from the sale of bonds and used primarily for capital investment purposes. Finally, “other state funds” are used to fund spending from revenues that are restricted by state statute or constitution. For example, casino taxes in New Jersey are dedicated to providing services for the elderly and the disabled. Similarly, the gas tax in many states is earmarked for road construction, maintenance, or improvements. In 2003 general fund spending was almost 44 percent of total state expenditures, followed by federal funds (29 percent), other state funds (24 percent), and bond fund spending (3 percent).
State spending in general is spread among seven functional categories, including elementary and secondary education, higher education, public assistance, Medicaid, corrections, transportation, and all other areas. (See Table 7–1.) Elementary and secondary education is the largest area of total state spending, followed by Medicaid. Medicaid was the fastest growing area of total spending for each of the last two years. The spending pattern for total state expenditures parallels that for the general fund, except for transportation spending. These general patterns mask several significant changes in relative spending over time, and significant differences in relative spending among individual states. For example, higher education was the second largest area of state spending until the late 1980s, when Medicaid emerged as the second largest area. The proportion of total state spending accounted for by elementary and secondary education, Medicaid, and corrections has in- creased significantly over the last decade and a half. Significant differences in spending among states reflect variations in the allocation of service responsibilities between the state and local governments, the costs of providing ser- vices, service preferences, the quality of services provided, and state financial resources.
How Do States Raise Money?
State government general revenue totaled about $1.1 trillion in fiscal 2001, almost double the 1990 level of $517 billion. Per capita general revenue increased from $2,085 in 1990 to $3,685 in 2001. Per capita general revenue varied considerably by state, with the top five states being Alaska ($9,532), Delaware ($5,595), Wyoming ($5,520), Vermont ($5,068), and Hawaii ($4,927). The bottom five states included Florida ($2,699), Nevada ($2,753), Texas ($2,835), Arizona ($2,858), and Tennessee ($2,964).
State revenues are generally categorized as either own-source—reflecting a variety of state-imposed taxes, fees, and charges—or intergovernmental revenue—indicating revenues received from another level of government. State general fund revenues best describe own-source revenues. In 2003 general fund revenues totaled $491 billion. See Table 7–2.
Of this total, personal income taxes represented the largest share, followed by sales taxes and all other taxes and fees, which include cigarette and tobacco taxes, alcoholic beverages taxes, insurance premium taxes, severance taxes, licenses and fees for permits, inheritance taxes, and charges for state- provided services. Forty-one states impose a broad-based personal income tax (all but Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming), and forty-five states (all but Alaska, Delaware, Montana, New Hampshire, and Oregon) impose a broad-based sales tax. All states impose selective excise taxes on items such as alcohol, tobacco, and gasoline.
Major Fiscal Policy Issues Confronting States
State governments are in a truly precarious fiscal position. By devolution or default, they are poised to assume a greater role in providing domestic ser- vices within the U.S. federal system at the same time that they are confronting significant fiscal problems resulting from a fiscal crisis, especially as it relates to the structural deficits being experienced by as many as forty-four states. The issues discussed below are illustrative of the kinds of issues that states must confront and address if they are to deal fairly and effectively with their citizens in adjusting to an expanded role in the federal system
Pressures for Spending Increases
Several factors may accelerate the trend toward increased state spending, including school financing, Medicaid, public employee retirement systems, and limitations on the use of labor-saving technologies in providing public services. The first three of these factors represent large areas of state spending that may continue to experience rapid growth. In addition, political and institutional constraints (such as collective bargaining agreements) may make it difficult to reduce or even control spending in these areas.
Schools
States (and their local school districts) face pressures to increase school funding to deal with a variety of concerns. These include projected enrollment increases, court- ed requirements to reduce disparities in school funding, public demands for smaller class sizes to address school quality, declining and outmoded quality of school facilities, demands for higher teacher salaries to remain competitive with other occupations, and dealing with federal mandates regarding educational services for pupils with disabilities. Although the extent to which these school-spending pressures will be shared with local school districts will surely vary from state to state, it is safe to assume that much of the additional spending will fall on state budgets. Hawaii, for example, has a statewide school system with no local districts, so all additional costs will accrue to the state.
Medicaid
As noted earlier, Medicaid is already one of the largest areas of state spending, and the fastest growing. Medicaid spending is likely to increase even more because of growing health care costs, which regularly exceed the overall rate of inflation, and the shift in the costs of providing health services for the elderly and disabled from the fully federal-funded Medicare program to the joint federal-state–funded Medicaid program. Iris Lav describes how this shift occurs: Changing medical practices have shortened the length of time that people are hospitalized and have increased the use of prescription drugs and ambulatory care. While these medical advances can reduce overall health care costs and improve quality of care, they have the paradoxical effect of in- creasing Medicaid expenditures while lowering Medicare costs. Further- more, Medicaid covers long-term care, whereas Medicare does not. A majority of the Medicaid expenditures for seniors and people with disabilities are for long-term care services. . . . As a result of these circumstances and trends, Medicaid has been financing a growing share of health insurance costs for the aged and disabled.17 Pensions
Rising state commitments to retired public employees have the potential to dwarf the fiscal concerns related to cyclical and structural deficits, with shortfalls projected to reach several hundred billion dollars.18 There are three sources of funding for state retirement systems—employee contributions, employer contributions, and investment earnings. Employee and employer contributions are about equal to distributions currently paid out by retirement systems. However, investment earnings are well below the level necessary to meet future obligations. This current situation is made even more tenuous in some states because of enhanced benefits still being provided by policymakers, changes in pension fund asset allocations in favor of riskier investments, and significant future payouts as more workers age and become eligible for benefits.
Limitations of the Use of Technology
In an often-cited article written in 1967, the noted Princeton University professor William Baumol described a theory of how inflation could affect the costs of delivering public services.19 The public sector competes with the private sector to attract and retain workers, primarily by offering comparable wage increases. However, because of technological changes that are introduced in the private sector, productivity increases offset the costs of higher wages paid to private sector workers, thereby keeping overall costs under control. Since it is more difficult to introduce labor-saving technology into the service- driven public sector, no offsetting productivity increases take place, with the result that increased wages mean increased costs for the delivery of any given quantity or quality of public services. In short, the more limited ability to in- troduce technological changes into the public sector will contribute to higher costs of services, even with no increase in either the quantity or quality of those services.
Outdated State Revenue Systems
Several researchers have argued that the tax system currently in place in most states is not adequate to address the revenue needs of those states. The tax systems were established when the economy, technology, and demographics were very different from those of today. These tax systems have not been modernized to reflect current circumstances.20
For example, the general sales and use tax is a major source of revenue for state government, representing slightly more than a third of general fund revenues in 2003. The state sales tax, which was first introduced in the 1930s, was established when the U.S. economy (and that of most states) was a goods- based economy, and most sales transactions were conducted face to face. Today’s economy is a services-based economy, with more and more transactions taking place through remote means, such as over the Internet or through mail- catalogs. State sales and use taxes have not been revised to reflect this new economic reality.
The Institute on Taxation and Economic Policy noted that “in 2003, ser- vices represented almost 60 percent of personal consumption nationally. Few states have successfully adapted to this change in consumption: only Hawaii, New Mexico, and South Dakota [tax] services comprehensively.”21 Similarly, policy analyst Michael Mazerov notes that “ a majority of the states apply their sales tax to less than one-third of 164 potentially taxable services. Eight of the 45 states with sales taxes impose them on fewer than 20 service categories.”22 He goes on to note that “full taxation of ‘readily available’ services could generate sales tax revenue equal to 25 to 35 percent of current sales tax collections in about three-fourths of the forty-five states currently levying a sales tax. The total revenue yield nationally would be approximately $57 billion a year.”
Similarly, remote sales—including sales through the Internet, mail- catalogs, and direct marketing—have cost states significant amounts of forgone sales tax revenues. Whenever the resident of a state makes a purchase from an out-of-state vendor but the good in question is to be primarily consumed within the state of residence, a “use” tax obligation is incurred. Because of the U.S. Supreme Court decisions in National Bellas Hess vs. Illinois Department of Revenue and Quill Corporation vs. North Dakota, the state of residence cannot force the out-of-state vendor to collect and remit the taxes generated by the transaction.24 Donald Bruce and William Fox estimate that the loss of sales and use tax revenues due to such remote transactions primarily involving the Inter- net could grow from $15 billion in 2003 to somewhere between $22 billion and $34 billion by 2008.25 The Streamlined Sales Tax Project (SSTP) was initiated by several organizations—including the Federation of Tax Administrators, the Multi-State Tax Commission, the National Conference of State Legislatures, and the National Governors Association—to address the concerns raised by the Supreme Court so that states may be able to compel out-of-state vendors to collect sales and use taxes, but Congress has shown little interest or inclination to enact legislation that embodies the work of the SSTP.
Other policies in the state tax system are similarly in need of updating. For example, many states with a personal income tax provide for special treatment of retirement income, without applying any type of means test to the taxpayer.26 When this special treatment was introduced, retirement income was a relatively small component of personal income. As the population ages and more individuals reach retirement age, income from pensions and other retirement accounts has become a more significant portion of total personal income. It now represents a significant personal income tax loss to the states.
The corporate income tax has also declined considerably as a source of revenue for state governments. This has occurred in part because states are at- tempting to reduce business taxes in to encourage economic development. Policy analyst and State Tax Notes columnist David Brunori holds that corporations have long sought to lower their state tax burdens, and have generally done so using a three-pronged approach: they employ really smart lawyers and accountants to plan around paying taxes; they secure all kinds of tax incentives to do essentially what they would be doing anyway; and . . . they have continued their assault on the traditional way that corporate taxes are levied in the United States.27 Expanding Reliance on Gambling Revenues In addressing their needs for more revenue, many states are looking to nontax revenue sources, such as fees and charges and gambling—including state-sanctioned lotteries, casinos, and racing. A recent report by the Institute on Taxation and Economic Policy finds the following: Some form of government-sanctioned gambling is now allowed in all but two states (Utah and Hawaii). By far the most popular forms of legalized gambling are lotteries and casinos: 37 states and the District of Columbia have state lotteries, and more than half the states have some form of casino gambling. Many states also allow “pari-mutuel” gaming, wagering on live events such as horse racing and greyhound racing. Advocates of state-sponsored gambling typically see it as a painless, voluntary tax—and one that is at least partially paid by residents of other states.28
Although states have shown a greater interest in all forms of nontax revenues, gambling revenues have been especially popular in the last several years. For example, in 2003 total lottery ticket sales increased to $43.5 billion from $2.4 billion in 1980, and net income to states increased to almost $14 billion from $978 million in 1980. See Table 7–3.
Casino tax revenue in 2004 ranged from a high of $887 million in Nevada to a low of $12 million in South Dakota. Note also that the casino industry pays other forms of state and local taxes, such as corporate income taxes, sales taxes, and local property taxes. 29 However, the potential of gambling revenues to help in addressing state fiscal problems should not be over- stated. Although these revenues allow states to increase spending, they will play only a small role in the overall state budget context.30
In many instances, the financial benefits of gaming revenues to the states are overstated. First, it is important to distinguish between gross revenues generated by state-sponsored lotteries and the net revenues available to states to fund services. A significant portion, up to 50 percent, of lottery proceeds must be devoted to administration (including the costs of promoting the lot- tery) and to pay the cash prizes to lottery winners. When these “net” revenues are considered, the fiscal benefits are much more modest. More generally, with the possible exception of revenues in Nevada, gambling revenues amount to a relatively small portion of total state revenues. As the late economist Steven Gold once observed,
Nevada’s gambling and …