What Caused the State Budget Gaps?

I know the conventional answer: the recession. And surely there is validity to the conventional answer. The recession was the proximate cause: it sent revenues in a free fall at the same time that it put extra demands on the states’ welfare systems.

But the budget gaps were pretty different from state to state. For example, California faced a 2010 budget gap that was 65 percent of its General Fund while North Dakota faced no budget gap at all. Might differences in state policy and differences in state institutions explain the vast difference in gap size? This was the motivation for my recent working paper, State Budget Gaps and State Budget Growth.

In it, I conclude that large gaps were the result of rapid growth in per capita spending, a lack of economic freedom, and weak balanced budget rules.

To arrive at this conclusion, I performed a series of statistical tests, focusing on the size of state budget gaps, measured as a share of state general funds. In these tests, I controlled for various factors that might influence the size of a state’s gap (its population, income level, demographic makeup, etc.). After controlling for these factors, I was able to estimate the impact of certain policy choices and institutions on the size of states’ budget gaps. In particular, I focused on:

  • Budget size relative to state income,
  • Growth in per capita spending in the two decades preceding the recession,
  • Levels of economic freedom, and
  • Stringency of state balanced budget requirements.

I found that states that spent a large share of state income—and have done so for many decades—had smaller (percentage) deficits. This may be because states grow accustomed to making their budgets balance or it may be because the same factors that permit steady revenue streams also permit large budgets. But this doesn’t mean policymakers should go on spending sprees and expect smaller budget gaps. In fact, a spending spree is likely to make a state’s budget gap worse. Other factors being equal, states whose per capita spending increased the most in the two decades preceding the recession had budget gaps that were nearly 20 percentage points larger than states whose per capita spending increased the least. Since the median state’s budget gap was 23 percent of its general fund, going from the slowest to the fastest-growing state can make a huge difference.

Economic freedom (characterized by low taxes and minimal regulation) makes an even greater difference. Using Jason Sorens and William Ruger’s measure of economic freedom, I found that other factors being equal, the most-economically free states tended to have budget gaps that were 25 percentage points smaller than the least-free states.

Lastly, states with weak balanced budget requirements had larger budget gaps. While every state but Vermont is required to balance its budget, some requirements are weaker than others. It turns out that those states with weak balanced budget requirements encountered larger deficits to begin with: theirs were 8 to 10 percentage points larger than those with strong balanced budget requirements.

So what caused the budget gaps? Policy makers may be all-too-happy to pin the blame on the recession. But my research suggests that policy choices in the decades preceding the recession made a big difference. Rapid growth in per capita spending, a lack of economic freedom, and weak balanced budget rules caused the gaps. The recession just exposed these underlying problems.