Category Archives: Balanced Budget

What would a business-cycle balanced budget rule look like in Illinois?

A few years ago, I testified before the U.S. House Judiciary Committee. I’d been invited to talk about the design of a federal balanced budget amendment and much of my testimony drew on the lessons offered from state experience. Since 49 of the 50 states have such requirements, and since these requirements vary from state to state, I noted that federal lawmakers could learn from the state laboratory.

The best requirement, I argued, would have the following characteristics:

  1. Require balance over some period longer than a year. This effectively disarms the strongest argument against a balanced budget amendment: namely, that it would force belt-tightening in the middle of a recession. In contrast, if budgets need to balance over a longer time period, then Congress is free to run deficits in particular years as long as they are countered by surpluses in others.
  2. Allow Congress some time to come into compliance. You don’t have to be a Keynesian to worry that a 45 percent reduction in the deficit overnight might be a shock to the system.
  3. Minimize the gamesmanship associated with revenue estimation: Across the country, states with balanced budget requirements have to estimate revenue throughout the year (I’m a member of Virginia’s Joint Advisory Board of Economists and our responsibility is to pass judgment on the validity of these estimates). But this invites all sorts of questions: what model to use for the economy, should revenue be scored dynamically or statically, etc. One way to sidestep all of these questions is to make the requirement retrospective: require that spending this year not exceed revenue from years past.

Michigan Republican Justin Amash has proposed an amendment along these lines. It would be phased-in over 9 years and from there on out would stipulate that outlays “not exceed the average annual revenue collected in the three prior years, adjusting in proportion to changes in population and inflation.” Because it requires balance over three years rather than one, Amash calls it the “business cycle balanced budget amendment.”

Writing in Time, GMU’s Alex Tabarrok points to Sweden’s positive experience with a similar rule. And economists Glenn Hubbard and Tim Kane also endorse such a rule in their book, Balance.

Now, some Illinois state lawmakers have put together a proposal for a state rule that appears to be largely based on this model. It requires:

Appropriations for a fiscal year shall not exceed the average annual revenue collected for the 3 prior years, adjusting in proportion to changes in population and inflation.

(Unlike the Amash plan, however, the Illinois plan is not phased in over a number of years. Rather, it takes effect immediately upon passage of the bill.)

To see how it might work in a state, I decided to take the Amash Amendment for a test drive, using Illinois data. The solid blue line in the figure below charts Illinois’s actual general revenue from 1990 to 2012 in billions of current dollars. The dashed blue line phases in an Amash-type “business cycle” balanced budget rule. Once fully phased-in, it would limit spending to the average revenue of the three previous years, with an adjustment for inflation and population growth.

BCBBA

Notice three things:

  1. From 1990 to 2002, and from 2004 to 2007, the rule would have kept Illinois spending in line with Illinois revenue, and would have even allowed the state to run surpluses.
  2. In lean years (like 2008) when revenue levels off, the limit actually continues to rise. That’s because it is based on a longer time trend. This means that it wouldn’t require the sort of draconian budget cuts that balanced budget critics often fear. The accumulated surpluses from previous years could also be used to soften the blow.
  3. Lastly, note the (9 percent) revenue uptick from 2011 to 2012. The amendment would prudently make legislators wait a few years before they can go out and spend that money.

The “pension tapeworm” and Fiscal Federalism

In his annual report to shareholders, Warren Buffett cites the role that pension underfunding is playing in governments and markets:

“Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made. During the next decade, you will read a lot of news –- bad news -– about public pension plans.”

He zones in on pension mathematics – “a mystery to most Americans” – as a possible reason for accelerating liabilities facing state and local governments including Puerto Rico, Detroit, New Jersey and Illinois. I might go further and state that pension mathematics remains a mystery to those with responsibility for, or interest in, these systems. It’s the number one reason why reforms have been halting and inadequate to meet the magnitude of the problem. But as has been mentioned on this blog before: the accounting will eventually catch up with the economics.

What that means is unrelenting pressure building in municipal budgets including major cities. MSN Money suggests the possibility of bankruptcy for Los Angeles, Chicago and New York City based on their growing health care and pension liabilities.

In the context of this recent news and open talk of big municipal bankruptcy, I found an interesting analysis by Paul E. Peterson and Daniel J. Nadler in “The Global Debt Crisis Haunting U.S. and European Federalism.”(Brookings Institution Press, 2014).

In their article, “Competitive Federalism Under Pressure,” they find a positive correlation between investors’ perception of default risk on state bonds and the unionization rate of the public sector workforce. While cautioning that there is much more at work influencing investors’ views, I think their findings are worth mentioning since one of the biggest obstacles to pension reform has been the reluctance of interested parties to confront the (actual) numbers.

More precisely, it leads to a situation like the one now being sorted out in federal bankruptcy court in Detroit. Pensioners have been told by Emergency Manager Kevyn Orr that if they are willing to enter into a “timely settlement” with the city and state, they may see their pensions reduced by less than the 10 to 30 percent now suggested. Meanwhile bondholders are looking at a haircut of up to 80 percent.

If this outcome holds for Detroit, then Peterson and Nadler’s findings help to illuminate the importance of collective bargaining rules on the structure of American federalism by changing the “rules of the game” in state and local finances. The big question for other cities and creditors: How will Detroit’s treatment of pensions versus bonds affect investors’ perception of credit risk in the municipal debt market?

But there are even bigger implications. It is the scenario of multiple (and major) municipal bankruptcies that might lead to federalism-altering policy interventions, Peterson and Nadler conclude their analysis with this observation:

[public sector] Collective bargaining has, “magnified the risk of state sovereign defaults, complicated the resolution of deficit problems that provoke such crises, heightened the likelihood of a federal intervention if such crises materializes, and set the conditions for a transformation of the country’s federal system.”

Does statehood trigger Leviathan? A case study of New Mexico and Arizona

I was recently asked to review, “The Fiscal Case Against Statehood: Accounting for Statehood in New Mexico and Arizona, by Dr. Stephanie Moussalli for EH.net (the Economic History Association).

I highly recommend the book for scholars of public choice, economic history and accounting/public finance.

As one who spends lots of time reading  state and local financial reports in the context of public choice, I was very impressed with Moussalli’s insights and tenacity. In her research she dives into the historical accounts of territorial New Mexico and Arizona to answer two questions.  Firstly, did statehood (which arrived in 1912) lead to a “Leviathan effect” causing government spending to grow. And secondly, as a result of statehood, did accounting improve?

The answer to these questions is yes. Statehood did trigger a Leviathan effect for these Southwestern states –  findings that have implications for current policy – in particular the sovereignty debates surrounding Puerto Rico and Quebec. And the accounts did improve as a result of statehood, an outcome that controls for the fact that this occurred during the height of the Progressive era and its drive for public accountability.

A provocative implication of her findings that cuts against the received wisdom:  Are the improved accounting techniques that come with statehood a necessary tool for more ambitious spending programs? Does accounting transparency come with a price?

What makes this an engaging study is Moussalli’s persistence and creativity in bringing light to a literature void. She stakes out new research territory, and brings a public choice-infused approach to what might otherwise be bland accounting records. She rightly sees in the historical ledgers the traces of the political and social choices of individuals; and the inescapable record of their decisions. In her words, “people say one thing and do another.” The accounts speak in a way that historical narrative does not.

For more read the review.

 

How are your state’s finances?

Just how well do your state’s finances compare to those of other states?

I sat down with our state policy group last week to discuss recent Mercatus research that ranks states’ fiscal condition based on the their 2012 Comprehensive Annual Financial Report (CAFR). The findings contained in State Fiscal Condition: Ranking the 50 States by Dr. Sarah Arnett are aimed at helping states apply basic financial ratios to get a general picture of fiscal health. Dr. Arnett’s paper uses four solvency criteria developed in the public finance literature – cash solvency, budgetary solvency, long-run solvency and service-level solvency. In this podcast, I discuss how legislators and policy analyst might use the study and the limitations of ratios and rankings in understanding a state’s deeper financial picture.

Credit Warnings, Debt Financing and Dipping into Cash Reserves

As 2013 comes to an end recent news brings attention to the structural budgetary problems and worsening fiscal picture facing several governments: New Jersey, New York City, Puerto Rico and Maryland.

First there was a warning from Moody’s for the Garden State. On Monday New Jersey’s credit outlook was changed to negative. The ratings agency cited rising public employee benefit costs and insufficient revenues. New Jersey is alongside Illinois for the state with the shortest time horizon until the system is Pay-As-You-Go. On a risk-free basis the gap between pension assets and liabilities is roughly $171 billion according to State Budget Solutions, leaving the system only 33 percent funded. This year the New Jersey contributed $1.7 billion to the system. But previous analysis suggests New Jersey will need to pay out $10 billion annually in a few years representing one-third of the current budget.

New Jersey isn’t alone. The biggest structural threat to government budgets is the unrecognized risk in employee pension plans and the purely unfunded status of health care benefits. Mayor Michael Bloomberg, in his final speech as New York City’s Mayor, pointed to the “labor-electoral complex” which prevents employee benefit reform as the single greatest threat to the city’s financial health. In 12 years the cost of employee benefits has increased 500 percent from $1.5 billion to $8.2 billion. Those costs are certain to grow presenting the next generation with a massive debt that will siphon money away from city services.

Public employee pensions and debt are also crippling Puerto Rico which has dipped into cash reserves to repay a $400 million short-term loan. The Wall Street Journal reports that the government planned to sell bonds, but retreated since the island’s bond values have, “plunged in value,” due to investor fears over economic malaise and the territory’s existing large debt load which stands at $87 billion, or $23,000 per resident.

This should serve as a warning to other states that continue to finance budget growth with debt while understating employee benefit costs. Maryland’s Spending Affordability Committee is recommending a 4 percent budget increase and a hike in the state’s debt limit from $75 million to 1.16 billion in 2014. Early estimates by the legislative fiscal office anticipate structural deficits of $300 million over the next two years – a situation that has plagued Maryland for well over a decade. The fiscal office has advised against increased debt, noting that over the last five years, GO bonds have been, “used as a source of replacement funding for transfers of cash” from dedicated funds projects such as the Chesapeake Bay Restoration Fund.

 

Maryland’s “severe financial management issues”

Budgetary balance continues to evade Maryland. In FY 2015 the state anticipates a deficit of $400 million. A fact that is being blaming on entitlements, mandated spending, and fiscal mismanagement in the Developmental Disabilities Administration. The agency has been cited by the HHS Inspector General as over billing the Federal government by $20.6 billion for Medicaid expenses.

For over a decade the state has struggled with structural deficits, or,  spending exceeding revenues. The state’s method of controlling spending – the Spending Affordability Commission – has overseen 30 years of spending increases, and its Debt Affordability Commission has compounded the problem by increasing the state’s debt limits in order to expand spending.

For the details, visit my blog post for the Maryland Public Policy Institute. Of related interest is the Tax Foundation’s recent ranking of government spending the states. Maryland ranks 19, and has increased spending by 30.5% since 2011  2001.

New resource: Mercatus Center’s 2013 State and Local Policy Guide

Are you interested in the practical policy applications of the kinds of research the State and Local Policy Project is producing?

For an accessible and very useful review have a look at the inaugural edition of the Mercatus Center’s 2013 State and Local Policy Guide produced by our Outreach Team.

The guide is divided into six sections outlining how to control spending, fix broken pensions systems, control healthcare cost, streamline government, evaluate regulations, and develop competitive tax policies. Each section gives an overview of our research and makes brief, specific, and practical policy proposals.

If you have any questions, please contact Michael Leland, Associate Director of State Outreach, mleland@mercatus.gmu.edu

Lessons from North Carolina’s proposed budget

In today’s Room for Debate at The New York Times, I discuss what’s good and what is worrying about North Carolina’s proposed biennial budget.

The good: a doubling of the state’s Rainy Day Fund and end to the estate tax. But a big controversy surrounds the legislature this week. Lawmakers decided to cut unemployment benefits by one-third. This move disqualifies the state from receiving additional emergency unemployment insurance funds from the federal government, affecting 170,000 jobless in the state.

The issue points to the perennial calls for reform to the federal-state Unemployment Insurance (UI) program. North Carolina is one of many states that must pay the federal government back what it has borrowed to offer extended benefits to its residents, or face higher payroll taxes. Their choices are tough ones to make: raise the state payroll tax (or taxable wage base) and replenish the trust fund – which has its own effects on the economy and the workforce – or cut benefits. A better solution is to re-think our approach to social insurance, something economists, such as Harvard’s Martin Feldstein, have been highlighting the structural flaws of UI since the 1970s.

n.b. update: a reader rightly notes at the NYT – the states must pay back the money they’ve borrowed from the federal government to continue paying benefits. But they don’t have to pay back the temporary EUC program. 

The battle of the taxes

In my last post, I discussed several exciting tax reforms that are gaining support in a handful of states. In an effort to improve the competitiveness and economic growth of these states, the plans would lower or eliminate individual and corporate income taxes and replace these revenues with funds raised by streamlined sales taxes. Since I covered this topic, legislators in two more states, Missouri and New Mexico, have demonstrated interest in adopting this type of overhaul of their state tax systems.

At the same time, policymakers in other states across the country are likewise taking advantage of their majority status by pushing their preferred tax plans through state legislatures and state referendums. These plans provide a sharp contrast with those proposed by those states that I discussed in my last post; rather than prioritizing lowering income tax burdens, leaders in these states hope to improve their fiscal outlooks by increasing income taxes.

Here’s what some of these states have in the works:

  • Massachusetts: Gov. Deval L. Patrick surprised his constituents last month during his State of the State address by calling for a 1 percentage point increase in state income tax rates while simultaneously slashing state sales taxes from 6.25% to 4.5%. Patrick defended these tax changes on the grounds of increasing investments in transportation, infrastructure, and education while improving state competitiveness. Additionally, the governor called for a doubling of personal exemptions to soften the blow of the income tax increases on low-income residents.
  • Minnesota: Gov. Mark Dayton presented a grab bag of tax reform proposals when he revealed his two-year budget plan for the state of Minnesota two weeks ago. In an effort to move his state away from a reliance on property taxes to generate revenue, Dayton has proposed to raise income taxes on the top 2% of earners within the state. At the same time, he hopes to reduce property tax burdens, lower the state sales tax from 6.875% to 5.5%, and cut the corporate tax rate by 14%.
  • Maryland: Last May, Maryland Gov. Martin O’Malley called a special legislative session to balance their state budget to avoid scheduled cuts of $500 million in state spending on education and state personnel. Rather than accepting a “cuts-only” approach to balancing state finances, O’Malley strongly pushed for income tax hikes on Marylanders that earned more than $100,000 a year and created a new top rate of 5.75% on income over $250,000 a year. These tax hikes were signed into law after the session convened last year and took effect that June.
  • California: At the urging of Gov. Jerry Brown, California voters decided to raise income taxes on their wealthiest residents and increase their state sales tax from 7.25% to 7.5% by voting in favor of Proposition 30 last November. In a bid to put an end to years of deficit spending and finally balance the state budget, Brown went to bat for the creation of four new income tax brackets for high-income earners in California. There is some doubt that these measures will actually generate the revenues that the governor is anticipating due to an exodus of taxpayers fleeing the new 13.3% income tax and uncertain prospects for economic growth within the state. 

It is interesting that these governors have defended their proposals using some of the same rhetoric that governors and legislators in other states used to defend their plans to lower income tax rates. All of these policymakers believe that their proposals will increase competitiveness, improve economic growth, and create jobs for their states. Can both sides be right at the same time?

Economic intuition suggests that policymakers should create a tax system that imposes the lowest burdens on the engines of economic growth. It makes sense, then, for states to avoid taxing individual and corporate income so that these groups have more money to save and invest. Additionally  increasing marginal tax rates on income and investments limits the returns to these activities and causes people to work and invest less. Saving and investment, not consumption, are the drivers of economic growth. Empirical studies have demonstrated that raising marginal income tax rates have damaging effects on economic growth. Policymakers in Massachusetts, Minnesota, Maryland, and California may have erred in their decisions to shift taxation towards income and away from consumption. The economies of these states may see lower rates of growth as a result.

In my last post, I mused that the successes of states that have lowered or eliminated their state income taxes may prompt other states to adopt similar reforms. If the states that have taken the opposite approach by raising income taxes see slowed economic growth as a result, they will hopefully serve as a cautionary tale to other states that might be considering these proposals.

Virginia’s transportation plan under the microscope

Last week Virginia Governor Bob McDonnell shared his plan to address the state’s transportation needs. The big news is that the Governor wants to eliminate Virginia’s gas tax of 17.5 cents/gallon. This revenue would be replaced with an increase in the state’s sales tax from 5 percent to 5.8 percent. This along with a transfer of $812 million from the general fund, a $15 increase in the car registration fee, a $100 fee on alternative fuel vehicles and the promise of federal revenues should Congress pass legislation to tax online sales brings the total amount of revenue projected to fund Virginia’s transportation to $3.1 billion.

As the Tax Foundation points out, more than half of this relies on a transfer from the state’s general fund, and on Congressional legislation that has not yet passed.

Virginia plans to spend $4.9 billion on transportation. As currently structured, the gas tax only brings in $961 million. There are a few reasons why. First, Virginia hasn’t indexed the gas tax to inflation since 1986. It’s currently worth 40 cents on the dollar. In today’s dollars 17.5 cents is worth about 8 cents. Secondly, while there are more drivers in Virginia, cars are also more fuel efficient and more of those cars (91,000) are alternative fuel. In 2013, the gas tax isn’t bringing in the same amount of revenue as it once did.

But that doesn’t mean that switching from a user-based tax to a general tax isn’t problematic. Two concerns are transparency and fairness. Switching from (an imperfect) user-based fee to a broader tax breaks the link between those who use the roads and those who pay, shorting an important feedback mechanism. Another issue is fairness. Moving from a gas tax to a sales tax leads to cross-subsidization. Those who don’t drive pay for others’ road usage.

The proposal has received a fair amount of criticism with other approaches suggested. Randal O’Toole at Cato likes the idea of Vehicle Miles Travelled (VMT) which would track the number of miles driven via an EZ-Pass type technology billing the user directly for road usage. It would probably take at least a decade to fully implement. And, some have strong libertarian objections. Joseph Henchman at the Tax Foundation proposes a mix of indexing the gas tax to inflation, increased tolls, and levying a local transportation sales tax on NOVA drivers.

The plan opens up Virginia’s 2013 legislative session and is sure to receive a fair amount of discussion among legislators.