Debtor's Dilemma

The core problem for states is not structural deficits. It's the polarizing disagreement over what to do about them.
May 2004
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Jobs, or a lack of them, are in the news. Last February's report from the U.S. Bureau of Labor Statistics showed that nationally non-farm employment was in the dumps. Had it not been for an increase of 21,000 jobs in state government, there would have been no growth at all. Then the March report showed a big bump back up--some 308,000 jobs, the largest gain since April 2000. A hunk of that new employment was due to construction and the resolution of the California grocery strike. Who knows what will happen next?

States have been grappling for three years with balancing budgets by fair means or foul. With few exceptions, they are fighting a losing battle as they encounter unyielding structural budget deficits. By a structural deficit, I mean that current tax sources even with full- employment growth in the economy are insufficient to pay the costs of existing programs.

The math is simple. Caseloads and costs for state-run programs grow over time, but revenues, even in the best of times, do not keep pace. When it comes to state spending, there is typically a tri-corner standoff, with health care, public education and transportation in a tug-of-war for 70 percent of the spending pie. With the elderly population and student enrollments growing, the cost of health services spiraling and traffic problems festering, more revenues are needed to meet legislated obligations.

California provides an arresting, if extreme, example. Grabbing the reins last fall in a dramatic recall election, Governor Arnold Schwarzenegger succeeded in getting voters to pass two propositions in March that clear the way for the state to sell up to $15 billion in bonds to fund the state's accumulated operating deficits and to take a constitutional vow never to amass such debits again. Meanwhile, the governor's budget, while using the bond issues to cover about half the deficit, contains cuts of $2 billion to local education and about $1 billion each for higher education, transportation and social services. Even at that, there remains a deficit of some $7 billion to be carried over to the next year. Since the option of a bond issue to fund deficits won't be around in the future, the cuts in succeeding budgets will need to be much more severe. Furthermore, the contemplated $15 billion in deficit funding bonds will likely cost $2 billion or so a year in debt service over the next 10 years. The state is going to pay for them by taking back part of the sales tax that would otherwise go to cities and shifting the property tax back to local governments-- away from the school districts--to make up the difference. The state would then pay assistance for school districts from the general fund. If this sounds complicated, it is. The "triple-flip" means that localities will have less money to pay for operations unless they raise taxes. As for the state, with no new taxes and no new deficit borrowing, future cuts will be seismic.

California may be worse than most, but it's not alone. Hands are being wrung about what to do about the states'"structural deficits." Scholars, policy wonks, and even politicians point out that states are trying to deliver on tax cuts and program commitments made unrealistically during the boom of the late 1990s. They point out that the failure to tax services while loading heavy sales taxes on goods has sapped growth and that holes blown in corporate and personal income tax bases have made them unreliable. Amid the lectures is the backdrop of the federal government's huge deficits, persistent tax- cutting and pending decline in its domestic spending, which will cascade future problems down to the states.

There are ironies in all this. Overall taxes (federal, state and local) as a percentage of personal income are at the lowest level since the 1950s, an era before the advent of the most expensive transfer programs. In another time, there might have been the argument that reductions in federal taxes cleared the playing field for states and localities to raise more funds.

Such words are no longer uttered. State structural deficits are not occasioning tax reform but rather delayed--and therefore deeper--cuts in spending. State government expenditures grew by 1 percent in fiscal 2003 and are budgeted to remain essentially unchanged in 2004.

The core problem, though, is not the deficits, but rather a polarizing disagreement over what to do about them. Advocates of minimalist government see the deficits as an unparalleled opportunity not only to cut spending today but to ensure it continues to be cut in the future. Their polar opposites argue that basic services are being scuttled with dire long-term economic and social consequences. Deeply divided over why taxes are needed in the first place, few are willing to review the basic question of how the tax system can be made better.