Rethinking the Rules

Tax and spending changes in recent years call into question the wisdom of prohibiting states from running deficits.
by | December 2002

Romano Prodi, the president of the European Commission, caused a flap recently when he said the European Union rule that a country couldn't run a deficit of more than 3 percent of its GDP was stupid. Since Prodi is charged with enforcing the rule, which is meant to support the stability of the Euro currency, his opinion matters.

In the United States, the federal government can run up as big a deficit as it likes, but states, of course, can't. Maybe, like our European cousins, we need to rethink the rules.

Our no-deficit prescription--enforced by state constitutions, statutes and the bond markets--has been dubbed the Golden Rule. Any borrowing beyond the current fiscal year is restricted to capital improvements. States are not supposed to plan for operating deficits or borrow to cover for them.

The logic is that the discipline keeps states from living beyond their means. Politicians cannot pile up operating debts to finance current consumption, which is then handed off to future generations to finance. Instead, when states start to incur deficits, they must reduce expenditures or increase revenues to plug the gap. Obviously, in good times such as those of the 1990s, the balanced-budget rule was easy to observe. The only issue then was whether to spend the extra money that was rolling in, give it back to taxpayers or set it aside for a rainy day.

But other changes have been going on that now call into question the viability of the Golden Rule. On the revenue side, the once-broad general sales tax is narrower and bringing in less money. Meanwhile, the personal income tax has grown in importance. Twenty years ago, about 75 cents in personal income taxes were collected for every $1 in sales tax. Now, that ratio is about $1.10 in personal income tax for every $1 of sales tax collected. The corporate income tax at the state level has rapidly diminished in importance. In 1980, about 58 cents were collected in corporate taxes for every $1 in individual income tax paid. That's now down to 15 cents. By being so tethered to income taxes, state revenues are on a boom-bust roller coaster.

On the expenditure side, states have seen their budgets skewed toward transfer payments geared to the special needs of the young and the old. The two foremost claimants are school aid and Medicaid. These represent more than half of all state general fund spending and are growing rapidly as school enrollments and medical costs have spiraled. Unlike the old days, when a lot of state spending was oriented toward financing transportation and public works, these human service outlays can't be postponed or easily reduced.

Facing at least a $50 billion deficit in FY 2003, what are states to do? It is clear that some sober thinking is needed. Here are some thoughts:

First, tax bases need to be broadened and tax volatility reduced. These are politically difficult, if not impossible, steps. But there is no doubt that the present structure of income taxes has accentuated wild swings in revenue.

To the extent that states cannot or will not stabilize their revenue regimes, there are two courses of action. One is simply to save more: Not just rainy day funds but enough to handle an occasional monsoon. Legislators find this repugnant for several reasons, including the thought of their successors being able to dip into the pot. But the riskier the revenue structure, the more that needs to be set aside.

Another strategy is to reconsider the Golden Rule. States with their unintended but de facto cyclically sensitive financial structures may need to do what the federal government does when it runs out of cash: borrow. A few states, such as Connecticut, already do that to cover an operating deficit, figuring that when revenues drop off sharply, they simply take time to make the budget cuts and build up revenues again.

Recent experience indicates that state revenues recover a year or two after the national economy heats up. As in the case of a rainy day fund, such cyclical borrowing needs to reflect discipline and be part of a program in order to be respected by the rating agencies and the financial markets. It should be noted that unlike consumers and businesses, states have lots of borrowing capacity. Twenty years ago, outstanding state general obligation debt equaled 21 percent of state general revenues. Today, it equals about 14 percent. So there is room to take on some debt.

A willingness to access the bond markets to finance orderly transitions over the economic cycle seems to be what is missing. This may be a bitter pill for those who became accustomed to cutting taxes while spending more. But, with changed responsibilities and altered fiscal systems, it may be time for states to think again.

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