Living With Less

No amount of casino gambling, Sunday liquor sales or sky-high taxes on tobacco and booze will close state budget gaps.
July 2003
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.

Reacting to a chorus of wails, the U.S. Congress, as part of the recently passed $350 billion (and counting) federal tax cut, is about to dole out some $20 billion in aid to states. This charity helps offset the relentless rise in state Medicaid spending and flagging general revenues.

Cash from any source is most appreciated, but the sum represents a Band-Aid applied to the hemorrhaging deficits, recently estimated at something like $85 billion for fiscal 2004. While California, New York and Illinois are impecunious standouts, most states are also in a very bad way and will likely remain so for a long time. Costs are growing, but revenues are essentially flat. The curtailing of state spending (and resulting lost incomes and jobs) represents a large question mark in Washington's efforts to revive the economy. To the degree the economy does recover over the next year or so, it will be dragging an anchor of reduced state spending and higher state taxes.

Are states in a perpetual bind, otherwise dubbed a structural deficit, where current revenue structures and existing tax rates just don't meet the growing costs of existing programs? It sure looks like it.

The states have painted themselves into fiscal corners with narrow and highly sensitive tax systems. No amount of Sunday liquor sales, casino gambling or sky-high sumptuary taxes on tobacco and booze (the latter two together account for 1.5 percent of state and local tax revenues) is going to close the budget gaps. After two years of nimbly dodging the bullet, states are seriously cutting spending--shrinking health care coverage, reducing and delaying school aid, and laying off state employees. As in the fiscal binds of the early 1990s, other remedies are being brought off the shelves. Privatization schemes-- often devices to accommodate borrowing--are again in vogue. Missing so far is consideration of how states are to live with their volatile fiscal systems.

Meanwhile, state spending is pounded by economic cycles and rapidly changing demographics. The rocket in everybody's budget is Medicaid, the costs of which are spiraling upward at four times the rate of growth in other costs. States are battling on every front to reduce the program's costs, from cutting back on benefits to seeking controls on the prices of drugs. But these are merely battles on the frontier. The real war--rationing medical assistance among those claiming Medicaid benefits--remains to be fought. In addition, third-party insurance and transfer payment schemes require rationing and regulation.

The unhappy but unavoidable fact is that, in a market-based economy, most health care consumption will be by those who can afford to pay for it. Americans appear resolutely opposed to the kind of discipline and costs required to have a health care system that would provide first-rate care regardless of one's economic circumstances.

There are other costly conundrums: public education with its rigorous standards and national testing; massive prison systems with 1 million inmates. Ambitious programs that appeared affordable a few years ago no longer are. The boom's easy money is gone, and the public will no longer abide the tax systems required to generate the needed revenues. Existing revenue systems that did a pretty fair job of getting of us this far are now too eroded and unreliable.

One need not look too hard to find the erosions. The corporate income tax, a victim of interstate (and international) competition and of being tied into the federal tax, is no longer a major contributor. (In 2002, the dollar amount of state corporate income tax collections was about the same as in 1994, while personal income tax collections had grown by $70 billion.) The sales tax, plagued by little growth and the shrinkage of its base, now operates at high tax rates, while missing great chunks of economic activity. State personal income taxes have become more volatile, while stitching them into the federal definitions to ease compliance has made them vulnerable to federal tax cutting. Many state inheritance taxes are biting the dust as the federal estate tax itself vanishes and the state tax credit terminates in a couple of years.

So, what's the prescription for states? Return to broad-based taxes that feature low rates. In the process, rescind exemptions and exclusions, and diversify among the available revenue sources. Redefining and lowering the social safety nets will make the hard spending choices that are consistent with a public attitude that is comfortable with large inequalities in wealth and outcomes. (Leaving no child behind will be easier if the race is shorter and slower.) Be prepared to deficit spend when necessary and to save more during good times when they return. When possible, adopt new taxes used by major competitors but at lower rates. Above all, be a fiscal conservative and take a longer view that husbands existing tax bases. They are, after all, endangered species.