Commentary

Proposals for Economic Growth and Job Creation

Mr. Chairman and members of the committee, thank you for inviting me to testify today on economic growth proposals, in particular on proposals for a federal bailout of the states.

Across the nation, substantial budget gaps are forcing state governments to make tough fiscal policy choices. Budget gaps are estimated to be as much as $50 billion for the states as a whole. In the short-term, states should close budget gaps by cutting spending. In the long-term, states should reform their budgets and shift to less volatile tax bases to avoid a fiscal crunch during the next slowdown.

A federal bailout of the states makes no sense for either the federal or state governments. The federal government has a roughly $300 billion deficit and cannot afford further spending increases. Any federal spending increase ultimately falls on federal taxpayers - the same taxpayers who pay the bills at the state level. Thus, increased federal aid to the states simply moves money from one pocket to another with no net economic effect.

For the states, a federal bailout also does not make sense. Current state budget woes are not the result of revenue shortfalls, but of spending excesses built up during the 1990s. The solution for states should fit the problem: State spending should be frozen or cut. A federal bailout would simply delay the tough spending adjustments that are needed in the states. Like all subsidy programs, a federal bailout now would probably lead to another bailout down the road because it would create a bad precedent and allow states to avoid needed budget restructuring.

Recent Fiscal Trends

Despite the word “crisis” being thrown around by state officials, aggregate data for the 50 states do not reveal a crisis. There has simply been a spending slowdown from prior rapid growth rates. The problem is akin to a motorist having to slow down when he exits the freeway onto a slower road.

Today’s state budget gaps appeared after general fund spending growth of 7.0 percent in FY1999, 6.6 percent in FY2000, and 8.0 percent in FY2001. Even as economic growth slowed and budget gaps appeared, state spending still increased in FY2002, and is expected to increase slightly in FY2003. States need to reverse some of these increases and pare back programs to a manageable size.

Looking at the tax side of state budgets, total state tax collections grew 7.1 percent in FY1998, 5.2 percent in FY1999, 8.0 percent in FY2000, and 3.7 percent in FY2001. For the first three quarters of 2002, total state and local receipts rose 3.4 percent. While income tax receipts have fallen, sales tax receipts have risen. Once the economy returns to robust growth, revenues can be expected to grow quickly once again.

Some pundits are blaming state tax cuts in the 1990s for current state budget troubles. Net state tax cuts in the late 1990s (FY1995 to FY2001) totaled $33 billion. But those cuts were not enough to return to taxpayers the $36 billion in net state tax increases that occurred during the early 1990s (FY1990 to FY1994). And note that during the tax-cutting years, state tax revenues grew a total of $186 billion despite the cuts.

Note also that federal grants-in-aid to states have soared. Federal grants to state and local governments increased from $285 billion in FY2000 to a proposed $399 billion in FY2004 under the new Bush budget.

I would ask the committee to take a skeptical view of the supposed state budget “crisis.” Budget gaps are nearly always called revenue “shortfalls,” yet are better described as “spending excesses.” Consider that the budget gaps are partly fictions created by prior budget forecasts that were far too optimistic-sort of like sales growth forecasts for telecom companies in the 1990s. Suppose that a fictitious Governor Spendthrift had planned for a 6 percent rise in her state budget, but Governor Frugal planned for an increase of 3 percent. Then suppose that actual revenue growth in both states turned out to be 3 percent. That would be no problem for Frugal. But Spendthrift would describe her situation as a 3 percent “shortfall.” Yet Spendthrift’s actual problem is a “spending excess” caused by an overly optimistic budget plan.

State Taxes and Spending During the 1990s

It is revealing to examine long-term state budget trends since 1990. Inflation averaged just 2.8 percent annually from FY1990 to FY2001, yet state general fund spending grew at an average annual rate of 5.7 percent. On the tax side, I have completed an analysis showing that state tax revenues grew substantially faster during the 1990s than a benchmark of inflation plus population growth. If state budgets had grown at this benchmark rate since FY1990, state budgets would have been $93 billion smaller than they are today - roughly twice the size of today’s budget gaps.

One problem is that during economic expansions, tax revenues tend to grow excessively quickly. Income taxes are generally progressive, thus taxpayers pay higher average rates when their earnings rise. Also, most states do not index tax brackets for inflation as the federal government does, thus subjecting state taxpayers to bracket creep. State budget growth has also been fueled by rapid growth in capital gains taxes. The easy money of the late 1990s encouraged legislators to spend with less restraint. Thus one solution is to limit spending growth during the booms by rebating excess revenues to taxpayers so that budgets are not overly expanded.

California

California is probably in the poorest fiscal shape of any state. The current budget gap is estimated to be $35 billion. The budget gap was caused by a remarkable run-up in state spending in the late 1990s. Indeed, spending doubled between FY1994 and FY2001 from $39 billion to $78 billion. State spending jumped 15 percent in FY2000 and then another 17 percent in FY2001.

California state employment has expanded rapidly as well. Employment, measured in full-time equivalents, jumped from 296,000 in FY2000, to 311,000 in FY2001, and to 326,000 in FY2002, even as a large budget gap was opening.

While general fund spending jumped almost $12 billion in FY2001, spending was only reduced by just over $1 billion in FY2002. Yet, as in other states, news headlines make such modest fiscal restraint sound draconian. A recent Los Angeles Times story declared “Wrenching Changes Likely With Budget Cuts,” but the “wrenching” changes listed included such items as the first university fee increase since 1994, small increases in admission charges for state parks, deferral of some transportation projects, and a modest tightening in eligibility for the state’s low-income health program. Those are hardly wrenching changes in a sprawling state government.

The boom-bust budget cycle in California and other states can be tamed by moving away from volatile income and capital gains taxes, which fueled much of the excess spending in the late 1990s. In FY2003, tax revenue from capital gains and stock options in California dropped to $5 billion after reaching a high of $17 billion in FY2000. Such taxes on capital are not only bad for high-tech economic growth, they leave state governments more vulnerable in downturns.

Federal Bailout Makes No Fiscal Sense

A federal bailout would encourage states to continue overspending, which is the problem that got them into the current fiscal problems. Ultimately, states will have to live within their means, so there seems little point in postponing necessary restructuring on the spending side of state budgets.

A federal bailout would either increase federal taxes or increase the federal deficit. The federal deficit is already roughly $300 billion, so it makes no sense to simply trade a larger federal deficit problem for a smaller state deficit problem. Ultimately, federal taxpayers pay for all increases in federal spending. Yet the taxpayers who pay the federal bills are the same ones who live in the 50 states and pay state taxes. Why try to fool taxpayers about the cost of state programs by making them pay more in federal taxes?

One effect of a bailout would be to reward fiscally irresponsible states with tax money from citizens in fiscally responsible states who have no need for a bailout. Taxpayers in states that have balanced budgets and have restrained spending would effectively transfer their hard earned dollars to the fiscally irresponsible governments of California and other states.

Budget Solutions for the States

Pursue Economic Growth Policies. The surest way to help states return to fiscal health would be to support policies that will spur the nation’s economy to a higher economic growth path. States should get behind President Bush’s tax cut and other pro-growth tax reforms to restore growth to all the states.

Cut Spending. States should turn current budget problems into opportunities to weed out excessive and wasteful spending added during the boom years. For example, in Virginia, Governor Warner is using the current budget gap as an opportunity to cut waste, such as reforming the state’s Department of Motor Vehicles. Former Virginia Governor Wilder has identified hundreds of millions of dollars of possible savings in the state budget. Also, states should consider cutting funding to local governments because many cities and counties have seen substantial increases in revenues as property assessments in many areas have soared even as the economy has faltered.

Limit Budgets During Booms. States should start planning now to avoid the next boom-bust cycle. To avoid budget gaps during economic slowdowns, states should limit spending growth during booms with a mandatory budget cap that provides automatic taxpayer rebates when revenues grow faster than a benchmark, such as inflation plus population growth. Then, if revenue stagnates during a downturn, annual tax rebates could be temporarily suspended. That action, along with use of rainy day funds and spending cuts, should be sufficient to balance state budgets without federal bailouts or tax rate increases.

Shift State Tax Bases Away from Volatile Capital Gains and Income Taxes. Reductions in capital gains tax revenues have played a role in the fiscal troubles of California, Virginia, and other states. Capital gains, corporate profits, and income are more volatile tax bases than consumption. I recommend that states move away from taxing capital gains and corporate profits, in particular, and toward consumption taxes to stabilize their revenues. Capital gains and corporate profits taxes are not only volatile, they are perhaps the most economically damaging taxes.

In conclusion, I do not think that the federal government should provide a special bailout for state governments. State budget problems are not as serious as many newspaper headlines suggest. Overall state spending has not fallen, and revenues will recover when the economy resumes a stronger growth. Besides, the supposed economic stimulus effect of further federal or state government spending is a mirage. Added government spending simply shifts money from some citizens’ pockets to others, without adding anything to the productive or supply side of the economy.

Thank you for holding these important hearings, and I look forward to working with the committee on these issues.

The following testimony by Chris Edwards, director of fiscal policy at the Cato Institute, was given before the Senate Finance Committee on Tuesday, Feb. 11, 2003.