What are behind the “budget gaps” that states are using to justify tax increases? In a sense, the gaps are fictions created by previous budget forecasts that were far too optimistic — sort of like sales growth forecasts for telecom companies in the 1990s. Suppose that a year ago Governor Spendthrift planned for a 10‐percent rise in tax revenues and spending, but Governor Frugal planned for increases of just 5 percent. Suppose that actual revenue growth in both states turned out to be 5 percent. No problem for Frugal. But Spendthrift is said to have a 5‐percent “revenue shortfall.” He decides to hike taxes, and is heralded in the media for boldly solving the state fiscal “crisis.”
A better picture of state finances can be obtained by looking at actual revenues and spending, as estimated by the U.S. Department of Commerce. Data for the first two quarters of 2002 show that total state and local receipts rose about 2 percent from the same period in 2001. (Income taxes are down, but sales taxes, property taxes, and federal grants to states are up). This is slower than the swift revenue growth of the 1990s, but is it too much to ask governments to restrain budget growth to roughly the inflation rate during economic slowdowns?
State politicians are like car drivers who have a tough time slowing down to 40 mph on a local road after a long highway cruise at 60 mph. Total state and local spending rose 4.7 percent in the first two quarters of 2002 over the same period in 2001. That only seems slow to state officials who got used to spending growth of more than 7 percent annually during the late 1990s.
To avoid budget crunches during slowdowns, states should limit spending growth during booms, sort of like setting a lower highway speed limit. States can do this with a budget cap like Colorado’s, which provides automatic refunds when state revenues grow faster than inflation plus population growth. Such a cap prevents governments from starting too many new spending programs in good times, thus making it easier to balance their budgets during the next downturn.
The state “budget gap” story is also being stretched into a long‐term “structural gap” theory. The Wall Street Journal has reported that “states face emerging structural budget problems,” which supposedly will prevent them from raising enough tax money in the future. For example, some analysts worry that the sales tax base is being eroded by the rise in consumption of untaxed services. It is true that state sales tax bases now represent just 42 percent of state income, but many governments have themselves to blame for carving out large exemptions to the sales tax base, such as for food.
The new bogeyman is untaxed Internet transactions, which are supposed to be eating away at taxable retail sales. Yet Internet sales, still only 1.3 percent of all retail sales, are not increasing much, according to Department of Commerce data. All in all, state sales tax revenues rose at a similar pace as personal income during the past decade, so it is hard to see where the crisis is.
If there is a structural problem in state tax systems, it is that individual income taxes raise too much money in boom years, thus causing states to overspend. Most states have progressive tax systems that burden people with higher rates as incomes rise. Also, most states do not index their income taxes for inflation, as the federal government has done since the 1980s. As a result, families need a state income tax cut every few years just to keep equal with the tax man.
State budget numbers can certainly be interpreted in different ways. Recent news stories have implied that state officials are innocent victims of sinister “budget gaps.” However, I think a more accurate news report would read: “Huge budget forecasting errors cause massive overspending by the states.”