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State Fiscal Conditions STEVEN D. GOLD The fiscal condition of state governments is a critical factor in determining how much aid states can provide to local governments. State fiscal conditions have been volatile over the past decade. The finances of most states were generally healthy in the late 1970s, but they deteriorated significantly in the early 1980s; they began to recover in 1983. Although most states are still considerably better off than they were in the depths of the recessions of the early 1980s, their fiscal conditions are generally not as strong as in the late 1970s, in part because of the legacy of the tax revolt, which in a number of states limits the reserves they are able to maintain. This report consists of four parts: (1) a discussion of various measures of state fiscal conditions; (2) descriptions of state fiscal conditions in recent years and the fluctuations that have occurred in state tax levels; (3) an analysis of state aid to local governments; and (4) the conclusion of the report, a discussion of future prospects for state fiscal conditions and local aid policies. The views expressed in this paper are solely those of the author and do not reflect the official position of the National Conference of State Legislatures, for which he serves as director of fiscal studies. 284

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STATE FISCAL CONDITIONS MEASURES OF STATE: FISCAL CONDITIONS 285 The two most widely cited measures of state fiscal conditions are the surpluses (or deficits) of state and local governments as esti- mated by the U.S. Department of Commerce's national income and product accounts and the year-end general fund balances for state governments as reported annually by the National Conference of State Legislatures (see, e.g., Gold et al., 1985) and the National Gov- ernors' Association/National Association of State Budget Officers (1986~. A third measure is the financial assets held by states. The Commerce Department's national income and product ac- counts (NIPA) estimate the operating surplus or deficit of state and local governments, usually on a combined basis but intermittently on a separated basis. Because this report is concerned with state finances, we will consider only the surplus or deficit statistics for state governments alone. The NIPA estimates cover all state govern- ment activities, including those of independent or quasi-independent institutions established by states. The estimates aggregate all state balances into a single number; they represent flows during a specific period of time, and they do not consider funds raised by borrow- ing as revenue, although they count expenditures financed by the borrowing. NIPA data are reported both to include and to exclude social insurance funds. Although these funds always have a large surplus because money is being accumulated to provide future pension ben- efits, they are not available to fund current services. Thus, while it is appropriate to include social insurance funds in macroeconomic analyses, they should not be considered when measuring short-run state fiscal conditions. This distinction is important because the sur- plus in the social insurance funds invariably dwarfs the remaining surplus. In 1985, for example, the total NIPA surplus for state and local governments was $59 billion, of which the social insurance funds surplus accounted for $52.9 billion (Levin and Peters, 1986~. The general fund is the account into which most state tax rev- enue is deposited and from which most current spending is financed. Each state defines its general fund in its own way, and accounting practices also differ substantially from state to state, so comparisons of general fund statistics among states must be made with care. As a general rule, the general fund does not include most revenue from charges and fees, nor do most states include federal aid in the gen- eral fund. Most states earmark certain taxes to go to special funds outside the general fund for example, for highway construction and

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286 Steven D. Gold maintenance. Despite the complications arising from the diversity of state fund structures, the general fund is the best indicator of state fiscal activity that is, if balances in budget stabilization funds are added to a state's general fund and if the spending, tax, and accounting practices that influence it are taken into account (Na- tional Governors' Association/National Association of State Budget Officers, 1978~. There are three important differences between state general fund balances and NIPA surplus/deficit estimates: 1. As explained earlier, the general fund is much less inclusive, excluding many autonomous state bodies, most if not all user charges, federal aid, and earmarked revenue. 2. Unlike NTPA estimates, state surveys of general fund balances make it possible to disaggregate national trends and to determine if a few large states are having a major impact on aggregate totals. 3. The balance in the state general fund is a stock of money, not a flow, and it includes any surpluses or deficits carried over from the previous fiscal period. A recent study by the National Conference of State Legislatures concluded that the general fund balance is a better indicator of state fiscal conditions than the NIPA surplus figure (Gold, 1986b). One important advantage is the disaggregation by state, which shows whether a small number of states may be distorting the national situation. A second advantage of using the general fund balance is that it avoids NIPA's treatment of capital finance; the NIPA measure distorts the state fiscal position by giving a bias toward deficit when debt-financed capital projects are expanding and a bias toward sur- plus when the financing for such projects is being retired. Third, the general fund is a better measure of available funds than NIPA, which includes statutorily and constitutionally earmarked funds. Indeed, NIPA's alI-inclusiveness is a disadvantage in periods such as the late 1970s and early 1980s, when oil prices rose sharply. During these periods, huge increases occurred in the permanent funds of a small number of energy states. These increases added significantly to the surpluses in these states, but they created a false picture of robust fiscal health because the revenue in such funds generally cannot be tapped without a constitutional change. An important issue in assessing the value of the. general fund surplus as an indicator of fiscal health is the extent to which states transfer money between it and other funds. If such transfers are

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STATE FISCAL CONDITIONS 287 large and are frequently made whenever the general fund is short of funds, it would be seriously misleading to ignore accounts outside the general fund. This is not the case, however. Some outside accounts were tapped during the period of state fiscal stress in 1982-1983, but such transfers are usually not significant from a national perspective. Overall, general fund balances fluctuate much more than balances in most other accounts. Although state special funds may have larger total balances than the general fund, they do not have to be considered if the balances are relatively stable (Gold, 1986b). An important qualification to this statement, however, concerns budget stabilization or "rainy day" funds. More than half of the states have established such funds, most within the past 5 years. Their function is to receive revenues during periods of relative fiscal ease so that budget adjustments during fiscal crises will not have to be as large. Because these stabilization funds are expected to augment the general fund when revenue receipts lag, the division of balances between a state's general fund and its rainy day fund is largely arbitrary, and it is appropriate to consider rainy day funds along with general fund balances in assessing state resources. Projections of general fund balances have often proved inac- curate: they tend to be too optimistic when the economy is in a recession and too pessimistic when economic trends are positive. A small error in forecasting revenues can lead to a large error in the projected year-end balance. Suppose, for example, that a state has projected a 4 percent year-end balance and $10 billion in revenues for the year. If revenues were just 5 percent below the level forecasted, which is not a particularly large forecasting error, the state would have a 1 percent budget deficit, which would probably be dealt with by reducing expenditures below the level originally appropriated. To avoid such a problem, it is prudent for states to maintain relatively large balances. A widely used benchmark is that the year-end bal- ance of both the general fund and the rainy day fund should be at least 5 percent of general fund expenditures. This standard is cited frequently by Wall Street analysts who evaluate the creditworthi- ness of states. Some states traditionally have maintained smaller balances, but this method usually requires accounting practices that enable them to tap other resources when revenue shortfalls occur. A third indicator of a state's fiscal condition is the financial assets held by the state, as reported by the Bureau of the Census in its series of annual reports on state governments. This measure is available for individual states, but for any particular state it suffers

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288 Seeders D. Gold from the same problem as NIPA data a high degree of aggregation. All state assets that are not in social insurance or bond funds are added together; consequently, a large proportion of this total may be the assets held by independent or quasi-independent organizations such as housing finance agencies and universities (Gold, 1986b). Although many past analyses have concentrated on a single figure the NIPA surplus or the general fund balance as a proportion of expenditures as an indicator of fiscal conditions, this approach is incomplete. It is necessary to consider as well the spending, tax, and accounting practices that were in effect in a state. If a state has a relatively large surplus only because it reduced spending and raised taxes, for example, that is quite a different matter from a surplus that occurs in the face of higher spending and reduced taxes. Most states adopt fiscal and accounting practices that understate the true degree of fluctuation in balances. In order to avoid a deficit, which is not permitted in most states by constitutional provision or statute, states may defer certain expenditures (e.g., aid to school districts) and accelerate revenues. This action was taken by many states during the 1982-1983 period of severe fiscal stress. Some of these actions were then reversed when fiscal conditions improved. Although changes in accounting practices affect how fiscal conditions appear from year to year, they have not biased trends systematically over time and consequently are not discussed in the next section of this report. STATE FISCAL CONDITIONS IN RECENT YEARS State fiscal conditions have been volatile over the last 10 years- very good in the late 1970s, very poor in the early 1980s, then improved in the mid-1980s but not as good as they were in the 1970s. Economic trends and changing tax policies are of primary im- portance in explaining these trends. Spending policies have followed rather than led the deterioration and improvements in fiscal condi- tions. Cutbacks in federal aid have been a negative factor affecting the fiscal condition of the states. Table 1 shows total general fund balances annually from fiscal years 1978-1985, as reported by the the National Governors' Associa- tion/National Association of State Budget Officers (NGA/NASBO). The balances peaked in fiscal year 1980 at $11.8 billion, representing 9 percent of expenditures. They then declined steadily until 1983, when they were only $2 billion or 1.3 percent of spending. In the next

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STATE FISCAL CONDITIONS TABLE 1 States' General Fund Year-End Balances (in billions of dollars), Fiscal Years 1978-1985 Year-End Percentage of Year Balance Expenditures 1985 8.0 4.3 1984 5.6 3.3 1983 2.0 1.3 1982 4.5 2.9 1981 6.5 4.4 1980 .11.8 9.0 1979 11.2 8.7 1978 8.9 8.6 NOTE: Fiscal years in 46 states conclude on June 30. SOURCE: National Governors' Association/National Association of State Budget Officers (1986:173. 289 2 fiscal years, general fund balances rebounded, reaching $8 billion in 1985. National figures on budget stabilization~funds are available only for 1984 and 1985 when the funds stood at $0.8 billion and $1.7 billion, respectively (National Governors' Association/National As- sociation of State Budget Officers, 19863.: Adding the stabilization funds makes the total balances in 1984 and 1985 $6.4 billion and $9.7 billion, respectively, or 3.8 percent and 5.3 percent of general fund expenditures. The improvement in state fiscal conditions that had been occurring since their Tow point in 1983 ended in fiscal year 1986. According to NGA/NASBO's survey, states ended that year with balances of $6.5 billion, of which $1.5 billion was in stabilization funds. This figure represented about 3.2 percent of expenditures. NIPA figures show a similar pattern during the 1980s, as Table 2 indicates. (Note that these figures are for calendar rather than iThe National Governors' Association/National Association of State Bud- get Officers reports smaller stabilization funds than the National Conference of State Legislatures because it does not include the balances in some states in which the entire year-end balance is included as part of the stabilization fund. This difference of treatment affects the division between the general fund and stabilization fund but not the total reported balance (Gold et al., 1985~. In earlier years, balances in stabilization funds were considerably lower, especially at the end of 1983.

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290 Stever' D. Gold TABLE 2 State and Local Surplus or Deficit (in billions of dollars) in National Income and Product Accounts, Calendar Years 1970-1984 Calendar Year Local States Governments 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 1971 1970 11.5 -0.9 -7.4 1.2 0.0 1.6 4.5 3.0 -1.4 -5.8 -3.9 0.6 3.4 -4.3 -4.4 6.4 5.7 3.0 -0.2 2.2 4.1 6.0 1.0 -2.9 0.2 3.2 1.4 -0.8 -0.7 SOURCE: Levin and Peters (1986). fiscal years.) After a $4.5 billion surplus in 1978, states' finances deteriorated significantly, plunging to a $7.4 billion deficit in 1982. A small deficit also occurred the next year, but the surplus soared to $11.5 billion in 1984. Separate surplus figures for state and local governments are not available yet for 1985, but the combined surplus fell from $15.9 billion to $6.1 billion, with the states presumably being responsible for most of this decrease (Levin and Peters, 1986~. Table 2 also shows the local surplus for comparison purposes. It has not been as unstable as the state surplus, nor was it as low in the 1981-1983 period. A major value of general fund data is that they are available for all states, thus permitting comparisons of state fiscal conditions. Table 3 shows balances (including rainy day funds) for fiscal years 1985, 1986, and 1987 (projected). The differences among the states were even greater in 1983, when 8 states ended the fiscal year with deficits and 15 others had balances equal to 1 percent or less of spending while 9 states had balances equal to 5 percent or more of spending (Gold and Benker, 1983~. One of the ironies of the present situation is the reversal of fortunes that has taken place in state fiscal conditions. Currently, the most fiscally stressed states are those rich

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STATE FISCAL CONDITIONS 291 in natural resources and the farm states, which were among the leaststressed when oil and grain prices were high in the 1970s; some of the northeastern states that were depressed in the mid-1970s are now relatively well off. Three major factors account for these fluctuations in fiscal con- ditions: (1) the economy, (2) changes in state tax policy, and (3) cutbacks in federal aid. Econonuc mends The American economy, which is the most important determi- nant of state fiscal conditions, underwent two recessions in the early 1980s in 1980 and 1981-1982. The first recession was intense but brief, and the second was the most severe in 40 years. Their impact is clearly visible in Tables 1 and 2: they caused massive revenue shortfalls that plunged many states close to deficit situations. The impact of the recessions on the states was particularly severe because many had based their fiscal year 1983 budgets on predictions that the recession would end by the summer of 1982 (Gold, 1983~. The economic recovery that began in December 1982 did not become apparent to state budgeters until mid-1983 because of the lags that exist between economic developments and state tax collections. The nation's improved economy was one of the two main reasons for the enhanced fiscal condition of the states in the mid-1980s. Tax Policies Tax policy was another important influence on state fiscal con- ditions. Although California's Proposition 13 dealt with local rather than state taxes, the tax revolt it dramatized encouraged many states to cut their state taxes. Thirty-two states reduced their per- sonal income or general sales taxes in 1978, 1979, or 1980. Some of these reductions were temporary, but many were permanent. They resulted in an immediate reduction in tax collections, which kept bal- ances below the level they would have otherwise achieved and also in many cases reduced the productivity of the tax system in future years (Gold, 1983~. The tax revolt not only resulted in tax reductions; it also inhib- ited the enactment of tax rate increases for a number of years. Only two states raised income or sales taxes in the 1978-1980 period, and there were no personal income tax increases and only five sales tax

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294 Steven D. Gold increases in 1981. This legacy of the tax revolt began to weaken in 1982, however. In John Shannon's colorful terminology, tax increases in the post-Proposition 13 environment were acts of fiscal desperation that occurred only when there was already "blood on the floor." Nine states raised their income or sales taxes in 1982, five of them in the last 2 months of the year. Looking back, this pattern was a precursor of the greatest explosion of state tax increases ever: in 1983, tax increases enacted by the states totaled $8.25 billion. (In a few earlier years particularly 1967, 1969, and 1971tax increases were a larger percentage of total state tax revenue, but in absolute terms tax increases were never as great.) Thirty-eight states raised at least 1 tax, and there were 16 personal income tax and 11 general sales tax raises. There were no significant tax cuts. These tax increases contributed substantially to the improvement in state fiscal conditions in fiscal years 1984 and 1985 (Gold, 1984~. By 1984, however, the tax increases were beginning to be re- versed. Many of them had originally been temporary, and contrary to the cynical attitude that temporary taxes are seldom lifted, most of them did expire, especially the increases in personal income taxes. In addition, as general fund balances grew, many states rolled back "permanent" increases enacted in 1982 and 1983. The great major- ity of sales tax increases remained in effect, but three-quarters of the states that increased their personal income taxes in 1982 and 1983 either eliminated or partially rolled back those increases by the end of 1985. These reductions contributed to the decrease in the NIPA surplus in 1985 and the drop in general fund balances in fiscal year 1986. Although numerous, most of these tax cuts were moderate in size. As a result, the net first-year reduction in tax revenue resulting from tax cuts legislated in 1985 was considerably less than 1 percent of total state tax revenue. When fully phased in, the tax cuts will represent less than 2 percent of total tax revenue (Gold, 1986a). Tables 4 en cl 5 summarize recent tax policy and provide some long-term perspective. Table 4 shows the magnitude of state tax increases and decreases legislated each year since 1963. The decrease in 1985 was only the third] over this 23-year period. One reason for the preponderance of net increases is that at least a few states every year raise their excise taxes on such products as gasoline and cigarettes. Yet these statistics about legislative actions tell only part of the story. Most of the increase in state tax revenue occurs as the result of economic growth and inflation, which together tend to push up

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STATE FISCAL CONDITIONS 297 the states that boosted their sales taxes to support education in this decade. What do these statistics (along with the history they encapsu- late) suggest about the ability of state governments to raise taxes from their present level? As a proportion of personal income, state taxes are about 5 percent below their peak level of 1978. Recent experience suggests that it is politically feasible to boost taxes when a strong case can be made for the necessity of such actionbecause of either financial difficulties (provided that a period of "belt tight- ening" has occurred before the tax increase) or the need to improve elementary and secondary schools. If a strong political case is estab- lished, taxes can be raised. In most states there is room to increase taxes without raising them to a higher proportion of personal income than they were previously. On the other hand, recent history also suggests that it is not easy to raise taxes for one reason (for example, a short-term fiscal problem) and then to maintain the new rate once the original reason is no longer valid (as may have often occurred in the past). As discussed in the final section of this report, the legacy of the tax revolt and interstate tax competition both constrain the ability of states to raise taxes. The situation appears different if local taxes are also considered. Local taxes are more than 20 percent below their highest level (in 1972) as a proportion of personal income. Combined state and local taxes are about 11 percent below their 1973 peak. Of course, it would not be easy to boost local taxes significantly, but that is one possible avenue for expanding state and local resources. This discussion has focused on tax revenue because taxes are the most visible and important source of revenue. Part of the reason taxes have risen so little, particularly at the local level, is the in- creased reliance of governments on nontax revenue. In 1984, charges and miscellaneous revenue per $100 of personal income were $4.59 per $100 of personal income for state and local governments, a major increase from $3.19 in 1973 (the peak year for taxes). Total own- source state and local revenue in 1984 was slightly above its previous peak of 1978; tax revenue, on the other hand, wan 10 percent lower. The increase in nontax revenue has been much greater for miscelIa- neous revenue (e.g., interest received) than for charges, and it has been considerably larger at the local than at the state level.2 An 2 Between 1978-1984, local general revenues rose 65.9 percent, with major components rising as follows: federal aid, 7.8 percent; state aid, 64 percent; taxes, 53.5 percent; charges, 104.7 percent; and miscellaneous revenue, 224.1

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298 Steuer~ D. Gold important part of this rise in nontax revenue, which did not sup- port core services, was for nontraditional activities such as mortgage subsidy programs. Federal Aid The third outside influence on state fiscal conditions, in addi- tion to the economy and the tax revolt, has been federal aid policy. Federal aid is commonly divided into two parts: grants for payments to individuals (e.g., as Aid to Families with Dependent Children tAFDC]) and all other grants. The first category has grown con- siderably over time, relative to the second category. In fiscal year 1986, for example, grants for payments to individuals were 46 per- cent of total fecleral aid, a significant increase from their 35 percent share in fiscal year 1980. This shifting composition of federal aid implies that aid to state and local governments that is not simply passed through to individuals has decreased much more than total aid has decreased. According to one estimate, federal aid to state and local governments, excluding grants for payments to individuals, was stashed 23.5 percent between 1980 and 1985 (Rymarowicz and Zimmerman, 1986~. Federal aid cutbacks have affected local govern- ments more than states, although the difference is hard to measure precisely. According to NIPA, between 1980 and 1984 federal aid to states rose 15 percent in nominal dollars whereas federal aid to local governments dropped 20 percent. These figures are somewhat misreading, however, because grants for payments to individuals are received primarily by states. Census Bureau statistics, summarized in Table 6, provide ad- ditional detail about the changing shape of federal aid to states. Federal aid for public welfare jumped from 39.9 percent of the total in fiscal year 1980 to 46.5 percent in 1984. The major reason for this increase was rapidly increasing Medicaid costs, which are included in the welfare category. Aid for health and hospital programs also rose at an above-average rate, but aid for education and highways trailed behind. Federal aid outside of these four major categories de- creased slightly, primarily because general revenue sharing for states was eliminated during this periocI. (Note that these statistics are for percent. For states, the corresponding percentages were: total, 74.9 percent; federal aid, 51.7 percent; taxes, 73.8 percent; charges, 89;9 percent; and miscellaneous revenue, 203.3 percent (Bureau of the Census, 1980, 1985a).

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STATE FISCAL CONDITIONS TABLE 6 Federal Aid to States, Fiscal Years 1980 and 1984 Percentage of Total Grants Percentage Change' Category 1980 1984 1980-1984 Public welfare 39.9 46.5 43.5 Education 20.6 18.4 9.5 Highways 14.3 13.6 17.2 Health and hospitals 3.7 4.3 40.5 All other 21.5 17.2 -1.4 Total 100.0 100.0 23.0 SOURCE: Bureau of the Census (19131, 1985b). 299 state fiscal years; because the NIPA data in the previous paragraph are for calendar years, the total change in aid differs between the two sources.) State expenditure policy has been relatively restrained. For the 6-year period 1979-1984, there were only 2 years when real genera] fund spending increased by more than 1.5 percent (Table 7~. In 3 years there were decreases in real expenditures. Much spending was deferred during those years, and a significant amount of "catch up" spending occurred as state fiscal conditions improved. General fund spending jumped sharply in fiscal years 1985 and 1986 for this reason. STATE AID TO FOCAL GOVE:RNM1:NTS Aid to local governments is the largest component of state bud- gets. The Bureau of the Census reports that, in fiscal year 1984, states provided $106.7 billion of aid to focal governments, accounting for more than one-third of total state general spending (see Table 10~. This statistic, however, is misleading. On the one hand, it counts federal aid that merely passes through states on its way to local governments (e.g., financing for AFDC in states in which such aid is partially a local function). On the other hand, it gives no credit for some very significant increases in assistance provided by states to local governments over the past quarter-century. The most important distortion arises from the fact that when a state assumes complete responsibility for a particular program, that program ceases to be a local responsibility; hence, the money spent by the state does not count as local aid. Consider, for example, two states: one of the states fully funds its $1 billion Medicaid program;

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300 Steven D. Gold the other finances three-quarters of Medicaid and requires counties to finance the other 25 percent. The first state is credited with no local aid for Medicaid; the second state will normally be considered to provide $750 million of aid in this area. This phenomenon is most important for Medicaid and AFDC, two programs with large expenditures for which many states have assumed complete financial responsibility since the 1960s. As states assume these programs, total state aid to local governments is reduced in Census Bureau statistics. The composition of aid by function is shown in Table 8. Educa- tion is by far the most important function supported by state aid, accounting for more than $5 out of every $8 of aid in 1984. This proportion has been relatively stable over the past quarter century, although state aid for elementary and secondary schools jumped 30 percent between 1983 and 1986. The increase in state aid was rel- atively larger than the increases in local funding and federal aid, and state aid accounted for 50.1 percent of the costs of elementary and secondary schools in 1986, compared with 47.9 percent in 1983 (National Education Association, 1986~. Public welfare spending (including Medicaid) has decreased con- siderably from 18.9 percent of the total in 1972 to 11.2 percent in 1984. Part of this decrease is due to the creation of the federal TABLE 7 General Fund Spending Increases (percentages), Nominal and Real, Fiscal Years 1979-1986 Year Nominal Real Increase Increasea 1986 1985 1984 1983 1982 1981 1980 1979 9.5 10.2 8.0 -0.7 6.4 16.3 10.1 10.1 4.3 4.6 3.3 -6.3 -1.1 6.1 -0.5 1.5 aReal increases were estimated using the implicit deflator for state and local governments. SOURCE: National Governors' Association/National Association of State Budget Officers (1986:4~.

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STATE FISCAL CONDITIONS TABLE 8 State Aid to Local Governments (percentage of total) by Function for Selected Fiscal Years 301 Function 1984 1980 1977 1972 1967 1962 1957 Education 63.3 63.7 60.5 57.7 62.2 59.4 56.6 Public welfare 11.2 11.2 14.3 18.9 15.2 16.3 15.3 General local govt. support 10.1 10.4 10.4 10.2 8.3 7.7 9.0 Highway ye 5.3 5.3 5.9 7.2 9.8 12.2 14.6 Othem 10.1 9.4 8.9 6.1 4.5 4.4 4.6 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 The largest categories of "other" aid are for health, transit, corrections, housing and community development, and sewerage. SOURCE: Bureau of the Census tl959, 1968, 1979, 1981, 1985b); Advisory Commission on Intergovernmental Relations (1977:10, 16-17). Supplemental Security Income program in 1974, which relieved both state and local governments of their welfare costs for the aged, blind, and disabled, but states' assumption of financing for local welfare programs also contributed. General local government support has been steady over the period 1972-1984, with slightly more than a tenth of local aid. Support for highways, however, has decreased sharply as a proportion, mirroring the decline in highway spending as a proportion of total state and local spending. The increase in miscellaneous aid, with its share more than doubling between 1967 and 1984, reflects the fact that states have become involved in some nontraditional areas. Aid for transit programs is a good example of an emerging focus of state aid. States gave local governments $1.5 billion of aid for transit in 1984, an increase of 143 percent since 1979 and 28 percent since 1982. In view of the functional distribution of aid just described, it is not surprising that school districts and counties receive much more state aid than municipalities. In 1984 their shares of total state aid were 52.4 percent and 22.4 percent, respectively, as shown in Table 9. School districts, of course, provide most of the educational services, although cities and counties are important in the education function in a number of states. Counties traditionally are the major providers of welfare services. Municipalities receive only 16.3 percent of state aid. Table 10 shows how aid to local governments has grown over

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302 Steven D. Gold TABLE 9 State Aid to Local Governments (percentage of total) by Recipient Government, Selected Fiscal Years Recipient 1984 1980 1977 1967 1957 School districts 52.4 51.8 47.6 50.2 48.1 Counties 22.4 22.2 22.6 24.9 27.6 Municipalities 16.3 15.2 19.3 21.3 20.2 Townships" 1.1 1.3 1.2 3.1 3.7 Special Districts 1.2 1.2 1.1 0.5 0.3 Combined and unallocable 6.6 8.5 8.2 0.0 0.0 aIncludes New England "towns." SOURCE: Bureau of the Census (1959, 1968, 1979, 1981, 1985b); Advisory Commission on Intergovernmental Relations (1977:10, 16-17~. TABLE 10 State Aid to Local Governments, Per Capita and as Proportion of Total State Spending, Selected Fiscal Years State-Local Aid 1984 1980 1977 1972 1967 1962 1957 Total (billions of dollars) 106.65 82.76 61.07 36.76 19.06 10.91 7.44 Per capita (dollars) 452.75 365.54 278.70 176.07 96.43 58.92 43.64 Per capita (1972 dollars) 185.44 200.19 194.42 176.07 137.17 99.81 84.90 As percentage of total state spending 34.4 36.3 36.8 37.2 35.7 34.9 35.3 SOURCE: Bureau of the Census (1979:9-10, 1981:52, 1985b). time. It was nearly 10 times as great in 1984 as it had been in 1962. Although the absolute amount of aid has grown impressively and continues to increase in per capita terms, per capita sect failed to keep up with inflation between 1980-1984, dropping about 6 percent over that 4-year period. Aid has also been remarkably constant as a proportion of tote] state spending, fluctuating between 34 percent and 37 percent since 1957. OUTLOOK FOR STATE FISCAL CONDITIONS The outlook for state finances over the next decade depends on the course of the economy, exogenous influences on tax policy (tax revolt sentiment and interstate tax competition), and trends in

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STATE FISCAL CONDITIONS 303 federal aid. Taking all of these factors into account, the prospects are not particularly rosy.3 The course of the economy certainly is the most important single factor affecting the outlook for state finances both in the aggregate and for particular states. Currently, the farm and energy-producing states are the most economically depressed, and their fiscal conditions are also among the worst. As for the national economy, growth has not been particularly strong in this decade. In view of the problems arising from the federal budget and international trade deficits and Third World clebt, the potential for serious dislocations appears significant. The legacy of the tax revolt continues to restrict potential state revenues. As one review of the experience in California concluded, the tax revolt "is dormant, not dead" (Citrin and Green, 1985~. Two Michigan senators were recalled in 1983 after they had voted for an income tax increase, and initiatives to repeal tax increases were defeated in Ohio in 1983 and Michigan in 1984 only after hard-fought campaigns. The widespread elimination in 1984 and 1985 of income tax (and some sales tax) increases that had been passed in 1982 and 1983 reflected the feeling of public officials that citizens did not wart tax rates increased permanently. The tax revolt also lives on in legislation and some state consti- tutions. Fourteen of the 40 states with personal income taxes have in- dexed them, at least partially. These provisions permanently reduce the built-in growth rate of this major source of revenue. Seventeen states have spending or revenue limits that place a lid on the growth 3 this prognosis is somewhat at variance with the conclusions of a 1985 Treasury Department study based on a simple model of the state and local sector. That study argued that if state and local governments maintained their current tax systems and service levels and if the Reagan administration's federal aid projections and economic forecasts were accurate, large surpluses would develop in aggregate state and local budgets. State and local governments would not allow this to occur, however, and would therefore reduce tax levels, increase services, or enact some combination of these options (U.S. Department of the Treasury, 1985~. The Treasury study also showed that if economic performance is much poorer than predicted by the administration and most leading forecasters, the fiscal situation of state and local governments would be much worse. The study is also open to question on several technical grounds, such as its assumptions about the responsiveness of state and local tax revenue to economic growth (an issue on which most estimates are outdated) and the expenditures necessary to maintain current service levels.

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304 Steverz D. Gold of state fiscal activity, usually tying it to the rate of increase of per- sonal income or to the sum of the inflation and population growth rates (Gold, 1984~. Enacted between 1977 and 1982, nearly all of these limits have not been restrictive in their initial years because growth in tax revenue was relatively sluggish, in part because of tax cuts. The limits are likely to become more significant in the future, however. Michigan and California are very close to their limits, and some officials have concluded that they have exceeded them. Virtu- ally none of these limitation measures has provisions that will allow some liberalizing of them if the state has to assume responsibilities cast off by the federal government. Several other factors add to the problems facing state tax sys- tems. Although difficult to measure, interstate tax competition ap- pears to have intensified, manifesting itself in the proliferation of business tax incentives and in pressure for states with high personal income tax rates to lower them. Because virtually all states engage in this competition, each state's actions tend to be canceled out by the behavior of other states; the result is merely reduced state and local tax revenue, with little if any economic advantage for the states. Reductions of maximum income tax rates also reduce the buiTt-in responsiveness of tax revenue to economic growth. In addition, tax bases are being eroded by economic trends: retirement income is often partially exempt from the income tax, and it is growing much faster than taxable income. Likewise, most services are exempt from the sales tax, and they are claiming a growing share of consumer expenditures. These developments dampen the growth of state tax revenue. Federal tax reform is likely to exacerbate interstate tax competi- tion because lower federal marginal tax rates imply that differentials in state and local tax rates will be more significant. Currently, ~high" federal tax rates "shield" state and local governments to some extent with above-average tax rates because each dollar paid to a state or locality substantially reduces federal tax liability. After federal tax reform, however, the Federal offset" will be considerably smaller. Other ejects of federal tax reform tend to offset each other. States with an income tax will benefit from a broader tax base to the extent that they conform to the federal definition of taxable income, but lower marginal rates will increase the cost of borrowing for state and local governments and perhaps result in a decrease in charitable contributions, which could increase the demand for state and Tocad services that substitute for charitable activity.

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STATE FISCAL CONDITIONS 305 Reductions in federal aid are a final negative factor for state finances. In view of the pressure to reduce the federal budget deficit, the major question appears to be the rate at which real federal aid decreases not whether it will continue to fall. Excluding grants for payments to individuals, the Reagan administration projects a real decrease of 37 percent in aid to state and local governments between 1985 and 1991 (Office of Management and Budget, 19863. Future fevers aid cuts will probably have greater fiscal effects on the states than past cuts have had because states will be under much greater pressure to replace lost federal revenue, given the nature of the programs affected. Reductions in such areas as transit and wastewater treatment will generally be too significant for states to ignore. As a result of these forces economic trends, constraints on tax policy, and federal aid cuts many states will probably experience some degree of fiscal stress in the next decade. Such stress implies that it will not be easy for states to increase their urban aid by a large amount, a statement that seems particularly valid because urban aid will face stiff competition from other claimants on state budgets, especially school, infrastructure, and social service programs. (Of course, to some extent, each of these "rivals has an important urban aspect itself.) One of the most potent political forces in most state capitals is the education lobby- and appropriately so because education is widely viewed as the most important service funded by states and localities. The education lobby has become even more powerful since 1983 because of the educational reform movement that has sprung from dissatisfaction with the products of the nation's schools. Improving the educational system could be very expensive. For example, to implement fully the recent proposals of the Task Force on Teaching as a Profession for the Carnegie Forum on Education and the Economy would cost about $48 billion per year. Even if educational reform claims only a fraction of this amount, it would draw scarce state dollars from possible urban initiatives. If fiscal stress develops as the preceding paragraphs suggest it may, how will state governments respond? One part of their response should be a thorough reexamination of existing programs to improve their efficiency and eliminate those of low priority; states should also consider new funding mechanisms (which in practice will often result in increased privatization). Furthermore, relations between state and local governments wit! probably change in important ways. States

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306 Steven D. Gold will recognize the need to reassess their existing policies toward local governments, and many restrictions currently in force will be relaxed, including restrictions on available taxes and some mandates. States will certainly replace some of the federal aid lost by local governments, but the mechanisms they use may not follow precisely the format used in federal programs. Much lost federal aid also will not be replaced by states. The same forces causing fiscal stress at the state level during the next decade will tend to produce even greater stress for many urban governments. States will not be blind to this development, but their ability to respond with increased aid will be constrained by the restrictions on their fiscal capacity discussed in this report. REFERENCES Advisory Commission on Intergovernmental Relations 1977 The States a?~dIntergovernmentalAids. Report A-59. Washington, D.C.: Advisory Commission on Intergovernmental Relations. Bureau of the Census 1959 Censor of Govermerds: 1957. Vol. 4, No. 2. State Payments to Local Goverr~mer~ts. Washington, D.C.: U.S. Department of Commerce. 1968 Census of Goverment~: 1967. Vol. 6, No. 4. State Payments to Local Government. Washington, D.C.: U.S. Department of Commerce. 1979 (renew of Goverments: 1977. Vol. 6, No. 3. State Payments to Local Governments. Washington, D.C.: U.S. Department of Commerce. 1980 Governmental Finances in 19~77-78. Series GF80, No. 5. Washington, D.C.: U.S. Department of Commerce. 1981 State Government Finances in 1980. Series GF80, No. 3. Washington, D.C.: U.S. Department of Commerce. 1985a Government Finances in 1985-84. Series GF80, No. 5. Washington, D.C.: U.S. Department of Commerce. 1985b State Government Finances in 1984. Series GF80, No. 3. Washington, D.C.: U.S. Department of Commerce. Citrin, J., and D. P. Green 1985 Policy and opinion in California after Proposition 13. National Tax Journal 38:15-35. Gold, Steven D. 1983 Recent developments in state finances. National Tan Journal 36:1-29. 1984 State tax increases of 1983: Prelude to another tax revolt? National Tan Journal 37:9-22. 1986a Developments in State Finances, 1983 to 1986. Public Budgeting arid Finance 7(Spring 1987~:5-23. 1986b State Government Fund Balances, Financial Assets, and Measures of Budget Surplus. In Federal-State-Local Fiscal Relations: Technical Papers. Office of State and Local Finance. Washington, D.C.: U.S. Department of the Treasury.

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STATE FISCAL CONDITIONS 307 Gold, Steven D., and Karen M. Benker 1983 State Budget Action in 1988. Denver, Colo.: National Conference of State Legislatures. Gold, Steven D., Corina L. Eckl, and Max R. Price 1985 State Budget Action ire 1985. Denver, Colo.: National Conference of State Legislatures. Levin, David, and Donald Peters 1986 Receipts and expenditures of state and local governments: Re- vised and updated estimates, 1959-84. Survey of Current Business 66(May) :26-29. National Education Association 1986 Estimates of School Statistics: 1985-86. Washington, D.C.: National Education Association. National Governors' Association/National Association of State Budget Officers 1978 Under~tar~ g the Fiscal Condition of the States. Washington, D.C.: National Governors' Association/National Association of State Budget Officers. 1986 Fiscal Survey of the States: 1986. Washington, D.C.: National Governors' Association/National Association of State Budget Officers. Office of Management and Budget 1986 Budget of the Orbited States Government, 1987Historical Tables. Wash- ington, D.C.: U.S. Government Printing Office. Rymarowicz, L., and D. Zimmerman 1986 The Effect of Federal Tan and Budget Policies ire the 1980s or' the State-Local Sector. Washington, D.C.: Congressional Research Service. U.S. Department of the Treasury 1985 Federal-State-Local Focal Relations: Report to the President arid the Cor~gre~. Office of State and Local Finance. Washington, D.C.: U.S. Department of the Treasury.