State fiscal crises: are rapid spending increases to blame?

• Author: Stansel, Dean

During recessions, state governments frequently face substantial midyear budget shortfalls. Numerous states are now experiencing such crises again. These fiscal crises are often blamed on the cyclical decline in revenue growth or reductions in federal aid. Others have suggested that enacting rapid spending increases during expansionary years--rather than using the revenue windfalls for tax cuts or increases in rainy day funds--may be an important contributing factor to those budget shortfalls. Using data from the 2001 recession, we find support for that "overspending" hypothesis. While neither the mere presence nor the size of a rainy day fund were significant predictors of fiscal stress, faster increases in spending are positively and significantly associated with fiscal stress. When rainy day funds work, it is the strength of their withdrawal rules that matter. These results have important implications for fiscal policy choices. States that restrain spending growth during expansionary years and implement strong rainy day fund withdrawal rules are likely to face less severe fiscal crises during recessions.

Cyclical fluctuations of state tax revenue create challenges for politicians. In periods of economic expansion, revenues flow in faster than expected. How those windfall revenues are used can have a major impact on what happens during subsequent periods of economic contraction when revenues flow in slower than expected. (1) Politicians have three basic choices: (1) use the windfall revenues to fuel larger spending increases (by establishing new programs and expanding existing ones), (2) deposit them in a budget stabilization fund, often called a rainy day fired (RDF), or (3) return them to taxpayers by cutting taxes. Compared to options two and three, increased spending tends to create a larger "crisis" when revenue growth eventually slows due to a recession. The reason is that when that rapid spending growth is used to establish new programs, it creates new groups of beneficiaries who have an interest in maintaining and expanding those new programs. Furthermore, large spending increases in current years tend to create expectations for large spending increases in subsequent years (in part due to current services budgeting processes). In fact, when spending growth for a program falls--from say a 5 percent increase to a 4 percent increase--that slowdown in spending growth is often labeled a spending "cut." Those changed expectations do not tend to occur when windfall revenues are returned through tax cuts or saved for a rainy day.

The state fiscal crisis created during a recession is not caused solely by slower revenue growth. The fact that some state expenditures are countercyclical in nature (e.g., welfare, which accounts for about one-fourth of state general expenditures) further compounds the problem. This phenomenon makes revenue smoothing (through tax cuts), rainy day funds, and spending restraint all that much more important in periods of economic expansion. One way to assess whether spending increases have been excessive is to compare them to increases in incomes. According to Crain (2003: 1), "The typical state budget in the 1990s outpaced state income growth by nearly 1 percentage point annually." The expansionary years of the 1980s saw similar growth of state spending. From 2000 to 2007, despite a recession in 2001, the record has shown a similar disparity, with the average annual nominal growth of current state expenditures at 5.5 percent and nominal personal income growth of only 4.7 percent. (2)

That rapid spending growth has led some to blame the states for their own fiscal woes. As Schunk and Woodward (2005: 113) described it, "There is an ongoing debate as to whether the extensive fiscal distress of 2001-2003 resulted from increases in spending during the 1990s. The Economist (2001) said of the 2001 recession, "The states are in financial trouble again; and it's their fault," referring to large spending increases during the 1990s. During the 1990-91 recession, The Economist (1991) argued that "a decade of runway state spending" in the 1980s was a "principal cause" of state budget troubles. Moore (1991) and Edwards, Moore, and Kerpen (2003) came to similar conclusions in supporting the overspending hypothesis. Gramlich (1991) examined the aggregate budget surplus (of all 50 states) over the period 1955-90. He found that the main cause of lower budget surpluses was the rapid increase in health care costs. Those higher costs have in turn led to higher state spending in that area. In contrast, political commentators often claim that reductions in federal aid are to blame. For example, Washington Post columnist David Broder (9.002) asserted, "The problem is not that states are profligate spenders." He called for large increases in federal government aid to state governments. McNichol and Carey (9.002) also dispute the claims of overspending, while Johnson (2002) blames the fiscal crises on the state tax cuts passed during the 1990s.

In the next section, we provide a discussion of previous literature in this area. We then explain the data and empirical model, and discuss the regression results, before offering our conclusions.

Previous Literature

Regardless of the cause, the smoothing of state government spending over the business cycle could help to alleviate the severity of the fiscal crises that occur during recessions. Wagner and Elder (2007) use a Markov switching regression to estimate the size of revenue shortfalls during recession. They find that the typical state will see a revenue shortfall of 13 to 18 percent of revenue during a normal downturn. In order to accumulate sufficient funds to offset that shortfall, states would have to save 2.5 to 2.8 percent of revenue per year during expansion periods. Schunk and Woodward (2005) provided simulation results of two spending stabilization rules. They found that if a rule had been in place to limit increases in real per capita spending to 1 percent per year from fiscal year 1994 through fiscal year 2004, spending would have been only 3 percent less than it actually was in fiscal year 2004. However, the spending reductions made during the 2001 recession would not have been necessary. One potential drawback of such a rule, as the authors concede, is the accumulation of large budget reserves (about 20 percent of total spending under the rule allowing 1 percent real per capita spending growth). Holcombe and Sobel...