State fiscal policies for budget stabilization and economic growth: a dynamic scoring analysis.

• Author: Merrifield, John
• Position: Report

Economic downturns expose unsustainable fiscal practices. Widespread fiscal crises create opportunities to compare policy options that address especially adverse circumstances, especially pro-growth fiscal constraints that can stabilize state budgets over the business cycle. Our policy option assessments depart from the normal practice of assessing rules and policies independently. Our premise is that the fiscal policy mix determines its outcomes. We include dynamic scoring to provide a richer view of the policy interactions.

In this article, we assess reforms that address fiscal stress issues. We were driven, in part, by our conviction that stable spending growth over the business cycle curbs fiscal stress-induced pressures to raise taxes and weaken caps on spending growth. To generalize our findings as much as possible, we apply our dynamic scoring model to California, Montana, and Utah--states familiar to us that span the blue state-red state gamut, with Montana in the middle. Utah is "'famously conservative" (Woo 2010), with one of the top business tax climates (Tax Foundation 2011). California's response to fiscal stress included large tax hikes, which helped create one of the worst business climates. With fiscal data and dynamic scoring, we simulate the economic growth and fiscal effects of income tax rate reductions and fiscal rules designed to constrain the growth in state spending and stabilize the budget over the business cycle.

The Fiscal Rollercoaster

In the five years that preceded the still lingering 2007-09 Great Recession, spending growth topped personal income growth in 37 states, including those with fiscal caps more extensive than the balanced budget rule, absent only in Vermont (Poterba 1994, Merrifield 2000). The expansion in those 37 states was enough to achieve a 50-state average spending growth rate 5 percent faster than personal income growth. Large budget deficits and fiscal crises arose when the Great Recession sharply cut revenues (Chapman 2009, Eaton 2009, Kalita 2009, Vock et al. 2009). Legislators could not sustain the good times' rapid spending growth achieved, in part, by overriding their statutory tax and expenditure limits (Stansel and Mitchell 2008).

A key reason for rapid state spending growth has been widespread use of personal income growth to define fiscal discipline (Shadbegian 1996, Waisanen 2010). An income growth-based cap is a convenient, politically comfortable limit when economic growth is normal, but uncomfortable when persona/income growth is modest, and a crisis when growth is negative, as it has been recently (Schunk and Woodward 2005, Wagner and Elder 2005). Fiscal instability and uncertainty seem to accelerate spending growth (Holcombe and Sobel 1997). Fiscal crises can be primary agents of tax hikes that typically survive into future high-growth periods; a process that ratchets spending upward over successive iterations of the business cycle. Fiscal stress also spills over into off-budget spending (Bennett and DiLorenzo 1982, Merrifield 1994), and into on-budget funding substitutes such as regulation and more responsibility for local governments.

Tax and Expenditure Limits

Early studies of tax and expenditure limits (TELs) found evidence that they had only a small effect on state budgets. (1) But more recent studies provide evidence that TELs can effectively constrain the growth in state spending (2) TELs that link spending growth to personal income are often nonbinding, and for binding TELs, the instability of personal income growth erodes support for TELs by creating periods of costly fiscal instability and uncertainty. (3) Eeonomic conditions and the phase of the business cycle are key determinants of the effectiveness of TELs. For example, they seemed to be more binding in low-income states. Florida introduced a tax and expenditure limit in the recession phase of the business cycle that was never binding. The cap rose more rapidly than actual growth in state revenue.

In 1971, Ronald Reagan, then governor of California, along with Milton Friedman, campaigned for the first state TEL. Though voters narrowly rejected the attempt to cap California's state spending at 7 percent of state income, the Reagan-Friedman effort set the stage for the TELs later introduced in California and 31 other states (New 2003, Poulson 2004). The first state to enact a TEL was New Jersey in 1976. The New Jersey TEL limited state expenditure growth to growth in state income. Like other statutory TELs, the New Jersey TEL did not notably constrain state spending growth, and expired after six years in 1982 (Bails and Tieslau 2000, Poulson 2004).

State constitution TELs have been the most effective spending rules (New 2003, Poulson 2004). California's Gann Amendment was a 1978 ballot partner of the more famous Prop 13 property tax limit. The Gann TEL yielded a large 1987 tax rebate, but a series of constitutional amendments gutted Gann, as proved by rapid spending growth thereafter (Vock et al. 2009, Poulson 2009a), leading eventually to large budget gaps, several budget gap crises, significant tax increases, and finally to some recent large spending reductions.

As the Gann Amendment started its slide into irrelevance, Colorado amended its constitution with a Taxpayer Bill of Rights (TABOR), which limits the growth of available revenue to population growth plus inflation. Surplus revenue generates tax rebates. Higher tax rates and new debt require voter approval. TABOR also prohibits imposition of unfunded mandates on local governments. In the 1990s, revenue growth topped the TABOR limit enough to yield $3.25 billion in tax rebates. When the 2001 national recession caused actual revenue to fall below the TABOR limit, the resulting new benchmark and its ratchet-down effect on future spending growth yielded a 2005 referendum that imposed a five-year time-out from the TABOR growth limit and adjusted the annual limit formula to avoid future ratchet-down effects. (4) Though the TABOR experience suggests that political support for spending caps erodes with fiscal stress, Colorado voters remained unwilling to create a budget-stabilizing, but tax rebate-reducing, rainy day fund (RDF), a key source of TABOR critique (Poulson 2009a).

Budget Stabilization and Emergency Funds

Some of the recently proposed TELs earmark surplus revenue for an RDF and an emergency fund (EF). Forty seven states have some kind of RDF or EF, but rules governing deposits and withdrawals vary widely? Wagner and Elder (2005) found that states with strict rules for RDF deposits and withdrawals experience a 20 percent reduction in spending volatility, as measured by the cyclical variability of per capita spending over time. Stansel and Mitchell (2008) found that states with stricter RDF withdrawal rules experienced less fiscal stress during the 2001 recession.

Capital Investment Funds

Capital expenditures tend to be very volatile over the business cycle. In periods of recession and revenue shortfall, state capital spending is typically among the first items cut. A binding TEL lacking a well-designed RDF may actually raise capital expenditure volatility over the business cycle, which occurred in Colorado (Poulson 2004). A solution to the volatility problem is a well-designed business stabilization fund (BSF) and a capital investment fund (CIF) designed to stabilize capital spending over the business cycle. A good case for countercyclical capital expenditure exists without reliance on the well-known Keynesian stimulus argument. Because of the cyclical nature of construction quality and price (Finkel 1997, Merrifield and Monson 2011), our simulations earmark some surplus revenue for a CIF to finance additional construction spending in slow growth periods.

TELs and Tax Policy

A binding TEL will yield a mixture of tax rebates and lower tax rates. Despite the tedious nature of tax rebates, controversy over the basis for estimating the appropriate rebate for each taxpayer, and evidence that permanent tax cuts have larger economic growth effects than one-time rebates (Padquit 2011, Poulson and Kaplan 2008, Taylor 2008), it will probably take some persistence in the payment of rebates to elicit the permanent cuts. Indeed, Colorado's TABOR yielded large tax rebates for several years in the late 1990s, before state legislators responded with several permanent tax cuts.

Dynamic Scoring Foundations

The evidence that Colorado's TABOR accelerated economic growth (Poulson 2009a, 2009b) is controversial. (6) The controversy is over whether a drop in the state's share of personal income accelerates economic growth. (7) For 1980-90, Peterson (1994) estimated a 9,2.1 percent private rate and a 7 percent public rate of return. The 15.1 percentage point gap is a proxy for the marginal cost of shifting resources from the private to the public sector. Some studies (most recently Bania and Stone 9.008) suggest that shifting resources from the private to the public seetor can increase economic growth. But their findings may not be that useful to our TEL simulation. Bahia and Stone omitted the effect of higher taxes on growth, and their large, heterogeneous productive services and infrastructure spending category obscures the likely effects of how spending would vary with or without a binding TEL. Studies of K-12 spending changes indicate that the Bania and Stone finding of a small positive impact on economic growth from greater spending on productive services and infrastructure may be a net effect of conflicting factors. Every state's disappointing K-12 performance indicates that there is much room for improvement, which is theoretically possible with additional resources. Though states continuously identify promising K-12 projects, Tomjanovitch (2004) found a significant inverse relationship between education spending and economic growth. Other studies suggest at least a normal marginal opportunity cost of shifting expenditure...