State Strategies to Manage Budget Shortfalls
Chapter 1. Causes of Budget Shortfalls
There are numerous causes of budget shortfalls, and they are interrelated.
This chapter provides an overview of the chief causes of state budget
shortfalls:
- Economic performance;
- Inaccurate revenue and expenditure projections;
- State tax and expenditure policy;
- The effects of federal actions on state budgets; and
- Court decisions.
Economic Performance
National and regional economic performance are the most important external
influences on state finances. The normal business cycle includes economic
declines, troughs, recovery periods and peaks that subject state finances to
unpredictability.
Although there may be time lags, when the national economy declines, finances
in most states also decline. Likewise, a national recovery tends to help most
states' finances to rebound. As evidenced by state fiscal conditions during the
recessions in the early 1980s and early 1990s, the health of most states'
finances can be traced directly to fluctuations in the business cycle (see figure 1).
Inaccurate Revenue and Expenditure Projections
Because of the unpredictability of the economy and the uncertainty
surrounding the duration of business cycle phases, state budgeters are left with
the very difficult task of accurately estimating both revenues and spending
needs. The problem is exacerbated when the economy is in a recession, because
revenues are likely to be falling at the same time that demand for government
services is increasing.
Inability to make accurate revenue projections
State revenue forecasters recognize they have an especially difficult
task--to accurately project revenues when the economy is unpredictable. Though
their projections are certain to differ from actual collections, the question
is, to what extent. Under the best conditions, forecasters' projections may be
within a couple of percentage points of actual revenues. But when the economy is
changing rapidly, the difficulty of making a reasonably accurate projection
increases. This is especially true for projections that apply to revenue
collections 12 to 18 months in the future. That is why some states have shifted
the frequency of their estimates from annual or biennial schedules to
semi-yearly or quarterly. Frequent forecasts, however, may lead to revenue
projection adjustments based on one-time events that are not sustained over a
longer period.
Figure 1. State Year-End Balances as a Percentage of General Fund
Expenditures: FY 1978 to FY 1996
Source: National Conference of State Legislatures, State Budget
Actions, various years
Forecasters also face the difficulty of making accurate economic assumptions
and correctly interpreting economic indicators. One example is consumer
behavior, which can be very difficult to predict. Although consumption may be
increasing, causing estimators to assume improving sales tax revenues, the
nature of the consumption may not support the assumption. In late 1995, for
example, consumer spending was very strong, but the purchase of goods was down
because consumers shifted their purchases to a wide range of services. [The
Wall Street Journal, Nov. 6, 1995, page A1.] Since services typically are
not included in state sales tax bases, increased use of services does not
increase sales tax collections.
In addition to external factors, forecasts may be subject to political
pressures, which may cause the forecast to be overly optimistic to allow a
higher level of spending. Or, intentionally low estimates may be made to
restrain spending or create a budget surplus. Recognizing the need for accurate
revenue projections, some states have attempted to improve the revenue
estimating process by using consensus forecasting. A consensus forecast is
mutually developed and agreed upon by legislative and executive branch
officials; other participants such as business economists or university faculty
also may be involved in the process. Consensus forecasts eliminate the time and
resources devoted to developing competing forecasts and they attempt to
depoliticize the process. (For more information on this issue, see Hutchison,
The Legislative Role in Revenue and Demographic Forecasting.)
Inability to make accurate expenditure projections
Most state budgets are based on the previous year's budget adjusted to
account for assumptions made about inflation, enrollment increases, caseload
growth and other factors. Although reasonable assumptions may be made, external
factors may cause the estimates to be off target. For example, economic
downturns typically increase demand for government services, especially
caseload-driven services such as Medicaid and Aid to Families with Dependent
Children (AFDC). Such downturns often cause state spending to increase above
budgeted levels. Because it is difficult to accurately predict the effects of
the economy on state programs, inaccurate spending projections are
inevitable.
In addition to external factors, internal pressures may lead to spending
projections that are based on unrealistic cuts in programs or unattainable
savings. A common example is early retirement programs for state employees. The
projected savings from these programs may fail to consider intermediate and
long-term costs. This issue is discussed further in chapter 5.
To improve expenditure estimates, more states are implementing expenditure
forecasting processes. North Carolina, for instance, has developed a forecasting
model for expenditures for 28 state departments over a 10-year period. The state
also has implemented a process that estimates how sentencing policies will
affect prisoner populations, what such policies mean for long-term prison space
and the implications for the state budget (see the case
study). Kansas has taken another approach. Because of its success with
consensus revenue forecasting, Kansas has implemented a consensus model to
forecast student enrollment numbers and caseloads for social programs to provide
policymakers with better estimates of expenditures for those programs.
State Tax and Expenditure Policies
State fiscal policy refers to the state's tax and spending policies. These
policies tend to have long-term implications for state budgets and may lead to
structural deficits, but they also can cause potential deficits in the short
term. State fiscal policy generally is driven by the legislative process, but in
a growing number of states, voter-imposed directives and restrictions are
increasingly influencing such policy.
Tax Policy
State tax policy decisions affect levels of revenue, taxpayer behavior, the
types of taxes that are levied, tax rates and bases, and the overall stability
and integrity of the state tax system. Most state tax systems are
antiquated--they are not designed to reflect modern economic circumstances and
behavior and, without rate increases or base expansions, they do not produce
revenue growth that keeps pace with economic growth. Although many policymakers
are aware of the shortcomings of their tax systems, they often have been
unsuccessful in making adjustments. Specific tax policy problems, such as those
discussed below, can contribute to short-term budget shortfalls and structural
budget deficits.
Lack of a balanced/diversified tax system. Lack of balance and
diversity in a state's revenue system is an important determinant of budget
problems. States with narrow tax bases can be particularly vulnerable to
shortfalls. States such as Louisiana and Oklahoma, for example, that were
heavily dependent on taxes from oil and gas production suffered significant
economic declines in the mid-1980s when the price of oil plummeted. (For more
information on the importance of tax diversification, see NCSL Foundation Fiscal
Partners, Principles of a High-Quality State Revenue System.)
More recently, state tax bases have eroded because of the changing nature of
the American economy and how consumers spend their money. Specifically, the U.S.
economy is shifting from the production and consumption of goods to the
production and consumption of services. Over the past decade, some states
gradually have extended their sales tax bases to include the purchase of
consumer services, such as dry cleaning, landscaping and janitorial services.
Generally, however, state tax systems have not been significantly adjusted to
reflect the shift to a service-based economy. (For a further discussion of this
issue, see Financing State Government in the 1990s.)
Some states do not levy certain kinds of taxes, such as income taxes, because
of strong tradition or because their state constitutions prohibit them. These
states typically have generated tax revenues through reliance on some unique
endowment, such as extensive mineral resources in Wyoming or special tourist
attractions in Florida.
Tax and revenue limits. In addition to long-time prohibitions on
certain kinds of taxes, state policymakers are facing restrictions on revenues
and tax increases. Seven states operate under tax or revenue limits or both. Tax
limits require that voters approve all or some portion of tax increases. Revenue
limits restrict the amount of new revenue that can be raised each year.
Increasingly, voters are imposing these kinds of limits. In 1992, for example,
Colorado voters passed a ballot initiative that requires that all state and
local tax increases be approved by the voters. Such policies may have long-term
implications for a state's ability to generate sufficient revenues to covered
desired levels of spending. Moody's Investors Service repeatedly has warned
investors of the potential long-term danger of such policies. (For a further
discussion of tax limits, see State Tax and Expenditure Limits.)
Level of tax effort. Tax effort measures the extent to which a state
utilizes its available tax base. The level of tax effort is determined by
comparing a state's actual revenues with its estimated capacity to raise
revenues. Public finance experts report a low correlation between level of tax
effort and budget shortfalls. However, because the tax system must produce
sufficient revenues to cover the long-term spending growth that existing
policies generate, states with low tax effort may be contributing to a deficit
that could be avoided or minimized. (For a complete discussion of tax effort see
U.S. ACIR, RTS 1991: State Revenue Capacity and Effort.)
Excessive use of tax earmarking. States should have the flexibility to
address budget shortfalls using both revenue and budget options. This
flexibility is threatened, however, when states make excessive use of
earmarking. Dedicating state revenues for specific purposes continues to be a
common practice in the states. Proponents argue that earmarking provides an
ongoing and continuous level of support for certain programs and often is
necessary to win voter approval of a tax increase because the voters know how
the new tax revenues will be spent. Opponents of earmarking argue that it limits
lawmakers' ability to set budget priorities, especially in the face of budget
shortfalls that require budget cuts. One report stated, "Lawmakers are
handcuffed by laws that reserve a large portion of the government revenue stream
for dedicated uses." { State Tax Notes, March 20, 1995.} (For a further
discussion of earmarking, see Earmarking State Taxes and Fundamentals of Sound
State Budgeting Practices.)
Expenditure Policy
State policymakers' spending decisions have both short- and long-term
implications for the budget. Some of these decisions are intended to avert
budget problems, such as state policies that constrain spending to some level of
expected revenues (discussed further in chapter 3). Other
policies, however, have led to programs whose costs grow automatically at a rate
that tends to outpace revenue growth. These policies are principal contributors
to budget shortfalls in the short run and structural deficits in the long
run.
Unchecked spending growth
At the same time that states have difficulty accurately predicting spending
needs, they often find it difficult to modify programs whose annual costs
outpace annual revenue growth, thereby creating a perpetual budget problem.
California often is cited as an example of this problem because, according to
some observers, the state's current services budget has tended to grow faster
than its economy largely because of open-ended entitlements. In recent years
California has attempted to get a handle on this problem by reducing welfare
grants (pending federal approval), limiting eligibility for welfare programs and
aggressively pushing HMOs for health care. { Telephone conversation with Peter
Schaafsma, Apr. 23, 1996.} Iowa has found itself in a similar situation: A large
percentage of its spending, such as state aid to schools, was driven by formulas
that were not subject to annual budget adjustments. Recently, more programs have
become part of the annual budget review process.
Medicaid spending, in particular, provides the best example of unchecked
spending growth in the states. For various reasons, Medicaid's share of state
budgets has outpaced state spending for most programs, causing other budget
areas, such as higher education, to receive less money. The growth in Medicaid
spending has also outpaced the growth of state revenues. Recognizing that
Medicaid in particular is a long-term budget problem, some states have sought to
control it through initiatives such as managed care. State efforts to control
Medicaid costs are discussed further in chapter 4.
Corrections costs also are growing rapidly. State sentencing policies are
increasing the number of prisoners and lengthening prison stays, which directly
affect state budgets. The future costs of policies such as "three strikes and
you're out" will be particularly high.
Guaranteed levels of spending
Favored or high-priority programs may receive minimum or guaranteed spending
levels. Like tax earmarking, this practice severely constrains budget
flexibility. Such provisions can contribute to a budget shortfall if revenue
growth is insufficient to meet the guaranteed level of spending and other
planned expenditures. The potential problem is particularly acute when state
finances are declining.
Spending limits
Nineteen states operate under some type of spending limit. These limits tie
the growth of spending to an index such as increases in inflation or population.
Generally, these limits have not been very restrictive because of their design
and the ease with which state governments can circumvent them. They may have a
greater impact on state finances in the future, however, if the federal
government requires states to take on more fiscal responsibilities under
devolution. Most state spending limits do not make exceptions for new program
responsibilities that may come from the federal government or any need to
replace federal funds with state funds. (For a further discussion of spending
limits, see State Tax and Expenditure Limits.)
Lack of adequate reserves
Reserve, or budget stabilization, funds are important because they can have
an immediate effect on a budget shortfall. Their purpose is to help states avoid
ad hoc budget or tax decisions. Their ability to address budget shortfalls,
however, depends primarily on their size. Wall Street analysts who monitor state
finances recommend that states hold reserves equal to 3 percent to 5 percent of
state spending. In most states, however, reserves have been well below the
recommended level and too small to address sizable or recurring shortfalls. Used
in combination with other strategies, however, even modest reserves have been
useful. Budget stabilization funds are discussed in greater detail in chapter 3.
The Effects of Federal Fiscal Actions
Federal policy decisions can have implications both for state revenues and
for state spending, and often the implications are closely interrelated. On the
revenue side, states do not know how much federal aid they will receive. Changes
to the federal tax code also may have revenue implications for states. On the
spending side, unfunded or underfunded mandates on states may impose significant
costs. As discussed later, developments in Washington, D.C., in the late 1990s
may exacerbate these problems.
The unpredictability of federal funds
The uncertainty regarding the level and timing of federal funds hampers state
forecasters' ability to predict revenue and spending levels. If federal funds do
not materialize as expected, the state is faced with the decision of whether to
make up the lost funds. Obviously, a decision to replace the lost federal money
with state money can lead to budget problems and a potential shortfall.
Linkages to the federal tax code
Most states link portions of their tax code to the federal tax code. For
example, as of January 1, 1996, 36 states and the District of Columbia linked
their personal income tax to the federal personal income tax, using either
federal adjusted gross income, federal taxable income or federal tax liability
as a starting point to determine state tax liability. These linkages mean that
changes to the federal tax code automatically affect state revenues. Although
this can lead to revenue windfalls, which occurred in many states when the
Federal Tax Reform Action of 1986 was passed, it also can lead to revenue
shortfalls if the federal government cuts tax rates or increases exemptions and
deductions. Although states can increase state taxes to offset such revenue
declines, an antitax climate may make that option politically difficult.
Federal mandates
Of perhaps greater concern to the states than the timing and level of federal
funds is the problem of federal mandates--requirements that impose programmatic
or financial obligations on the states. Although unfunded or underfunded federal
mandates on the states are unlikely to cause an immediate budget crisis, they
hamper state flexibility and over the long term can lead to serious budget
problems. As evidenced in the area of Medicaid, mandates can impose significant
costs on the states. A budget shortfall can result if the state's revenue system
cannot produce sufficient new revenues to cover the new costs. Another problem
arises when a state is forced to use its own funds to provide federally mandated
services that are supposed to be reimbursed. California has faced this problem
for several years because it has not been fully reimbursed for the costs of
programs for immigrants.
The effects of federal fiscal actions are emerging as an important concern in
the late 1990s as the federal government seriously examines devolution and the
shifting of responsibilities from the federal government to state and local
governments. Under some proposals, states would receive more flexibility and
less funding. Other proposals would continue existing mandates with less
funding. In recognition of the potential financial liability that looms, some
states have taken steps to avert or minimize their risk. In Maryland, for
example, policymakers eliminated $50 million in federal funds from the FY 1997
budget under the assumption that the state would not actually receive those
funds. In FY 1996, Ohio officials created a Human Services Stabilization Fund of
$100 million in anticipation of federal budget changes that would impose more
responsibilities on the state with no commensurate increase in federal
funding.
Court Decisions
Court decisions are another cause of budget shortfalls. On the revenue side,
a tax may be ruled unconstitutional, requiring the state to eliminate or change
it, thereby causing state revenues to drop. The adverse effect is compounded
when court decisions also require monetary relief for back taxes paid. Although
states are likely to be alerted to forthcoming court decisions that would
adversely affect state revenues, such decisions may still contribute to a budget
shortfall if the tax was an important source of state revenues.
Just as court decisions can contribute to budget shortfalls on the revenue
side, they also can impose significant financial obligations that were
unplanned. Recent and widespread litigation regarding school funding formulas is
a common example. Since the early 1980s, more than half the states have been
involved in such lawsuits. In mid-1995 alone, 16 states were involved in some
stage of school finance litigation. { Terry Whitney, "School Finance Litigation
Affects 16 States," The Fiscal Letter, (NCSL) 17, no. 3, (May/June 1995):
11.} The decisions in these cases may impose a substantial funding obligation on
the states because most of the lawsuits deal with the question of equitable and
adequate spending per pupil. As a rule, this has meant that states spend more
because they "equalize up" rather than spending less by equalizing down. Other
areas where court decisions have imposed considerable costs on state budgets are
prisons and correctional systems and mental health programs and
institutions.
Continue to Chapter 2, State Efforts to Manage
Budget Shortfalls
Written December 1996, posted January 2003, reviewed December 2003
Email statebudget-info@ncsl.org for more information.
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