State Strategies to Manage Budget Shortfalls

Expenditures That Cut Across Programs

Front Matter
Chapter 1. Causes of Budget Shortfalls
Chapter 2. State Efforts to Manage Budget Shortfalls
Chapter 3. State Methods to Avoid or Minimize Budget Shortfalls
Chapter 4. Options to Reduce State Spending in Major Program Areas
Chapter 5. State Expenditures That Cut Across Programs

Government Employment
Obstacles to Reducing Government Employment
Techniques for Reducing Government Employment
Case Study: The Maine Productivity Realization Task Force
Early Retirement Incentive Programs
Case Study: Early Retirement Programs in Minnesota and Virginia
Privatization as a Means of Reducing State Employee Numbers
Guidelines for Privatization
Case Study: The Massachusetts Privatization Law
Case Study: Experience with Privatization in Minnesota and Wisconsin
State Aid to Local Governments
Case Study: New York's Experience With Reductions in State Revenue Sharing
Case Study: California's Experience with Reductions in State Aid to Education

5. State Expenditures That Cut Across Programs

Chapter 4 examined possible savings in large state programs like education and health care. This chapter takes a cross-sectional approach to potential state cost reductions by looking at expenditures that are not tied to a particular state program but instead cut across program lines--government employment and aid to local governments.

Government Employment

Government is a labor-intensive activity. In 1992, state governments employed 4.6 million people. More than 25 percent of them were part-time employees, but the full-time-equivalent (FTE) number was 3.8 million employees. These employees were paid more than $140 billion in salaries, wages and fringe benefits, representing 20 percent of all state spending and 43 percent of state spending on current operations (see figure 3). {State spending for salaries and wages was $112.7 billion plus 25 percent of that amount added as an allowance for fringe benefits. State current operations cost $322 billion in FY 1992. State/local total for salaries and wages was $383.2 billion and in the text is adjusted by a factor of 25 percent for fringe benefits. Total direct expenditure for current operations was $824 billion. (Government Finances 1991-1992, Preliminary Report, page 1.) (Current operations are recurring expenditures except for intergovernmental payments and interest on debt.) The resources devoted to state employment, as well as its size, visibility and growth, make it a source of savings whenever reductions in state government are sought.

Figure 3. Components of Total State Spending, FY 1992

Source: NCSL compilation based on Bureau of the Census reports

Although short-term reductions in state employment are not uncommon, the number of public employees tends to grow at a fairly steady rate. From December 1994 to December 1995, public employment fell in 20 of 48 reporting states, but such reductions are often temporary: From 1990 through 1995, net employment fell in only seven states. {"State and Local Employment Growth," State Policy Reports, 14, no. 3, Feb. 1996: 4-14.Public sector employment is less sensitive to cyclical changes in the economy than private sector employment. Private sector employment is highly responsive to recessions and recoveries: Employment can fall in absolute numbers during a recession, and unemployment rates shrink when recoveries create new jobs. The public sector is not impervious to cyclical change, but its fluctuations are moderate compared with those of private sector employment in part because demand for government services grows when the economy is weak.

Public employment tends to grow steadily because almost 50 percent of public employees (49.7 percent of state and local FTE employees in 1992) work in education. Education employment tends to be driven by demographics. The effect of population-driven growth in education is to smooth out other fluctuations in state and local employment growth.

Public employment growth rates tend, over time, to be close to state population growth. From 1990 to 1995, state and local employment growth in 34 states was within one percentage point of population growth. The states in which public employment fell in that period (California, Maine, Maryland, Massachusetts, Michigan, New York, New Jersey and Vermont) tended to be states whose economic and demographic growth was far below the average for the 50 states. {Ibid., 11.{

Obstacles to Reducing Government Employment

Hiring freezes and calls for employee reductions are ineffective for several reasons.

Layoffs are more difficult for state governments than for the private sector for technical reasons. Even without regard to labor agreements where unions exist, state personnel rules were designed by an earlier generation to make it difficult for elected officials to use jobs for patronage. Those rules make it hard to fire people without abolishing jobs.
Even when jobs are abolished, it may be hard to reduce employee numbers. Civil service rules often provide "bumping rights" for people who do lose jobs, which means that they can replace other people in a civil service system. Someone eventually is out of work, but the process can take months or years as the result of a single employee's displacement.
Hiring freezes can, in theory, reduce employee numbers by natural attrition, but they usually make exceptions for emergencies. The officials who decide what openings merit emergency filling may be more sympathetic to agency needs than to elected officials' call for fewer employees. It can be difficult to provide the necessary administrative oversight to make a freeze effective.
According to some analysts, bureaucratic values are so focused on growth that officials are highly resistant to reductions in force, so they create procedural obstacles, or at least do nothing to facilitate calls for workforce reductions.
Growth in an occupation that is widely deemed essential (prison guards) can overwhelm reductions in occupations that are being phased out (ward attendants in state mental hospitals).
Demand for some state services increases during recessions when calls for restrained state employment are most frequent. Health, welfare, Medicaid, children's services, and social service workloads increase during recessions, and law enforcement and public education workloads may, too.

Techniques for Reducing Government Employment

Three ways that state governments have reduced public employment and compensation are:

Use of a special commission to recommend efficiencies that lead to reduced employment;
Early retirement incentives; and
Privatization of governmental functions

These techniques address some of the obstacles listed above. In various ways they circumvent or effectively resolve bureaucratic inertia, employee resistance and economic and legal obligations to existing employees. None of them can live up to the greatest claims of their advocates, and each of them can lead to new problems while attempting to solve old ones.

A fourth method is the severance program the governor of Rhode Island proposed in his budget for FY 1997. State employees who agreed to leave state service voluntarily on or before July 1, 1996, and agreed not to accept employment from any state agency for five years would receive a severance benefit equal to two weeks' pay for each year of actual state employment plus six months' state health insurance coverage.

Case Study: The Maine Productivity Realization Task Force

Early Retirement Incentive Programs

Many state governments--as many as one-third in the period from 1990 through 1995--have created early retirement incentive programs designed to reduce the ranks of employees without layoffs, cut personnel costs enough to cover the increased pension obligations and cut spending overall. To encourage voluntary early retirement, such programs offer some category of employees various incentives that are not ordinarily available. Usually the incentive is available for a short time--approximately three months--with enough advance notice that employees can consider their options. Incentives vary and may include provisions to allow retirement with a normal pension at an earlier age than usual, a pension benefit increment, increased health insurance benefits or a combination of these.

These programs have a number of fiscal and management advantages:

They have the potential to reduce the number of employees and save salary costs.
Savings can be significant since such programs are usually aimed at long-term employees, who tend to have higher salaries.
Programs can improve efficiency if they eliminate less-efficient employees. A covert but never officially stated purpose of such incentive programs can be to encourage "deadwood" to retire.
They avoid the damage to morale done by involuntary layoffs and can enhance morale by giving the employees who remain opportunities for promotion.
Employees welcome such opportunities; they generally consider they have nothing to lose. Employers generally welcome them as well.

The advantages of early retirement incentive programs can be lost if a program is not carefully designed. Policymakers have to be careful not to swap short-term savings in salary and benefits for greater long-term liabilities to the pension system. Many studies contend that the real potential for savings from early retirement incentives lies in reduction in the number of employees--not in the replacement of senior employees with juniors.

If so, an early retirement program is most effective as a cost-saving device only when linked to a commitment to reduce public employee payrolls and keep them reduced. Thus, an early retirement incentive program is a cost-saving device only when it is combined with a broader program of reducing the size and activities of government.

Those are not the only potential pitfalls. Without very careful design, an incentive program may merely accelerate retirement decisions by a few months at substantial cost to the state. An early retirement incentive program that rewards people for retiring six or nine months earlier than they would have anyway is likely to be a waste of resources. An incentive program that merely shifts costs from current salary and benefit lines to the pension system is badly conceived as well, since it is usually considered poor policy to shift current expenditures from current taxpayers to future taxpayers. Almost unavoidably, retirees will include experienced employees whom agencies might benefit from keeping.

Cost-shifting is especially a danger when state provisions allow the local government participants in a statewide pension plan to retire at no additional cost to the local government, with the pensions costs absorbed by state government. This provides a state subsidy to local governments on an erratic and unplanned basis.

Case Study: Early Retirement Programs in Minnesota and Virginia

The following discussion of things to look out for in the design of early retirement incentives is based on thorough evaluations of programs in two states, Minnesota and Virginia. The Minnesota program was offered to city, county, school district, university and state employees in 1993. The Virginia program was available to a similar range of state and local employees in 1991. Both evaluations offer pointers for the future, as well as explanations of some unexpected problems that emerged as programs were administered.

In both Minnesota and Virginia, auditors found that the early retirement programs brought a net fiscal loss to state government.

In Minnesota, the increase in pension and insurance costs was about $100 million on a present-value basis for about 3,300 early retirements. This seemed particularly expensive since it appeared to the auditors that 50 percent of those who received augmented early retirement benefits would have retired in 1993 without the incentive (partly because the program included special incentives for employees over age 65 that attracted a very large proportion of such employees to retire).
In Virginia, the increase in pension costs was about $238 million (present value) to cover the additional retirement benefits for the 3,535 state employees who took early retirement. The costs in Virginia were higher than in Minnesota. The Virginia program was available to younger employees than the Minnesota program, which means that on average benefits will be paid for more years. Unlike the Minnesota program, Virginia included no special incentives for employees over age 65 (whose life expectancy is shorter).

Auditors in both states recommend that early retirement incentives ought to be targeted to programs, departments or agencies that have an immediate need to downsize or reorganize and not made available across state government.

The Minnesota finding is that downsizing is essential for savings from an early retirement incentive, and those savings are likely to result from budget decisions independent of an incentive program. Therefore, the primary benefit of a retirement incentive program is to ease the removal of employees who would have to be dismissed anyway.
The Virginia recommendation is that early retirement incentives should be one tool among others available to programs that have to downsize or reduce spending, not a governmentwide policy for its own sake.

Because savings depend on reducing employment, vacancies need to be tracked and replacements controlled in a more sophisticated way than states ordinarily practice.

In Virginia, the original goal was a net savings of $37.1 million for FY 1992's state budget (without taking any additional payments to the Virginia Retirement System into account). Saving $37.1 million required that no more than 50 percent of the retirees be replaced. However, replacements were not tracked, and no method existed for deciding how to weigh the costs of (1) using salary savings to fill vacant positions other than those created by the early retirement program and (2) re-employing retirees as contractual, part-time or temporary employees--a widespread practice. Although the goal of budgeting $37.1 million less was met, it appears that only part of the savings came from early retirements and that agencies used a variety of sources to live within their reduced budgets.
In Minnesota, 61 percent of positions vacated remained empty for somewhat less than a year. This was a slightly higher proportion than was needed to cover program costs for state government. However, to cover costs, the positions would have to remain permanently unfilled, and within a year agencies planned to fill many vacancies. Moreover, no data existed on the salary savings that had been used to fill other, existing, vacant positions.

There are unforeseen costs, not all of them monetary.

Compensation paid to temporary employees.
Recruitment and training costs for replacement employees.
Organizational costs as promotions created a ripple effect down through agencies.
An increase in the number of employee grievances attributed to hiring inexperienced managers.
An unexpected exodus of experienced, key employees.

The advantages remain:

With careful design, early retirement incentives can assist in the smooth and economical downsizing of government.
Incentives help avoid the disadvantages of involuntary dismissals and allow a graceful end to careers in government.
Incentives make room for new ideas and management practices.
With targeting, control of replacements and better reporting on vacancies than is the ordinary rule, early retirement incentive programs can save money.

Privatization as a Means of Reducing State Employee Numbers

Privatization includes a broad range of concepts, from asset sales to the use of volunteers, with its emphasis on replacing government activities with private sector activity. Rationales for privatization range from a conviction that public sector activities ought to be minimal, for reasons of both economic efficiency and personal liberty, to the views that introducing competitiveness to government may improve efficiency, save some money or reduce hostility to government. The discussion here focuses on the connections between privatization and employment issues. {A good summary of the broad issues of privatization and some ways for policymakers to approach it is Legislative Analyst, "Privatization in California State Government" in The 1996-97 Budget: Perspectives and Issues. Report from the Legislative Analyst's Office to the Joint Legislative Budget Committee (Sacramento: The California Legislature, 1996): 173-189.

The most widespread form of privatization is contracting for services, long a practice in state and local governments. According to state officials, the reasons that privatization will expand are, in order of importance:

Cost savings;
Lack of agency personnel or expertise;
Flexibility;
Speedy implementation; and
High-quality services.

Privatization in the form of contracting out for services is far more widespread in state and local government than advocates of privatization sometimes may realize. As long ago as 1982, state and local contracts let to private vendors amounted to $65 billion, well over 10 percent of spending for that year. {Donald F. Kettl, Sharing Power: Public Governance and Private Markets (Washington, D.C.: The Brookings Institution, 1993): 156. Private sector contracts accounted for between 18 percent and 20 percent of Colorado state expenditures (other than higher education expenditures) in FY 1986, FY 1987 and FY 1988. In FY 1988, social services contracts accounted for somewhat less than half of the total contractual spending, and highway construction and maintenance for another third. A study of Minnesota state government's contracts for FY 1990 reported $496 million in contracts, of which 78 percent was construction of highways and bridges. {State of Colorado, Office of the State Auditor, Privatization in Colorado State Government: Follow-Up Performance Audit (Denver, Colo.: February 1993); Privatization in Colorado State Government: Performance Audit (March 1989); State of Minnesota, Office of the Legislative Auditor, Program Evaluation Division, State Contracting for Professional/Technical Services (St. Paul, Minn.: February 1992).

Some authorities contend that contracting for services saves money because the private sector tends to pay less and provides fewer benefits than public employment.

When comparisons are made of total compensation, not just wages, and are confined to low paying jobs (e.g., janitorial and food services), public sector workers make much more. Many claimed savings from privatization build on the [compensation] differences, not on productivity differences. {Hal Hovey, "Public Employees Under Attack," State Policy Reports 12, no. 5 (Mary 1994): 2-3.

Others find different reasons for private-sector costs being lower than those in the public sector. According to the Council of State Governments:

Savings from competitive contracting of public services could be due to the fact that private firms give fewer days off with full pay; use more part-time workers; have great managerial authority to hire and reward good workers, and, if necessary, to discipline or fire unsatisfactory ones; utilize more productive equipment; have clearer job definitions and greater accountability; and have more workers per supervisor. State managers may want to consider similar tools of management improvement. {Keon S. Chi, "Privatization in State Government: Options for the Future," State Trends Forecasts 2, no. 2 (November 1993) : 26.

However, Albert Shanker, president of the American Federation of Teachers, warns:

Contractors often make their money by lowering wages and cutting benefits. Low-wage workers with no benefits can end up eligible for food stamps, public housing and public medical services, all costs to the community. {"Does Privatization Work?" (paid advertisement), State Legislatures 21, no. 5 (May 1995): 28.

Guidelines for Privatization

When services are available on the open market, what services should governments try to produce internally and what should it obtain from the market? One study suggests use of a contractor when:

The workload or funding is likely to vary;
New equipment, specialized personnel or significant capital investment are required;
Service sites are scattered throughout the state; or
Others can provide greater value or service levels than state employees.

The study recommends retaining a service as part of state government when:

Employees provide the service incidentally as part of their routine activities;
The state investment in facilities or equipment remains useful;
The activities are tied closely to an agency's basic mission; or

The activities help to fund the agency or reduce costs or otherwise are important to running the agency. {Minnesota, Contracting for Services, 81-82.

Case Study: The Massachusetts Privatization Law

The Massachusetts legislature in 1993 enacted legislation over the governor's veto to prevent potential private contractors from greatly reducing salaries and benefits from the public employee level. The effect of the legislation is to require potential contractors to show they can find efficiency savings other than in salaries and benefits and at the same time provide the quality of service government employees can provide. The Massachusetts law provides that:

Contractors must provide health insurance benefits comparable to those for similarly paid positions in state government.
Contractors must offer positions created by the contract to state employees whose jobs are lost because of the contract.
Agencies must estimate the cost of their providing the services that are the subject of the contract and provide for state employees' unions or other organizations to bid against external bidders.
Agencies must certify that the cost of contracting out is less than the cost of internally producing the services in question.
The state auditor's statement that the law has been observed will be necessary in order for a contract to be valid.

These provisions almost require a contractor to demonstrate savings in service delivery from some source other than reduced employee compensation--the guidelines allow only a limited reduction in compensation. The guidelines also encourage government employees to compete with potential private contractors.

No contract was submitted to the Massachusetts State Auditor for review from the time the law was enacted in December 1993 through April 1996. In April 1996 the auditor's office indicated it expected the Massachusetts Bay Transit Authority, which operates trains and buses in eastern Massachusetts, to submit a number of proposals for contracting for various management and maintenance operations. No other proposals appeared to be in progress. This suggests that potential contractors have found it difficult to demonstrate the advantages of contracting and that, without significant reductions in salaries, wages and benefits, savings from contracting are hard to find.

Case Study: Experience with Privatization in Minnesota and Wisconsin

State Aid to Local Governments

State aid to local governments--counties, municipalities, school districts and special districts--amounted to about $200 billion in FY 1992. As shown in figure 3 earlier in this chapter, aid to local governments represents almost 30 percent of state spending. As shown in figure 4, most of this aid--64 percent--was for education. Those two facts set the parameters of any discussion of reductions in aid to local government as a means of dealing with a state government budget problem: Intergovernmental aid is a very large part of state budgets, but most of it is for education, which usually is immune to budget cuts.

There are two basic ways for state governments in fiscal distress to reduce aid to local governments:

Squeeze the cuts out of the share of state aid for purposes other than support to education (an amount that varies greatly from state to state). This often has meant reductions in state general-purpose aid to local governments--aid not earmarked for a particular expenditure.
Replace some fraction of state government aid to education with funding from another source.

Figure 4. State Aid to Local Governments, FY 1992

Source: NCSL compilation based on Census Bureau reports

Both practices impose hardships on local governments, especially because most local governments have limited authority to raise additional revenue. Both practices are likely to undermine one of the functions of state aid to localities, which is to compensate for local or regional differences in wealth and tax bases within a state. {A good general survey of the topic is Steven D. Gold and Sarah Ritchie, State Action Affecting Cities and Counties, 1990-1993: De Facto Federalism (Albany: State University of New York, Center for the Study of the States, April 1994): 23.

Case Study: New York's Experience With Reductions in State Revenue Sharing

Case Study: California's Experience with Reductions in State Aid to Education

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