Ed Lotterman: States need mechanism to bank bigger budget reserves

boise@edlotterman.comMarch 11, 2014 

Along with several other states, my home state of Minnesota has returned to a budget surplus after some sharp deficit years. Whether that is because of luck or good policy is a matter of divided opinion. But there reportedly is about $1.3 billion on the table.

Here, as in every other state that now faces a surplus, there already are many suggestions on how to "use it" -- ranging from tax cuts to new spending. This is premature, fiscally irresponsible and dangerous to the states’ economies. These surpluses are not long-lasting "structural" ones, and that should be taken into account.

Many states face a lop-sided set of constraints. They have statutory, or in many cases, constitutional bans on borrowing for ongoing operations. Budget deficits are banned. But they have no good mechanisms for saving surpluses. So whenever there is a surplus, which almost always is due to a prosperous general economy, there are pressures to cut taxes or start new spending programs. Then the economy slows. Panicked and wasteful measures are implemented to stave off deficits.

States instead should first build up reserve funds for the days they go back to running deficits (which they will). But most really don't have good statutory ways to do that.

The problem is an old one. Finances vary sharply with overall economic activity for virtually every state government as well as for our federal one. This is true both for taxes and spending.

This is particularly true, however, for states like mine with heavy dependence on a progressive income tax. And the more any sales tax exempts necessities like food or basic clothing, the more volatile the state’s revenues. In a recession, people cut back on buying nice-to-have but non-essential items like new cars or appliances or boats. They don’t cut back nearly as much on buying things like food that frequently area exempted. Thus revenues fluctuate by a much larger factor than underlying household income.

Moreover, when the economy slows, outlays automatically rise with the state portion of unemployment, Medicaid and sundry welfare programs. If by law states must have balanced budgets, they then must struggle to close the resulting gaps. In my home state we often resort to smoke-and-mirrors accounting tricks like "borrowing" from school districts and moving disbursements on paper from one fiscal year to another. This creates a fiscal mess, and promotes inefficient use of resources and economic waste.

It also is an example of how manure flows downhill. State elected officials crow about their budget toughness while school districts have to scramble to solve a problem crammed down their throats.

When the economy grows, as it is doing now, tax revenue can grow sharply. Some outlays fall, although that is usually hidden by the long-term growth of the state budget, even when that occurs at a low rate. We may achieve a budget surplus, perhaps even enough so that officials can vaunt "a boatload of money." Republicans claim the surplus is evidence that the state is overtaxed. Democrats are quick to identify social injustices that can only be remedied with new spending programs.

The core of the problem is that elected officials and the laws governing state finances do not take into account the idea of a "structural" budget deficit or surplus. In economics, "structural" contrasts with "cyclical." Cyclical phenomena are those caused by the regular short-term fluctuations in economic activity, growth and recession, which we call "the business cycle." Structural ones are driven by longer term changes caused by technology or people's preferences.

A framing carpenter who got laid off when new housing construction collapsed in 2009, but who is being hired back now as building recovers, was cyclically unemployed. The increases in the numbers of people working as coffee-dispensing baristas over the past 20 years or addiction counselors over the past 30 are structural phenomena as was the plunge in steam locomotive mechanics in the 1940s. (My dad was one of them.)

It is only prudent to make big changes in either taxes or spending, taken individually, if you have a structural budget deficit or surplus. A structural deficit is one that you would have even if the economy was at stable full employment, neither in recession nor in the throes of an unsustainable boom. A structural surplus is one that similarly would exist if the economy was at a stable center.

If you have a surplus that would disappear as soon as the economy slows from an overheated state, it is cyclical. Ditto for a deficit that crops up only because the economy is in recession.

Prudently-managed state finances would pile up reserves whenever there was a cyclical surplus to be able to fund the deficits that inevitably occur when there is a recession. There would be no spending increases based on the "we're-running-a-surplus" argument unless it was clear that surplus was structural and wouldn't disappear when the boom faded. The same is true for taxes -- no cuts would be made unless the surplus clearly was one that would persist across the business cycle.

Of course, you could always have spending increases paired with tax increases and tax cuts paired with real spending cuts.

Moreover, you would have to increase taxes or cut spending whenever there was a structural deficit -- one that would not go away even when the economy was on an even keel.

Given how volatile state finances are, it is also prudent to amass much larger "rainy day funds" than we have done in past periods of prosperity. Recent history tells us recessions can last a long time. And statutory limitations on borrowing for current operating mean we cannot legally have a "borrow in bad times and pay off the debt in good times" policy.

The problem with reserve funds is that they are so tempting to legislators. Let a big pot of money accumulate and the tax cutters and new program spenders will both look at it and salivate. You need a credible mechanism to isolate the funds from the ordinary budget process.

One possible measure is to set up independent boards, modeled somewhat on the Federal Reserve Board, that would have to certify the existence of a true structural surplus before additional spending programs could be created or taxes cut. They would manage a large reserve fund that could only be drawn on when the board certified certain statutory conditions were made.

As with the Fed's board, members of these panels would be appointed for staggered long terms. They would be as non-partisan as possible. No members could be currently elected officials. Ideally, it would be made up of former senior elected or appointed officials such as past governors, members of congress or state supreme court justices.

Creating such boards would free legislators, many on a two-year election cycle treadmill, from the siren songs of fiscal populism. It would foster more efficient use of tax dollars more efficiently.

Yes, structuring larger reserve funds is a slim bet politically. But many states have exhibited fiscal wisdom at some time in their history, and there is no reason why that could not happen again, even if recent history is not encouraging.

Economist and writer Edward Lotterman can be reached at boise@edlotterman.com.

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