Business Columns & Blogs

Ed Lotterman: When state and federal government have surplus funds but a deficit in prudence

Adages may be old, but they still can be wise. “Don’t count your chickens before they are hatched” should be a foundation stone of good economic policy.

However, financial prudence does not seem to be a virtue of baby boomers and succeeding generations, so this good advice often is ignored. Case in point is what the governor and legislature of my home state of Minnesota are proposing to do with a very tentative and probably ephemeral projected budget surplus. Unfortunately, their eagerness to dispose of anticipated money before it is in hand probably is typical of state governments nearly everywhere.

If we only were willing to learn from the histories of each of our own states and that of our national government, we would not be so precipitous in trying to use up this money as fast as possible.

Yes, here we do have a projected budget surplus for the next two years. Some other states are in the same enviable position. Yes, our particular state economist and staff who put the economic forecast and budget projections together are very capable and do an admirable job. And yes, having such projections helps us manage public funds better, at least if we use the information wisely.

But as eggs in nests in the coop are not chickens, projection are not money in the bank. It is folly to add major spending programs based on even a very good forecast. And it is double folly to make major permanent cuts in taxes based on the same tenuous estimates.

Economic forecasting is inexact. Economist’s models are pretty good at predicting variations in output and employment as long as the general trend remains the same: If the economy is growing and continues to grow, good forecasts can be made on the magnitude of that growth and of variations around the general trend.

Ditto when an economy is shrinking.

However, none of these models is good at calling turning points, when economic activity switches from expansion to contraction or vice versa. Few modelers or forecasting firms predicted the financial crisis that began in 2007 or the recession that followed. Here, the top researcher at the local Fed district bank still was saying we could avoid a recession a couple of months past the date where after-the-fact work by the National Bureau of Economic Research showed that a slump already had started.

Moreover, in many states, government revenue and outlays are highly sensitive to variations in the overall economy. This is extremely salient in my state and is a built-in feature of our exclusion of many “necessities” from sales taxes and our conscious concentration of the state income tax on high-income individuals. When the economy slows, revenue falls sharply and outlays increase. When the economy speeds up, outlays ease and tax revenue rises sharply. Fluctuations in the budget are sharper than in the underlying state economy.

Furthermore, the performance of the state economy depends enormously on what happens to the U.S. and global economies. So unrest in the Mideast or a disorderly Greek exit from the euro or the inevitable slowing of China’s economic growth can negate our state models in a hurry.

Finally, there is an unexploded land mine in the forecasts themselves. By a peculiar and iniquitous state law dating from 2002, these forecasts must take into account the effects of inflation on revenue growth but must ignore effects of the same inflation on spending. One of the most respected local business economists has been articulate in pointing this out, but apparently to little avail. This statutory restriction on the state’s forecasters ensures a systemic overestimation of future surpluses. And if actual inflation turns out to be higher than levels incorporated in the estimates, the magnitude of the problem increases.

The governor and the leadership of both of our parties understand this problem. Yet they act as if it does not exist. Yes, cumulative consumer inflation over the past five years is only 9 percent. But it is dangerous to assume that inflation will not be a factor going forward. Even at a couple of percent a year, the statutory divergence between inflated revenues and uninflated spending can grow large. This factor alone wipes out most of the surplus projected for 2020.

All this is particularly galling in terms of the fiscal history of the state over the past 15 years. In the late 1990s, with a booming state and national economy, my state ran successive budget surpluses. We hailed “a boatload of money,” and “rebate” checks were mailed out. Now, most of this was the result of a seldom-to-be-repeated economic boom, but we did continue to increase outlays and cut taxes. When the economy first slowed in the new century, and then crashed after mid-2007, we had large budget deficits. This was not only entirely predictable, but had been predicted.

To paper over the results of our folly, we engaged in all sorts of ad-hoc budgeting gimmicks and shameful stiffing of local governments. Economic growth and an increase in the income tax rate for the highest-earning households finally brought us back to balance. But we don’t yet have large amounts of money in the bank. It is clear that if we adopt the new spending favored by the governor and the Democrats together with the tax cuts pressed by the Republicans, we are going to be back in fiscal crisis within a few years.

The tax cuts are particularly problematic because they will remove one of the most stable components on the revenue side. The eliminations would include a tax on business property that fluctuates less with the business cycle than do sales and income tax revenues. Eliminate that, and we will be even more dependent on revenue that inevitably whips up and down more than the underlying economy.

Patience is not a virtue of our age. In the famous experiment of putting a toddler in a room with a marshmallow and saying another marshmallow would be given when the adult comes back as long as the first one is untouched, most state governments would grab and gobble the marshmallow before the psychologist was even through the door. But why can’t we just wait one legislative cycle to see how revenues and outlays actually turn out? Is it really impossible to not gobble the marshmallow right away?

The ideal, as I have argued before, would be for states to have independent boards mandated to oversee a large reserve fund and certify a true structural surplus situation before taxes could be cut or new spending programs implemented. That, obviously, isn’t going to happen. But that doesn’t prevent the legislatures from simply showing maturity and discipline in fiscal matters for a couple of years.

There are few statutory impediments to states running temporary budget surpluses if, in fact, tax revenues, inflation and spending all turn out as well as incorporated in rosy forecasts. Yes, money in state coffers won’t earn high investment returns from fund managers. But waiting to watch the chicks hatch before we start dividing them up might well keep us from relapsing into the wasteful gimmickry we resorted to five years ago. The return to society from fiscal prudence would be great.

This is not to resort to wild-eyed “coming crash of 2016” scenarios, but there are many uncertainties in the economy, and the dangers are larger and more numerous on the downside than on the upside. This is the time for bipartisan maturity and restraint, not fiscal binges on either the spending or taxing sides of state finances.