Arizona Policy Choices

Balancing Acts: Tax Cuts and Public Policy in Arizona

Blue-chip times

States benefiting from a booming economy are taking a cautious approach to spending so far. Such caution is well justified by history.

Hal Hovey, Editor, State Budget & Tax News and State Policy Reports
© State Government News, May 1997

State finances are in outstanding shape.

Everything seems to be going right. Revenues are up, spending is down, balances and rainy-day funds are growing faster than expected, and the outlook is for more of the same. The whole situation seems too good to be true. It probably is.

There are always a few examples of states with self-inflicted fiscal problems. But mostly states run into fiscal problems because of circumstances state officials can't control recession, federal actions, and demographic and economic factors affecting taxes and spending. Right now, each one of these is bringing good news.

The economy: The nation's economy is on a roll a long one at that. The economy has grown smoothly for a longer period without a recession than all but twice since 1945. The consensus economic forecasts are for more of the same for at least another year. Certain aspects of recent economic growth have particularly favorable effects on state finances. One is the concentration of gains in activities states tax the heaviest wages and salaries rather than pensions or benefits, purchases of durable goods like vehicles and furniture rather than services, corporate profits and capital gains. Another aspect is the strong growth in employment. Employment has been growing at about 1.9 percent a year, about twice as fast as population nationally. The results are beautiful fiscally more rapid growth in taxpayers than tax users, fewer unemployed, fewer people eligible for welfare and other programs with means-tests for eligibility. Also, the good news is widely spread geographically, with Hawaii the only state that is in recession. Figure 1 shows the recent job growth for each state. While Western states are showing the strongest economies and state fiscal positions, 37 states have comfortable job growth of 1 percent or better. Even some of the other 13 states, such as New York, are reporting revenues well above estimates. The good news has resulted in state tax collections in fiscal 1997 that are about 2 percent higher than states anticipated when they adopted budgets early in 1996. Besides adding to the surpluses, this unanticipated revenue provides new, higher tax bases as states estimate their new budgets.

Federal actions: In 1995, 1996 and early 1997, state officials expected the worst from the federal government. States anticipated dramatic federal aid cuts in current and future budgets because of federal budget-cutting plans and the proposed balanced budget amendment. States also feared federal tax reforms would have adverse impacts on state taxing authority. Instead, the balanced budget amendment and sweeping tax reforms appear dead until at least 1999. Moreover, the federal deficit has dropped without federal aid cuts. Welfare reform has provided windfalls to states, and the partisan competition that developed in passing the current federal budget produced extra aid for education and other grant programs.

Cost of government: There also has been good news concerning state costs. Health-care inflation is now about the same as the general inflation rate, down from twice that rate in the first half of the 1990s. This produces savings in Medicaid, health care for state employees, and state-paid health costs for inmates, foster children and others. Welfare caseloads have declined dramatically, even before implementation of federal welfare reform. Growth in prison populations has slowed and crime rates are declining. The effectiveness of chemotherapy and changing doctrines of appropriate care are emptying expensive state institutions as community programs serve increasing numbers of developmentally disabled and mentally ill.

News unexpected: Good news affecting state finances is even better news when it comes as a surprise. Expected good news leads states to adjust their finances by making tax cuts and increasing spending. Unexpected good news produces revenues above estimates, swelling surpluses and rainy-day funds, and lapsed appropriations, further swelling balances. State officials didn't anticipate fully the strength of the economy. Feared federal aid cuts didn't occur. States anticipated more inflation in health-care costs than developed. And states didn't expect the windfall revenues and new flexibility of federal welfare reform. Also, a booming stock market produced higher-than-anticipated growth in assets of state pension funds, bringing many states to full funding of these plans.

Cautious Approaches

By a combination of accident and design, state officials have created a cautious, fiscally conservative record in dealing with their good fortune.

Building hedges against future adversity: State officials used some of their good fortune to rebuild their balances and rainy-day funds. Those balances now exceed 5 percent of spending, a target for some states, and are higher than anytime in the 16 years since 1980. Figure 2 shows what has been happening.

Caution in cutting taxes: With a few exceptions, state officials have not turned their prosperity into deep permanent tax cuts that might impair their future fiscal outlooks. Instead, states held down tax cuts in 1995 and 1996, and likely will hold them to less than 1 percent of spending in 1997. To avoid impairing future fiscal capacity, some states have passed one-time tax rebates rather than permanent tax cuts. Other states have spent extra general fund money to avoid increases in other taxes. Colorado used a surplus to relieve pressures for highway taxes. South Carolina and Wisconsin financed local tax reductions by lowering property taxes. In 1997, the largest tax cuts are appearing in states that are required to stay within constitutional limits on spending or taxes, such as Missouri and Washington.

Cutting spending: States have attempted to curtail costs of their cash welfare and Medicaid programs. These efforts have been particularly vigorous where the benefits provided (and thus state costs) have traditionally been higher than national averages. Examples: cash welfare in California and Medicaid in New York.

Cautious approaches to raising spending: State officials are talking more about "not just throwing money at the problem" and less about "unmet needs." The results appear in many overall policies. These include attempts to reduce state employment and shift selected state functions and programs to the private sector. For example, much of the state emphasis in elementary and secondary education is on relatively inexpensive actions. These include measuring student performance, rewarding successful schools, receiverships for districts that are failing educationally, and promoting competition through choice programs such as charter schools. Much of the new spending is inherently one-time, such as providing computers and Internet links in every classroom.

The exceptions: Not all states are equally cautious in managing their finances. The most cautious approaches are appearing in fast-growing Western states where the rapid pace of the economy seems too good to be sustainable. Some Northeastern states, particularly New Jersey and New York, have cut taxes aggressively out of fear that their slow economic growth is caused by excessive tax burdens. But state officials seeking corresponding spending cuts, such as Gov. George Pataki of New York, are discovering barriers to their implementation ranging from federal mandates to reluctance to curtail long-established public services.

Risks to State Finances

Historically, in prosperous times states plant and nurture the seeds of future fiscal crisis. Viewing their good fortune as permanent, they spend too much, save too little and cut taxes too much. These actions mature into dramatic fiscal crises when a recession ends a temporary favorable run of fiscal good luck. During the deep midyear spending cuts and steep tax increases of 1983, budget cuts disrupted public programs, and tax increases upset taxpayers by occurring when people could least afford them. The combination destroyed many elected officials' careers. This pattern easily could repeat. Signs are that state officials are starting to take good news for granted anticipating a permanency in reduced welfare dependency, slow growth in health-care costs, increasing federal aid, high returns on pension-fund investments and rapid growth in tax collections. The most worrisome sign is that many proposals would use one-time windfalls to finance permanent cuts in taxes and increases in school aid for property-tax cuts. The temptations are obvious because the short-term advantages are clear and the long-term risks are speculative. In a recent issue, State Policy Reports listed seven risks to state finances: recession, financial market corrections, return to normal tax collections, adverse federal actions, return of familiar spending pressures, overconfidence, and "cascading problems" the tendency of unfavorable developments to build on each other just as favorable developments recently have been building on each other. The overriding fiscal issue of the 1997 legislative sessions is just how much risk state officials can afford to take.

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