Analyzing State Government Spending

Policy Study

Analyzing State Government Spending

States significantly overspent even when the economy was good

Even if the recession is technically over, by any measure the U.S. economy is a long way from whole, with unemployment still at 9.1% as of May 2011. As well, the economic downturn has put a great deal of pressure on state budgets. The Center for Budget Policies and Priorities pegs states falling short of desired revenue by $112 billion in the coming fiscal year. As economic activity declines, states collect less tax revenue. As people lose jobs and incomes drop, demand increases for state services like job training, health care support, welfare and unemployment compensation. The combination often leads to dramatic cuts in state services or even tax increases.

State leaders have responded to these drops in revenue with warnings of dire budget cuts and tax increases. Of course, the cuts are always calculated from what spending would have been if they had continued to increase it, not measured from any objective assessment of need. Hence the logic of tax increases is compelling to those who can only see spending increasing. In 2009 and 2010 36 states raised taxes or fees, including:

  • New York: Total enacted and proposed new taxes, 2009-2011: $8.2 billion; $419 per person.
  • California: Total: $11.5 billion; $312 per person.
  • Delaware: Total: $253 million; $286 per person.
  • Wisconsin: Total: $900 million; $159 per person.
  • Arizona: Total: $1 billion; $154 per person.
  • Kansas: Total: $425 million; $151 per person.
  • Washington State: Total: $982 million; $147 per person.
  • Oregon: Total: $541 million; $141 per person.
  • Massachusetts: Total: $890 million; $135 per person.
  • New Hampshire: Total: $161 million; $121 per person.

Meanwhile the “stimulus” bill, the American Recovery and Reinvestment Act (ARRA), sent unprecedented sums from the federal Treasury directly to the states. Federal Funds Information for the States estimates that over $200 billion of the spending in ARRA was routed through state government.

Routing these federal funds through the states is partly explained by the evolution of the relationship between the federal and state governments. State governments are, to a certain extent, subsidiary branches of the federal government. Federal grants to transportation, education and welfare alone give the federal government tremendous influence over how states spend in those areas. Today, on average, for every dollar state government spends, around 28 cents comes from the federal government.

What’s missing from discussions of state budget crises is any context. Even if one accepts the “shortfall” numbers at face value, it is not immediately clear to what extent the budget shortfall is due to the general economic downturn, or to policy decisions made by state leaders. For example, if a state has built a budget around revenue growing by 10% and revenue only grows by 8%, one could argue the state is experiencing a “shortfall”, but not in a way that is meaningful to most people. If the economic downturn were the only culprit, all state budgets would be compromised, which is not the case. Missing from most stories are the answers to questions like: How do current revenue and spending compare to past years? How do they compare to population growth and inflation? What sources of revenue are falling? How has spending in different areas changed?

Nor do we know whether the current or projected budget is built on years of rapid increases in overall spending. If your current budget is built on several years of rapid expansion, a projected cutback may seem more severe than it actually is. If over the last six years you had received 10% raises each year, and spent them on a new car, RV and nicer vacations, yet this year you have to take a 20% cut, it may seem like a “shortfall.” But in fact your income is still nearly 50% above where it was six years ago-not much of a hardship. Looking at state government’s revenue and spending over the past decade tells a similar story.

Indeed, during the past decade, government grew considerably faster than the private sector. As Figure 1 shows, “[W]ith the exception of 2004 and 2005, government consumption and investment have grown more quickly than private expenditures and investment every year this decade. In the last ten years, the private sector has, on average, grown 1.2% annually, while the government has, on average, grown 3.5% annually.”

Looking at state budgets in one- or two-year time frames is interesting, but ultimately irrelevant. It is worth asking, are we treating an illness or a hangover? Have the states been efficient stewards of public resources that now, reeling from an economic calamity, need federal support? Or, have they been on a spending bender during a robust economy, like other sectors of the economy, living as if the boom-years would never end? Will a federal infusion now merely put off the necessary steps that need to be taken to put state budgets on a more sustainable footing? Do we feed the addiction or feed the recovery?

To help answer these questions, we looked at census data on state government finances from 2002-2008, and the picture is revealing. Census data provide a fairly thorough and consistent way to compare state revenue and spending over the years, though the most recent year of data is 2008. The years 2002-2008 provide a picture over a seven-year span, beginning just after the dot-com bust and going into the first year of the most recent recession and the beginning of the state budget crisis.

This comparison shows not only total revenue and spending trends, but shifts in where revenue has come from and where it has been spent. State lawmakers often like to complain about “federal mandates” on certain programs. Left unsaid, however, is that states are subjected to these mandates only because they choose to accept federal funds. For example, many state officials have complained about the testing requirements in the No Child Left Behind law. They had to comply with these requirements because of the education dollars they received from the federal government-about 8.3 cents on the dollar of total education spending. If states had turned down the federal money-again only pennies on the dollar-they would be free of not only the NCLB mandates, but every other federal mandate on education policy. But states don’t seem willing to turn away from federal funds no matter how much it distorts their decisions. Taking all of this into account, this study focuses on general expenditures, so as to capture state spending including federal funds to reflect that bargain that states choose to accept.

This study ranks all the states in every category to show how each compares to other states and the national average. But perhaps most importantly it allows a comparison of all the states to the “baseline”-the growth of population and inflation. Over the span of seven years, some could argue that state revenue and spending has to grow with population and inflation as they increase the level of services required and the cost of providing them. To address this concern we combine a 20% inflation from 2002 to 2008 with the average state population growth of 5% to set a baseline of 25%. State revenue and spending growth that significantly exceed that baseline are excessive, and our findings demonstrate excessive state-level government growth during these years. This study concludes that the perceived “shortfall” that has driven many states into a financial crisis is no more than the consequences of spendthrift states being forced to rein in years of profligate spending.

Revenue

States receive around 30% of their revenue from the federal government. This is because many federal policies and programs use grants to the states as funding mechanisms, incentives and instruments of control.

This study shows that state revenues grew substantially between 2002 and 2008 at a rate greatly exceeding the rate of population growth and inflation. In those years states’:

  • Total revenue grew 48%
  • General revenue grew 42%
  • Transfers from the federal government grew 33%
  • Sales tax revenues grew 32%
  • Personal income tax revenues grew 43%
  • Corporate income tax revenues grew 102%
  • Average population and inflation grew 25%.

And these calculations include the dip in revenues in 2008 due to the recession. In 2007 total state revenues exceeded $2,000,000,000,000 ($2 trillion), nearly double the $1,097,000,000,000 ($11 trillion) they were in 2002, before falling substantially to $1,619,000,000,000 ($1.7 trillion) in 2008.

Put another way, states overall had increased revenue by $563,000,000,000 ($563 billion) more than justified by inflation and population growth. Even after the recession began in 2008, they were still taking in $182,000,000,000 ($182 billion) more than they needed to cover population growth and inflation since 2002.

Let’s put this in personal finance terms. In 2002, you come out of the recession with a job that pays you $50,000 a year. Over the next six years you receive cost-of-living adjustments from your employer so you can maintain your lifestyle. In 2007, you are earning $60,500, before the recession of 2008 causes your employer to cut everyone’s salaries by 10% to avoid more layoffs, putting your salary back to $54,450. But your neighbor “state government,” however, saw his salary grow to a stunning $90,500 and even the recession only knocked him back to $74,000-36% better off than you!

Taxes Per Capita

Across the nation, state total tax collections averaged $1,862 for every man, woman and child in 2002. In just six years, that figure had risen to $2,574, an increase of more than $700 for every citizen (which means an average roughly $2000 per household increase in state taxes). This increase of 34% is well above the 25% baseline.

Obviously, not every dollar of a state’s total tax collections is paid directly by residents. The biggest increase in per capita collections was in states with significant natural resources that benefited from higher prices for oil, gas and other minerals. But demand for state services should roughly align with the rate of growth in population and the economy, unless the scope of government services is expanding as well. Since states were largely providing the same services in 2008 as they were in 2002, the growth in per capita tax collections represents higher costs for the same services, or surplus revenue. The magnitude of the increase-jumping by a third in just six years-is an indication of just how much costs were increasing or surplus revenue was flowing into the states’ coffers.

It is clear that over this seven-year period, states collected far more in taxes than was necessary to meet their needs. A prudent course for state governments would have been to systematically cut their taxes during this period of strong economic growth while controlling the growth in the cost of services. In doing so, they could have kept their per capita tax collections relatively stable. Because they didn’t do this, their budgets are now based on a level of per capita tax collection that is unsustainable during an economic downturn.

Spending

As with state revenue, there are various ways to look at state spending. Total state expenditures, obviously, encompass every dollar spent by state government, irrespective of its source.

Notice in Figure ES3 how both total revenue and total expenditures greatly exceed the baseline. More interesting is that revenues exceeded expenditures for many years. In 2007 total revenue exceeded total expenditures by $264 billion, while in 2008 total revenues fell short of total expenditures by $137 billion. You would think the extra money collected in 2007 would have covered that, so why did the states all scream budget shortfall? Where did that extra revenue go? These data do not show the answer. One would think the states would have had massive rainy day funds to use to weather the recession. They certainly did not give the excess revenue back to the taxpayers.

This spending above baseline adds up. By 2008 states were spending $117 billion per year more than if they had stuck to the baseline. And this spending occurred when welfare and unemployment rolls were declining. Unemployment, for example, fell from around 6% in 2002 to around 4.6% in 2007, before rising again to 5.8% in 2008 as the recession began. Yet states massively expanded spending on welfare during this period. How ironic that the $117 billion per year in spending above the baseline by states was more than they requested in bailouts from the federal government at the height of the recession.

Five states (LA, WY, AZ, NM, DE) grew spending by more than 50%-more than twice the rate of growth of the baseline. And six more states grew their spending by more than 45% (NV, TX, ID, MD, MS, FL)-a spending spree. Two of these states, Louisiana and Mississippi, experienced devastating storms in 2005, which accounts for much of their increased spending. A few other states experienced faster population growth than the nation as a whole, but not twice as much, and in none of these states does this growth account for the higher spending.

It defies common sense to spend today what you won’t have tomorrow. The economic growth from 2002 to 2008 pumped staggering sums of new money into state government coffers. As with economic booms in the past, state governments acted as if the good times would never end. But they did.

Conclusions and Recommendations

For the five years immediately preceding the economic downturn, states experienced both robust revenue growth and steady increases in overall spending. Their total spending far outpaced inflation. In fact, states collectively spent hundreds of billions more than was necessary to maintain programs at 2002 levels, after accounting for population growth and inflation. As this period coincided with falling unemployment and a generally strong economy, it is not unreasonable to ask how states could have justified such a large increase in spending.

There is no industry today that expects its costs to increase every year at more than the rate of inflation. Such a business model is unsustainable in today’s globalized economy. Every industry and company is under constant pressure to trim costs and streamline service delivery to compete in the free market. Economic downturns provide an extra incentive to do this and generally help set the stage for a robust recovery. State governments shouldn’t be immune to this. After 2007 we were clearly experiencing an economic downturn. If the states had merely maintained their existing programs in between economic downturns, they would have been able to deliver a $1 trillion tax cut at the end of 2007 to help the economy recover quickly.

Instead of seeking a temporary bailout from the federal government, states should roll up their sleeves and put their own fiscal house in order. No function, program or agency should be considered sacred, and each merits rigorous review and evaluation to determine whether it is achieving its mission, delivering services in a cost-effective manner and, ultimately, whether it merits continuation or not.

The recommendations that follow focus on implementing systemic, proven reforms designed to drive large, enterprise-wide changes across state government to help keep the costs of government-and the taxpayer burden-in check:

  1. Reform #1: Adopt an Effective State Spending/Revenue Limit
  2. Reform #2: Employ Outcome-Based Budgeting
  3. Reform #3: Adopt a Sunset Review Process for State Agencies, Boards and Commissions
  4. Reform #4: Utilize Non-Partisan Revenue Forecasts and an Independent Certification of the Budget
  5. Reform #5: Create a Statewide Real Property Inventory and Take Advantage of Asset Sale and Lease Opportunities
  6. Reform #6: Expand the Use of Privatization and Competitive Contracting
  7. Reform #7: Establish a State Privatization and Efficiency Council
  8. Reform #8: Implement Public-Private Partnerships to Finance Transportation Infrastructure
  9. Reform #9: Enact School Empowerment and Student-Based Budgeting Reforms
  10. Reform #10: Reinvent Higher Education Systems

Michael Flynn is Director of Government Affairs for the Reason Foundation, a nonpartisan think tank whose mission is to advance a free society by developing, applying, and promoting libertarian principles, including individual liberty, free markets, and the rule of law.

Adrian Moore

Adrian Moore, Ph.D., is vice president of policy at Reason Foundation, a non-profit think tank advancing free minds and free markets.

Leonard Gilroy is Senior Managing Director of the Pension Integrity Project at Reason Foundation, a nonprofit think tank advancing free minds and free markets. The Pension Integrity Project assists policymakers and other stakeholders in designing, analyzing and implementing public sector pension reforms.

Adam Summers is a senior policy analyst at Reason Foundation, a nonprofit think tank advancing free minds and free markets. He has written extensively on privatization, government reform, law and economics, and various other political and economic topics.