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After the fiscal gold rush

Persistent budget shortfalls have created subtle spending shifts and a kitchen-sink mentality to close budget gaps without cutting services

January 1, 2004


Ron Wirtz Editor, fedgazette
After the fiscal gold rush

Too bad you can't fit government into a beaker, or under a microscope, because the last few years have been a great experiment in public finance.

The economic downturn was a huge revenue shock to state governments, changing state budgets from overflowing to overbearing in the course of a single year in some cases. In research terms, this type of external shock can often induce change in the subject being studied. In this case, the financial jolt of rapidly slowing tax revenue offers an opportunity to gauge changes in both public demand and legislative action regarding government services and the taxes that pay for them.

Unfortunately, spending on public services is unwieldy enough—literally thousands of taxing jurisdictions, lots of intergovernmental transfers, programs enough to fill a telephone book, etc.—that detailed conclusions about shifts in spending for public services are difficult, particularly in the near term. But a look at major state spending areas over the last few years shows that some hard choices are being made among district states faced with tighter budget conditions.

First a step back for the big fiscal picture. States nationwide enjoyed a cumulative year-end fund balance—a.k.a. tax surplus—of $50 billion as recently as 2000, according to the Council of State Governments. But the revenue growth train hit the proverbial cow and plunged down the tax hill as states tallied up a projected shortfall of about $80 billion for fiscal year 2004, according to the National Conference of State Legislatures.

That budget shock occurred for a number of reasons, all of which can be boiled down to a simple recipe: a rapid deceleration of revenue growth—the result of a slower economy and numerous tax cuts made during flush times—coupled with a continuation of high spending rates. Much of South Dakota's budget troubles can be traced to its residents voting to repeal the state's inheritance tax, which eliminated $25 million in annual revenue.

Minnesota tallied a $4.2 billion shortfall for its 2004-05 budget in spite of projected revenue increases of 3 percent annually. The problem? Earlier projections estimated that revenue growth would be more than twice that level, but missed badly when (among other things) capital gains imploded along with the stock market and recent state tax reforms and rebates took hold. Spending projections, meanwhile, didn't budge, staying the course at 7 percent annually.

Minnesota has a lot of company in the district. All district states have faced budget problems over the last few years. Michigan, Minnesota and Wisconsin have been dealing (to different degrees) with fiscal shortfalls for the last two or three years that reach into the billions of dollars. The Dakotas and Montana have also experienced some fiscal tightness, though generally smaller in terms of dollars and the proportional size of the shortfall to their total budgets. North Dakota was the only district state not faced with a shortfall for its current budget but had a small gap in its previous two-year budget.

How states have dealt with respective revenue shortfalls offers a chance to see whether public spending trends of the past two and a half decades (see "An acquired taste for public goodies") have continued or changed trajectory. State budget deficits also offer insights regarding the public's preference toward tax-and-service trade-offs. Indeed, the choices facing lawmakers and the general public have shifted dramatically. For a number of years, thanks to a strong economy and budget surpluses, the choice was between more public spending or tax cuts—either way, the public got more of something it wanted. Starting about 2001, the public had to start choosing which it wanted less of: its own money (higher taxes) or public services.

And the survey says ...

Given the decades-long, high-spending trends before the recent recession, did budget shortfalls influence a change in our appetite for public services?

The short answer, it appears, is yes, but it comes with qualifiers. Anecdotes abound on the subject, including ones that say people don't want their services cut. Generally, polls have shown that the public wants spending cuts rather than increased taxes to close budget shortfalls (though the opinions tend to shift depending on specific spending choices offered). Lawmakers have mostly acquiesced to budget cutters, pulling back spending and in the process revealing subtle but important changes in spending priorities.

Public opinion polls show widespread support for holding the line on taxes. Given six major options to close the $4.2 billion budget shortfall in Minnesota, a January 2003 Minneapolis StarTribune poll found that 76 percent said spending cuts were appropriate; next to last was raising taxes, at 37 percent. The poll also found that a slight majority of residents disapproved of the Legislature's handling of a budget shortfall the previous year, which was eliminated largely through accounting shifts, budget reserves and small spending cuts.

In Minnesota, shortly after Gov.-elect Tim Pawlenty released his budget proposal for dealing with the state's shortfall, a February 2003 poll commissioned by the St. Paul Pioneer Press and Minnesota Public Radio found that about 60 percent believed Pawlenty was cutting the right amount from state budget, while 27 percent said he should raise taxes. (See additional discussion on public opinion polling, taxes and government spending.)

Recent elections also offer a window into the mindset of voters and their views of government spending trends. From an ideological standpoint, the district and nation are under a widely acknowledged shift to the political right that champions lower taxes, which has favored Republicans at election time. District states are strongly held by Republicans, as 11 of 12 chambers of state Legislatures in the district (two for each state) are controlled by the party, with only the Minnesota Senate still held by Democrats; four of six governors are Republican as well.

Republican control is not uncommon in the Dakotas and Montana but is more unique in Michigan, Minnesota and Wisconsin. Taxes were a touchstone issue in the 2002 elections in Minnesota, which saw no-new-tax Republicans win U.S. Senate and gubernatorial races; Republicans there also held onto their state House majority, and closed their minority gap in the Senate.

In Wisconsin, Republicans also took control of that state's Senate and strengthened their voting block in the House. Democrat Jim Doyle won the governor's seat, but did so with a campaign promise not to raise taxes in closing the state's $3.2 billion budget hole. In his first biennial budget proposal, he stated, "There are theoretically two options for closing the revenue and spending gap—increase taxes or cut spending. But there is only one real option—cut spending."

It's hard to know the exact relationship between fiscal conditions, public opinion and budget actions by lawmakers, but it's worth noting that general fund spending by all states grew by an annual average of 5.9 percent for fiscal years 1993 to 2001—when budgets were brimming from a hot economy—followed by a dramatic fall to 1.3 percent, 0.3 percent and -0.1 percent from 2002 to 2004, according to the National Association of State Budget Officers. General fund spending among district states for the current budgets tended to be a little higher—in part because of clearer expectations of rebounding economies—but only averaged annual increases of between 1 percent and 1.8 percent.

Spending cuts: scalpel or hatchet?

With general fund spending slowing considerably, states have been forced to make explicit decisions about who would bear the greatest burden. A detailed, program-by-program analysis of spending trends is complicated by numerous factors, such as periodic changes in program responsibility, accounting vagaries and the presence of multiple revenue streams for certain programs. Indeed, when queried, state officials were often hard-pressed to identify year-to-year changes.

But a look at major spending categories in district states shows that K-12 and corrections were spared from cutbacks at the state level; spending on health and welfare also saw comparatively generous increases, but many states were forced to scale back programs to deal with rapidly rising costs. In contrast, higher education has been the biggest target among major spending categories. Local and intergovernmental aid was also a popular target, as were the bureaucracies of state agencies.

K-12 education. District states generally viewed K-12 as untouchable for spending cuts. In the face of a $4.2 billion projected budget gap, Minnesota managed to increase K-12 spending by 17 percent (almost $2 billion) over the biennium, much of it because of earlier property tax reform that shifted local K-12 funding to the state. Still, that figure was $600 million less than earlier spending projections.

Despite a projected $230 million shortfall and declining K-12 enrollment, Montana increased K-12 funding by about 3 percent for its current biennium, while South Dakota upped its 2004 commitment by about 2.5 percent. Though it didn't face a budget shortfall for the current biennium, North Dakota made K-12 funding a priority, increasing its general fund appropriation by 5.8 percent ($33 million) while cutting funding to other categories, including higher education.

Wisconsin lawmakers agreed to jettison the state's commitment to fund two-thirds of K-12 education, which automatically loosened the state's financial noose. The state did, however, still increase K-12 general fund spending by about $130 million for its current biennium.

Corrections. Thanks to growing prison populations across the district, states are spending more on corrections despite tight budgets. Wisconsin's prison population has grown nearly threefold since 1987 due to higher admissions and longer sentences. Over the current biennium the state increased general funding for corrections by 3 percent, or $53 million. The Department of Corrections expects to open two new prisons during the current biennium and has approval to add as many as 527 staff positions. It is the lone state agency among more than 50 allowed to use tax dollars to add more jobs.

Montana lawmakers handed out a $15.5 million increase for corrections in their two-year budget, or about 3.5 percent annually. North Dakota upped general fund spending on corrections by $4.4 million (or 5.7 percent). Minnesota added $9 million to its two-year corrections budget (a little better than 1 percent), but that was scaled back considerably from an earlier projected increase of more than $60 million.

Health and human services. States generally have seen small to large spending increases in this category. Wisconsin anted an additional $60 million for its biennium, or about 1.5 percent, while North Dakota increased general fund spending in this area by 11 percent, or $41 million.

Montana offers a good example of the conflict of maintaining health funding in light of tight budgets and exploding costs. The state upped its spending by $11 million (a 2.2 percent increase), but double-digit hikes in health care costs have mandated "significant service reductions" in programs over the last several years, according to the Legislative Fiscal Division. Most recently, the state made reductions in child care and services to the mentally ill and tightened Medicaid eligibility. A similar scenario occurred in Minnesota, where its most recent health and human services budget went up 10 percent but was rolled back from a projected spending increase of 20 percent.

Such budget trimming can be particularly tough because it can lead to a double whammy of losing matching federal funds. For example, a hypothetical 10 percent cut to certain social service programs in Wisconsin would result in a loss of $75 million in matching federal funds for these programs, according to a budget summary by the governor's office.

Higher education. States have lowered the boom on higher education. The National Council of State Legislatures estimates that states' higher education appropriations in fiscal year 2004 will decline 2.3 percent from the previous year.

Wisconsin lawmakers cut $250 million from the university system over the biennium (8 percent of the system's budget). That's on top of the $44 million lopped off in 2002. Michigan has cut its support for higher education twice in the last two budget cycles, including cuts of up to 7 percent at some institutions for the current school year. Minnesota slashed its higher education spending by 7 percent (about $180 million), with the University of Minnesota absorbing a 12 percent decrease.

A report by the National Council of State Legislatures points out that higher education is a "frequent casualty" of tighter budgets because it does not have the safety "immediacy" often attached to corrections spending or the federal funding attachments of Medicaid and other programs. Higher education also has alternative funding sources in the form of tuition and fees, as well as endowment revenue and research funding from federal and private sources.

As a result, tuition has been rising rapidly. In Montana, tuition rates have increased by over 220 percent since 1992. According to state documents, tuition revenue in Minnesota is expected to double between fiscal year 1997 and 2005, to about $950 million. Wisconsin authorized its university system to increase tuition by $150 million over the biennium. Schools there are expected to boost tuition by up to 36 percent over the next two years, while more than 600 positions throughout the system (including vacancies) were on the block for elimination. This year, for the first time ever in Wisconsin, tuition revenue is expected to exceed the state's higher education appropriation.

Even without a budget shortfall, North Dakota cut general fund spending on higher education by $5.4 million (or about 1.5 percent) for the next two years. In response, the state Board of Regents approved tuition increases ranging from 6 percent to 22 percent for the 2003-04 school year, including increases of about 16 percent for both the University of North Dakota and North Dakota State University.

State agencies. Bureaucracies were a common target for reduced spending, in part because public opinion polls often indicate that the public believes they are wasteful and top-heavy. Minnesota scaled back state agency budgets by an average of 15 percent, slicing almost 1,000 from its workforce. North Dakota clipped $11 million from state agencies, virtually all of it from the Information Technology Department, easily the state's largest agency in budget terms. Wisconsin Gov. Jim Doyle proposed the elimination of eight agencies, boards or commissions, with functions distributed to other bodies; he ultimately signed a budget that reduced state agency spending by about $400 million, including 2,300 state-job cuts.

Local aid/shared revenue. Local governments came under intense fire during state budget negotiations in many states. According to the National League of Cities, fiscal year 2003 saw a 2 percent decline nationwide in the amount of aid received by cities. In 2002, Wisconsin's then-Gov. Scott McCallum proposed eliminating shared revenue to local governments by 2005—a lightning rod that initially found some support, but ultimately contributed to his losing the gubernatorial election that year. But the state nonetheless cut shared revenue in the following budget by $50 million. Two of three municipalities in the state will see their shared revenue drop 15 percent or more for fiscal year 2004, according to the Legislative Fiscal Bureau.

Minnesota State Auditor Pat Awada released a report last February that recommended a 42 percent decrease in local government aid to cities. State lawmakers settled on cuts of 3.5 percent for 2004 and 5.7 percent in 2005. Michigan reduced shared revenue an average of 3 percent annually for fiscal years 2003 and 2004.

A tax by any other name

That's not to say that states depended solely on spending cuts to balance out-of-whack budgets. States often—and liberally—used one-time revenue infusions to close their fiscal gaps. Most often those one-time revenues were budget reserves (rainy-day funds) and funds from tobacco settlements.

And when they were used, they were often gutted. Before replenishing its budget reserve in the latest biennium budget, Minnesota's rainy-day fund was below $100 million after being tapped to stave off earlier budget gaps. Michigan used most of a $1.2 billion rainy-day fund between fiscal years 2002 and 2003. North Dakota faced a $43 million shortfall in its 2001-03 biennium and closed a majority of that gap by making $25 million available from the state-owned Bank of North Dakota. Montana nibbled $4 million out of its rainy-day fund to close its most recent budget gap.

South Dakota was one of the first states to sell future tobacco receipts, doing so in August 2002 in exchange for a lump sum of $248 million that was then reinvested and expected to add about $10 million in annual interest earnings. Minnesota sold off tobacco payments to buy down $1 billion of the state's $4 billion budget deficit for the 2004-05 biennium. Wisconsin reportedly sold all of its $5.9 billion share of tobacco settlements for 30 cents on the dollar to help with its budget crunch.

To free up additional resources, states also changed accounting rules or simply shifted resources from a dedicated fund with a cash surplus to the general fund. In its most recent budget session, Montana transferred $26 million from its workers' compensation insurance fund to the general fund. South Dakota met modest budget gaps in fiscal years 2002 and 2003 in part by transferring millions from the Property Tax Reduction Fund to the general fund. It faced another budget shortfall in fiscal year 2004 and used a one-time accounting measure that, in essence, allowed the state to count two years' worth of annual interest earnings from state cash flow, a measure that netted almost $12 million.

District states tacked on only a few new taxes, the most common of which fell on cigarettes. Michigan increased its tax by 50 cents (at $1.25, it's the third-highest in the nation) to help close its 2003 shortfall. Montana slapped a 52-cent tax increase on cigarettes and other tobacco products (as well as a 3-cent sales tax on lodging accommodations). South Dakota recently raised its cigarette tax by 20 cents to 53 cents per pack. North Dakota proposed an increase of up to 25 cents per pack, while Minnesota Senate Democrats offered a whopping $1 tax increase; neither proposal passed.

Fees also rose—most obviously in tuition, but states also hunted and pecked for smaller solutions. In Minnesota, new surcharges and court fees were imposed on users of the state's judicial system, which were expected to net about $90 million. Wisconsin increased fees by $400 million in its current budget, including a $10-per-vehicle increase for both vehicle titling and annual registration and a 30 percent increase in fees to individuals using the state court system. Last year Wisconsin Gov. Doyle also renegotiated tribal gaming compacts—technically considered more of a fee than a tax increase because the state has no taxing authority over tribes—a move expected to add about $150 million in state revenue over the biennium.

Meat or fat, sir?

Despite these many budget changes, there appears to be little agreement on the long-term effect of how states resolved short-term budget crises. Tim Mathern, a North Dakota state Senate Democrat, said via e-mail, "It was meat or fat dependent on the legislator making the decision. For example some thought arts funding was fat because people can physically live without it. Some thought arts were a very important part of societal activity and a draw for businesses and new employment, therefore meat."

Among about 30 district legislators who commented for these articles, many Democrats saw a lot of meat cutting going on, while most Republicans believed there was still more fat for the taking. Al Juhnke, a Democrat in the Minnesota House, wrote via e-mail, "We went past the meat and are cutting into the bone in Minnesota. We are starving our educational institutions, radically reducing economic development monies and limiting our infrastructure investments. All of these measures will move our economy in a negative direction in the near future if they are not corrected."

John Sinrud, a Montana House Republican, hit on a common party theme. "Has the public's appetite decreased for services that the government provides? Yes. People that I've talked to want less dipping into their pocketbooks."


Ron Wirtz
Editor, fedgazette

Ron Wirtz is a Minneapolis Fed regional outreach director. Ron tracks current business conditions, with a focus on employment and wages, construction, real estate, consumer spending, and tourism. In this role, he networks with businesses in the Bank’s six-state region and gives frequent speeches on economic conditions. Follow him on Twitter @RonWirtz.