Failed States

After a long spending binge, governors go begging for a handout. It won't be their last.

Of the $787 billion in "stimulus" money Barack Obama authorized with his presidential pen on February 17, at least $144 billion was earmarked for a particularly unstimulating purpose: covering the budget deficits of state governments. The 12-digit sum, touted as "state and local fiscal relief" on the administration's glass-half-full website recovery.gov, quickly exposed a fault line between the nation's governors. On one side were a handful of fiscal conservatives, led by Republicans Bobby Jindal of Louisiana and Mark Sanford of South Carolina, arguing that bailouts and federal mandates create moral hazards and unfunded liabilities requiring future tax hikes. The other, more powerful side was represented by moderate Republican Arnold Schwarzenegger of California.

"Gov. Sanford says that he does not want to take the money, the federal stimulus package money," Schwarzenegger told ABC's This Week on February 21. "And I want to say to him: I'll take it. I take it because we in California…need it."

But does California, or any other state, really "need" federal money during this economic downturn? Only if you accept the premise that state budgets should roughly double every decade.

When Gray Davis, a Democrat, became California's governor in 1999, the state's budget was $75 billion. Tempted by dot-com windfalls and beholden to public-sector unions, Davis bumped that number to $104 billion in four short years of boom and bust, after which he was bounced out of office for his fiscal irresponsibility and replaced by a Milton Friedman–quoting action hero who promised to bring "fiscal sanity" back to Sacramento. Five years later, after facing another boom, another bust, and a series of bruising political defeats at the hands of public-sector unions, Schwarzenegger had hiked the budget to an astonishing $145 billion. In 10 years, state spending in nominal terms increased 92 percent.

One good way to measure fiscal stewardship is to see whether state spending growth exceeds the rate of population growth plus inflation. Under Davis, budgets rose an average of 6.7 percent a year, as opposed to a population/California price index growth rate of 4.8 percent. Under Schwarzenegger, spending has increased 6.8 percent annually, compared to a population/inflation rate of just under 5 percent. A governor who was swept into office by damning Davis' $38 billion budget deficit, vowing not to raise taxes, and mocking his predecessor's vehicle license fee hikes announced on February 20 that he would address his own $42 billion budget deficit by raising taxes and doubling those same fees.

Asked to explain the contradictions on This Week, Schwarzenegger praised the federal stimulus ("a terrific package"), urged Republicans to be "team players" for Obama (who, he said, was doing a "great job"), and unleashed a spectacular metaphor in favor of abandoning a limited-government philosophy. "You've got to go beyond just the principles," he said. "You've got to go and say, 'What is right for the country right now?' I mean, I see that as kind of like, you go to a doctor, the doctor's office, and say, 'Look, can you examine me?' The doctor says, 'You have cancer.' What you want to do at that point is you want to see this team of doctors around you have their act together, be very clear, and say, 'This is what we need to do,' rather than see a bunch of doctors fighting in front of you and arguing about the treatment. I mean, that is the worst thing. It creates insecurity in the patient. The same is with the people in America."

But if the people in America have fiscal cancer, it's just the latest in a long series of relapses.

There They Go Again

In 2002 the National Governors Association issued a press release saying the "states face the most dire fiscal situation since World War II." In 1990 The New York Times reported that states and cities faced a "fiscal calamity." Fire up Google, pick almost any year, and you'll find plenty of stories about a "fiscal crisis" around the nation.

For decades statehouses have followed a predictable schedule. In good economic times, they collect a lot more tax revenue than they really need. But instead of giving the money back to taxpayers or putting it in a rainy day fund, they pretend the good times will never end. When the good times do inevitably come to a close, governors plead poverty and either ask the federal government for help or raise taxes on their beleaguered citizens. Eventually, the economy rebounds and the vicious cycle starts again.

In the 2009 version, the liberal Center on Budget and Policy Priorities warned in February that governors faced a combined funding shortfall of $350 billion, causing "at least 40 states to propose or enact reduced services to their residents, including some of their most vulnerable families and individuals." That same month, Corina Eckl, fiscal program director for the bipartisan National Conference of State Legislatures, described the budget figures as "absolutely alarming, both in their magnitude and the painful decisions they present to state lawmakers." Across the country, newspapers have been filled with stories of closed parks, furloughed state workers, cigarette tax increases, and even, in California, IOUs instead of tax refund checks. "The easy budget fixes are long gone," Eckl said. "Only hard and unpopular options remain."

Is that true? Consider the boom cycle preceding this latest recession. In the five years between 2002 and 2007, combined state general-fund revenue increased twice as fast as the rate of inflation, producing an excess $600 billion. If legislatures had chosen to be responsible, they could have maintained all current state services, increased spending to compensate for inflation and population growth, and still enacted a $500 billion tax cut.

Instead, lawmakers spent the windfall. From 2002 to 2007, overall spending rose 50 percent faster than inflation. Education spending increased almost 70 percent faster than inflation, even though the relative school-age population was falling. Medicaid and salaries for state workers rose almost twice as fast as inflation.

Recessions exert a great deal of pressure on state budgets. As economic activity declines, governments collect less tax revenue. As people lose their jobs or suffer drops in income, there is more demand for services such as job training, health care support, welfare, and unemployment compensation. The combination, it is often argued, throws state budgets out of balance and, because states are generally required to enact balanced budgets, often leads to tax increases, dramatic cuts in services, or both. These actions, it is argued, further dampen consumer demand and worsen the economic situation. The chief rationale for federal support of state budgets is to counter this cycle.

By studying the period from 2002 to 2007—that is, the period that began as the economy came out of the mild 2001 recession—we can judge how states spent money when times were better and their services weren't as desperately needed. In this period, unemployment dipped to around 4 percent, a historic low in modern times; gross domestic product posted steady gains; and most economic measures pointed upward. Meanwhile, the states indulged in fiscal irresponsibility from which no taxpayer should feel eager to bail them out.

Total Revenue

The top-line figure for state funding is total revenue. It encompasses every dollar available to state governments: tax revenue, money from the federal government, income from trust funds, earnings from investments, even state employee contributions to pension systems. In 2002 total combined state revenue was $1.097 trillion (see Figure 1). In 2007 this figure had risen to almost $2 trillion. That's an 81 percent increase, at a time when prices plus population increased 19 percent. So total revenue increased more than four times faster than inflation and population growth.

Here's a hypothetical that puts this trend in a more understandable context. In 2002 you and your friend (call him "Mr. State Government") come out of the recession with jobs paying $50,000 a year. During the next five years you receive cost-of-living adjustments from your employer, so by 2007 your salary is $59,500. Your pal, on the other hand, has jacked his annual earnings up to $90,500.

But the 81 percent increase over five years only tells part of the story. Since 2002 total revenue collections have been well above the levels needed to maintain services each year. This windfall has a cumulative impact. In just five years, taking inflation into account, the states collected $2.2 trillion more than they would have needed to maintain revenues at 2002 levels.

Let's put this another way. After 2007 we were clearly experiencing an economic downturn. If the states had merely maintained their existing programs between economic downturns, they would have been able to deliver a $2 trillion tax cut at the end of 2007. Imagine the impact that might have had.

General Fund Revenue

Some will argue that total revenue isn't the appropriate focus. Since a portion of that money is out of the direct control of elected officials, the argument goes, it doesn't truly reflect the choices they have faced or the decisions they have made.

The general fund better reflects the day-to-day activities of state government. It includes all the programs we traditionally associate with states: education, Medicaid, road building, departments of motor vehicles, etc. Money in the general fund comes mainly from tax revenue and federal funds.

In 2002 states' general fund collections were $1.062 trillion (see Figure 2). By 2007 general fund revenue had risen to almost $1.5 trillion, an increase of 37 percent, or almost twice the national growth rate of inflation plus population. Of the 50 states, only one (Wisconsin) saw its general fund expand at a rate below the state's population growth plus inflation. Alaska and Wyoming led the charge with 91 percent and 74 percent, respectively, compared to rates of population growth/inflation of 20 percent and 18 percent. Even in Mark Sanford's South Carolina, the general fund grew by 45 percent, compared to a 21 percent rate of population growth plus inflation.

Intergovernmental Funds

About 30 percent of state general fund money comes from the federal government. These funds support federal initiatives in education, road building, and Medicaid, among other uses. Given the well-publicized increase in federal spending during George W. Bush's administration, it is worth examining whether states shared in the windfall.

Interestingly, this is one area where federal spending rose relatively modestly, at least in comparison with other priorities. In 2002 states received $335 billion in revenue from the federal government (see Figure 3). In 2007 they received $430 billion, a 28 percent increase. It is noteworthy that in examining government financing, a 28 percent increase over five years now seems modest. It is worth remembering that this increase is still 50 percent faster than the rate of inflation and population growth.

Taxes

About half of state general fund revenues come from taxes. In 2002 states collected $535 billion in taxes; by 2007 that had grown to $749 billion, an increase of 40 percent, or more than twice the rate of inflation and population growth (see Figure 4).

The robust growth in state tax revenue during this five-year period is only part of the story. The pace of this growth is notable: rising slowly out of the recession, increasing rapidly, and then beginning to taper off in advance of the general economic slowdown. In 2002–03, the rate was 2.4 percent. By 2004–05, it had leaped to 10 percent. In 2006–07 it was down to 5.4 percent—a more moderate level, but still far ahead of inflation.

The decline in the rate of tax revenue growth ought to have sent a signal to state budget drafters. Instead, they seem to have looked beyond the data and assumed continuing strong revenue growth. State budgets for fiscal year 2008, which were drafted toward the end of the period analyzed here, called for more than an 8 percent annual spending increase on average. Small wonder states had to make mid-year adjustments to their budgets in the middle of 2008 as the economy began to cool.

Golden Failure

In fiscal year 1990–91, California took in more than $38 billion in general fund revenues. In 2008–09 revenues are $102 billion. If the state had simply limited spending increases to the 4.4 percent annual average growth in consumer price index plus population, the state would be sitting on a $15 billion surplus this year instead of a $42 billion deficit.

A significant portion of California's spending increase stems from the growth in state employees. Today there are more than 356,000 workers on California's payroll, or 9.3 state employees for every 1,000 residents. The biggest hiring binges came during Gray Davis' dot-com exuberance, and then again during the pre-recession Schwarzenegger administration (see Figure 5).

This increase in personnel is important because so much of the budget is devoted to employees' wages and benefits, and because their pension benefits, which are locked into place for all current employees, are both colossal and precarious. The California Public Employees' Retirement Security System, which until last year was the largest public pension fund in the United States, lost a staggering 20 percent of its value in just three months of 2008 (see "The Next Catastrophe," February).

By chance, the National Governors Association held its annual meeting in Washington, D.C., the weekend after both the stimulus and California's new budget were passed into law. Mark Sanford and Bobby Jindal, both considered possible future leaders of the GOP, drew early headlines with their Hamlet-like deliberations on whether they would accept stimulus money. (In the end, they narrowed their considerations to the unemployment insurance component of the federal mandate, a comparatively trivial sum.) Schwarzenegger, always a media darling, regained the initiative with his Obama praise and Sanford baiting on This Week. Pundits speculated hopefully that perhaps the new president would give Arnold a job once his term expires in 2010.

Martin O'Malley, Maryland's Democratic governor, dismissed Sanford as "fringe." Sanford shot back in The National Journal. "There is a larger problem if we get so Balkanized with 'you-don't-want-yours-give-it-to-me,' " he told the magazine. "That means nobody is minding the store." On Fox News on February 22, Sanford described the stimulus as sounding "like the Soviet grain quotas of Stalin's time—X number of jobs will be created because Washington says so." He added that "one of the real issues here is we have $52 trillion in accumulated debt in Washington, D.C. And we don't have a giant piggy bank that we can now raid now that times are tough. All this money is going to be borrowed from the future—from future generations, from Social Security. So in essence, we're digging yet another hole for ourselves with regard to unsustainable spending."

For more than two centuries, the states have been the laboratories of democracy. Whether they become laboratories of sound economics depends largely on whether Sanford's words become real-world deeds.

Michael Flynn is director of government affairs at the Reason Foundation. Adam B. Summers is a policy analyst with the Reason Foundation.