Why the States Are Broke
Bloated governments, budget gaps, and Parkinson's laws
"For the first time in a long time, someone is going to be minding the store," declared the newly elected governor of a large Midwestern state. The occasion was an April speech defending his proposed budget and restating his campaign promise not to raise taxes. In response, the opposition leader in the state Senate repeated his call for major tax increases to close a yawning budget gap. Among other things, the senator wants to expand the state's sales tax to cover services. "There will be no haircut tax under this administration," the governor's deputy replied testily.
Meanwhile, in a nearby state, another governor was calling for a $2 billion sales tax expansion. His plan would tax services ranging from lobbying to dry cleaning, on top of already enacted increases in excise taxes on cigarettes and gasoline.
The no-new-tax governor was Illinois' Rod Blagojevich -- a Democrat. His legislative antagonist was Pate Philips -- a Republican. And his tax-increasing neighbor was Republican Gov. Bob Taft of Ohio.
Democrats as fiscal conservatives? Republicans as tax hikers? Welcome to the topsy-turvy world of government finance, where political labels can confuse more than inform, where experts specialize in deliberately misleading "analysis," and where all is not as it seems.
Since the onset of recession in 2001, the national economic debate has centered around President George W. Bush's proposed tax cuts, his terror-induced wave of new federal spending, and Capitol Hill squabbles about budget deficits and interest rates. For most Americans, however, these issues are distant, theoretical, and mostly rhetorical. More important are the images they're seeing on breathless local television newscasts and morning chat programs. In Kentucky they've seen convicts released early from crowded prisons. In California they've heard of possible mass layoffs of schoolteachers, following on the heels of a two-week stint of work without pay for Oregon teachers and new janitorial duties for their counterparts in Oklahoma. In Missouri state employees were unscrewing every third light bulb to cut energy bills.
Such images might help explain why polls show so little enthusiasm for the president's proposed tax cuts. Americans already have seen federal tax relief offset by tax increases at the state and local levels, with more hikes expected soon. And they're spooked by the apparent incompetence and penury of the governments that patrol their streets, pave their highways, and educate their children.
The federal government, far removed from the people and subject to interest group politics and the vagaries of international events, is supposed to be the broken institution. States, competing with each other and informed by grassroots common sense, are supposed to exemplify the genius of the American experiment. But reality is more complex. State governments are stumbling, taxing, and growing. Self-proclaimed fiscal conservatives aren't paying enough attention to big-ticket items such as Medicaid or to the long-term structural changes that could at least slow government's growth. And so they remain hostage to basic laws of voter preferences and bureaucratic behavior that push taxes and budgets ever upward.
Numbers don't lie, although I can't say the same for their political abusers. The share of gross domestic product consumed by the federal government shrank for most of the 1990s, with rates of annual spending growth often in the low single digits. At the same time, state and local governments experienced an almost unprecedented growth spurt in both revenues and expenditures. Their share of GDP rose to nearly 13 percent in 2001, up from 11.4 percent in 1990.
Bill Clinton's federal budgets grew more slowly than George W. Bush's have, while the undeniable rise of Republican influence in state capitals during the 1990s did not necessarily result in fiscal discipline. Indeed, a USA Today analysis showed that from 1997 to 2002 Republican-controlled states saw slightly higher annual spending increases (6.85 percent) than Democrat-controlled states (6.79 percent). Taxpayers were usually better off when the governor and the legislative majority hailed from different parties.
The data reveal other surprises. So far, by most accounts, the recession that began in 2001 is one of the mildest on record. Yet also by most accounts, state governments since 2001 have experienced one of the most severe fiscal emergencies since the Great Depression. Is something unique and inexorable going on here?
Many alleged experts on government finance say so. Writing from academic roosts or from policy groups such as the Brookings Institution or the Center for Budget and Policy Priorities, they blame the current crisis on "structural problems" in state tax codes created by the New Economy, uncontrollable inflation in education and health costs, excessive tax cutting by the surging Republicans during the 1990s, and international trade policy. Supposedly non-ideological groups such as the National Governors' Association (NGA) and the National Conference of State Legislatures (NCSL) repeat and amplify these messages to a broader audience, as do gullible or ax-grinding reporters.
States are having trouble, NGA Executive Director Ray Scheppach declared on New Hampshire Public Radio earlier this year, because of "a perfect storm" of long-term fiscal trends. "Most states have systems sort of built for a manufacturing economy of the 1950s," he said, rather than for "a high-service high technology international economy of the 21st century. There's a deteriorating tax base. We don't tax services, and that's where growth is."
The reality is more prosaic. What we have seen in various states is little more than the confirmation of old maxims about how and why governments grow and what, if anything, can be done to arrest that growth. One useful way of thinking about this is to recognize that state lawmakers are obeying Parkinson's laws.
C. Northcote Parkinson, an oddball with an odd name, was a British novelist and historian whose output ranged from Napoleonic-era military fiction to a history of sea-borne trade. But his major claim to fame was Parkinson's Law (1957), which began a delightful series of books about how organizations make decisions, particularly bad ones. Here are some of Parkinson's best-known laws and how states are illustrating them:
1. "Expenditure rises to meet income."
In his 1960 book The Law and the Profits, Parkinson noted that bureaucracies, public and private, will usually find ways to spend pretty much whatever money comes in. That is, they don't build their annual budgets from the ground up. They discover the level of expenditure they can finance without breaking too much of a sweat, then work backward to justify that level as "essential" to meet the institution's "needs." The problem is exacerbated in governmental settings because there is no search for profit and few competitive pressures to tame the natural appetite for spending.
Among the states, it is notable that most of the governments with the biggest fiscal problems during the last two years don't fit the profile suggested by superficial media reports. Let me say first that I define "big fiscal problems" differently than some do. After a dozen years of experience closely watching a state legislature in action, in my home state of North Carolina, I can testify that projections of state budget deficits, which are what get reported to the outside world, usually are the result of political calculations as well as mathematical ones. So don't pay too much attention to whether a state "projects" a $1 billion deficit or a gap three times that amount. I can "project" a $100,000 deficit in my own household finances next year based on the fact that the vacation home my family "needs" to purchase cannot be financed at my current level of income. Similarly, governors and legislatures looking for excuses to raise taxes can and do manipulate budget numbers to project massive deficits on the basis of pie-in-the-sky expectations for state employee raises, new programs, and the like -- even excessive projections of growth in admittedly burgeoning programs such as Medicaid.
A better way to measure the relative magnitude of fiscal problems is what governors and legislatures actually do about them. Since 2001, reports the Rockefeller Institute of Government, 20 of the 50 states have enacted "significant" tax increases (amounting to at least 1 percent of general fund revenue), with 10 of those raising broadly applied tax rates on items such as individual income or retail sales. (The rest have mainly fiddled around with excises on cigarettes.) If the NGA/NCSL establishment is correct, then the states with the lowest rates of taxation to start with or the highest rates of expenditure growth over time, or both, would be the most likely to resort to tax hikes to bail themselves out of fiscal fixes. But no such pattern exists. About as many of these tax-raising states have fallen below the national average in spending growth in recent years as have exceeded it. Similarly, a slight majority of the tax-raising states were above average in tax burdens before the recent recessionary budgets, so it would be hard to argue that their resort to tax increases was due to some sort of basic inadequacy or to excessive tax cuts in the past.
The fiscal data offer even worse news for those who believe the states need to rely less on the archaic and regressive sales tax and more on progressive income taxes. This policy prescription is intended to head off future fiscal crises by allowing state revenues to track more closely the dynamics of our service-driven economy. Since a sales tax is essentially limited to physical goods, it is argued, it will inevitably fail to keep up with an economy increasingly composed of service industries that aren't taxed at retail. Income taxes pay no attention to whether goods or services are being sold and are thus supposed to be a more robust revenue source in the New Economy.
But seven of the 10 states that have been "forced" to raise broadly applied taxes in the last two years were already more heavily reliant on the income tax than the average state. And the only two states to have raised these taxes in both 2001 and 2002, New Jersey and North Carolina, already had the sharply progressive income tax systems that allegedly would be best. New Jersey had six rates that topped out at 6.37 percent for single taxpayers making more than $75,000. North Carolina's top rate was even higher: 7.75 percent for those making at least $60,000. (A 2001 tax bill added yet another rate of 8.25 percent for income above $120,000.)
Heavy reliance on progressive income taxes is actually a recipe for more budget woes. Other things being equal, it gets states into trouble because of what might be called fiscal turbulence. Rising incomes, supercharged in the 1990s by big capital gains, push more taxpayers into higher tax brackets. This accelerates the growth of tax revenues above the rate of overall growth in incomes and the economy. Flush with cash, state lawmakers create new programs to satisfy various "unmet needs": class size reduction, infrastructure construction, health care, and the like. Yes, they may also create a small savings account or toss off a few tax cuts to mollify fiscal conservatives, but rarely do they make fundamental changes such as lowering marginal rates. (Indeed, the much-hyped "deep" state tax cuts of the 1990s only partially offset the tax increases that legislatures had imposed during the 1990?91 recession.)
Of course, what quickly goes up can quickly come down. When boom yields to bust, and especially when capital gains booms yield to stock market busts, states dependent on progressive income taxes see their projected revenues fall faster than average as households and businesses shift to lower brackets. The result is a large, unforeseen hole in the budget.
Parkinson's insight here is that it's not really projected budget deficits or the perceived need for more spending that guides fiscal decision making. It's a breeze for politicians to justify new government expenditures, at least to themselves. What they struggle with is how to justify higher levels of taxation. They see recession-driven drops in revenue growth as prime opportunities to sell higher taxes. Rarely do they go back later, when the economy recovers and coffers are bulging, to repeal all or even most of their previous increases. It's a ratchet effect, similar to the one the historian Robert Higgs has observed in federal government growth during times of war.
2. "Work expands so as to fill the time available for its completion."
This is the most famous of Parkinson's laws. Anyone familiar with elastic deadlines can immediately grasp it.
In the state government context, the implications are subtle but critical. Most state legislatures operate under time constraints. They begin their regular sessions in January and end on a fixed date, often in March or April. But 10 states extend their regular sessions beyond four months a year, and another 10 operate without any meaningful restriction on how long they can meet in regular session. Interestingly, 13 of these 20 states are also among the 20 that have raised taxes during the last two years. Three additional states with lengthy legislative sessions -- New York, Missouri, and South Carolina -- may enact tax increases in 2003.
Why do legislatures that meet longer tend to end up with larger fiscal problems and a greater recourse to hiking taxes? Because the Parkinsonian "work" lawmakers do to fill the time allotted to them consists to a large extent of sitting in committee meetings at which a parade of government managers, state employees, and special interest lobbyists make the case for how much their pet program is "needed" and would be "sliced to the bone" unless the state raises taxes. Other "work" involves dreaming up new programs or pork barrel projects to attract media attention.
Furthermore, the longer a politician is parked in this big-government echo chamber, the more he or she forgets any previous convictions about limited government or the need for frugality. Average taxpayers, after all, don't spend much time lobbying and cajoling politicians in the often distant state capital. Studies from the Competitive Enterprise Institute, the National Taxpayers Union, and my own organization, the John Locke Foundation, have confirmed a version of this effect for long-serving members of Congress and state legislatures. The more years a politician spends in office, the more he or she votes for bigger government. It's no great stretch to expect a similar effect based on how much time state legislatures spend in session each year.
Sometimes the link is even more direct than that. Michael LaFaive, director of fiscal policy at the Michigan-based Mackinac Center for Public Policy, relates the story of how his state's legislature reacted in 2000 when an unforeseen surplus of $600 million materialized. By midyear it was already evident in the stock market and elsewhere that the national economy was clouding up. But instead of banking the funds for a rainy day, Michigan lawmakers went on a spending spree. "This might not have happened had we had a part-time legislature," LaFaive says, "because it probably wouldn't have been in town to react impulsively" to the discovery of the surplus. As it was, only two House members out of 110 voted against the spending measure, which included a $10 million polar bear exhibit at the Detroit Zoo and a $5 million aviation museum in Kalamazoo.
3. "The matters most debated in a deliberative body tend to be the minor ones where everybody understands the issues."
Whenever you hear state lawmakers waxing eloquently about how they are "cutting spending to the bone" by shuttering state aquariums, turning down the thermostat in state buildings, or sending state employees to fewer out-of-town conferences, you can see one of Parkinson's lesser-known laws in force. It is easy for politicians, the news media, and the general public to sink their teeth into these sorts of savings. You can gain of lot of rhetorical mileage out of anecdotes that involve relatively small amounts of money and evoke emotional reactions. Just a paragraph ago, I did it myself.
Still, bureaucrats misusing state vehicles to visit girlfriends and construction offices peddling contracts to pay off political contributors aren't the cause of growing governments and rising taxes. It's a good thing to find savings wherever you can, and certainly government-run attractions such as museums and historic sites should be generating their own fee income if the public is as enamored with them as their hand-wringing champions claim. But the real causes of burgeoning state governments are large, sprawling, lobby-infused programs, such as Medicaid and public universities, that too few lawmakers fully comprehend or are willing to take on.
Medicaid, the joint state-federal health care program for the disabled and the poor, is eating up an ever-increasing share of state general fund money. Expenditures grew by an average of 12.5 percent in 2002 alone, representing tens of billions of dollars in new spending. (Washington is paying 57 percent, while the states pick up 43 percent.) There is no shortage of sound explanations for why Medicaid is such a mess. Basically free to its beneficiaries, the program offers more benefits than the average private health plan does and thus encourages wasteful consumption of care. And as both Congress and the states expanded eligibility and the benefits package of Medicaid in the 1980s and 1990s, it became increasingly attractive for low-income persons, sometimes far above the federal poverty line, to adjust their finances (or at least what they reported their finances to be), drop their private coverage, and sign up for free health care.
Expansion has been particularly costly in health care for the disabled and elderly portions of the caseload, where much of the growth and a whopping three-quarters of the annual cost can be found. There is a fast-growing industry of lawyers and financial advisers specializing in ways for middle-class families to get their parents or other relatives qualified for Medicaid. The program now pays for two-thirds of all nursing home residents, nearly half of all births in many states, and the health care expenses of about a quarter of all children under the age of 5, with no real evidence that the health care outcomes are significantly better or that Medicaid expansion has had the net effect of reducing the ranks of the uninsured.
Even these facts do not fully capture the insidious impact of Medicaid and similar shared-responsibility programs on state budgets. Because Washington matches states more than dollar-for-dollar for Medicaid expenses, state policy makers have strong incentives not to pursue even obvious opportunities for savings. If they adjust benefits, tighten eligibility, rein in reimbursements, or just try to police fraud and waste better, they keep only a fraction of each dollar "saved," but they get all the public opprobrium. And this assumes the political actor has a deep knowledge of the program and its wacky finances in the first place. "The information deficit is huge," says Michael Greve, a scholar at the American Enterprise Institute. "Medicaid is intentionally and deliberately complicated. And when something goes wrong, [lawmakers] don't have anyone local to yell at. State officials point to D.C. and say, 'They did it.'"
Research by Greve and his colleagues shows clearly that recent Medicaid growth doesn't reflect the "we couldn't help it" line peddled by politicians and their handlers. States such as Florida and Arizona that attract high proportions of retirees "should be a basket case" when it comes to Medicaid inflation, Greve says, but the reality is that they have controlled costs better than most. Moreover, Medicaid spending has grown rapidly during boom years, not simply during recessions, when people lose their jobs and work-based health insurance.
In a further illustration of Parkinson's law that "expenditure rises to meet income," Greve and his colleagues also found that one of the strongest predictors of Medicaid growth in the 1990s was growth in state revenue collections. If state politicians saw money coming in, a combination of gullibility and moral hazard led them to spend much of it on the Medicaid monster.
Why the Laws Are Bronze
Not every state is in desperate fiscal shape and ravenous for higher taxes. Not every Republican governor spouting limited-government rhetoric turns out to be phony; some, such as Florida's Jeb Bush, Montana's Judy Martz, and Colorado's Bill Owens, really have controlled spending and held steady or even reduced their tax rates during the recent downturn. And the performance of both governors and legislatures in some states is proof that Parkinson's laws aren't forged in cast iron. They're made of wrought iron, or perhaps even bronze, and thus do have some room to give.
One fiscal strategy that sounds like a gimmick -- push-ing candidates to take a no-new-tax pledge, a core mission of the group Americans for Tax Reform -- has turned out to be surprisingly useful. Lingering pressure from their campaign stances has encouraged not only Illinois' Blagojevich but also new Democratic governors in Michigan, Oklahoma, Kansas, Virginia, and Arizona to resist hikes in broad-based taxes. When Republican lawmakers in particular vote to raise taxes after previously promising not to, the political blowback can be fierce. In North Carolina this year, the Democratic minority in the House allied with dissident Republicans to organize the chamber and, later, to pass the third major tax increase in as many years. Already some of the freshman Republicans in the coalition who betrayed their no-tax pledge are reconsidering their position as the folks back home find out and as potential primary challengers emerge.
On an institutional level, tax or expenditure limitations (TELs) have been valuable tools in the fiscal restraint arsenal. But not all TELs are created equal. A 2001 Cato Institute study found that measures placed into state constitutions or law by citizen referendum and requirements that taxes and spending rise no faster than inflation plus population growth have had large and beneficial effects on state budgets. But when legislatures pass mild revenue or expenditure caps, easy to evade and largely unenforceable in the breach, the result can be more spending from lawmakers who think they're behind political cover.
Setting up political or institutional counterweights to the public choice dynamics that drive government growth in state capitals can yield some fascinating and hopeful outcomes, especially when accompanied by serious attempts to organize taxpayer lobbies, free market think tanks, and alternative media conduits for political information. For the first time in decades, for example, governors and legislators under fiscal pressure are rethinking their slavish devotion to pouring massive funds into state university systems. Colorado, with both a political tailwind and a strong TEL, is considering a voucher system for higher education to replace its current set of institutions and subsidies. College administrators themselves are proposing more-limited privatization measures for state systems in Massachusetts, South Carolina, and Wisconsin. On the Medicaid front, Florida and a handful of other states are experimenting with a defined-contribution approach that gives patients more financial incentives to shop wisely and more choices about where and what to buy. The early results look encouraging.
No reforms or political victories, however promising, can repeal the basic laws of government finance. Politicians will continue to tax. They will continue to spend. And they will continue to spin, holding endless conferences and issuing countless reports to justify their actions. Parkinson got that one exactly right when he reportedly told a lecture audience: "Government's handling of a difficult matter by appointing a commission…is just like a person going to the toilet. There is a sitting, a report, and then the matter is dropped."