Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm (Misconceptions Also Divert Attention from Needed Structural Reforms) by Iris J. Lav and Elizabeth McNichol

“…Most states… face a set of fundamental problems in their revenue and budget structures that will continue once the economy recovers. These problems, often called ‘structural deficits,’ make it difficult to fund the ongoing cost of public services year after year. Structural deficits occur when annual revenue growth, in the absence of legislated changes, lags behind economic growth and behind the annual growth in the cost of services.

“In significant part, this is a problem of health care costs, which... are projected to grow much more rapidly than revenues over the foreseeable future. In addition, the cost to states and localities of K-12 education has grown faster than the economy over the past 20 years, rising from 3.58 percent of GDP in 1988 to 4.02 percent of GDP in 2008; it remains to be seen whether that trend will continue after the economy recovers.  And while efforts at improving efficiency in these and other areas of the budget are always appropriate, there are limited opportunities for states to reduce cost growth in either area. 

“Since education and health care expenditures account for more than half of state budgets and more than a third of local budgets, jurisdictions cannot balance their budgets year after year if these two spending areas are growing faster than the economy and revenues are growing slower than the economy. Yet that is the situation in most states, and it can lead to poor public finance practices even in good economic times, as policymakers often devise temporary solutions rather than fixing the underlying problems.

“Most states’ revenue systems are in dire need of modernization; they have remained largely the same for the last 40, 50, or 60 years. But the world is very different than it was 60 years ago. The role of services in the economy has greatly increased, Internet commerce has come on to the scene, telecommunications and exotic forms of commerce have multiplied, and income has become far more concentrated among the wealthy, to mention just a few trends. State revenue systems have not kept up.

“For example, few states adequately tax the sales of services on an equal basis with the sales of tangible goods. Similarly, most Internet sales go untaxed. And the majority of states focus their taxes on moderate- and middle-income residents; they fail to maintain progressive income tax systems that adequately tax the rapidly growing incomes of the top 1 percent or 5 percent of earners. In addition, states do large amounts of spending through their tax codes by giving tax breaks that are intended to accomplish policy purposes such as economic development, and provide large tax exemptions for the elderly and for retirement income regardless of the income of the taxpayer. Yet they rarely scrutinize this spending through the tax code on the same basis as on-budget spending. Together, these and other chronic problems cause revenue growth to lag behind economic growth. Fixing these problems for the long term should be high on states’ agenda.

“In addition, most states need to overhaul the processes by which they enact budget and revenue changes. For example, there are no more than a handful of states in which budgets include accurate projections of revenues and expenditures, adjusted for expected cost inflation and utilization changes, for as much as four or five years into the future. Without such information, policymakers have no way of understanding the long-term budgetary impact of the changes they are making, especially when such changes are phased in over several years. Moving to accurate multi-year budgeting is one of the most important reforms that states can adopt.

“Illinois is an extreme example of the implications of failure to fix these types of problems. It has a flat, low-rate income tax that does not adequately capture income growth, and income tax revenues thus routinely lag behind economic growth. The state relies heavily on a state and local sales tax that is almost exclusively applied to goods and excludes almost all services. It is among the states that exempt from state income tax the largest share of income received by elderly individuals, regardless of their income levels. Illinois also does a relatively poor job of scrutinizing its spending through the tax code. Its budget considers only the single upcoming fiscal year, and policymakers often have taken budget actions without full consideration of the longer-term implications.

“Because Illinois is chronically short of the revenues it needs to cover its expenses, it has engaged in a number of poor fiscal practices over the years. It has postponed payments to vendors, failed to make adequate pension contributions or borrowed money to make the contributions, securitized or sold assets, and taken other dubious actions. As a result, it has had a particularly difficult time coping with revenue declines during this recession, with a fiscal year 2012 deficit projected to equal half of its general fund budget, and has developed an large overhang of longer-term debt and unfunded liabilities.

“But it is important to remember that the root cause of Illinois’ problem is a revenue system in urgent need of modernization, one that cannot support the level of expenditures that the state has chosen. Proposals have repeatedly been made over the last 25 years to remedy many of these problems, but political gridlock has prevented solutions to Illinois’ well-known budget problems from being enacted. In January 2011 Illinois temporarily increased its personal and corporate income tax rates to close a portion of its budget gap. But it still plans to borrow to cover its pension contributions and has not addressed the fundamental problems in its revenue systems that are the principal cause of its large structural deficit.

“Most states are not in as dire shape as Illinois. Nevertheless, if states fail to reduce their structural deficits and improve their budget processes, it will be more difficult for them both to maintain needed services and to prepare for the next cyclical downturn by accumulating adequate reserves. Nor will they have the funds to fix the problems that have been identified in the funding of public pensions and other areas.”

From the Center on Budget and Policy Priorities:  http://www.cbpp.org/cms/index.cfm?fa=view&id=3372