Magazine

The States Should Find Their Own Way Out of This Hole


By Gary S. Becker

State and local governments are asking for federal assistance to help them cope with smaller tax revenues resulting from the weak U.S. economy. But increased federal aid is not the solution. These governments' fiscal problems are mainly of their own making, because they expanded spending to unsustainable levels during the good economic times that began in the mid-1990s.

U.S. gross domestic product grew rapidly at 4% a year from 1995 to early 2001. State and local government spending increased even faster, especially after 1996. It reached almost 13% of GDP in 2001, up from 11 1/2% five years earlier, whereas federal spending as a share of GDP declined over most of the 1990s. Moreover, despite all the complaints about the states' fiscal plight, revenues from taxes and federal transfers were actually about 20% higher in 2002 in real terms than during the mid-1990s.

The problem facing these governments is that the rapid expansion in spending committed them to unrealistically high levels of support for education, health care, and other services. The largest state, California, finds itself in the worst situation -- it faces a shortfall of almost $35 billion in tax revenue for this fiscal year compared with its spending commitments -- although the finances of New York, Texas, New Jersey, Illinois, and many other free-spending states are also in serious trouble.

Sacramento's revenue in 2002 was almost 20% higher than the level four years before as California, with its central position in the high-tech and biotech industries, flourished over most of this period. But state spending grew even more rapidly. California's support of K-12 education rose from $37 billion (in 2001 dollars) in 1995-96 to more than $51 billion in 2001-02. Spending on higher education and other sectors also expanded substantially. The collapse of investment, employment, and stock market value in its main industries greatly reduced receipts from its capital-gains and income taxes. The pain caused by this dropoff in revenues would have been far less if Sacramento had behaved prudently during the boom.

The nation's largest city, New York, has been hit hard by the terrorist attacks of September 11, its subsequent efforts to prevent further terrorism, and by a steep slowdown in the hotel and restaurant industries because of the attack on the World Trade Center and the slump on Wall Street. But the Big Apple seemed headed for financial difficulties even before the damage of September 11: Its spending had expanded sharply as it rode the boom in securities, banking, and other industries that are vital to the city's economic health.

Expenditures by the city government increased by more than 20% in real terms from the early 1990s, to reach $40 billion in 2000. Mayor Michael R. Bloomberg has proposed big tax hikes to cover a budget of more than $44 billion for the fiscal year beginning in July. Rather than raising property taxes by more than 18% and seeking state authorization to hike sales and income taxes, the mayor would have done better to drastically slash the city's bloated spending. Bloomberg could confront the unions to raise work hours from 35 to 40 a week, shift some medical costs to public employees (who pay nothing right now), and try reducing Medicaid recipients to less than 20% of the city's population.

State and local governments are finding it difficult to come back to reality after their tax receipt "bubble" burst. They are under enormous pressure to maintain spending from construction companies, building unions, teachers, police, fire personnel, and other beneficiaries of the generous expansion in their spending.

Although politicians realize that it is unpopular to increase tax rates during bad economic times, they face even stronger political pressure to continue spending and not pare down costs. This is leading New York City, California, and other state and local governments to propose steeply higher taxes. Yet they surely must realize that tax increases when the economy is weak make their fiscal problems worse in the long run, since it's then more difficult to compete against other regions for scarce investments and new businesses.

Compounding their short-term problems is the fact that -- unlike the feds -- balanced-budget requirements prevent state and city governments from financing revenue shortfalls with debt. Although that legal requirement could be partly circumvented by treating some spending as capital outlays that can be financed with debt, most state and city governments remain under strong pressure to narrow deficits either through higher taxes or lower spending.

There is no easy solution to the boom-and-bust cycle in state and city finances. But a crucial first step is the recognition that their difficulties during bad economic times result primarily from the reckless expansion of spending while the good times rolled. Gary S. Becker, the 1992 Nobel laureate, teaches at the University of Chicago and is a Fellow of the Hoover Institution.


Steve Ballmer, Power Forward
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