Growing Economy Aids State Budgets

Published February 1, 2004

Year-end 2003 economic reports suggested the U.S. economy is on the road to recovery.

“After two years of poor resolution, the economic landscape is coming into focus,” said Duncan Meldrum, president of the National Association for Business Economics (NABE) and chief economist for Air Products & Chemicals, Inc. “We see a stronger expansion developing [in 2004], one that should be sufficient to gradually put idle resources, both workers and factories, back to work.”

Meldrum added in a December 2003 news release highlighting NABE’s projections, “The [economic] panel’s expectations for GDP growth in 2004 was upgraded moderately from when we last surveyed the group in September. Our forecasters now project an average GDP gain of 4.5 percent for 2004.” Such an increase is “above average” and the best of the emerging decade to date.

“The reports of the demise of the United States economy are greatly exaggerated–especially by Democratic Presidential candidates,” noted a recent American Legislative Exchange Council (ALEC) report. “Current economic indicators are great. Especially in the third quarter of 2003: GDP growth of 8.3 percent, corporate profit increase of 11.8 percent, decrease in the unemployment rate, a 2.4 percent increase in productivity–all point to a recovering and re-surging economy in the U.S.”

State Revenues Lag Economic Growth

“Surely this will be good news for state budgets that have recently been awash with red ink. Good economic news almost surely will improve state government finances,” said Dan Mitchell, McKenna Senior Fellow in Political Economy at The Heritage Foundation.

Tax revenue growth, however, typically lags behind economic growth. The third quarter’s 8.3 percent increase in GDP will not immediately result in an increase of 8.3 percent in tax revenues. It takes time for higher economic growth to translate into higher state tax revenues and “healthier” state budgets.

Some tax revenue sources will track economic growth more closely than others, however. “Sales taxes closely follow economic growth,” said Chris Edwards, a fiscal policy analyst at the Cato Institute. Other state taxes, like those levied on personal and corporate income, take longer to reflect improved economic growth.

States are already experiencing more robust overall revenue growth. Numerous states have reported revenue growth ahead of expectations in recent weeks and months, and groups like the National Governors Association do not expect budget deficits to be as severe in 2004 as they were in 2003.

Watch State Spending

Nevertheless, policy analysts are reluctant to say states will quickly rebound. “The economic indicators are both good news and bad news,” explained Mitchell. “The good news is that it makes tax increases less likely. The bad news is that it makes budgetary discipline less likely.”

Edwards agreed, noting that a recovering economy “will reduce political will to streamline services.”

State spending data maintained by the National Association of State Budget Officers (NASBO) confirm the fears of both analysts. State spending grows at a lower rate in poor fiscal times (like the recessions of the early 1980s and 1990s) than in booming fiscal times (like the mid- to late 1980s and 1990s). State spending bottomed out at 0.7 percent real growth in 1991, in the midst of a recession, and peaked at 5.2 percent real growth rate in 1999, a year of strong economic growth.

Taxes May Hurt Economic Growth

Even with a growing economy, state tax increases are not completely “off the table” in 2004. Alabama, Kansas, Oregon, Pennsylvania, and Virginia are currently considering tax increases, which experts warn could blunt the economic recovery in those states.

“Numerous econometric studies have established a strong correlation between higher taxes and lower economic growth,” said John Berthoud, president of the National Taxpayers Union.

Tom Hinton, director of state relations at The Heritage Foundation, said “there will always be pressure to increase taxes as long as state shortfalls exist. Thankfully, it is easy to see what states do a better job, as we watch business and people move in or out. California’s mass exodus of people [and] companies is a prime example.”

In most states, lawmakers will find it difficult to balance their budgets next year and beyond–even with a recovering economy, avoidance of growth-busting tax increases, and a commitment to spending restraint. “States will need to implement permanent reforms to keep budget growth under control,” said Berthoud.

Texas offers one example of a state committed to structural reform. Lawmakers in the Lone Star State reorganized the state’s health care delivery system in 2003, saving the state a projected $1 billion a year–without a serious reduction in health care services delivered to its citizens.

Policy Recommendations

Edwards has identified several structural reforms state lawmakers can adopt during times of economic expansion, making it easier to weather times of economic retraction. He recommends, for example, that states adopt “sunset commissions,” authorizing most state spending programs for only 10 years. By requiring that a program be periodically reauthorized, the sunset commission strategy helps ensure spending programs do not live on in perpetuity, regardless of their effectiveness.

Edwards is also concerned about transparency in state budgeting. “It’s really tough for the average citizen to find out exactly how much his state is spending and how much spending has gone up,” he noted, recommending states take steps to make historical trends in tax and spending more apparent to the voters, so they can hold lawmakers accountable.

Edwards would also like to see states revisit their corporate income taxes. “Smart states will repeal their corporate income taxes,” he said. “They raise only 5 percent of total state revenues, are extremely complicated, and capital is so mobile that states cannot go after them.”

Fiscal relations between the federal and state governments also need improving. According to data compiled by the federal Bureau of Economic Analysis, federal grants-in-aid to states in 2002 reached $304.6 billion–21.3 percent of total state receipts.

A major threat to liberty and lower taxes in the long run, said Hinton, is “the drug of the federal dollar that keeps states in an addicted stupor.” Some states receive as many as three federal dollars for each dollar they spend on such programs as Medicaid–which means a one-dollar cut in Medicaid spending actually results in a four-dollar cut. This often keeps bloated federal-state spending programs off the chopping block when states are looking to pare spending.

NTU’s Berthoud is concerned about overall federal spending–not only the grants-in-aid program–and the impact it could have on state recovery. “I worry that excessive federal spending by Congress and the Bush administration may ramp up pressure for federal tax hikes in the coming couple of years. Those tax hikes would have an adverse effect on state economies and budgets.

“State lawmakers should not be under any allusions that economic recovery will quickly end their fiscal problems,” said Berthoud. “Lagging revenues, self-made problems, and even the fiscal relationship with the federal government will provide plenty of fiscal challenges in the years ahead.”

Chris Atkins is director of tax and fiscal policy for the American Legislative Exchange Council and a contributing editor to Budget & Tax News. He can be reached from the ALEC Web site at