Do States Control Their Fiscal Destiny? Not as Much as They May Think.

By: Josh Goodman - May 23, 2011 12:00 am

California, Florida, Illinois, New York and Texas elected five very different governors last fall, but they all agreed on one thing: their capacity to solve their states’ problems. “Once we take the right steps,” Florida’s Rick Scott said in his inaugural address, “I am absolutely convinced that Florida will become the most exciting place in the world to live and work.” Likewise, New York’s Andrew Cuomo declared that “the decisions we make…this year will define the trajectory of this state for years to come.” No one said, “I hope our state does well, but there’s only so much I can do about it.”

Perhaps they should have. For the uncomfortable truth is that when or whether the five most populous states make it back to budgetary stability and economic prosperity depends on a lot more than just what happens in their state capitols.

Will the national and global economy experience a more robust recovery? Will the federal government be able to implement a health care overhaul in a way that doesn’t hurt states financially? Will courts and voters limit the options available to state budget-writers? The answers to those questions will go a long way toward determining states’ fiscal condition in the years ahead — possibly more than any governor’s vow to create thousands of new jobs.

Of course, states have some control over their own destinies. In each of the big five, it’s easy to find examples of decisions over the years that moved their budgets away from structural balance — whether it was a single-shot gimmick that papered over a budget gap, a tax cut that didn’t come with commensurate spending reductions or a new program that lacked a revenue stream to pay for it. Since states created many of their own problems, it stands to reason that they can play a role in solving them too. To do that, though, requires state leaders to work within the biggest constraint they face: the will of the voters they represent.

Limited powers

In some cases, a state’s fiscal future depends on factors that no government can manage with any degree of certainty. Florida, which has an unemployment rate around 11 percent, is counting on growing its way back to prosperity. To achieve that goal, state lawmakers overhauled growth management rules this year in a way that’s intended to encourage new development. That development won’t happen, though, if the housing market doesn’t recover. As long as lots of homes sit vacant, there’s no reason to build more. It also won’t happen if people from other states — especially seniors — decide they’d rather move somewhere else. Even a couple of bad hurricanes could make the state look like a less attractive place to relocate. Florida’s lawmakers can’t control the weather.

The situation in Florida reflects a broader truth: Governors talk a lot about jobs and the economy, but there’s relatively little they can actually do on those subjects. States have no equivalent powers to the Federal Reserve. They can’t manipulate interest rates and inflation. States also can’t run deficits in their operating budgets — at least not legally. Balanced-budget requirements often mean that when a state takes one action designed to boost its economy, it has to do something else that retards it. Tax cuts may come at the expense of job-creating infrastructure projects, and vice versa.

What states mostly have to do is hope the feds — and a variety of international actors — make decisions they find favorable. It’s telling that the states in the best economic and fiscal shape right now, such as North Dakota and Alaska, are ones whose natural resources are currently fetching high prices, not ones that have made smarter economic decisions than their counterparts.

Nor can states necessarily even control their own budgets. The two things states spend the most money on are Medicaid and K-12 education. Those are also two areas where outside forces play a large role in what they spend.

Most states have tried as best they could to protect K-12 education from cuts as their fiscal problems have mounted the last few years. Now, with federal stimulus money running out, they have begun cutting school funds in earnest. It’s an open question whether those cuts will stick. Many states spend heavily on education because courts have said they must, based on provisions in their state constitutions that require them to provide an adequate or equitable level of education for all. School budget cuts in New York and Texas both could face new funding lawsuits in the months ahead.

The constraints on budget writing don’t just come from the courts; they come from the people. Every public official in California is well aware of that. In that state, for example, citizen initiatives have mandated that education spending increase every year while also placing a cap on the revenue source most commonly relied upon to fund education: the property tax. Lawmakers’ power is limited.

When it comes to Medicaid, the restrictions largely emanate from the federal government. Florida, for example, approved an ambitious plan to place Medicaid beneficiaries on managed care. But that decision requires federal approval. If the Obama administration rejects the expansion of managed care, the state will have to find a new way to limit Medicaid costs.

Those federal restrictions on Medicaid will only increase as the federal health care law goes into effect. In many ways, that law is a great deal for states. The federal government will pay the full cost of caring for newly eligible Medicaid beneficiaries through 2016, then gradually scale back to paying 90 percent starting in 2020. Yet that 10 percent will cost states a lot of money. Plus, states have to consider the cost of adding new Medicaid recipients who were previously eligible for the program but didn’t sign up. States have fallen well short of enrolling all their eligible citizens, but they will be required to go further in this direction once the health law goes into full effect. States won’t have the option of tightening eligibility standards if their budgets are strained.

The key question is whether there’s a way to provide this additional care without spending more money. The federal law included ambitious measures designed to control long-term health care costs. Whether those measures succeed will determine states’ fiscal futures just as much as anything the states themselves do.

The power to tax

None of this is to say that states aren’t making tough decisions where they have the authority to. Illinois, which has the nation’s worst-funded state employee pension system, last year created the nation’s highest retirement age at 67. Illinois also has (after California) the nation’s second-worst bond rating, a reflection of the stratospheric gap between the money it brings in and the amount it has been spending. So this year the state approved major tax increases to help close that gap. It’s possible that if Illinois had taken these steps five, ten or twenty years earlier, it wouldn’t face the vast fiscal problems it does today.

The Illinois revenue increases highlight the one area where state officials do have very broad legal authority: taxation. While there are significant outside constraints on what states spend, most have discretion to determine how much money they bring in and where they get it from. New York and California depend heavily on personal income taxes; Florida and Texas don’t even have them. While taxes are headed up in Illinois, they’re likely headed down in New York, where a temporary income tax increase is set to expire December 31.

As states try to get their fiscal houses in order, many of the big questions that they face relate to the way they tax. Can states make their tax systems less volatile, smoothing out boom-and-bust cycles in the economy? What will they do about sales taxes that are targeted to an ever-narrowing portion of the economy because they focus on tangible goods, rather than services? Is there a way for states to bring in enough revenue to pay their bills in a way that the public will accept? Those are difficult questions, but at least, unlike many of those on the spending side, they’re questions that states will mostly be able to answer for themselves.

One important element over which any state has virtually absolute legal authority is the system of institutional rules that helps to determine the choices it makes. California is a good place to see that. In California, many observers have placed the blame for the state’s severe structural budget problems on longstanding rules that have empowered the political fringes and made long-term thinking less likely.

Those rules have been changing lately. California no longer requires a two-thirds vote to pass a budget, thanks to a ballot initiative backed by key legislators. That should help bring fiscal stalemates to an earlier end. As a result of another initiative, the state has placed the drawing of legislative district lines in the hands of an independent redistricting commission that won’t draw as many safe seats for incumbents, and may lead to more pragmatic legislators. California has abolished partisan primaries through a measure legislators placed on the ballot, replacing them with a new system also intended to aid centrist candidates.

State policymakers weren’t unanimously in favor of these changes. Nor could lawmakers have made them on their own. They needed the voters to go along. That’s why other rules that have been linked to California’s lack of fiscal foresight, such as the state’s stringent legislative term limits, haven’t changed yet. Still, the lesson in California is that while institutional structures shape politics, politicians also can change institutional structures, potentially in ways intended to place states on a more sustainable fiscal path.

Political realism

Given that states can control some problems much more easily than they can control others, it’s fair to say that their fiscal future depends in large measure on keeping straight which ones are which.

But that’s not as easy as it sounds. There are plenty of things that states could do under law, but that political reality won’t allow. State leaders have only a limited power to change their budget strategies unless the public will go along. If it weren’t for that particular complication, states likely could balance their budgets now and into the future without much difficulty. New York and Texas demonstrate that.

Texas lawmakers currently are stalemated over the budget for the next two years. The state may be much as $27 billion short of what it needs to continue paying for existing services during that period. Texas doesn’t have a personal income tax. New York, with nearly 6 million fewer people than Texas, has a personal income tax that’s projected to net $78 billion over the next two years. If Texas were to create an income tax, even one far more modest than New York’s, its current budget hole would disappear.

Likewise, New York could come closer to structural balance if it emulated Texas in certain ways. Despite its smaller population, New York enrolls around 1.5 million more people in Medicaid than Texas does, and spends far more per recipient. Had New York decided long ago on a Medicaid program with a fiscal footprint more like that of Texas, the state would have saved tens of billions of dollars over the years.

Yet few leaders in Texas have seriously considered an income tax. Few in New York have seriously considered a Medicaid program anything like the one Texas has put in place. The reason is that those changes would come with tradeoffs that voters have deemed unacceptable. In other words, the two states’ budgets reflect their citizens’ values. Those values constrain lawmakers, ruling out some potential policy options. But, of course, it’s also completely appropriate that the public gets a say.

After all, balancing the budget isn’t an end in itself. The reason states care — or should care — about structural balance is as a means to do what their citizens want in a sustainable way. As Illinois has found out, the longer a state goes without matching its ongoing spending to its ongoing revenue, the more likely it is to be forced into the sorts of drastic spending cuts and tax increases that don’t respect the public’s wishes. The only dependable route to long-term fiscal health is to provide a relatively consistent level of services and a relatively consistent level of taxation sufficient to finance them — in ways acceptable to the public — whether it’s low taxes and low services in Texas or high taxes and high services in New York.

The hard part, of course, is that public expectations are often unrealistic. The services voters expect don’t necessarily match the taxation they’ll accept. That reality, as much as anything else, explains why states got themselves into fiscal trouble. To fix their budgets in the years ahead, they’ll have to guide the public’s expectations toward a level of taxes and services that are sustainable, even while staying as close as possible to their citizens’ particular values. States will have to hope that’s something within their power to do.

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Josh Goodman

Josh Goodman helps lead research on fiscal management and place-based economic development programs as part of Pew’s state fiscal health project. Goodman has served as a primary author for Pew studies that examine how states should evaluate tax incentives and maintain budget discipline when implementing those incentives.