Earlier this week Minnesota officials said that the state faces a budget deficit of about $2 billion through the middle of 2003.
Minnesota is not alone—some 46 states reportedly face budget shortfalls. A few, such as Arizona, already have their legislatures engaged in heated debate about what spending to cut or what taxes to increase.
Amid the concern, a few economic lessons have become clear.
The first, a lesson in practical government finance, is that state revenues are highly dependent on the business cycle. When the economy is booming, state sales and income tax revenues go up. When the economy busts, proceeds from these taxes go down.
Thus, decisions about what level of taxation is appropriate and which government services are justified need to be made in a medium- to long-term context and not at one extreme or other of the business cycle.
When the economy is doing great and tax money is rolling in, those who favor a larger role for government in the economy inevitably propose spending programs. They point to burgeoning state coffers as proof that the money is available.
Under the same circumstances, those who want lower taxes point to the same burgeoning revenues as proof that taxes are too high.
In Minnesota, the state mailed rebate checks to most households in each of the past three years. Tax critics were quick to point out that such rebates were merely returning money “to its rightful owners” and that taxes should be permanently lowered.
The rhetoric reverses when the state faces budget shortfalls. Bigger government advocates call for increased taxes to fund the programs they favor, while anti-tax groups call for cutting spending.
Both sides should recognize that neither the height of a boom, nor the depth of a bust is a good circumstance for making longer-run fiscal decisions.
A second lesson to be taken from the current situation is the trap of what’s called automatic stabilizers.
During the past 50 years, many economists believed that government could reduce the up-and-down range of the business cycle by taking fiscal and monetary action.
That is, government should reduce taxes and increase spending in recessions and do the reverse when prosperous conditions threatened inflation.
States face a trap, though: As they increase taxes and cut spending to balance their budgets, the effect is to further slow economic activity.
One solution for states like Minnesota, which are prohibited by law from running deficits, is to run substantial surpluses when prosperity reigns. Minnesota has about $1 billion in such reserves.
Yes, tax and spending changes must be made, but they needn’t be as abrupt or severe as if we had no cushion.
There are some additional minor lessons.
The projected budget deficit depends in great part on projections. They now point to recession into 2002. Typically, actual budget performance usually varies from projections.
Lesson: Econometric forecasts are very useful tools. And Minnesota has one of the premier revenue-forecasting operations among the 50 states. However, models, and even the most careful revenue forecasts, aren’t perfect crystal balls.
Finally, there’s an interesting economic theory to recall.
Two centuries ago, economist David Ricardo argued that if a government cut taxes it would have little effect on overall demand or consumption. Prudent people, Ricardo argued, would foresee that such a tax cut would eventually lead to a deficit and thus an eventual tax increase in the future.
Such prudent people would therefore refrain from spending their saved taxes and would put this money away to have it available when taxes were inevitably increased to make up the shortfall.
Ricardo’s view of human nature says that all of us who got state rebate checks in recent years salted the bucks away in a bank account. A tax increase now won’t hurt, because the money is right there awaiting use.
How many of you did just that? My guess is there were very few.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.