(This column is part two in a two-part series. Part one, “Finding a fair tax system,” discusses the history and inadequacies of the current taxation system.)
The fiscal problems that many state and local governments are facing are largely due to fluctuations caused by the business cycle. States derive most of their income from sales and income taxes, both of which drop in recessions and increase in booms.
Local governments, particularly school districts, get increasing proportions of their income from intra-governmental transfers.
The level of such “aid” depends on legislative decisions driven in part by whether state coffers are flush with cash. At the same time, increasing proportions of their expenditures are mandated by state or federal law.
Today’s recession, and the angst that has set in over various budget shortfalls, should serve as a powerful motivator to figure out ways to reduce the volatility in state and local government finance.
Two measures would alleviate, though not entirely remove, these difficulties.
First, governments need better tools to estimate their revenues and expenses through the business cycle and determine what levels of taxing and spending would result in a balanced budget over a five- or eight-year term. Second, they need some politics-proof mechanism to save up the surpluses generated when the economy is booming and disburse those savings when the economy is in recession.
Neither of these measures is easy. Perhaps neither is even possible. But the problems are such that legislators should make a good faith effort to see what it can change.
Minnesota now has the rudiments of such a system in its “rainy day” fund. The governor and Legislature did agree to set aside part of the surpluses generated in the late 1990s to be used when the economy sours, as it did in 2001.
Simply increasing the size of such rainy day funds relative to the state budget and enshrining them in permanent legislation is one option. But such an action would still beg the question of how large a fiscal cushion is enough and how bad must things get before it’s tapped.
Most states now try to forecast their revenues. Populous states such as New York, California and Illinois can afford to spend considerable sums on this effort, with mixed results.
Minnesota is fortunate that it’s large enough to afford a competent forecasting staff and that our relatively clean government keeps revenue forecasts from being tainted by political bias.
Smaller neighbors, such as North and South Dakota, with populations less than 1 million, tend to lack the resources necessary to produce as sophisticated forecasts as Minnesota.
The task of determining the appropriate level of reserve funds and when they should be increased or drawn down is not an easy one for the Legislature.
Advocates of larger government spending tend to see surpluses, even ones resulting from short-term booms, as evidence that resources are available for new programs.
Small government champions see the same surpluses as evidence that taxes should be cut.
Given the pressures of a two-year election cycle, it is hard for either the increased spenders or tax cutters to see beyond the short-term interests of the voters who put them into office.
One suggested approach to fiscal smoothing would be to give Minnesota’s state economist, who is responsible for revenue forecasts, the authority to set desirable allocations to the rainy day fund in times of surplus and to decree when economic growth had lapsed to a point where withdrawals would be prudent.
This, however, might place an unduly heavy burden on one official. More importantly, it would increase the politicization of the job, now remarkably free from partisan pressures.
Other models might come from Congress, which has to deal with similarly delicate decisions.
There always is so much local opposition to closing any military base that Congress effectively cannot vote to close any. But it has formed bi-partisan base closing commissions that reviewed the usefulness of large numbers of bases and then recommended a closures list on which Congress had to take an up or down vote without any changes. This has worked twice reasonably well.
The Federal Reserve is another option. Congress has recognized that it cannot make monetary policy itself and that it should not be left to the executive branch. It created the Federal Reserve Board and the Federal Open Market Committee, which includes the Board and the presidents of the 12 Federal Reserve Banks.
The Fed clearly is a creation of government, and it could be abolished or modified any time a majority in Congress and a president agreed on so doing. But while these elected officials suffer it to exist, it has autonomy to make decisions about the medium-and long-term economic well being of the country without being directly subject to election pressures.
Minnesota could create such a nonpartisan body, appointed by the governor and confirmed by the Legislature. It would make determinations—based on materials research and recommendations by the state economist and by public groups—on the optimal level of state budget reserves during prosperity and their depletion during recessions.
Such a body would not be a panacea for all budgetary ills. But it might remove some of the “short-termism” inherent in the current system.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.