Budget shortfalls blamed on overspending, tax cuts
Rapid increases in government spending, permanent tax cuts for individuals and woefully inadequate levels of savings have put Arizona on a treacherous financial path during the past 15 years. Now, lawmakers are trying to detangle the state’s twisted finances and unwind one of the biggest budget knots in state history.
The state has the second-worst budget deficit in the nation for the upcoming fiscal year, ranks last nationally in job growth and will have to find a way to address a deficit of more than $3 billion.
Conventional wisdom says learning from past mistakes is the only way to prevent them from repeating, but policymakers so far have focused largely on staking out ideological positions, instead of dissecting the financial decisions of the past decade that brought the state to this point. What has been said in public tends to be a simplified, black-and-white explanation that sweeps aside the complexity of the state’s financial bind in favor of political rhetoric.
The reality is that there are multiple factors that led to Arizona’s massive budget imbalance, and the weight that should be given to each is the subject of a debate that has been colored by political ideology. Budget problems that seem obvious to those on one side of the political spectrum are understood completely differently by those on the other side.
Fiscal conservatives blame lawmakers who voted to increase government spending, criticism that started long before the state was in such a dire financial predicament. The complaints have grown louder and come more frequently now that the state is in such a mess. “This is a government problem, where we’ve got spending out of control. This has never been a revenue problem,” Senate Majority Leader Chuck Gray said at a March 4 press conference.
Democrats, however, say today’s problems resulted from massive tax cuts that began in the mid-1990s, which have left the state without billions in revenue each year. When adjusted for inflation and other factors, the tax cuts equaled roughly $2.7 billion in lost revenue last fiscal year. The loss of revenue from those taxes is amplified by the general economic downturn, which has left the state unable to pay its bills.
The best way to address the deficit under that world view is to protect as much government spending as possible and find ways to weather the storm until the economy turns around.
“We’ve seen from economists that the way to stimulate the economy — there’s no better way (than) with government spending,” said Rep. Steve Farley, a Tucson Democrat. “If you give it back in tax cuts, like some of the majority would like to do for big businesses, a lot of that will go to investment banks in New York. It won’t stay in the local community.”
Marshall Vest, director of the Economic and Business Research Center at the University of Arizona, said the fundamental issue in Arizona’s temperamental revenue swings — very high highs in the good times, exceedingly low lows in the bad times — is that the state’s economy is too reliant on real estate and growth industries.
“Any time real estate becomes a driver of the economy, it’s not a good thing. If you get a bubble going…eventually, the bubble is going to burst, and it’s not a pretty sight, as we’re seeing today,” he said.
It’s no secret the national economy was toppled by the meltdown of credit markets and the financial sector, but it’s likely that Arizona would be in poor shape even if the ripples caused by the bursting of the housing bubble hadn’t devastated Wall Street.
Housing prices were so out of control here that tens of thousands of homes were built because of speculative market demand, not because there were actually people to live in them. When the bubble burst and the speculators were no longer buying houses, it became obvious the market was flooded. Some analysts estimate the housing surplus was as high as 80,000 homes at its peak, an inventory that takes years to absorb in a normal market.
Arizona, like all states, is no stranger to the tug-of-war between those who want to cut taxes and those who want to maintain or increase government spending. But the result of the state’s rapid swings in revenue is a structural deficit, in which ongoing expenses exceed permanent revenues. Arizona has had a structural deficit for decades, said Tom Rex, a researcher at ASU’s L. William Seidman Research Institute at the W. P. Carey School of Business.
The overspending problem really started to get out of hand in the middle of this decade, says Jim Rounds, an economist at the Scottsdale-based Elliott D. Pollack Co. As the housing bubble began to form, state spending ramped up by nearly 16 percent a year for three straight years.
In fiscal years 2005, 2006 and 2007, state spending increased at a rate that far outpaced population growth and inflation, a standard many fiscal conservatives hold as the maximum acceptable growth rate of government.
Population-plus-inflation growth in those three fiscal years was 6.8 percent, 7.0 percent and 5.9 percent, respectively, while total general fund expenditures increased 15.8 percent, 16.2 percent and 16.3 percent. By 2007, the general fund budget was $10.2 billion — $3.7 billion larger than it was in fiscal 2004 and $4.2 billion larger than in fiscal 2003.
Rounds said the state paid for a bulk those spending increases — many of which were for the creation of new programs or for the expansion of existing ones — by using one-time tax revenues that were generated by the real estate bubble.
Even when the economy started to show signs of weakening, policymakers didn’t heed the warnings and continued to spend, said Arizona Tax Research Association President Kevin McCarthy.
McCarthy points to the fiscal 2008 and 2009 budgets as particularly heinous examples of unwillingness by state officials to rein in spending in anticipation of a downturn. The signs were on the wall that the one-time revenues resulting from the housing boom were about to evaporate.
“We built a budget that had a very shaky foundation, and the bottom fell out of it,” McCarthy said. “When the money started to dry up…they kept spending money they didn’t have.”
But comparing spending now to what it was in 2003 is unfair, says Vest, the UofA economist. “It’s not quite that simple,” he said.
The spending levels in 2003 came at the end of the last economic downturn and represent where the state was after trimming spending by more than 5 percent in two years, which skews the basis for claiming runaway spending, he said.
A major reason for the large increase in spending beginning in 2004, Vest said, was to restore public service levels to where they had been previously and where they should have been, given population increases and inflation.
In fact, figures from the Joint Legislative Budget Committee show state government spending grew by an average of 5.3 percent per year during the past decade. Population growth plus inflation also averaged 5.3 percent per year during that time period.
Even JLBC’s most cautionary figures for the time period, which account only for operating expenditures and exclude one-time expenses and savings, show government growth averaged 6.7 percent per year, only 1.4 percent higher than population-plus-inflation. The real issue, according to both Vest and professor Dennis Hoffman, director of the Seidman Institute at ASU, is that temporary revenue was used to backfill revenue lost as a result of permanent tax cuts enacted multiple times since the mid-1990s.
“I think the data really speak pretty loudly to the fact that it’s a shortage of revenue that’s (primarily) contributed to the problem,” Hoffman said.
A series of tax cuts under Gov. Fife Symington in the 1990s and another income tax reduction approved in 2006 have come home to roost now that the economy is bad and tax collections have dropped off a cliff, Vest said.
Individual income tax rates were cut each year of Symington’s term, beginning in fiscal 1993, resulting in permanent revenue reduction of nearly $800 million. When factoring inflation, that total jumps to about $1.2 billion.
Additional income tax cuts were enacted during Gov. Jane Hull’s term in all but her final year, when the state was grappling with a downturn in the economy caused by the bursting of the tech bubble and the fallout from the Sept. 11 terrorist attacks.
More tax cuts were made in fiscal 2007, when the Republican-controlled Legislature and then-Gov. Janet Napolitano agreed to a 10-percent reduction in the income tax rate, which equals a loss of nearly $500 million in state revenue.
The decrease in revenue from tax cuts since 1993 is a little more than $1.7 billion. But when inflation and population growth are considered — the state has grown from 3.9 million people to nearly 6.5 million in that time — the effect of the revenue reduction skyrockets to nearly $2.7 billion.
“Had Arizona not passed permanent tax cuts…we would have had another $3 billion in the budget annually,” Vest said. The big problem with the cuts, in Rex’s eyes, is that they were done at high points in the economic cycle, when the state was flush with cash and not concerned about the future impact on state revenues.
Yet the risks associated with those tax cuts might have been mitigated if the state had reduced its spending at the same time, said Vest, Rex and Hoffman. Instead, spending levels rose while the revenue needed to support them eroded. “We’re really looking at fiscal mismanagement,” Vest said.
But ATRA’s McCarthy said the gaping hole in the argument that tax cuts were the primary cause of the state’s financial woes is the idea that the money would just be sitting around now, waiting to be used.
“I think there’s a lot of intellectual dishonesty going on when that argument’s being made. If you can intellectually make the argument that we wouldn’t have spent the money, you’re lying to yourself,” he said.
A further problem, Rounds said, is that lawmakers as recently as last year continued to expand spending, despite the tax cuts of 2007. “While (the cuts have) reduced the revenue base, the state knew how much money was coming in the door and spent more than that,” he said. “The bottom line is, the state spent too much.”
The budgets that broke the camel’s back, in McCarthy’s eyes, were those for fiscal 2008 and 2009, which together represent a structural deficit of $2 billion. During the formation of both budgets, analysts told lawmakers the economic expansion was about to end and revenues were going to decrease.
“These were conscious decisions. They knew they didn’t have the revenue, and they did nothing to adjust the budget,” he said. “If those two budgets wouldn’t have been structurally out of balance to the extent they were…we would have been much better able to handle the problems we didn’t know were going to surprise us.”
Chief among those problems, of course, is the national recession, which experts say is clearly the worst economic downturn since the Great Depression of the 1930s. McCarthy said the state would still be facing a budget crisis and a $1.5 billion structural deficit without the dramatic loss of revenue resulting from the economic collapse, but one that would be more manageable than today’s situation.
The middle ground in the taxes-versus-spending debate doesn’t have many inhabitants. But Gov. Jan Brewer seems willing to set up shop there. Eileen Klein, who heads the governor’s Office of Strategic Planning and Budgeting, said there is truth to the arguments from both sides.
“I think it’s all of the above, honestly,” she said.
One way to avoid running into the structural-deficit problem in the future, or at least mitigate its severity, would be to require ongoing expenditures and revenues match up in the state budget, Klein said.
On the tax side, she said the state needs to revamp its tax code in order to diversify the economic base in Arizona, which would diminish the impact of downturns.
Both of those reforms are included in Brewer’s oft-repeated five-point plan to weather the recession, Klein said. “It’s imperative that we do that,” she said.
Already, legislative Democrats have proposed one major tax reform. Their most recent budget proposal includes cutting the state sales tax rate to 3.4 percent from 5 percent, while expanding the list of items and services taxed. That move, economists say, will stabilize sales tax collections during swings in the economy.
House Speaker Kirk Adams says the time to implement comprehensive tax reform is now, while the economy is struggling, because there won’t be any political will to make needed changes when revenues are pouring in.
The clock is ticking on action this session: A budget must be approved by June 30, and there has been little, if any, formal debate on tax reform proposals. But while experts say the recession will end later this year, they also warn that the economy won’t rebound quickly and Arizona will still be in a budget quagmire for the next several fiscal years.
If that happens, Adams and other lawmakers say, tax reform will remain a pressing issue and will be a top priority at the Legislature next year.