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Funding Public Higher Education
A brief overview of the fiscal landscape facing the states

By Brian Stenson

As the roller coaster of state fiscal health begins another cycle, public higher education appears to be well-positioned to recover some of the ground it lost during recent years. At a minimum, the growing attention paid to global competition challenging America for science and technology prominence should spur policymakers to invest more heavily in higher education. And there are signs that some states are doing so. However, there are many challenges ahead for state governments, and it will not be easy for higher education leaders to make significant headway.

Tax collections surged in almost every state as the national economy rebounded in 2005. The Rockefeller Institute of Government tracks state tax collections, which are the best indicators of fiscal health. Its latest report, covering October through December of 2005 (the second quarter of fiscal year 2005-06 for most states), shows that state tax collections were strong, if less so than the prior quarter. When compared to the same period in 2004, tax collections grew 7.6 percent. This growth rate was the second fastest increase for that quarter since at least 1991.

The increase was broad-based in at least two respects. First, all three major taxes registered impressive increases compared to the third quarter in 2004. Collections from the corporate income tax rose an eye-popping 24.8 percent. This was the ninth straight quarter of double-digit growth for that tax source.

Moreover, strong tax collection performance was recorded in almost every state; only two saw an absolute decline from the prior year. Eighteen states enjoyed double-digit tax collection growth, led by Alaska's 74.7 percent. States in the southwest saw the greatest gains (average growth was 15 percent), while the Great Lakes states had the lowest (a still-respectable 4.2 percent, particularly given their slower-growing populations).

State tax collections are affected by actions taken to increase or decrease taxes, an important variable also tracked by the Rockefeller Institute. Collections in the October-December quarter were reduced by tax cuts enacted by the states. Although the dollar amount was small ($65 million in net tax reductions), their existence alone is significant. This was the second consecutive quarter of net tax cuts, and the prior quarter (July-September) was the first period since 2001 in which tax collections showed a net decline because of legislated tax actions.

This strength in tax collections is leading many states to project budget surpluses in the 2005-06 fiscal year. And projections for 2006-07 and subsequent years show a distinct improvement from the multi-year outlook of a few years ago.

While the evidence suggests that states are at the beginning of a period of revenue growth, both history and other budget factors indicate that higher education advocates should not expect a windfall of taxpayer support in the coming years.

The history of funding support for public higher education is relatively straightforward. Data from the U.S. census show that higher education spending by the states has not only held its own vis-a-vis other elements of the state budgets, it has actually grown slightly. Whereas direct spending on higher education in 1995 accounted for 13.8 percent of total general expenditures, this figure was 14.3 percent in 2004.

Total spending on higher education appears to have been maintained during the recent fiscal crisis: Spending growth averaged 6.6 percent per year from 1995 through 2001, and 5.2 percent from 2001 through 2004. Of course, in times of budget stress, fiscal policymakers are quite willing to reduce public support for programs where an alternative revenue stream, such as tuition, is available to support existing services, thereby preserving limited tax dollars for areas without such alternative revenue sources.

Thus, as reported by the Illinois State University's Grapevine, from 1995 through 2001, state tax appropriations for higher education averaged just below six percent growth per year, but from 2001 through 2004, state support grew by less than one tenth of one percent annually.

Just as important is that states face a variety of other budget pressures. These may well undermine the ability of state budget planners to invest substantial amounts of new funding in public colleges and universities. These pressures range from perennial issues such as tax cuts and Medicaid to newer challenges such as post-retirement benefits that leave even seasoned fiscal analysts wondering.

The recent recession and the period immediately following it ravaged state revenues. In general, the states held the line as best they could on most spending programs. But to balance their budgets, states were forced to take other actions.

They enacted modest tax increases. The Rockefeller Institute's regular survey of tax collections indicates that 2003 saw the most concentrated tax increases. Eighteen states raised taxes by a total of $6.8 billion, which represented approximately 1.4 percent of all state tax revenues.

They raised fees and charges. For example, according to the Washington Higher Education Coordinating Board, the average tuition rate jumped by more than 30 percent between 2001 and 2004.

They drew down budget reserves and found one-shot resources. In the fiscal crisis following the 2001 terrorist attacks, New York, for instance, balanced its 2002-03 budget with $6.3 billion in nonrecurring actions, including the use of "rainy day" funds.

We now expect states will act to reverse some of those actions. The Rockefeller Institute's preliminary review of the larger states' proposed budgets indicates that cutting taxes and replenishing reserves is a priority of the governors. For example:

  • Arizona Governor Janet Napolitano proposed cuts targeted to specific purposes (such as encouraging business spending on research and development), which in total would cost about $100 million in the first year.
  • Connecticut Governor M. Jodi Rell's budget would repeal the state property tax on automobiles and the corporate tax surcharge and phase out the estate tax. The plan would cost $295 million in 2006-07.
  • Maryland Governor Robert Ehrlich, Jr. recommended a reduction in the estate tax and several other targeted cuts.
  • Massachusetts Governor Mitt Romney would cut the top rate on the income tax in two steps, reducing revenue in 2006-07 by $132 million, growing to $488 million in the next year.
  • New York Governor George Pataki proposed a multi-year plan to reduce the personal income tax, the corporate income tax, and the estate tax, and to provide school property tax relief. The plan would reduce tax collections by $844 million in the first year and by $3.3 billion in the third year.
  • Pennsylvania Governor Edward Rendell recommended $221 million in business tax reductions.

Some of these same governors, along with others, are including in their budgets deposits to their state's rainy day funds, which were drawn down during the early years of the decade. For example, Governor Ehrlich proposes to deposit $1.4 billion to Maryland's budget reserve, and New York's Governor Pataki proposes to apply New York's $2 billion current-year surplus to a reserve for use in the 2007-08 and 2008-09 budgets.

Virtually every discussion of state budget trends starts with Medicaid, the health care program for low-income Americans. State budgets have strained to finance Medicaid spending growth boosted by rising costs for prescription drugs and an expanded use of long-term care. More recently, a number of factors, notably slower spending growth for drugs and the recent implementation of the Medicare Part D drug benefit, and state and local efforts to curb Medicaid spending for nursing home care, have helped slow the overall rate of growth for Medicaid.

The Rockefeller Institute's preliminary review of the budgets of the larger states indicates that few governors are proposing sweeping Medicaid cutbacks for 2006-07. But according to a recent article in the journal Health Affairs, the pace of Medicaid spending will increase again in 2007 to 8.5 percent—spending growth will average 8.6 percent annually until 2015. This rate of spending growth can be expected to exceed the growth in tax collections and economic performance in most states by several percentage points. As a result, Medicaid spending will continue to exert significant pressure on state budgets.

Federal budget planners are again attempting to curb Medicaid spending. The reconciliation budget bill for 2006 includes a multi-year agenda of Medicaid cuts. And George Bush's 2007 budget recommends sharp—some say draconian—cuts in most programs of domestic spending. Although Congress has exhibited little appetite in recent years for such sharp reductions, the federal government has budget pressures of its own.

Growing calls to reform the tax code make it difficult to believe this can be done in a way that is budget neutral, meaning that spending may have to be cut to balance the budget effects of changes to unpopular current features such as the alternative minimum tax. The costs of the post-hurricane rebuilding effort and the war in Iraq add to the pressure to cut spending and thereby avoid further exacerbating the federal budget deficit problem.

Although everyone can readily grasp the fiscal impact of new spending to rebuild New Orleans, some new demands on state budgets are far more arcane. Much attention has been focused recently on private sector pension troubles, but the public pension systems have their own challenges. Public pensions typically are managed through a pension system that uses actuarial techniques to estimate future payment obligations; contributions and investment earnings are intended to match these obligations. Thus, during the stock market's boom years of the 1990s, earnings led pension managers and state officials to reduce contribution rates and grant new benefits. When the market correction was over by 2003, the asset value of the pension systems had dropped sharply.

A new report by Standard and Poor's finds that compared to 2000, when pension system assets matched their long-term liabilities, assets in 2004 equaled only 84 percent of liabilities. The funding gap of $284 billion will have to be made up over a period of years through increased contributions by employers and through investment earnings. As a point of comparison, according to Standard and Poor's, this unfunded liability is almost exactly equal to the total amount of state government tax-supported debt, and in many states is far larger than the outstanding debt.

Another retiree benefit, health insurance coverage, may well become the next hot issue in state fiscal quarters. For years, almost all states financed the costs of these benefits from their annual operating budgets without setting aside any reserves for obligations they have incurred, but don't yet need to pay. These deferred costs are expected to grow rapidly as baby boomers reach retirement age, health care costs continue to surge, and life spans lengthen.

Now, the Government Accounting Standards Board (GASB) has issued guidelines requiring that states start to disclose this hidden cost in their financial statements. As the new GASB disclosure requirement does not become effective until 2007-08, no comprehensive accounting is available of the magnitude of this unfunded liability. However, Maryland estimates its liability at $23 billion, compared to its $30 billion budget.

Bringing to light the practice of granting benefits that are deferred until retirement may encourage states to be more open about their budgets. And to the extent it leads policymakers to set aside reserves to offset these liabilities, fewer resources will be available for current services; New York City Mayor Michael Bloomberg has proposed setting aside $2 billion between now and the end of 2006-07 as a reserve against these future obligations.

This brief scan of the fiscal landscape facing the states indicates that budget planners will have no shortage of budget challenges, even as tax revenues are soaring. Although higher education leaders should be able to make a strong case that additional public support is warranted, they are bucking a long-term trend and stiff competition from other budget areas.

Brian Stenson is deputy director of the Rockefeller Institute of Government, and former vice chancellor for finance and business for the State University of New York.

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National CrossTalk Spring 2006



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