Impact of Fiscal Conditions on Higher Education
State funding for higher education has always been heavily influenced by states'
fiscal situations. State elected officials have often viewed support of higher education
as more discretionary than funding for many other programs. As a result, changes
in state fiscal conditions are often multiplied in their impacts on higher education.
When finances are tight, higher education budgets are often cut disproportionately.
When financial conditions are good, higher education often receives larger increases
than most other programs.
These fiscal responses mean that the outlook for state higher education funding
depends critically on the outlook for state finances overall. This chapter addresses
Baseline Budget Projections
The approach used in this paper is similar to that used by most legislative bodies
when developing and enacting budgets and making fiscal projections -- typically called
baseline or current service budgeting. The starting point is current
spending and revenues. The projections are based on applying current government policies
to predicted future changes in the environment in order to measure the fiscal consequences
of continuing those policies.
For revenues, that means predicting the revenues from current taxes, given likely
changes in the national and state economies. For spending, it means predicting the
workloads, such as the number of children in public schools, that drive spending.
The underlying assumption is that decision-makers will be tempted to hold constant
their spending for units of workload, such as spending per pupil. But to keep activity
constant, such as maintaining the same pupil-teacher ratios and quantities of teaching
supplies per pupil, spending must reflect inflation as well as growth in workloads.
The result of such an analysis is a current service, or baseline, budget. Such
budgets provide the starting point for formulating governors' budgets and considering
legislative budget options. The time period covered by the forecasts is a fiscal
year or biennium, depending on the fiscal practices of individual states.
If the projections indicate that revenues from current taxes likely will exceed
the spending needed to maintain current services, the government has fiscal flexibility
to expand spending further or reduce taxes. If there is a projected shortfall, decision-makers
must either raise taxes to finance their current programs or curtail their spending
Some states and the federal government extend their fiscal projections to longer
time periods. They use roughly the same approach -- basing expected revenues on predicted
economic conditions, and basing spending on predicted changes in price levels and
workloads for government programs.
THE ENVIRONMENT FOR STATE FINANCES
The condition of the nation's economy is the single most critical factor influencing
the fiscal condition of state governments. Economic growth brings large gains for
state revenues because of impacts on tax bases. For example, in a rapidly expanding
economy, rapid growth in incomes brings rapid growth in income tax revenues and rapid
growth in purchases brings rapid growth in revenues from sales taxes. Economic growth
also affects spending. Large portions of state expenditures are for means-tested
safety net programs, such as cash welfare and Medicaid (health care for low-income
households). In strong economic times, more people hold jobs and eligibility for
safety net programs is reduced. Conversely, in economic downturns, the caseloads
in these programs increase as more people become eligible because of low incomes.
From year to year, the performance of the nation's economy seems quite unpredictable.
At any given time, there is constant speculation over whether the nation is on the
verge of recession or economic "overheating," that is, rapid but unsustainable
growth. Over the long run, economic growth is more predictable. Changes in the nation's
real (inflation-adjusted) output are driven by the combination of: (1) the number
of workers, and (2) their productivity or output per unit of time. Many factors affect
productivity, such as technological innovation, education and training of workers,
and capital investment. But over multi-year time periods changes in both productivity
and the number of workers have proven to be relatively predictable.
For its projections, this paper relies on the baseline economic assumptions used
by the U.S. Congress in its budget deliberations. These assumptions are quite similar
to those used by those states that make long-term budget projections, as well as
to the assumptions underlying forecasts used in business planning in the private
The projections assume that each year of the forecast period will be characterized
by about the same rate of economic growth. This is not because those making the forecasts
believe that the nation will be free of periods of slow growth or recession alternating
with faster-than-normal growth. It simply means that, without exception, those who
make long-term projections of government budgets are not confident of their ability
to forecast exactly when these periods will begin and end. They are confident, however,
that the variations will average out over the projection period to about the rate
of economic growth being assumed.
Standard demographic projections from the U.S. Census Bureau underlie both the economic
and workload projections used in this report.1
Because federal aid finances about a quarter of all state and local spending, the
fiscal outlook of state and local governments is highly sensitive to changes in federal
funding. These projections assume that federal aid will continue to finance the same
percentage of state and local outlays as in the past. State government costs are
also sensitive to federal mandates, which are presumed not to undergo major changes.
There are no assumptions about the relative electoral success of major political
parties underlying the projections. This can be viewed as either: (1) an assumption
that that success will not change in major ways, or (2) an assumption that such changes
Sensitivity to Assumptions
Long-term fiscal projections are sensitive to the assumptions described above. This
sensitivity is explored in Appendix D.
SPENDING GROWTH PROJECTED TO PARALLEL PERSONAL INCOME GROWTH
Total Spending Increases
Detailed projections of state and local spending on a state-by-state basis were developed
by State Policy Research, Inc., during 1998. The nationwide projections produced
an unsurprising result. To maintain their current services, state and local governments
will need to increase their spending by about the same percentage as the increase
in total personal income of all Americans. Specifically, over the next eight years,
an increase of 39.6% in spending will maintain current services while personal income
growth is expected to be about 36.5%. Thus, current service spending can be accommodated
with a slight rise in the percentage of incomes spent by state and local governments,
from about 16.0% to 16.3%.
Having spending for current services so closely tied to personal income makes
sense. First, it is reasonable to expect that voters will support adjusting purchases
of public services about as fast as incomes grow. The projections imply improvements
in purchasing power, as measured by real per capita income gains. To maintain balance
between public and private outlays, citizens are likely to want to devote some of
this purchasing power to public goods and services. It makes little sense, for example,
to spend more on vehicles while not maintaining roads on which to drive them or on
security alarm systems without adequate police responses to the resulting alarms.
Second, many of the factors driving personal income increases are also driving
increases in the costs of government. Inflation is the best example. Demography offers
other examples. A growth in population not only contributes the workers who produce
economic growth, but also produces more citizens to be served by governments. Growth
in those segments of the population that create high spending needs, such as children
in school, is roughly proportional to the growth in the segments creating economic
growth, such as those in the 18 to 65 age group.
Differences Among Functions
Within the growth in total spending for current services, there are differences among
major government functions. The somewhat higher-than-average growth of the college-age
population and trends in college attendance will likely make higher education costs
rise more rapidly than the costs of most other programs. Growth in the population
over age 65, and particularly in the population over age 85, will tend to force Medicaid
costs -- a large portion of which pays for nursing home care -- to rise more rapidly
than total state and local outlays.
REVENUES GROW MORE SLOWLY THAN PERSONAL INCOME
Problem Widely Recognized
While spending for current services will grow at about the same pace as personal
income, state and local revenues from existing taxes will not do so. The result is
a shortfall in state and local budgets that is almost entirely attributable to the
characteristics of state and local tax systems. This problem with current tax systems
is well known. It has been the subject of a series of reports from organizations
of state and local officials identifying the problem and proposing reforms in state
tax systems to reduce if not eliminate it.3
Causes of the Problem
As economists would put it, the problem with state and local tax systems is their
low elasticity. To provide revenues adequate to finance current service spending
without tax increases, these tax systems would have to have unit elasticity
-- that is, growth in revenues would be proportionate to growth in personal income.
For example, a 10% increase in personal incomes would result in a 10% increase in
tax revenues. Because of its graduated personal income tax rates, the federal income
tax would raise much more than 10% additional revenue for every 10% increase in personal
income. To offset this tendency, the federal government adjusts the standard deduction
and tax bracket break points for inflation every year. But even with the adjustment,
federal income tax revenues grow at a better pace than personal income because: (1)
personal income growth enters the income tax base, and (2) additional increments
of real income (that is, income adjusted for inflation) are taxed at successively
higher marginal income tax rates.
State and local tax systems show the reverse. The main culprit is states' high
reliance on sales taxes on goods. As individual incomes rise, people spend a successively
smaller portion of incremental income on taxed goods and higher proportions on non-taxed
outlays for services. Even without increases in personal income, the share of consumer
spending associated with goods tends to decline. Because productivity increases are
concentrated in manufacturing, prices of manufactured goods tend to decline while
those of services, where productivity has less of an impact, tend to rise. As a result,
successively larger portions of incomes go to purchase services.
Low elasticity of state and local tax systems is also associated with high reliance
on taxes and fees based on units of purchase (e.g., packages of cigarettes, bottles
of alcoholic beverages, gallons of gasoline) rather than on prices. For more complex
reasons, business taxes also have less-than-unit elasticity, since smaller portions
of economic activity are associated with the types of businesses (corporations engaged
in manufacturing) for which state and local tax systems were designed.
These characteristics of state and local tax systems mean that every growth of
10% in personal income is associated with growth of about 9.5% in state and local
THE OUTLOOK FOR FUNDING CURRENT SERVICES
With revenues growing more slowly than personal income and outlays growing faster,
state and local governments have a structural deficit in funding current services.
This mismatch between what would be needed to continue current programs and revenues
from current taxes is about 0.5% a year. That is, to maintain current services, state
and local governments nationwide would have to increase taxes by about 0.5%. Alternatively,
they could maintain current tax systems and keep budgets balanced by holding spending
growth to about 4.5% annually rather than the 5% needed to maintain current services.
Problem Not Obvious in Recent Years:
These structural deficits usually appear when states make long-term projections of
their fiscal situations. But they are a marked contrast to the widely publicized
surpluses that have been appearing in state budgets in recent years. Why the difference?
- The nation's economy has been growing faster than its long-term sustainable growth
rate, swelling state as well as federal tax collections.
- Unusual percentages of the economic gains from growth have accrued to economic
players with higher-than-average tax rates, namely corporations and high-income households.
- Federal aid, particularly funding associated with welfare reform, has provided
windfall revenues for state governments.
- Several fortuitous circumstances have benefited state finances, including extraordinary
returns on pension fund investments (which cut the amounts required for employer
contributions), a rapid decline in welfare caseloads, and unusual moderation in cost
increases in health care.
- Gains from these factors have been concentrated at the state level, without corresponding
gains in local government finance. Therefore, surpluses reported by states are not
indicative of the combined circumstances of state and local governments discussed
in this report.
Interdependence of State and Local Finances
The impact of the combination of stronger state and weaker local finances on support
of higher education is not obvious at first blush. Because most higher education
money comes from states, strong state finances might suggest a favorable environment
for higher education spending, regardless of local situations. In practice, however,
local fiscal pressures are rapidly translated into state fiscal pressures. Evidence
of this appears in discussions of taxes and tax relief. In many states, there is
strong sentiment for reducing reliance on property taxes, such as personal property
taxes on motor vehicles and residential property taxes. When states seek to reduce
burdens of local property taxes, they do so by replacing all or most of the local
Evidence of the interaction of state and local finances also appears in spending.
For example, in the state campaigns of 1998, candidates almost universally stressed
increasing state aid for local public schools. Besides whatever impact this might
have on how well children are educated, one effect is to reduce reliance on local
property taxes for funding of schools. This effect can be viewed as using some state
revenue growth to enhance local revenue growth, which is not matching the strong
growth seen by states.
Problem Likely to be Obvious in Next Few Years
The flip side of the better-than-normal state financial conditions will be, as everyone
who looks at the subject concludes, an ensuing period when state finances show worse
problems than the normal mild structural deficits. There are two basic reasons for
this, one behavioral and one economic.
The behavioral reason stems from the tendency to assume that the future
will be like the immediate past. This is particularly important in state government,
which has institutional factors encouraging a short-term outlook. The old adage that
elected officials rarely look beyond the next election has an element of truth. Also
important is the turnover of legislators -- always rapid, but accelerated by the
increasing use of term limits. The office of governor also turns over rapidly, with
most governors limited to eight years of continuous service.
These factors mean that the average state legislator and governor in 1999 has
never held his or her current office except during the period of unbroken prosperity
that has lasted since 1992. In this context, there is a tendency to assume that strong
tax collection growth will continue unabated and that actual collections will always
exceed those predicted by revenue estimators. Revenue estimators themselves are not
immune from adjusting their estimating procedures to deal with their recent errors,
which have been underestimates.
So on top of whatever institutional inability state elected officials inherently
have to look beyond the next election, all the behavioral factors at work encourage
more optimism about future state finances than projections suggest is merited. Historically,
this factor alone has led state officials to over-commit their resources by adopting
aggressive tax cuts and spending increases.
The economic reason to expect a sharp reversal of state fiscal fortunes
lies primarily in the likelihood that past economic patterns will be repeated. If
they are, the past eight years of rapid growth will be followed by some years of
recession or slow growth with resulting negative impacts on state finances.
Problems would arise even if the nation were to revert to its normal long-term
growth pattern of increases of about 2.4% in real (inflation-adjusted) Gross Domestic
Product rather than the nearly 4% growth in 1998 and 1999. Such a situation would
likely reverse some of the five factors listed on pages 6 and 7 that have contributed
to the current strong fiscal positions of the states.
IMPACTS ON HIGHER EDUCATION
The last five years have been about as good as it gets in state funding of higher
education. By all available measures of state government spending, appropriations
per full-time equivalent (FTE) student have increased by substantially more than
the rate of inflation. Not included in these calculations are the significant developments
in state tax policies that have provided special tax treatment for college savings
and a variety of tax benefits in some states for outlays for college costs.
This favorable fiscal environment has meant that state elected officials have
exerted little pressure for major changes in higher education. With minor exceptions,
they have not forced consolidation or closures of institutions, elimination of programs,
restrictions on tenure, mandates regarding minimum faculty teaching loads, enrollment
caps, and other devices to attempt to force cost reductions. Nor have they squeezed
appropriations for public institutions to the point that large tuition increases
were required in order for the institutions to match the increases in costs occurring
(on a national average basis) at private and public institutions.
In fact, many states have budgeted more favorably for higher education than necessary
to match enrollment changes and inflation. Some states have been financing the costs
of tuition freezes and a few rollbacks. Many have increased scholarships, particularly
in grades 13 and 14. The environment for the establishment of new institutions in
rapidly growing states has been favorable, as has the environment for the expansion
of offerings at existing institutions.
The national budget projections suggest that this environment will not continue.
Even if the national economy and state finances return to normal growth patterns
without a downturn, higher education will find itself in an environment where merely
maintaining current services (through appropriations reflecting inflation and enrollment
increases) will be difficult. Specifically, if higher education shared the fiscal
pain equally with all other functions, spending growth would be slightly below the
amounts needed to maintain current services. Without tax increases, appropriations
to higher education each year would be about 0.5% short of the total funding needed
for maintaining those services. New initiatives in higher education would require
offsetting reductions in the current spending base.
In a normal growth environment, higher education would constantly be on the defensive
against those seeking deeper cuts in order to finance tax cuts or new initiatives
in other fields, such as elementary and secondary education.
If the long-term pattern of normal growth is preceded by recession or slower-than-normal
growth, higher education would experience even more fiscal pressures, recreating
the fiscal environment of 1990 to 1993 and 1984 to 1986.
DIFFERENCES AMONG STATES
Few individual states exhibit the structural deficit of 0.5% a year that is represented
by the national average. Both tax systems and spending pressures vary among the states.
Some states rely heavily on personal income taxes with their high elasticity.
Others have no personal income tax and rely heavily on sales and excise taxes with
quite low elasticity. Some states will see little growth in government workloads,
such as those associated with enrollment increases, while others will see faster-than-average
growth. Inelastic tax systems and rapid workload growth are frequently found together.
Table 1 provides the baseline projections (in year
eight) of each state's structural surplus (+) or deficit (-) for state and local
Reasons for Differences in Outlook
The reasons for the major differences among the states can be divided into three
categories: (1) differences in tax systems, (2) differences in spending needs, and
(3) differences in economic growth rates.
Most of the states that have surpluses also have tax systems that rely
heavily on graduated personal income taxes, which take increasing shares of personal
income as inflation and economic growth drive those with more income into higher
tax brackets. These states do not rely heavily on sales taxes. Of the ten states
showing structural surpluses, ten have personal income taxes and nine use graduated
rates. Bottom-ranked states typically do not rely significantly on graduated income
taxes. The bottom-ranked states typically rely heavily on sales and excise taxes
and/or on revenues from royalties, severance taxes, and other revenues associated
with natural resources.
Many of the states with surpluses have few demographic pressures on spending
because of slow population growth and stable or declining school enrollments. This
is a characteristic shared by Iowa, Minnesota, Nebraska and several other top-ranked
states. Conversely, many of the states showing the largest structural deficits have
been showing substantial increases in enrollments, which are expected to continue.
Steady economic growth causes both an increase in revenues, because taxes
are collected on a stronger economic base, and an increase in spending needs, because
of rising population and enrollments. However, these factors do not necessarily produce
balanced growth in spending needs and revenues within individual states. The imbalance
becomes particularly notable in states where past economic growth has abruptly slowed.
This results in a slowdown in the growth of tax collections without a proportional
slowdown in the growth of spending needs (such as when young workers with children
are drawn to a state during prosperous times, only to witness an abrupt economic
downturn). Hawaii is a good example of this effect.