Foreword
 
Executive Summary
 
Preface
 
The Outlook for State Finances
 
Prospects for Funding Higher Education
 
Fiscal Impacts on Higher Education Policy
 
Increasing Spending Outside of Higher Education
 
Cutting Spending Outside of Higher Education
 
Raising Taxes
 
Sensitivity Analyses
 
Participants, Symposium on Emerging State Policy Issues
 
Endnotes
 
About the Author
 
About the National Center

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State Spending for Higher Education
Page 4 of 14

Chapter One: The Outlook for State Finances

INTRODUCTION

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 that outlook.

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 patterns.

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

Economic Environment
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 sector.

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.

Demographic Environment
Standard demographic projections from the U.S. Census Bureau underlie both the economic and workload projections used in this report.1

Federal Policy
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.

Political Environment
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 are insignificant.2

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 tax revenues.

THE OUTLOOK FOR FUNDING CURRENT SERVICES

Structural Deficits
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?

  1. The nation's economy has been growing faster than its long-term sustainable growth rate, swelling state as well as federal tax collections.

  2. 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.

  3. Federal aid, particularly funding associated with welfare reform, has provided windfall revenues for state governments.

  4. 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.

  5. 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 revenue losses.

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 Past
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 Future
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

State Situations
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 governments combined.

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.

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