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ASU report cites causes of state budget deficit

November 10, 2008

The state government general fund shortfall in the current fiscal year is projected to be near $1 billion — even after transfers of monies from the rainy-day fund and other funds — according to a report produced by the Office of the University Economist at Arizona State University. This is in addition to a shortfall of more than $1 billion in the last fiscal year. At current trends, a larger deficit is projected for the next fiscal year. 

“While the current economic recession is significantly worsening the size of the budget deficit, the real problem is a structural deficit caused by substantial tax cuts not offset by equivalent spending decreases, and by not putting enough money into the rainy-day fund,” said Dennis Hoffman, university economist. “The state faces the prospect of budget deficits every time economic growth slows.”

Relative to the size of the Arizona economy, state government general fund revenue has fallen significantly since 1995 — likely reaching a historical low in the near term — and expenditures also have declined. “Spending increases beyond the needs of a growing state are not a cause of the current deficit or the long-term structural deficit,” said Hoffman.

State and local government revenues and expenditures in Arizona also are historically low compared to the rest of the nation. For example, the Tax Foundation ranks the Arizona tax burden, defined as per capita taxes as a share of per capita income, as 41st in the nation in 2008, the lowest on record.

Much of the structural deficit results from numerous and substantial tax reductions passed by the Legislature over the last 15 years. “These revenue reductions were not matched by spending cuts of a commensurate size because of the increasing population-driven demands for public services and infrastructure, such as education and public safety,” according to Hoffman.

The structural deficit in part is the result of an outdated tax code that creates large cyclical swings in revenue and that causes revenue to grow more slowly than the pace of the overall economy. “Many of the changes to the tax code during the last 15 years exacerbated these problems,” Hoffman added.

Other actions also have contributed to the near-term dilemma. For example, the Legislature weakened the provisions of the original legislation setting up the budget stabilization fund. The result is less monies available for transfer from the rainy-day fund to the general fund, and a greater need for spending reductions or revenue enhancements to balance the budget, during a recession.

A deficit of $1 billion represents 10 percent of the state’s general fund appropriations. However, since 45 percent of the general fund is protected from budget cuts, the remainder of the general fund is facing a deficit equal to 18 percent of its budget.

Government spending reductions will harm the Arizona economy  

The current state government general fund deficit will need to be closed through spending cuts and revenue enhancements, according to a report produced by the Office of the University Economist at Arizona State University.

“All of the ‘easy’ budget fixes were used to balance last year’s budget,” said Dennis Hoffman, the university economist. “Further, only limited monies remain in the rainy-day fund.”

Hoffman cited several reasons why the mix of expenditure reductions and revenue enhancements used to balance the budget should be carefully considered.

First, unlike much of the private sector, demand does not decline for most public-sector services during a recession. In some government programs, demand rises. Thus, imposed decreases in public spending during recessions come at the same time that demand for public services is stable or rising, resulting in a reduction in the quantity and/or quality of government services. For the most disadvantaged of those consuming public services, real hardship can ensue.

Second, spending reductions by governments during recessions worsen economic conditions. Less spending for goods and services by governments will result in reduced demand for private-sector goods and services. If spending reductions are accomplished by employee layoffs, then private-sector businesses are affected further as laid-off workers either leave the state or cut back substantially on their purchases. “It is not realistic to expect that many laid-off government employees will find jobs in Arizona until the recession has ended,” Hoffman added.

The result of state spending cuts of $1 billion would be to very significantly worsen and lengthen the economic recession. A total of approximately 20,000 workers (8,000 state government and university workers and 12,000 others) might lose their jobs.

Third, cutting the public-sector workforce causes public-sector revenues to decline as the laid-off workers spend less and experience losses in income. Further, the savings to state government of not paying the former workers’ salaries and benefits are partially offset by rising payments to the ex-workers for unemployment insurance and other public welfare programs. 

Fourth, the negative economic effect of a tax increase would be no larger than that of a government spending decrease. “In fact, it should be less,” Hoffman said. “Some of the tax payments would come from personal savings. A portion of a tax increase would be exported to nonresidents and to the federal government (since state taxes are federally deductible).

Hoffman said that the negative effect of a tax increase would be spread across the state, with individual households and businesses suffering only slightly. In contrast, a spending reduction would have substantial negative effects on a relatively small number of businesses — those selling directly to state government and to laid-off government workers. A relatively small number of individuals also would bear the brunt of a government spending reduction: laid-off government employees and workers at hard-hit businesses

Fifth, the size of a tax increase would be relatively small. Even in the extreme example of a tax increase of $1 billion that affected individuals only and was not exported, the increase would equate to only about $150 per Arizona resident, or $400 per household. A tax increase of this magnitude would offset only about a third of the state tax cuts implemented between 1993 and 2008 and would be considerably less than the federal tax rebates distributed in May. Arizona still would rank as a low-tax state at 37th, just lower than Mississippi, according to Tax Foundation data (assuming no other states increased taxes).

Sixth, without enhancing revenues, the state will be unable to adequately support a growing population. In particular, Arizona faces substantial infrastructure needs over the next quarter century.