Causes of the Financial Crisis

Short-Term Causes of the Fiscal Crisis

Our nation is in the midst of a recession that will likely prove to be the most severe since the Great Depression. In times of recession, state budgets are caught in a vise of shrinking revenue and growing need for safety net services. As the market drops and capital gains profits vanish, capital gains taxes decline. As workers lose their jobs the income taxes they pay decline. And as income from investments and labor decline, people purchase fewer goods and sales tax receipts fall.

On the spending side, when people lose their jobs in a recession they rely on government to preserve access to basic needs such as health care for their families – and in the most dire cases shelter when their families are at risk of becoming homeless.

For these reasons, in a recession revenues decline and the need for spending increases. That has happened in Massachusetts and in states across the country.¹

Long-Term Causes of the Fiscal Crisis

There are also more long-standing causes of our state’s fiscal problems. While the short-term causes of our state budget gap are largely issues outside of the control of state policy makers, the long-term causes are the direct results of policy choices.

While Massachusetts had substantial surpluses in the mid- to late 1990s, by 2008 the state budget was in deficit – even though the effects of the national recession had not yet hit. Why did this happen, and what could the state have done differently? To answer these questions, we need to look at two factors: changes in state spending and changes in state revenue. This MassBudget Brief examines the trends in those two sides of the state budget over the past decade.²

To make sense of changes in spending and tax revenues, the first question that has to be answered is: “compared to what”? To see how spending changes relate to the state’s fiscal stability, we need to compare state spending growth to economic growth. If state spending grows faster than the overall economy, then budget deficits will emerge unless the state consistently raises taxes and takes a larger share of the income earned in the state to pay for the services provided through government.³ If state spending grows at the same rate as the overall economy, then the state will not experience an eroding fiscal condition, so long as tax revenue remains stable as a share of the economy.

 1. See Elizabeth McNichol and Iris J. Lav, “State Budget Troubles Worsen,” Center on Budget and Policy Priorities, Updated December 10, 2008, http://www.cbpp.org/9-8-08sfp.pdf (accessed December 11, 2008).

 2. This brief looks at trends over a decade because both FY 1998 and FY 2008 represent a similar part of an economic cycle, making for an appropriate comparison.

 3. In order to gauge economic growth, this brief uses growth in total personal income. Personal income as used in this brief is derived from the Bureau of Labor Statistics official definition, but includes two adjustments as recommended by the New England Public Policy Center of the Federal Reserve Bank of Boston. These adjustments are to include capital gains in the calculation, because it provides a more complete picture of economic growth, and also to provide a residential adjustment for earnings of residents of other states that work in Massachusetts. For a discussion of adjusting personal income to better reflect growth in the economy, see New England Public Policy Center of the Federal Reserve Bank of Boston, “Assessing Alternative Measures of State Income,” July 30, 2008, available at http://www.bos.frb.org/economic/neppc/memos/2008/weinerpopov073008.pdf. For the analysis in this brief, we follow the methodology recommended by the Federal Reserve Bank. In this brief, “personal income” and the “economy” are used interchangeably when discussing the size of the economy.