Overview of the State Budget Situation

Between FY 1998 and FY 2008 net state spending grew at a modest rate, but did not keep pace with economic growth in the state. During this same period, an even slower rate of revenue growth set the stage for many of the budget problems faced today.

How has state spending changed over the past 10 years?

In FY 1998, net state spending⁴ was approximately 6.9 percent of our total economy, as shown in Figure 1 and Table 1. Had spending as a share of the economy increased between 1998 and 2008 that would explain why the state went from surpluses to deficits over that period. But that didn’t happen. By FY 2008 net state spending had declined to 6.63 percent of our state economy (as shown in Figure 1 and Table 1).

In FY 2008 the state was spending less as a share of the economy than it was in the late 1990s. If spending had grown with the economy over that period, FY 2008 net state spending would have exceeded its actual amount by more than $1.07 billion. The trends varied in different areas of government and in different parts of that decade, with an increase during the 2002 recession when incomes declined as the need for services increased, but the overall trend was down.

How has state revenue changed over the past 10 years?

Since spending declined compared to our economy, our fiscal condition should have improved – had state revenue kept pace with the economy. But revenue growth did not keep pace with the economy. While state revenue amounted to 7.4 percent of our economy in 1998, by 2008 it had declined to 6.5 percent of the economy. This decline translates to $3.34 billion in lost revenue in FY 2008.⁵

State revenue is made up of several sources: taxes, fees, and other sources, such as the state lottery and the payments the state receives from tobacco companies as a result of litigation in the 1990s. While there were declines in several of these sources, the largest declines were in state taxes, as shown in Figure 2.

In general, revenue declines have been prompted by two factors:

1. Between 1998 and 2008 the state cut the income tax substantially. The rate on earned income was reduced from 5.95 percent to 5.3 percent. The tax rate on dividend income was reduced by more than 50 percent, from 12 percent to 5.3 percent. Finally, the personal exemption – the amount everyone is allowed to deduct from their income before paying taxes was increased from $2,200 per person to $4,400 per person, giving each taxpayer a cut of $117. Altogether these tax cuts cost the state $2.5 billion a year. As discussed in Section 2, there were other tax policy decisions during this time that mitigated the decline in income tax revenues somewhat.
2. Sales taxes declined steadily as a share of the economy. The decline in sales taxes was not due to specific tax policy changes, but rather to changes in the economy that undermined the ability of our tax system to collect sales taxes. These changes included the increased use of the Internet to purchase goods and the relative decline in spending on goods relative to services. Because of these trends, sales tax collections in FY 2008 were down over $1 billion dollars from their FY 1998 level.

A more in depth discussion of revenue trends in Massachusetts can be found in Section 2 of this brief.

How do Economic Growth, Spending and Revenue Compare?

As Figure 3 shows, between FY 1998 and FY2008 our economy grew at a rate of 2.64 percent a year in real terms.⁶ During this period the growth in net state spending (not including federal reimbursements) was 2.26 percent. This means that the amount of state money being spent altogether on education, healthcare, human services, local aid, and the other areas of the state budget was growing more slowly than the economy as a whole. Thus each year the state was spending a smaller share of its resources on the things we pay for through government. At the same time, revenues were growing even more slowly than state spending, at 1.48 percent, leading to the structural imbalance the state budget faces today.

What would the state’s fiscal condition look like if tax and other state revenue had remained a constant share of the economy?

In FY 1998, the state enjoyed a structural budget surplus of approximately $1.05 billion.⁷ Because of this surplus the state was able to invest in a number of long term needs, including $300 million for capital infrastructure and an additional $300 million in the state’s rainy day fund to better prepare the state for future needs.

If state revenue had remained 7.4 percent of the economy from FY 1998 to FY 2008, the state would have continued to enjoy a budget surplus, represented in Figure 4 by the shaded portion of the 2008 revenue share. The total value of this surplus over the decade could have exceeded $20 billion. For the reasons described below, however, it is unlikely that surpluses would have been that large under any circumstances.

What Could the State Have Done Differently Over the Past Decade?

In periods of economic growth state revenue will generally grow more quickly than the cost of maintaining existing services. This creates a strong temptation for states to cut taxes aggressively or increase spending substantially. When a state follows either of those paths, it enters the next recession unprepared. As described earlier in the brief, during the 1990s, Massachusetts responded to short-term surpluses caused by the dot-com boom with significant, permanent tax cuts which cost $2.5 billion a year.⁸ In addition, declining sales tax revenue cost an additional $1 billion a year. As a result, the state entered the recession early in this decade in a very precarious position. Had the state not cut taxes deeply in the late 1990s, a series of other policy options would have been available.

The State Could Have More Effectively Addressed Long-Term Challenges

The state could have spent more on the maintenance and repairs of capital assets and paid for more of its capital spending directly rather than by borrowing in the bond markets. Such action could have mitigated the looming crisis in transportation funding.⁹ The state also could have more aggressively paid down unfunded pension liabilities which would have reduced the future costs of these liabilities and strengthened the fiscal conditions of the Commonwealth.¹⁰

Budget Cuts Could Have Been Less Severe During the Last Recession

Had the same share of the economy continued to be devoted to state taxes and fees, the deep budget cuts implemented in the recession at the beginning of this decade probably would have been much less severe. During the last recession, the state cut funding for local aid, K-12 and higher education, public health, environmental protection and other areas of government.¹¹ Over the past several years state spending has increased as some of the funding cut in those areas has been restored. Yet in many areas total spending, as a share of the economy, is still below the levels it was at before the last recession (described in more detail in Section 2 of this paper).

The State Could Have Allowed a Smaller Reduction in Overall Taxes

Instead of making substantial, permanent tax cuts, the state could have been more cautious in its revenue policies, in anticipation of future downturns. Some of the reductions in taxes, such as the $1 billion dollar decline in sales tax receipts, were not the result of active policy choices. Had the state taken no actions to reduce taxes, this billion-dollar reduction still would have occurred as a result of a number of factors, including the growth in the Internet and in the service sector of the economy. The state also could have chosen to protect some of the sales tax by broadening the base to include services and reduced other taxes instead.

The State Could Have Deposited More Money into the Stabilization Fund

Even if the state had invested half a billion dollars a year more in addressing long-term challenges, had implemented a billion less in budget cuts in FY 2002, and allowed sales tax receipts to decline as they did, the remaining surpluses still could have been large enough for the state to have built $7.6 billion in reserves.

What is the relationship between the short-term and long-term issues?

Even if the state were to keep revenue and spending at a constant share of the economy over the long term, there would still be business cycles that would create periods of fiscal difficulty. In comparing FY 1998 and FY 2008 we are comparing two similar points when the state was about six years into an economic recovery. To be able to maintain services and fiscal stability, state revenue should be a similar share of the economy in similar points in the business cycle.

In periods of recession, however, revenues will fall even if they are a constant share of the economy. If the economy shrinks and there are no changes in tax policy, tax revenue will decline. At the same time, state spending is likely to increase even without any changes in state policy: if everyone below a certain income level is eligible for a particular safety net protection – like Medicaid – then the number of people using those services will increase as more people lose their jobs and their incomes fall below the eligibility threshold.

For these reasons, balancing the state budget becomes more difficult during periods of recession. That is why states need to build reserves in good times. While the state has gone through cycles of cutting taxes in the 1990s, cutting spending and raising some taxes in the FY 2002 to FY 2004 budget crisis, and restoring some services in the past several years, the state faces the current recession with only modest reserves and revenue levels significantly lower, as a share of the economy, than they were in the late 1990s.

How Different Would Our Fiscal Condition Look Today if There Had Been Different Fiscal Policy Choices Made Over The Past Decade?

In the late 1990’s the state responded to the strong economic climate by making significant tax cuts. There would be two major differences in the state’s fiscal condition if the state had not enacted these tax cuts.

First, the state could have a significantly larger balance in the Stabilization Fund. As described above, even if the state had allowed the erosion of the sales tax and had invested $5 billion more in meeting long-term challenges over that period and $7 billion more in reducing cuts, the balance in the Stabilization Fund still could have grown by $7.6 billion. A Stabilization Fund balance of that amount could significantly cushion the fiscal blow that the state now faces.

Second, the gap heading into FY 2010 would be significantly smaller if the revenue base had not been reduced by $3.34 billion. Assuming, again, a middle path in which taxes declined by $1 billion, ongoing spending increased by $1 billion, and the state had made a series of half billion dollar investments in meeting long-term challenges, then the FY 2010 gap would be approximately $1.3 billion smaller than it will be. In addition, the spending to meet long-term challenges could appropriately be suspended during the recession allowing $500 million in savings without eating into core operating funding for state government.

 4. We use the term “net state spending” to describe state spending paid for by all sources of revenue other than revenue from the federal government. It is important to differentiate net state spending which excluded federal sources from total spending which includes spending from federal revenues because we want to identify the extent to which spending trends have caused pressure on the state’s treasury. Net state spending does not include funds deposited into the state Stabilization Fund, the Capital Improvement and Investment Trust Fund or the Debt Defeasance Trust Fund.

 5. This foregone revenue is calculated by applying the FY 1998 share of personal income devoted to state revenue (7.4%), applying that percentage to FY2008 total personal income ($384.4 billion) and subtracting FY 2008 actual state revenue from that number.

 6. Real growth is measured as Compound Annual Growth Rate (CAGR). This brief calculated real growth by first adjusting fiscal year 1998 numbers for inflation and then using the CAGR formula to calculate annual growth.

 7. This surplus is the difference between ongoing state revenues, shown in table 2, and ongoing state spending, shown in table 1. We considered the following FY1998 expenditures to be one time surplus spending: $317.4 million for the Commonwealth Stabilization Fund, $200 million for tax reductions, $300.7 million for capital improvements, $162.5 for the Tax Exemption Escrow Trust and $60 million for a teacher, principal and superintendent quality fund.

 8. More information is available in “Trading Places: The Role of Taxes and Spending in the Fiscal Crisis,” available at http://www.massbudget.org/file_storage/documents/trading_press.pdf and “Tax Cuts and Continued Consequences: States That Cut Taxes the Most During the 1990s Still Lag Behind,” available at http://www.cbpp.org/12-19-06sfp.htm.

 9. For more information on transportation funding issues, see the Transportation Finance Commission’s report, “Transportation Finance in Massachusetts: An Unstable System.” The report can be found online at: http://www.eot.state.ma.us/downloads/tfc/TFC_Findings.pdf

 10. For more information on estimates of the state’s unfunded pension liability, see the Pioneer Institute’s white paper on public pensions, available online at http://www.pioneerinstitute.org/pdf/06_pension_paper1.pdf

 11. For more information about budget cuts during the 2003-2004 recession, see the MassBudget report, “Real Cuts, Real People, Real Pain,” which can be found online at http://www.massbudget.org/file_storage/documents/Real%20Cuts%20-%20Real%20People%20-%20Real%20Pain.pdf