by:
Peter Schirmer
Michael T. Childress
Charles C. Nett
See our Budget Game based on this report.
Governments at all levels are feeling squeezed between limited resources and seemingly limitless pressures to increase spending, but it was not always this way. Just thirty years ago, when the U.S. economy was robust and expanding, the national debt was much smaller, there were more employees per Social Security recipient, and programs such as Medicare and Medicaid were in their infancy, economists worried about a drag on the economy resulting from public revenues growing faster than public expenditures (Giertz, et al., 1995). In the 1960s, governments had "structural surpluses." Today, governments have "structural deficits."
A structural deficit is not a single-year shortfall, which might occur as the result of an unforeseen natural disaster, a new mandate from the federal government, or a sluggish economy. Rather, a structural deficit is a long-term crisis; it occurs when revenues are projected to consistently grow more slowly than expenditures over several years. Because many states cannot actually run a deficit, certain expenditures may be neglected, sometimes for years, in order to balance the books. Two of the most frequent victims of neglect are infrastructure and higher education.
Does Kentucky have a structural deficit? Will the current revenue structure (consisting of various taxes, fees, investments, governmental transfers, and so forth) be able to support the current level of services in coming years, or will spending cutbacks be necessary in order to maintain a balanced budget? This report suggests that Kentucky does, in fact, have a structural deficit.
Our claim is based on projected revenues and expenditures through 2004. The revenue projection simply assumes that without any major changes to the tax structure general fund revenues will grow at the same rate as personal income—a rather generous assumption given recent growth rates and tax cuts. But this report focuses on expenditures and the possible impact that a variety of trends may have on state spending during the next decade. Of course, no one knows for sure how fast technology will improve or whether the poverty rate will increase or decrease. We cannot be certain that managed care will yield the expected savings for Kentucky's Medicaid system or that the prison population will continue to grow as rapidly as it has in the past. But we can make reasonable assumptions about how these things might change, and how they might affect expenditures.
What we assume will not change is the quality of state services. In other words, the state will not add new restrictions on Medicaid coverage, it will not increase or decrease police protection, it will continue to give its children as good an education as they receive today, and so forth. This report essentially asks, "With the changes taking place in society, the economy and the populace, how much money will Kentucky need to spend 10 years from now in order to give its citizens the same quality of services they receive today?" The answer is, "More money than we'll have."
We project expenditures to grow approximately 6 percent a year through 2004, compared to 5.3 percent annual growth for revenues. The difference may not seem like much, but at this rate, expenditures would grow 79 percent between 1994 and 2004, while revenues would only grow 67 percent. Even starting with a surplus in 1994, we project that expenditures would exceed revenues by more than 4 percent in 2004. This deficit will exist only in theory, because in practice spending will have to be less than revenue.
Overall, general fund spending is growing faster than general fund revenue, but not all expenditures are increasing at the same pace. In fact, if we divide state spending into functional categories—primary and secondary education, higher education, police and corrections, health and human services, highways and all other—we have more bad news: our investment in education is declining compared to spending on prisons and health care. This trend is already taking place in Kentucky, and we project that it will continue:
Of course, a healthy populace and a safe society are essentials of a high standard of living. Yet we contend that the best (not to say the only) way to cultivate a high standard of living for future generations is by increasing Kentuckians' knowledge, abilities and talents—the paramount goal of the education system.
Our baseline forecast of general fund spending for different functions of government projects a general fund "deficit" of 4.6 percent in 2004. But we are not actually forecasting that Kentucky will have a deficit, because it is prohibited by law. Rather, it suggests that spending is growing at an unsustainable rate, given the current tax structure and our assumptions about a variety of factors.
We have already noted that the revenue and expenditure projections assume that the tax and spending structures will not change in the coming years. But what if we were to make a change? What if, for example, Kentucky decided that its spending for education was too low compared to other states and should be increased? Our budget model allows us to change a variety of factors which can create alternative budget scenarios. In this report we explore four alternatives to our baseline forecast:
The budget projections based on these alternative scenarios do not pinpoint the exact amounts by which expenditures or revenues will change. Rather, they illustrate the magnitude of the impact these events might have on the budget.
The "expanded commitment to higher education" scenario includes a gradual increase in both spending per student and college enrollments to meet the regional averages by 2004. Our analysis suggests that spending for higher education would grow nearly 90 percent between 1994 and 2004, compared to a 50 percent increase in the baseline projection. The total cost of the expanded commitment to higher education could be more than $1 billion over 10 years. If other functions are kept constant, higher education spending could rise to over 16 percent of general fund revenues, but total general fund spending for all categories would then exceed general fund revenues by more than 8 percent.
In the "expanded commitment to primary and secondary education" scenario, we look at the cost of raising state and local expenditures per pupil to match the regional median. Even assuming local governments bear their share of the increase, we project a huge cost—$1.8 billion cumulative—and a deficit of more than 9 percent of general fund revenues in 2004. In this scenario, spending for primary and secondary education is projected to grow 87 percent between 1994 and 2004, compared to a baseline increase of 70 percent.
One of the contentious items of the budget debates of 1995 was Medicaid. Congress considered a variety of proposals to reduce federal spending over several years. One of the proposals called for Kentucky to get about $13.3 billion for Medicaid between 1996 and 2002. The Urban Institute in Washington projected that this plan would cost Kentucky around $4.3 billion between 1996 and 2002; Kentucky's Cabinet for Human Resources projects losses to Kentucky totaling about $3.4 billion. Our estimate is that the state would lose roughly $700 million by 2002 and $2 billion by 2004. The Urban Institute and the Cabinet for Human Resources project gloomier scenarios than we do, but even using our estimates the state could have a general fund deficit of nearly 14 percent by 2004, and health and human services spending could amount to more than one-third of all general fund revenue, if we are to maintain the quality of services in the Medicaid program.
We look at a recession scenario to demonstrate the importance of the rainy day fund. This fund supports state spending in lean years, when slow economic growth leads to slow revenue growth. In our recession scenario, even though the analysis actually projects expenditures to grow a little slower (spending increases for human services are offset by a lower inflation rate), it also projects revenues to increase by only about 1 percent, compared to a 5 percent increase in the baseline forecast. Instead of a deficit of 3 percent in 2002, the slow revenue growth would create a deficit of more than 5 percent.
Many trends are largely outside the province of policymaking, particularly at the state level. If Kentucky is to continue to maintain—let alone improve—the quality of services it currently provides, it must be proactive in managing the trends affecting spending. The state must develop and adopt strategies for strengthening its financial outlook in years to come. We offer four recommendations:
The current provisions for funding Kentucky's budget reserve fund are rather weak: the reserves cannot exceed 5 percent of actual general fund receipts, and any deposits made to the fund out of excess revenues are made after the state implements its surplus expenditure plan, if it so chooses. Protection of the reserve fund is even weaker: reserve funds may be appropriated at any time by the General Assembly. It's like saving money by putting it into your wallet instead of the bank. In the absence of a sound budget reserve fund, the budget effects of a recession could be brutal.
In its 1994 report, the Governor's Commission on Quality and Efficiency examined past budgets and noted that Kentucky has suffered budget shortfalls in 9 of the last 12 budget cycles and 4 of the last 7 years. In our report, we predict that budget shortfalls will continue to be a way of life, funds will not be available to make an expanded commitment to education, and a recession or a change in federal Medicaid policy would require severe spending cuts. Whether the Commission studies the past or we gaze into the future, the conclusion is the same: in the words of Jim Gray, chairman of the Commission, "We must change the way we manage our government."
Perhaps nowhere is innovation and increased efficiency more urgent than in education, particularly higher education. Not only are we compromising future economic development, but by placing more of the financial burden on students, we could be limiting the potential of Kentuckians after they receive their degrees. Educational debt discourages students from pursuing lower-paying careers such as teaching, but it can also deter students from seeking advanced degrees. Many graduate students today face mountains of debt once they start working (Graham, 1995).
While it is beyond the scope of this report to examine possible education reforms in much detail, we will note that various experts have criticized the higher education system in Kentucky for duplication of services, "turf fights," and lack of coordination, all of which decrease efficiency. To increase efficiency, businesses and other private associations might share in the costs and planning of higher education. In Louisville, for example, plastics manufacturers, working together with the Louisville/Jefferson County Office for Economic Development, have begun planning a 520-hour curriculum to be taught at Jefferson Community College (Louisville/Jefferson Co. Office for Economic Development, n.d.). The bottom line is, some sort of change is necessary. Otherwise, Kentucky's unpleasant discovery in 1995 that we couldn't afford to significantly increase higher education funding will be a recurring event.
As with education reform, we will not offer many specific recommendations on tax policy. Others have done that for us. The Kentucky Commission on Tax Policy, in particular, has completed an extensive study of the state tax structure and makes numerous detailed recommendations. (The Commission has no authority to enact any of the changes.) In the absence of tax reform, it seems clear that revenues will not keep pace with expenditures, and state services as they now exist will be compromised. It is highly unlikely that Kentucky will be able to expand its commitment to education (or, for that matter, other kinds of workforce training, economic development or environmental protection) if expenditures and revenues continue along their current paths.
References
Giertz, J., McGuire, T., and Nowlan, J. (1995). The Illinois structural deficit dilemma: The growing gap between state expenditures and revenue realities. Champaigne-Urbana, IL: University of Illinois, Institute of Government and Public Affairs.
Governor's Commission on Quality and Efficiency. (1994). Wake-up call for Kentucky: Out of crisis into action. Frankfort, KY: Author.
Graham, E. (1995, August 11). Study now, pay later: Students pile on debt. The Wall Street Journal, pp. B1, B3.
Louisville/Jefferson Co. Office for Economic Development. (n.d.). Industry networks. Louisville, KY: Author.
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