States Should Think Long-Term When Addressing Their Short-Term Fiscal Crises

States Should Think Long-Term When Addressing Their Short-Term Fiscal Crises

Just prior to the pandemic, many states were finally recovering from the fiscal crises created by the 2007-09 recession. But, as with so many things, the pandemic has derailed these gains. If history is a guide, no matter how long the current recession lasts, the fiscal crises facing the states will last even longer.

Consider what happened to the states following the last budget crises that began in 2007. According to the state finance data collected by the U.S. Census, total state tax revenues across all 50 states peaked at $780 billion in 2008. By 2010 revenues crashed to $706 billion, and took until 2012 (a full 4 years) for all 50 states to surpass the $780 billion revenue haul.

The current economic downturn has restarted this volatile and painful state revenue roller-coaster. According to the state revenue projections compiled by the National Conference of State Legislatures (NCSL), around 70% of the states are expecting outright revenue declines for fiscal year 2021. California’s revenue decline, which is currently projected to be the largest according to NCSL, could be more than 20%.

Fiscal crises tend to elicit short-term thinking and short-term solutions. Weathering the current storm at any cost tend to be the prime directives. But, the current fiscal crises are the predictable result of the states’ volatile fiscal systems.

Instead of attempting to regain fiscal solvency through budget gimmicks, states should turn to fundamental fiscal reforms (both large and small) in order to create long-term fiscally sustainable budgets.

Given the immediate need to balance their budgets, states should begin by improving their budget management practices. Wasting money is always problematic, but the costs from unnecessary expenditures are harder to bear during fiscal crises.

As an example of the types of savings opportunities available, most states are not adopting the cutting-edge technologies that could reduce the costs of the pharmacy benefit manager (PBM) services states use to manage their employees’ drug benefits. The exceptions are New Jersey, which adopted the practice in 2017 and, more recently, New Hampshire, where Governor Sununu just signed the legislation authorizing a reverse auction in July 2020.

States contract with PBMs to manage their drug formularies, or the list of prescription drugs covered by the state’s health plan. Most states select PBMs using their traditional procurement processes. Instead of this traditional approach, modern big data analytics enables states to conduct online reverse auctions. An online reverse auction creates a competitive process where PBMs will engage in multiple rounds of bidding in which they – along with the state – can see their own price bids and the bids of their competitors.

This dynamic encourages PBMs to underbid one another, achieving financial gains for the state and taxpayers. My analysis of the potential savings for New Hampshire found that an online auction could create tens of millions of dollars in annual savings. New Jersey’s online reverse auction has reduced prescription drug costs by 25 percent, which will lead to $2.5 billion in savings over its five-year contract period.

There are similar savings opportunities across the states. State agencies must be encouraged to consistently find these types of savings opportunities that would help states operate more efficiently.

Reforming budget processes will only go so far, however. Spending reform also requires spending prioritization. Spending prioritization means that states should eliminate wasteful programs, exclusively focus on executing their core missions, and refrain from funding new programs until budget stability is regained.

Defunding the high-speed train construction project in California exemplifies the opportunity. California has been sinking tens of billions of dollars into its high-speed train boondoggle. Despite significant curtailments to the project, its costs continue to mount. The California rail authority estimates that the ultimate cost could be as high as $100 billion compared to an initial cost estimate of $34 billion.

The project was ill-considered and a poor use of taxpayer funds even prior to the current financial crisis. Now, facing a potential $54 billion budget shortfall, the costs of throwing good money after bad are even larger. While reprioritizing the wasteful expenditures for the train to nowhere is complicated, it is the fiscally responsible policy that would meaningfully address the current budget deficit while also improving long-term fiscal health.

Long-term fiscal sustainability also requires fundamental tax reform. Too many state tax systems are excessively volatile, which accentuates the revenue losses caused by economic downturns. The state budget crises caused by the 2007-09 economic downturn led to state revenue declines that were significantly larger than the overall decline in personal income.

The inherent instability of the current state tax systems is the root cause of this excessive volatility. The volatility is even more pronounced in the states with excessively high marginal income tax rates, such as California and New York. Consider that 1% of New York’s taxpayers pay 42% of the state’s personal income tax revenues. The top 1% pay 47% of the income tax revenue in California, which imposes the highest state marginal income tax rate in the country.

This high dependency on a few taxpayers who experience large swings in their incomes inevitably leads to an excessively volatile state revenue cycle. Personal incomes surge during economic expansions causing government revenues to grow even faster. State governments tend to spend all of these revenues so when incomes plunge during economic contractions huge budget deficits emerge. The large deficits emerging today are simply another manifestation of this predictable cycle.

Unfortunately for California, it is considering raising the income tax rates further in response to its current budget problems. Instead of the California approach, states should pursue reforms that create a flatter tax system, which is levied on a broader tax base. Such a tax system would create more stable revenues for the government and improve the incentives for economic growth – a win-win for the public and private sectors.

The types of reforms suggested above require political discipline to implement; budget gimmicks and short-term fixes are always more convenient. However, this short-term approach has proven to be unable to tame the volatile state budget cycle that is once again plaguing state capitols. Instead of simply focusing on politically expedient short-term budget fixes, states should respond with fundamental reforms that create a more efficient, viable, and predictable fiscal system.

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Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.