The Arizona Budget Crisis was Predictable
by Alberta H. Charney, Ph.D.
"The combination of (1) under funding the rainy day fund during an upswing period, (2) numerous tax cuts which are likely to permanently downsize the General Fund, (3) a super-majority requirement for all tax increases, (4) the strong cyclicality of revenues, and (5) an increased demand for social services during recessions will result in severe expenditure cuts in some government services in the next economic downturn."
- Alberta Charney, Arizona's Economy, August 1994
Looking back, five factors caused the current severe budget crisis and both the crisis and the severity of the crisis were entirely predictable. Only the timing of the crisis was unpredictable.
Rainy Day Fund
The Arizona Legislature established the Budget Stabilization Fund (commonly known as the Rainy Day Fund) in 1990 to smooth out the fluctuations in Arizona's revenue streams, calling for payments to be made to the fund during periods of rapid state income growth and for funds to be paid out during periods of slowdowns or downturns. Although a wonderful idea, this fund was poorly designed to serve the needs of the state for three reasons.
First, money coming into the fund was limited to seven percent of the General Fund revenue at the end of each fiscal year. But, revenue streams frequently fluctuate by more than seven percent in a given year. Thus the limit of seven percent on the rainy day fund is too low to adequately cover one year of revenue fluctuations.
Second, the fund makes no allowances for slowdowns or downturns that cover more than one fiscal year. If a recession extends through two fiscal years, the rainy day fund will likely dry up during the first year, requiring severe cuts during the second fiscal year of the recession.
Third, the funding formulas were designed to smooth out revenue streams, but they ignored the increased demand for social services that occur during difficult times.
Tax Cuts and the General Fund
Throughout the 1990s, enormous tax cuts permanently downsized the General Fund. According to the Joint Legislative Budget Committee staff, more than $1 billion was cut from General Fund revenues since 1993. This $1 billion estimate is only the sum of the tax losses estimated at the time of each cut. However, this figure substantially underestimates the revenue loss because each of those lost tax sources would have grown with both population and inflation between the time the tax cut was made and now. When the tax cut estimates for each fiscal year are permitted to grow with population growth and inflation, the tax cuts enacted since 1993 amount to a figure closer to $1.8 billion lost each year from today's General Fund.
While the idea of continual tax cuts sound good, the purpose of state taxation is to provide needed public services. During the decade of the 90s, Arizona teacher salaries dropped from being a tie for 23rd among the 50 states to 41st in FY 2000. (Prop 301, a 0.6 percent increase in sales taxes earmarked for education that boosted teacher salaries, improved the ranking to 36th in FY 2002.) Average per-pupil expenditures in primary and secondary schools have fallen from 33rd in 1989 to 49th in 2002.
State employee salaries are extremely low across the board and our universities are experiencing brain drain as faculty leave to take higher paying positions elsewhere. The average state and local government employee salary suffered a 14.9 percent decline in purchasing power from 1990 to 2001, while employees in the private sector enjoyed a 20 percent increase in real income.
During the decade of the 90s, the decade of prosperity, the state legislature chose to significantly cut the level of public services in Arizona. With the funding of public services already at an all-time low, additional cuts will be extremely painful and can literally destroy some of our institutions.
The Super-Majority
In 1992, a referendum was passed which requires a super-majority of two-thirds of the Legislature to pass a tax increase. Previously, the tax structure could be adjusted by a simple majority of legislators. Tax cuts can be implemented by a 50 percent majority, but making up that lost revenue by imposing new taxes, raising existing taxes, or reversing a tax cut requires a two-thirds majority. Even revenue-neutral changes require a super-majority, e.g., the Legislature cannot improve the fairness or equity of the tax structure without a two-thirds majority because such equity adjustments require a tax increase on one group of taxpayers, which offsets a tax decrease on another group of taxpayers. The super-majority requirement acts like a ratchet, in which tax decreases made during an economic expansion become permanent.
Cyclicality of Revenues
As mentioned earlier, Arizona's revenue sources are extremely volatile. The three major sources of revenue - the state sales tax, the individual and corporate income taxes - are extremely volatile revenue sources that decline during economic downturns. The state sales tax has been known to fall by as much as 15 percent during a recession. The state individual income tax has seen declines as large as 10 percent, and the corporate income tax can fall by as much as 30 percent. These three revenue sources comprised almost 91 percent of all revenues to the General Fund and more than 94 percent of all tax revenues to the General Fund in FY2002.
The Next Downturn
The demand for social services significantly increases during a recession. Many of the social services are formula-based, in that a family's income and size determines whether they are eligible for various services. When a recession causes unemployment to increase, more families become eligible for those services. A recession, therefore, not only reduces revenues, it substantially increases the number of people needing and qualifying for public support and public health care. The $1 billion deficit projected for FY03-04 results largely from a projected $800 million increase in operating expenditures, driven by increasing case loads in AHCCCS and welfare, and more students in public schools. These increases either are voter mandated, court ordered or formula driven.
Knowing how these five factors work together is important because they work together to create a structural deficit that isn't going to go away anytime soon. During the prosperous decade of the 1990s, the Legislature chose to significantly cut the level of public services in Arizona. With the funding of public services already at an all-time low, budget cuts going forward may literally destroy some of our public institutions and seriously compromise Arizona's ability to compete in high-tech industries of the New Economy.
When revenues are as volatile as the sales and income taxes, revenues can fall by 10-15 percent per year in a recession and that recession can last for more than one fiscal year. This fact, combined with the increase in the number of families that become eligible for welfare and public health care, suggests that the Budget Stabilization Fund limit be increased to as much as 40 percent of the General Fund.
The super-majority should be eliminated through a referendum so that the Legislature can make critical decisions regarding the structure of the tax system, as well as the level of taxation, through a majority vote. Additionally, future tax cuts should be temporary so that revenues are available during the next recession.
In the meantime, the Legislature is hamstrung in any attempts to raise critical revenues or restructure the tax system. Arizonans want and need public services and an infrastructure upon which to build a 21st century economy.
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