Academic journal article Chicago Fed Letter

Changing Fiscal Policy in the Seventh District

Academic journal article Chicago Fed Letter

Changing Fiscal Policy in the Seventh District

Article excerpt

State governments make major changes to their fiscal systems only infrequently. When they do take place, changes are driven by such forces as recessions, changing demographics, regional decline, and sustained revenue growth. The Seventh District has experienced all of these events over the past 15-20 years.' A period of sustained economic and revenue growth during the mid1990s has followed on the heels of regional decline, rising costs of public services, and recession. District states have reacted to their good fortunes by initiating innovative changes to both their tax systems and spending programs. This Chicago Fed Letter discusses how the current economic expansion is lifting state government revenues in the District and the varied fiscal responses of state governments.

The 1980s through the recession of 1990-91 was a period of almost unrelenting fiscal pressure on state and local governments in the Midwest. During the recessionary early 1980s, downturns in both manufacturing and agriculture hampered revenue growth while driving upward the demand for cyclically sensitive services, such as welfare, public health care, and unemployment insurance. Although the economy improved later in the decade, federal government (nondefense) downsizing, along with the trend toward devolution of responsibilities to state and local governments, pressured the spending side of the fiscal equation. In some areas, such as prisons and environmental regulation, federal courts or the U.S. Congress pushed costly mandates onto state government spending. On the revenue side, federal grants to state-local governments generally declined in importance during the 1980s. In addition, rising costs for state-local government services, such as Medicaid, tended to push budgets upward. Consequently, most District state governments entered the 1990s in less-than-perfect shape. Budgetary balances were low entering the 1990-91 recession, and reserves were quickly exhausted, causing state governments to scramble to make ends meet. Since that time, two trends have benefited District states' budgetary health. First, the U.S. economy has experienced its third longest expansion in the modern era. Second, the Midwest economy outperformed the nation during the first several years of the expansion. Over the past two years, the region's economic growth has fallen short of the nation's. Nonetheless, state governments have shared in what has been an unexpected nationwide revenue surge from incomerelated tax sources. What began as a worrisome decade for Seventh District states has unfolded into much improved fiscal positions, as shown by endingyear general fund balances in individual states and by the overall surplus position of the state-local government sector in the U.S. (figures 1 and 2). Governments have seized this opportunity to remedy unfinished business from the 1980s and to undertake a few bold innovations. Most commonly, they have used unexpected revenue surpluses to shore up education funding. On the tax-side, adjustments have taken two primary forms. First, states have lowered tax rates or broadened exemptions on existing taxes. Second, they have adjusted their aid to local governments, usually local school systems, to alleviate the tax citizens find the most onerous-the property tax.

Michigan

During the 1990-91 recession and its immediate aftermath, Michigan experienced one of the sharpest budget imbalances, ending fiscal 1992 with a general funds deficit of over $700 million. However, a surging state economy in 1993 and 1994 helped the state to avoid major tax increases or expenditure cuts, and it ended fiscal 1994 with a surplus of $400 million; revenues continued to exceed estimates well into 1995. Against this backdrop, voters approved a profound change in the state's tax structure and its system of school funding. "Proposal A" improved school funding, especially to low-spending districts; transferred funding reliance from local to state funding sources; and remedied a perceived imbalance in the state's revenue structure by shifting from property taxation to sales taxation (along with other tax system changes). …

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