As we find ourselves heading into a particularly brutal state budget-debate season, the focus, naturally enough, is on the fiscal realities ahead and how to come to terms with them. Still, we ought not to neglect the story of how we find ourselves in the current mess. After all, this has been, in historical terms, a remarkably mild recession, with statewide unemployment not even reaching 5 percent so far. But the impact of this moderate slump on the state budget has been devastating. How did we go from surplus to deep deficit within months–the fiscal equivalent of overnight?
The answer could be found at the lightly attended and mostly unreported annual revenue hearing on March 6. The story that unfolded at that meeting of fiscal chiefs–House, Senate, and administration–and in subsequent interviews with budget watchers is how the New Economy, with all its excitement and promise of prosperity long into the future, lulled state governments like ours into a false sense of fiscal security.
In testimony, Department of Revenue Commissioner Alan LeBovidge compared the drop in revenue since last summer to “a 100-year storm,” a once-in-a-century confluence of disasters. “Not only did the bubble burst on the dot.coms, but the national economy went into recession,” he lamented. “Next came Sept. 11. Finally, we have Enron and its related fallout in the national markets.”
That’s all true enough. But the real problem was not how the revenue vanished but how it appeared in the first place. In the three years before the fiscal bottom fell out, the state budget became increasingly dependent on revenue associated with financial ephemera. Specifically, tax revenue got pumped up on the “irrational exuberance” of rising stock prices, stock-option compensation for executives, and swollen year-end bonuses.
Of course, there’s nothing new in these sources of earnings, and the income and capital-gains taxes the state collects on them have long been fiscal mainstays. But in the high-tech, dot-com, and financial-markets boom of the ’90s, these sources of new wealth and incentives for management performance loomed especially large. Between fiscal ’88 and ’96, state capital-gains tax revenue, derived from the sale of securities, mutual funds, and other investments, ranged between $172 million and $389 million. But in fiscal ’98, capital-gains taxes jumped to $802 million and, in fiscal ’01, reached a peak of $1 billion.
Even more striking is the runup of bonus and stock-option compensation, the income-tax revenue from which inflated the fiscal 2000 and ’01 budgets. Every year, in December and the following January, there is a spike in taxes withheld from one-time disbursements, rather than regular wages and salaries, that represent year-end bonuses. At the hearing, University of Massachusetts-Boston economist Alan Clayton-Matthews traced the dramatic rise of the seasonal bulge in lump-sum payments in recent years (see chart, below).
From fiscal ’96 to ’98, bonus season accounted for roughly $5 billion in additional income for executives and lower-level employees in Massachusetts. In fiscal ’99, bonuses grew to $6.5 billion. But in 2000 and ’01, bonus-season earnings jumped to $10 billion, with the state reaping an income-tax bonanza. In addition, in calendar 2000, the bonus season never ended. Typically, lump-sum payments disappear (falling below the income trend line, in many years) in the spring and summer quarters. But in 2000, $3.3 billion in one-time earnings was reported midyear. Clayton-Matthews attributes this to the exercise of stock options by high-tech executives and other employees. Once the Nasdaq hit its peak in March of 2000, the rush was on to cash in before company shares fell below the option price. The income from these transactions, with taxes withheld at the end of fiscal 2000 and the start of 2001, gave the state another atypical infusion of revenue.
In this way bonuses, stock options, and roaring financial markets swelled the state’s coffers well beyond what would be expected from underlying growth of business profits and wage and salary income, even in what was widely recognized as an exceptional period of economic prosperity. Call it the perfect calm before the perfect storm.
When the storm clouds burst, the state paid dearly. DOR estimates that nearly $1 billion of the $1.8 billion drop in revenue from fiscal ’01 to ’02 can be attributed to the dwindling of these income sources.
Massachusetts is not alone in any of this. But in magnitude of impact, the Bay State finds itself in the select company of other high-tech and high-finance states. According to State Legislatures magazine, California’s stock-option and capital-gains tax revenue grew from $2.5 billion in 1994 to nearly $18 billion in 2000. Now, with those revenue sources dwindling, the Golden State faces a budget shortfall of $14 billion. A similar financial bubble has left New Jersey with not only a projected $5.3 billion budget gap for next year but also a cut in its credit rating. In March, Moody’s Investors Service downgraded the Garden State’s bonds because so much of the state’s personal income, and therefore income tax revenue, comes from stock-market-related dividends and bonuses. “We don’t think the kind of revenue we saw in the ’90s will be seen for another four or five years,” a Moody’s analyst told The New York Times.
Which is the problem for Massachusetts, as well. Even a sluggish recovery will restart the process of employment and personal-income growth. But those portions of income that came from the superheated financial markets of the 1990s–capital gains, stock options, even outsized annual bonuses handed out by companies with fast-rising market values–are gone forever. So, too, is the tax revenue associated with them.
For this reason, not only the Massachusetts Taxpayers Foundation but all three economists who testified at the revenue hearing endorsed, with varying degrees of enthusiasm, a delay or rollback in the Question 4 income-tax cut–a piece of expert advice reported only by State House News Service. “Somehow, some way, you need to get the tax rate back to a level that is sustainable,” State Street Bank economist Frederick Breimyer told the state budget panel.
The view here is that in the Legislature and the administration alike there has been too little vigor and too little creativity devoted to finding savings in the state budget–much expanded in the last few years–that would not harm vital services. As painful as it is for those who manage state government–and as unnerving as it may be for those who count on government help–a time of fiscal crisis can be an impetus for changing the way the state does business. As a variety of current and former officials made clear in a Commonwealth Forum on “The Challenge of Change” last October it can be impossible to achieve real structural reform in government during times of prosperity. But a budget crunch can provide a context, and an impetus, for change. (I explore this topic further in my interview with former Indianapolis mayor and certified government innovator Stephen Goldsmith. See “Efficiency Expert,” page 72.)
“The time for profound performance change, in my judgment, is during a fiscal crisis,” said former Senate Ways and Means chairman Patricia McGovern. “That is when you can get people to move. That is when you can engage the opinion leaders, the people who work in government, the media, and the public to support your ideas for change…. We can use this difficult time as an opportunity.”
To date, there has been too little talk like this in the halls of the State House. That makes a knee-jerk leap to new or renewed taxes unseemly, if not disdainful of the public, who as taxpayers foot the bill and as voters passed Question 4.
Still, it might have been relevant to know, back in November 2000, that the boundless revenue that made an income-tax rollback seem not only affordable but long overdue was built on New Economy sand. Now that the speculative bubble has burst, taking the tax proceeds with it, we might well want to reconsider whether it’s wise, at this tenuous moment, to reduce the income-tax rate to a level it has not been, with the exception of a brief three-year period in the 1980s, for a quarter of a century. (According to DOR records, the state income-tax rate was 5 percent from 1971 to 1974; 5.375 percent from 1975 to 1985; 5 percent from 1986 to ’88; 5.375 percent in ’89; 5.95 percent in ’90; 6.25 percent in ’91; 5.95 percent from ’92 to ’99; 5.85 percent in 2000; 5.6 percent last year; and is 5.3 percent currently.)
And going forward, hopefully toward renewed prosperity, state budget writers may have to adjust the relationship between revenue and spending to reflect the New Economy’s preference for stock rewards and performance bonuses, which are more volatile than wages and salaries. “We think of the income tax as a relatively stable tax,” says Clayton-Matthews. What happened in the late ’90s should be a “a signal,” he says, that we may “have to plan our budgets for the business cycle.” That, he says, could mean stockpiling even bigger “rainy day” reserves than we managed to accumulate in the ’90s, in the face of demands for both more spending and more tax reduction.
And it could mean tracking, on an ongoing basis, revenue from bonus and stock-option earnings, then using a portion of that windfall revenue to fund one-time expenditures rather than build up the operating budget. This was done, to a limited extent, in the late ’90s, when a portion of state surpluses was devoted to capital expenditures. (The biggest example of this practice, unfortunately, was $500 million used to defray Big Dig overruns in fiscal 2000.) If the state learns nothing else from the current fiscal crisis, it ought to be that some of the dividends of entrepreneurship are harder to take to the bank than others.