Point of reckoning

the massachusetts state budget has reached a point of reckoning. First and foremost, a stubborn — and insufficiently appreciated — structural imbalance approaching $1 billion threatens the state’s ability to manage or grow current programs and services, much less add new ones. Spending increases are outpacing revenue growth, with health care voraciously consuming a bigger slice of the fiscal pie.

This imbalance is exacerbated by volatility in revenue growth. Recent history reveals an over-reliance on the capital gains tax for more than half of the state’s new tax receipts between 2002 and 2006. In other words, simply maintaining existing programs hinges on a revenue source that reacts in concert with Wall Street’s boom and bust cycles.

Two trends add a sense of urgency to this discussion: The nation is on the brink of recession, if it’s not in recession already. As a result, Massachusetts is vulnerable to a dramatic drop in capital gains tax revenue. In 2002, a similar vulnerability led to an almost $800 million decline in capital gains receipts in a single year. Today, such a plunge would come at a time of rapid increases in health care spending: first from rising costs; second from the expansion of the Medicaid rolls in response to a recessionary increase in unemployment; and finally, from the effects of the full implementation of the state’s new universal health care law.

While Massachusetts is similar to other states in facing these pressures, the Bay State is also different because of its demographic trends. We continue to lose more people than we attract, with the exception of foreign immigrants. Relative to the size of our state, the level of out-migration from Massachusetts in recent years ranks the third highest in the nation. As a consequence, Massachusetts — unlike the majority of other states — is unable to rely on increased tax revenue from new workers and new businesses as a way to grow itself out of a recession. Moreover, the state’s existing population is older than the national average, which places greater strains on public programs and services.

Our research analyzes 20 years of Massachusetts budget history (see charts below), which at its core is a series of choices that reflect the state’s collective values and priorities. There have been clear winners and losers over the last two decades. Most notably, health care emerged as the state’s top funding priority, with a long-term commitment to expand access to the poor, disabled, and uninsured. Similarly, a vigorous reform movement within K-12 education resulted in dramatic increases in expenditures. The state added almost $1.3 billion of new spending for education reform after adjusting for inflation, but, at the same time, non-school aid to cities and towns declined by almost $800 million. State support for public higher education fell by more than $300 million, with large swings in spending that led to major tuition increases. Public safety spending more than doubled from $600 million to $1.4 billion over 20 years, while the overall human services budget remained almost flat. These priorities were largely preserved through the wrenching fiscal crisis of 2002-2003 and continue to be reflected in today’s budgetary decisions.

The structural budget imbalance that Massachusetts faces reflects long-term trends and is not particular to the current year. The state has gradually introduced an unsustainable level of risk and volatility on both the spending and revenue sides of the ledger, and short-term responses like an increase in the cigarette tax or casino gambling really don’t address the problem.

As a way to jumpstart a statewide conversation on how to get the Commonwealth’s finances back on track, MassINC offers the following recommendations:

Minimize the effects of capital gains tax revenues on the budget. In recent years, Massachusetts has become heavily dependent on capital gains revenues for new revenue growth. From 2002 to 2006, the state collected an inflation-adjusted $2.2 billion in new revenues. (This amount was offset by revenue losses in the sales tax and several other taxes.) More than half of the positive growth (54 percent) came from highly volatile capital gains taxes.

Steps should be taken to better manage the known risk with capital gains taxes. For instance, state leaders could calculate a historical average of capital gains receipts and use only that amount in the budget in any given year. Surplus receipts could then be set aside as a reserve for use in years when revenues fall below that average. Such an effort would help avoid making ongoing spending commitments based on a level of revenues that cannot be sustained and would help create a cushion against the inevitable drops in those revenues.

Broaden the base of the tax structure. This would reduce the state’s dependence on capital gains taxes. While potentially revenue neutral, this effort involves shifting tax burdens from some taxpayers to others. That said, tax increases in one area, like the sales or gasoline tax, could be offset by decreases in other taxes to ensure no one group bears a disproportionate burden. This is a politically complicated option that will require leadership, consensus building and compromise.

Improve the transparency of Medicaid spending. Medicaid is both the largest program administered by state government and one of the least understood. Its spending totaled $7.4 billion in 2006, 26 percent of the budget. Since 1987, the program has been responsible for almost two-thirds of all spending growth.

There are a number of reasons why the state’s Medicaid spending has increased so much, including rising health care costs, a broader array of benefits than are federally mandated, a greater proportion of more-expensive-to-care-for elderly and disabled clients than other states, and a longstanding policy commitment to expand access. Medicaid spending has also increased as a result of the state’s efforts to strategically leverage federal dollars to fund programs.

The need for transparency — clearer, more timely information and analysis on how much is being spent, how that spending is financed, and who is being served — could not be more urgent. A recent report by the Center for Medicare and Medicaid Services’ Office of the Actuary projects Medicaid spending to grow by 7.9 percent per year through 2017, a rate well above the overall growth expected in the economy. Discussions in Washington suggest the federal government, which pays for about 50 percent of Medicaid’s costs, could be on the verge of reducing its reimbursements to states. The state’s universal health care initiative has raised the stakes even further, with new, difficult-to-predict cost pressures and a major new layer of programmatic and financial complexity.

Bring greater transparency to all government spending. Between 1987 and 2006, the share of total state spending that occurred outside the annual budget increased from almost 20 percent to almost 33 percent. Today’s large amount of off-budget spending prevents revenues and spending from being seen all together, creating obstacles to a true set of choices around revenues and spending. The use of two different reporting standards for the state’s financial activities is a further impediment to understanding the budget.

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Measure outcomes, eliminate duplication, and end programs that have outlived their purpose. While public policy experts agree that the structural imbalance cannot solely be solved through greater efficiencies, it is imperative that the state foster a sense of accountability through regular outcome measurement. This will require tough political choices that are necessitated by the structural imbalance combined with a possible national recession. A blue ribbon commission modeled on the federal base-closings commission might provide the best option to tackle these politically sensitive issues.

Cameron Huff is an independent consultant from Billerica. Dana Ansel is research director at MassINC. For more information on this topic, read A Point of Reckoning: Two Decades of State Budget Trends at www.massinc.org.