Weathering the perfect fiscal storm

One year ago, the Massachusetts Taxpayers Foundation warned of an impending “perfect storm” in the state’s finances that would spell the end of the generous spending growth of recent years. Although the Commonwealth generated revenue surpluses totaling almost $3 billion in the previous three years–while increasing expenditures by almost 20 percent and cutting taxes by over $1.5 billion–powerful forces were converging on the state. Slowing economic and revenue growth, the impact of major new tax cuts, and sharp increases in health care costs would soon create a new and much more difficult environment for state programs and services that would likely last for years to come.

That perfect storm is now upon us. Like the nation, the state is in the midst of a significant economic recession, and state revenues have plummeted from average annual increases of 10 percent between 1996 and 2001 to a decline of 3 percent this year. On top of this steep drop, the Question 4 income tax cut approved by the voters in the fall of 2000 and other previously enacted tax reductions will reduce revenues by $1.6 billion from fiscal 2002 to 2004. Costs of the $5.5 billion Medicaid program, the source of health care coverage for almost one million Massachusetts residents, are surging 10 percent to 15 percent a year, with no end in sight. And previous commitments to increasing school aid each year to keep up with inflation and enrollment growth and to supporting a capital program burdened by the costs of the massive Central Artery project are further straining the state’s resources.

For the last six months, the state’s leaders have tried, however slowly and acrimoniously, to come to grips with the immediate impact of this new fiscal reality: a $1.5 billion deficit in the fiscal 2002 budget that opened up between July, when the House and Senate adopted their respective versions of the budget, and December, when a compromise spending plan was finally adopted. This shortfall was the result of a sudden and severe drop in the rate of revenue growth in the first few months of the fiscal year–forcing a $1.1 billion reduction in the revenue estimate on which the legislative budgets were based–and sharp growth in unavoidable costs, especially in Medicaid.

To close the deficit, the state relied on cuts of more than $600 million from the budgets approved by the House and Senate and use of $800 million of the $2.3 billion rainy day reserves that had been wisely accumulated during the good times. While these measures have at least come closer to balancing the budget for 2002, further deterioration in the revenue picture or additional growth in unavoidable costs could reopen the gap this spring. Unfortunately, the storm is far from over. According to the foundation’s analysis, even with the $600 million in spending cuts in the 2002 budget and an extremely tight limit on future annual expenditure growth of 3 percent, the state will face budgetary gaps of $1.5 billion in fiscal 2003, $1.4 billion in 2004, and $1.0 billion in 2005. These imbalances result primarily from slow growth projected in baseline revenues and the impact of Question 4 and other tax cuts that are still being phased in. Even in the highly unlikely event of a rapid rebound in the economy, the state would still face shortfalls of roughly $1 billion a year over the next several years.

The state cannot resolve its problems without further spending cuts.

Indeed, these projections, however staggering, actually understate the problem. Holding future budget growth to 3 percent a year would require level funding of most state government agencies and programs other than health care, even before the cuts that would be needed to achieve balance. That’s because Medicaid is likely to grow at a rate of 10 percent a year or more, and there will be inevitable increases in other obligations such as debt service. These unavoidable increases will consume practically all of the expected growth in annual revenues during this period. If the state fulfills its ongoing commitment to sustain education funding in poorer, largely urban school districts and to provide resources needed to improve MCAS performance, other state programs will be even harder hit. While delaying or slowing down Question 4’s final scheduled cut in the income tax rate from 5.3 percent to 5.0 percent would ease the pressure, producing about $200 million in additional revenues in fiscal 2003 and $400 million in 2004, it is clear that the state cannot resolve its coming financial problems without further major spending cuts.

The immediate danger is that the state will use up most of its remaining $1.5 billion in rainy day reserves in fiscal 2003, rather than rationing the funds over a four-year period. While this would help avoid spending cuts–which could be as much as 50 percent larger than the 2002 cuts–in a gubernatorial election year, it would set the state up for a major fall after the election. It will also be tempting to make cuts in ways that are phony or unwise, such as the governor’s recent plan to sharply reduce annual pension funding and extend the planned repayment period for the state’s unfunded pension liability from 20 years to 30 years. Such proposals only shift the problem to the future and divert attention from tougher issues, such as how to rein in surging Medicaid costs, that will have to be addressed.

An oft-cited factor in the state’s successful recovery from the last fiscal crisis of the early 1990s was bipartisan dedication to fiscally sound budgeting. The budget process for fiscal 2002–chaotic, politically divisive, and much delayed–stands in appalling contrast to that earlier achievement. The governor and Legislature face a major challenge in restoring the kind of cooperative leadership that will be needed to weather successfully the years of fiscal storm that lie ahead.

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How our leaders rise to this challenge will be on public display in the coming months, as first the governor, then the House and Senate, take on the thorny task of shaping a budget for fiscal 2003. While a more timely budget is almost assured in this election year (in part because the Legislature is scheduled to conclude its formal business by July 31), each branch can–and must–take concrete steps to avoid a repeat of this year’s budgetary meltdown and produce a more responsible outcome:

  • Early agreement on revenue projections. One of the great lessons of the state’s last fiscal crisis was that getting agreement on tough spending choices is almost impossible if there is no consensus on revenues. Unfortunately, that lesson was ignored in fiscal 2002, as was the 10-year-old state law that requires the administration and Legislature to reach consensus on a tax-revenue forecast early in the budget process. Given the huge financial problems the state faces, it will be absolutely critical for budget makers to agree on a 2003 revenue forecast, preferably before Gov. Swift submits her budget recommendations in late January, but certainly by the end of March.
  • Truth in budgeting. In difficult times, there is enormous temptation to push costs into the future or resort to accounting tricks and gimmicks to give the appearance of fiscal discipline. Too often, these tactics also serve to foist politically unpopular choices onto other participants in the budget process. For 2002, the most egregious example of giving in to such temptation was the governor’s veto of $135 million of the state’s annual pension appropriation, a 15 percent reduction that would drag out repayment of the state’s pension liability for another full decade. The administration slyly cast this plan as a choice between deferring costs that did not need to be paid immediately and hurtful cuts to services for our most vulnerable citizens. But surely the need for cuts in human services has more to do with the phasing in of the Question 4 tax cut on a rigid three-year timetable in the middle of a recession, which will reduce revenues by $400 million in fiscal 2002 and an additional $400 million in 2003. It will be unfortunate–and telling–if this pension proposal, which was rejected by both branches of the Legislature, resurfaces in the governor’s 2003 budget submission.
    Good information was all too scarce in the 2002 process.
  • Full fiscal disclosure. Sound budget-making depends on good information, a commodity that was all too scarce in the fiscal 2002 budget process. This was particularly true for individual lawmakers who were asked to give their votes for sometimes painful cuts. Some of the missing information, such as the amounts spent in the prior year and authorized to be spent in the current year in each line item, is basic to understanding what is being asked of them. At the same time, those trying to make sense of the fiscal picture faced an impossible task in the 2002 budget process due to the absence of financial statements–balance sheets–detailing revenues, spending, and other assumptions underlying each proposed budget. While the governor’s annual budget submissions have always included such balance sheets, neither the House nor the Senate publish this information. And even the administration failed to include a balance sheet in its 2002 “fiscal recovery” budget, obscuring a crucial fact for evaluating its fiscal soundness: the unprecedented and risky reliance on over $150 million of unidentified agency savings at the end of the fiscal year in order to produce a “balanced” budget.
  • Cooperation in identifying areas for savings. Budget cuts are never easy, but making them responsibly is even more difficult without talking to the agency managers who actually run the programs being cut. Both the administration’s and the Legislature’s budget writers fell short in 2001 in their consultations with the department heads who know what can–and cannot–be realistically cut. The period between January and June should be viewed as a window of opportunity for the governor and lawmakers to work collaboratively with agencies to identify money-saving changes that might actually improve services, not just minimize pain. Crises open up possibilities for change that would be politically infeasible in less desperate economic times. Let’s make the most of those opportunities.
  • Tackling health care costs. Any serious effort to deal with the new fiscal imperatives must address the huge Medicaid program, whose costs comprise a quarter of the budget and are growing 10 to 15 percent annually. One of the original “budget busters” that contributed to the state’s fiscal crisis a decade ago, Medicaid has greatly exceeded its initial appropriations in each of the last three years. At the same time, funding for the 1996-97 expansions of health care eligibility has proven to be insufficient, and the promised savings from reduced demand on the state’s uncompensated care pool have not materialized. Another recent initiative, the open-ended senior pharmacy program, holds the potential for dramatic future cost growth, especially with drug expenses rising 20 percent annually. Further complicating the picture, Medicaid reimbursement rates are several hundred million dollars short of meeting the true costs of health care providers, creating a cascade of financial problems for hospitals, nursing homes, and other care givers. It will be imperative to take on this critical cost center in 2003 as part of a long-term strategy to bring the program’s finances under control, a goal that will become increasingly important as the state’s elderly population continues to grow. Health insurance premiums for state employees are also rising, although somewhat less rapidly than Medicaid. Although the administration’s plan to increase state employees’ share of health premiums from 15 percent to 25 percent stood little chance of passing in better times, the Legislature should reconsider its earlier objections to this sensible proposal, which would produce immediate savings in the budget and help temper future cost growth.

No matter how orderly and open the process, developing the next budget–or two or three–will be far from easy. We’ll know soon enough whether the state’s leaders are up to the task.

Michael J. Widmer is president and E. Cameron Huff is senior research associate of the Massachusetts Taxpayers Foundation.