The last big bad budget wolf - the structural deficit

Maryland's legislature is just about set to begin its consideration of the state budget for the upcoming fiscal year. And, it could be much less exciting that in years. In previous blog posts, we pointed out that after solving six large, consecutive budget shortfalls, projections for the upcoming budget were in balance.

When Governor O'Malley unveiled his proposed budget on January 16, there were no big surprises. The budget is balanced without any large tax increases or extraordinary budget cuts (though there are many budget cuts of the "routine" variety).

The budget season though, still has some suspense. It's like the story of Little Red Riding Hood. It should be an easy task to deliver a basket of goodies through the woods to Grandmother's house.  However, there are big bad wolves lurking in the woods, and they could cause trouble for Little Red.

In the case of Maryland's budget, there are three big bad wolves we are worried about. In a previous post, we discussed big bad wolf number one: the still-unresolved federal fiscal cliff. If Congress deadlocks on a settlement of the federal government's finances - or if the resolution involves precipitous spending cuts - the fiscal and economic impacts could devastate Maryland's revenues and budget.

We also discussed the state's impending funding shortage in dedicated funding for transportation. If the legislature wants to provide funds for future road and transit projects, but does not want to raise taxes on gasoline (the primary traditional source of transportation funds), it may turn to the sales tax or another traditional general state revenue. This could "crowd out" funding for local schools, colleges, health programs, and other priorities in the state budget.That was the second big bad wolf.



Sources:DLS, DBM and MBTPI calculations

That brings us to the final wolf: the "structural deficit." A structural deficit is the situation when the amount of revenue during the year does not cover the ongoing expenditures during the year. The state can have both a positive year end balance and a structural deficit if it is using accumulated balances from previous years to get through the current year. That situation meets the constitutional requirement to balance the budget, but it is not sustainable into the future.

In developing this budget, the governor faced a structural deficit in the neighborhood of  $400 million. The governor's proposed budget reduces this to less that $200 million through a combination of budget cuts and by shifting state transfer tax revenues to the general fund for a period of five years. (These transfer tax revenues were dedicated to the purchase of open space and recreational land and facilities).

Some of the larger cuts include:
-$73 million in state savings from additional federal Medicaid funding through the Affordable Care Act.
-$63 million from placing a ceiling of 2.5 percent on rate increases for health and human services providers.
-$32 million in cost savings in the employee health insurance program.


These reductions should be enough to manage the structural deficit. $200 million is well within the ability of the state to make normal year-to-year budgetary adjustment. Simply put, a structural deficit in this range is essentially the same as a structurally-balanced budget.

The budget cuts incorporated by the governor in the proposed budget will require detained examination as the legislature and legislative staff  conduct their analysis and hearings on each agency's budget. Some of the cuts may have severe effects on vulnerable Maryland or might have unintended effects that will increase future costs. If some mistakes of this type have slipped through, the governor should be prepared to restore funding in a supplemental budget.

With the effects of an economic recovery (even a weak, uneven one), sound financial management, and a bit of luck, Maryland may have avoided for now the big bad wolf of the structural deficit.

The Big Bad Wolf of Transportation

In our previous blog posts on the budget situation, we used the story of Little Red Riding Hood to illustrate the budget situation. Because Maryland has managed its finances responsibly through the Great Recession and its aftermath, and because the nation and the state are experiencing an economic recovery (albeit a slow, fitful, and uneven recovery), this year’s budget situation is much less challenging than the previous five or six budgets.

It’s like Little Red Riding Hood delivering her basket of goodies to Grandmother’s house. It ought to be an easy, straightforward task. However, there are Big Bad Wolves in the woods, and if Little Red happens to encounter one of them, the trip will suddenly become dangerous.

On January 16, Governor O’Malley delivered his budget and it was indeed less difficult and complicated than previous budgets. There is a comfortable ending balance, an increase in the State Reserve Fund, no large, highly visible cuts, and no significant tax increases.



Image: wpclipart.com

However, we cautioned about three “Big Bad Wolves” lurking in the woods. The first wolf was the federal fiscal cliff.

Today, we meet the second Big Bad Wolf: Transportation Finance.



Maryland has a system for funding transportation that relies on dedicated revenue. The revenue sources include transportation-related revenues like gas taxes and vehicle titling and registration fees, as well as a share of the corporation income tax. The gas tax is the largest of these sources. It has not increased since it was set at 23-1/2 cents per gallon in 1992. William Donald Schaefer was the governor.

Since the tax is a flat number of cents per gallon, the amount or revenue does not adjust for inflation. The price of gas in 1992 was $1.09 per gallon.

Soon, the revenue will be insufficient to cover any new highway or transit projects at all. It will only cover operating costs and routine maintenance.

Increasing the gas tax would be the most straightforward way to finance the state’s transportation needs. However, legislative leaders are wary of supporting a gas tax increase. It is perceived as being wildly unpopular with voters.

So … here is where the Big Bad Wolf of Transportation comes in. One way to increase transportation funds without raising gas taxes would be to use general fund revenue sources to finance transportation. And this could endanger adequate funding for education, healthcare, public safety functions, and the other important services that rely on those sources. Governor O’Malley keeps talking about a sales tax increase to solve the transportation problem. Virginia Governor Robert MacDonald has proposed a transportation finance package in that state that involves both increasing the sales tax and diverting a share of existing sales tax revenues for transportation needs.

• To avoid being attacked by this Big Bad Wolf, Maryland should fund its transportation needs with a gradual, phased-in gas tax increase.
• To reduce the economic effect as well as the "regressive" effect on low-income Maryland workers, the gas tax increase should be accompanied by a small increase in Maryland’s Earned Income Tax Credit.
• Finally, the revenue should be used to a balanced transportation program, including significant transit, pedestrian and bicycle improvements.

The federal fiscal cliff may still huff and puff and blow Maryland's budget down

In our recent posts, we showed that Maryland's billion-dollar-plus budget shortfalls have been eliminated due to  a combination of good financial management, the national economic recovery (tepid though it is) and some good luck.

The first wolf is called Cliff. Fiscal Cliff. 

Image: wpclipart.com

It's true that Congress acted early in the year to avert the worst effects of large automatic tax increases on everyone. The deal passed by Congress on New Year's Day permanently continued the income tax rate cuts for most taxpayers. It extended for five years expansions of the earned income and child credits that help mostly working and low-income households. Social security payroll taxes have increased 2 percent for virtually all workers. Emergency unemployment benefits are extended for one more year.

However, Congress deferred decisions related to automatic spending cuts and the federal debt limit. Congress has actually arranged for three "scheduled crises" to hit while Maryland's legislature is in session and working on the budget.  

1. On March 1, unless Congress does something automatic, across-the-board but cuts to federal defense and domestic programs will take effect.The cuts would be 8.6 percent of domestic programs and 9.6% of defense programs.

The Department of Legislative Services estimates that these cuts would reduce direct Federal grants to Maryland's state government by about $117 million.  

A more serious problem would be the effect on Maryland's economy (and the resulting effect on state government revenues). The Pew Center on the States estimates that federal employment and procurement make up 20 percent of Maryland’s economy: defense 10 percent and non-defense 10 percent. For Maryland DC and Virginia combined, federal nondefense jobs make up 4 percent of the region's workforce.
  
2. Congress also has to deal with the federal debt ceiling. In 2010, after an earlier budget stand-off, Congress raised the limit on federal debt to a little under $16.4 trillion. late last year, we hit that amount.The Treasury can juggle things to keep paying off existing debt and the government's expenses for a  few weeks. By late February or early March, though, those options will run out. Failure to set a new debt limit by then would result in the government defaulting on the debt and/or failing to make other payments. Most observers believe that this would cause a national and international economic crisis, while doing irreparable harm to America's credit.

3. By March  27, Congress also has to extend the government's existing appropriations.The government is being funded by a "continuing resolution" that ends on this date. If Congress does not enact Appropriations Bill (unlikely at this point) or authorize a new continuing resolution, most government operations would shut down.

If the federal government deadlocks on any of these issues, or resolves them in ways that hurt states' budgets and economies, it will cause a problem for Maryland's budget. There could be serious losses of federal revenue for Maryland and maybe some negative shocks to the state economy, which would also throw the budget out of balance. This could put the state right back in the position of needing to resolve a large budget shortfall.

So, we are not out of the woods yet.