Does My State Have a Structural Deficit?

Does My State Have a

Structural Deficit?

The Federal Budget

State Budgets

The Oregon Case

Bruce Gates & Fred Thompson

Atkinson Graduate School of Management Willamette University, Salem OR

Cash Deficits

•

Surplus/Deficit = Revenue

-Outlays

•

Deficits have two components

•

Cyclical = revenue shortfall

due to the business cycle

•

Structural = revenue shortfall

at full employment

The Distinction between Cyclical and

Structural Deficits is Important Because

• State governments can make up

cyclical revenue shortfalls in a

variety of ways

• Real structural deficits can be

repaired only by

permanent

reductions in outlays

or

Literature on State Structural Deficits

• Making California’s State Budget More User-Friendly and Transparent

WZ Hirsch, DJB Mitchell - California Policy Options, 2002

• Making California’s State Budget More User-Friendly and Transparent: Further Thoughts. WZ Hirsch, DJB Mitchell - California Policy Options 2003

• Wisconsin's Structural Deficit: Our Fiscal Future at the Crossroads

Andrew Reshovsky, Robert M. Lafollette School of Public Affairs, University of Wisconsin-Madison. 8p. May 2002 (Also State Tax Notes, Vol. 25, No. 6, August 12, 2002)

• Idaho’s Structural Deficit: A Problem that Won’t Go Away Judith Brown and Don Reading, Idaho Center on Budget and Tax Policy, March 2005

• It's Not Just the Recession: The Budget Crisis and Washington State’s

Structural Deficit M.P. Watkins and Jason Smith, Economic Opportunity Policy

Institute, Seattle WA, July 2003

Many analysts define a structural deficit as not having enough revenue to meet current needs -- argument for more taxes

Some (Reshovsky, Watkins & Smith) distinguish between structural deficits and cyclical deficits but implicitly compute the former in terms of data series that run from peak to trough of the business cycle -- this extrapolation is also usually an argument for more or different taxes

The Business Cycle

The phases of the business cycle

are:

•

Expansion,

•

Peak

(or boom)

,

•

Contraction, and,

•

Recessionary trough.

The duration of business cycles is

irregular and the magnitude of

the swings varies.

•

In the past, ups and downs have often

characterized aggregate business activity.

•

Despite these fluctuations, there has been

an upward trend in real GDP in the United

States and other industrial nations.

Time Real GDP Business peak Recessionary trough Contraction _Expansion

A Hypothetical Business Cycle

Business peak

Recessionary trough

Source: Economic Report of the President, various issues.

The Business Cycle

6 8 4 2 0 - 2 1960 1965 1970 1975 1980 1985 1990 1995 2000 Annual growth

. - 15% - 10% - 5% 0% 5% 10% 15% 20% Annual

Federal Revenue Growth

1950 1960 1970 1980 1990 2000

The Economics of Revenue Growth

• Nominal increase have averaged over 10 percent per year over the past century. However, inflation accounts for

two-thirds of the total increase

.

• During the last 50 years (1950-2000), federal government revenues grew at an average annual rate of 3.5 percent.

• Double-digit nominal occurred increases during 32 of the 50 years, while the increases were negative during only 11 of the years.

Sources: Derived from computerized data supplied by FAME ECONOMICS. Also see Economic Report of the President (annual).

•

Between 1953 and 1965, the general price level

increased at an average annual rate of only 1.3%.

•

Here are the annual inflation rates for the last 48 years.

•

In contrast, the inflation rate averaged 9.2% from 1973

to 1981, reaching double-digits during several years.

•

Since 1982, the average rate of inflation has been lower

(about 3.2% from 1983-2001) and more stable.

The Inflation Rate, 1953-2001

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 10 5 0 Inflation rate 15 1953-1965 average inflation rate = 1.3 % 1973-1981 average inflation rate = 9.2 % 1983-2001 average inflation rate = 3.2 %

Government Revenue

As a Share of National Income

•

In 2000, government revenue as a share of

national income rose to the highest level since

World War II.

Government revenue as a share of National Income (as a share of national income)

Total government revenue

(federal, state, & local)

40 % 30 % 20 % 10 % 1946 1950 1960 1970 1980 1990 2000 37.9 25.6 Federal revenue

Real Federal Expenditures

Per Capita:

1792-2000

• Real federal spending per person (measured in 2000 dollars)

grew slowly during the first 125 years of U.S. history, but it soared throughout most of the 20th century.

$ 7,000 $ 6,000 $ 5,000 $ 4,000 $ 3,000 $ 2,000 $ 1,000 $ 0 1800 1850 1900 1950 2000

Real federal spending per person (in 2000 U.S. dollars)

Federal Expenditures and Revenues

• The federal deficit or surplus as a share of the economy is shown here. Note the growth of budget deficits during the 1980s and the movement to surpluses during the 1990s.

18 20 22 24 1960 1965 1970 1975 1980 1985 1990 1995 2000 Expenditures Revenues Expenditures

Federal Government Expenditures and Revenues (as a share of GDP)

Source: Economic Report of the President, 2001. Note, recessions are indicated by shaded bars.

Budget Deficits & the National Debt

• Through most of the 1950s & 1960s, federal budget deficits were small as a % of GDP; occasionally there was a surplus. • During this period, the national debt declined as a % of GDP.

1950 1960 1970 1980 1990 2000 2 % - 2 % - 4 % 0 % Federal deficit as a share of GDP 1950 1960 1970 1980 1990 2001 80 % 40 % 20 % 60 %

Privately held federal debt as a % of GDP National debt

as a % of GDP Other federal debt

Surplus

Deficit

Gross & net federal debt as a share of GDP

Budget Deficits & the National Debt

Privately held federal debt as a % of GDP National debt

as a % of GDP Other federal debt

Surplus

Deficit

Gross & net federal debt as a share of GDP

• During 1974-1995, budget deficits were quite large, causing the national debt to increase as a % of GDP.

• During the 1992-2002 period, the national debt fell as a share of the economy.

Conclusions

•

About half of the federal

government’s deficits over the past

fifty years were cyclical in nature.

•

Between 1976-1993, structural

deficits were between 1 and 3

percent of GDP.

•

After 1994, the federal deficit was

eliminated by a combination of

spending restraint, revenue

increases, and boom.

State Deficits

•

Most states have less volatile revenue structures than

the federal government

•

Even so they often experience substantial cyclical

fiscal effects

•

Because most are required to balance their budgets,

structural deficits mean something different for states:

Surpluses must equal deficits over the course of

the business cycle

• Rainy day funds

• Countercyclical borrowing

• Hedging

See C. Hinkelmann & Steve Swidler, “Macroeconomic Hedging with Existing Futures Contracts,” Risk Letters, forthcoming;

“State Government Hedging with Financial Derivatives,” State and Local Government Review, volume 37:2, 2005; “Using Futures Contracts to Hedge Macroeconomic Risks in the Public Sector,” Trading and

Regulation, volume 10, number 1, 2004.

See C. Hinkelmann & Steve Swidler, “Macroeconomic Hedging with Existing Futures Contracts,” Risk Letters, forthcoming;

“State Government Hedging with Financial Derivatives,” State and Local Government Review, volume 37:2, 2005; “Using Futures Contracts to Hedge Macroeconomic Risks in the Public Sector,” Trading and

Regulation, volume 10, number 1, 2004.

Oregon’s Fiscal Gap

Primarily (but not entirely) Driven by

Revenues (actual revenues - CSB)

Budget Shortfall/Surplus over Time

-400 -300 -200 -100 0 100 200 300 1980 1985 1990 1995 2000 2005 Year

Oregon’s Deficits Have a

Cyclical Component

Budget Shortfall/Surplus over Time

-400 -300 -200 -100 0 100 200 300 1980 1985 1990 1995 2000 2005 Year

Analytical Problems

•

We used negative job growth as a

recession identifier because we

lacked a formal mechanism to date

recessions at the state level.

Evidence of A

Structural Deficit?

Frequency Histogram of Budget Shortfall/Surplus

0 1 2 3 4 5 6 7 -137 -238 -163 -88 -13 63 138 213

Magnitude of Shortfall or Surplus (in Millions, Real $ [2002 CPI=100])

Frequency

Normal Distn: Mean = -20, Std Dev = 140 Triangular Distn: Min = -350; Max = 250; ML = 69 Observed Cum Freq

Problem

•

Doesn’t adjust for scale, just

inflation

•

Positive correlation between

budget gap and time could be

due to structural deficit or to

selection bias

Analytical Solution

•

Monte Carlo Simulation

•

Weiner Process

•

Trough to Trough Revenue

and Spending

•

Trough to Trough Spending,

Results of Monte Carlo Simulation

Weiner process, Peak to Peak Revenue, Trough to

Trough Outlays, Constant 2002$

r = 4%; Sigma = 260: Del t = 0.01; E-O-Y = $5,116

y = 5006.6e0.0002x R2 _{= 0.2254} $4,000 $4,250 $4,500 $4,750 $5,000 $5,250 $5,500 $5,750 $6,000 0 10 20 30 40 50 60 70 80 90 100 Time Value Baseline

Implications

•

Other things equal, revenue growth is

faster than outlay growth

•

Oregon doesn’t need to increase taxes to

offset a structural budget deficit

•

Oregon could rely on a rainy day fund of

sufficient size to mitigate the adverse

consequences of cyclical revenue

shortfalls (if it had one) or mitigate them

via a program of countercyclical

borrowing

Warning

This Analysis is Concerned with

Cash Deficits and is Based on the

Assumption that the Future will be like the

Past

Source: Baker, Besendorfer, and Kotlikoff (2002). Intertemporal state budget imbalance = the present value of future expenditures + net debt) - the present value of future receipts.

This implies that OR should increase taxes or reduce spending by about 15 percent