Late last October, Governor Dan Malloy approved a two-year $40.2 billion budget for Connecticut more than 100 days after the fiscal year began. A strongly bipartisan effort, the package included spending cuts, new taxes and fees, and new fiscal controls meant to stabilize and improve the state’s financial future.
Many of these new controls are commendable, but if Connecticut implements strict budget rules without exceptions for recessions and other unanticipated events they could create a new form of state fiscal risk.
Connecticut’s proposed fiscal controls include strengthening an existing spending cap, enacting a bonding cap that limits borrowing to a specific dollar amount, creating a revenue volatility cap that puts income tax revenue above a certain dollar amount into an emergency budget reserve, and instituting a requirement that future bond documents pledge that these caps remain in place for at least 10 years.
Before Connecticut locks in its new fiscal controls this May with the issuance of new state debt, it’s worth examining how these limits might work under different economic conditions. I have spent much of my career looking at both the intended and unintended consequences of fiscal rules. My colleague Megan Randall and I summarized the state of knowledge of such rules in a report and set of two-page fact sheets.
Based on our research, addressing tax volatility and enacting rules to encourage saving during boom periods are good steps for budget stability. However, locking in strict budget rules without allowing for exceptions under difficult economic conditions, may be short-sighted. And enforcing these rules through bond documents could be especially risky.
Below are some lessons and examples of other states’ experiences with different fiscal institutions.
1. Rules are good, but so are exceptions: While it may seem counterintuitive, Connecticut should consider possible conditions or processes for overriding or amending its new budget limits at the outset. Colorado’s Taxpayer Bill of Rights (TABOR) originally limited revenue growth to the prior year’s actual revenue plus any increase in population and inflation. This meant any decline in revenue due to a recession would lead to a permanent ratcheting down of maximum revenue limits and hence, in spending levels (due to balanced budget requirements). And this is exactly what happened following the 2001 recession. Because of the TABOR rules, as the economy improved and state revenues increased, the state had to rebate those funds to taxpayers, rather than restore spending to pre-recession levels. This approach can impede an economic recovery.
In response to this unintentional cutting of services, in 2005, Colorado’s legislature proposed and voters approved Referendum C, which temporarily suspended TABOR limits for five years. After five years, the revenue limit was redefined to be based on the prior year’s revenue cap, rather than the actual level of revenue. This change meant that Colorado could restore spending levels following a downturn and have money to invest in infrastructure projects, leaving the state in a stronger fiscal position when the Great Recession hit.
2. Institutions (and governments) interact: In addition to TABOR, Colorado had a minimum per pupil spending requirement for K-12 education. The revenue cap and spending requirement interacted so that state equalization funds intended to help low-wealth school districts actually began to go increasingly toward higher-wealth, fast-growing school districts limited by the revenue caps.
A similar unintended consequence occurred in California, where Proposition 13 in addition to limiting property tax rates and assessments led to the state allocating property taxes across local governments. This reduced local control over public schools, left cities and counties scrambling for other revenues and shifted more school funding responsibility to the state.
Connecticut might want to study how spending caps and dollar limits on state revenues could affect local governments’ already high property taxes. In addition, the state should understand how the current spending cap expansion to include aid for poor cities and towns (formerly exempt from the cap) could shift responsibility for programs in those areas away from the entire state and toward those communities least able to pay for them.
3. Bond markets and borrowing costs respond to fiscal limits: While imposing fiscal discipline can lower financing costs for states, in work with James Poterba, I found that some fiscal institutions, especially those that limit the ability to pay back debt, can actually increase borrowing costs. These higher costs are likely to occur during economic downturns or if a state experiences an unexpected problem with its budget. Bond market reactions seem most negative with respect to limits on borrowing and constraints on the ability to pay-off existing borrowing.
Connecticut legislators should consider how their new set of fiscal limits, especially the bond covenant provision, might increase borrowing costs and undermine the state’s ability to borrow in times of need. All else equal, limiting the level of indebtedness likely increases the ability to pay back existing debt. But, to the extent the fiscal caps lead to unexpected budget deficits, future borrowing costs are likely to be higher. And the inability to change strict budget limits seems especially risky.
Indeed, this was part of the message from the state’s Commission on Fiscal Stability and Economic Growth, charged with examining ways of putting Connecticut on a path that would lead to economic growth and a more stable fiscal future. While not commenting on whether the individual fiscal limits would be good or bad for Connecticut’s future, the commission did suggest that more examination was needed on the potential effects of these caps.
As the Fiscal Commission, the Governor, and Comptroller have recommended, it seems wise to postpone a guarantee that the state maintain these budget rules for a decade at the risk of the state’s bonding authority, at least until the potential consequences are better understood. Based on research and the examples I’ve shared, I’d suggest going even further and canceling the bond document budget lock. Tying the state’s credit rating and solvency to a guarantee not to change fiscal rules that might need amending seems foolish. It’s not so much tying one’s hands as tying one’s hands and jumping off a cliff without knowing whether deep water or rocks lie below.
