A Blueprint for Budget Reform

The ongoing state budget “crisis” strongly underscores the urgent need for North Carolina to adapt significant state budget reforms. For several decades, North Carolina has been on an unsustainable spending spree, with wild roller coaster-type swings along the way. Fortunately, there are three obvious ways to reverse this trend:

• Link budgets to economic realities, not just politicians’ wish lists.
• Put North Carolina taxpayers back in charge of approving new debt.
• Force legislators and state agencies at reasonable intervals to justify all spending, not just spending increases.

During flush economic times, state budget writers aggressively ratchet up state spending commitments (even though demands for government programs like Medicaid are low). Then, when a recession inevitably hits, lawmakers are thrown into panic mode. They desperately search for ways to continue their elevated level of spending, plus support increased demand for public programs resulting from the downturn.

The result typically is a massive tax hike, with taxpayers being forced to bail out irresponsible, short- sighted budget writers.

Here is what decades of such irresponsible budgeting have done to North Carolina:

• From 1980 to 2010, North Carolina’s state budget more than tripled[i], even after adjusting for inflation.
• Also during that time, inflation-adjusted state budget expenditures grew at three times the pace of population growth (see Figure 1).
• North Carolina’s top marginal income tax rate is highest in the Southeast and tied for 11^th highest in the nation. [ii]
• North Carolina’s corporate income tax is also highest in the Southeast[iii], and only 16 other states tax the first taxable dollar of corporate income at a higher rate than North Carolina.
• North Carolina has the seventh worst state business tax climate.[iv]
• North Carolina currently has the fifth-highest unemployment rate[v] in the nation (July, 2012 data).
• From 2000 to 2010, the number of unemployed North Carolinians nearly tripled[vi], while state government added more than 40,000 additional workers[vii] between 2001 and 2010.
• Also during that time, North Carolina’s per capita income growth trailed national and regional averages significantly, causing our state’s average income to fall further behind the national average, and even to dip below the regional average.[viii]

Figure 1

It is time for North Carolina to jump off the spend-and-tax roller coaster. If state leaders want to turn the state’s economic woes around, implementing meaningful budget reforms is a must.

Three major reforms should be enacted in the 2013 session in order to rein in out of control government growth in North Carolina.

1. Taxpayer Bill of Rights (TABOR)

A Taxpayer Bill of Rights (TABOR) would level out the dramatic rises and dips in the state budget’s spend-and-tax cycle, and put the brakes on the long-term spending spree of state budget writers. The basic premise behind a TABOR is to install sensible restrictions on the growth rate of state spending by restricting the growth rate of the budget each year so that it does not exceed a combination of inflation and population growth.

Rather than extreme ratcheting up of spending by 8 or 9 percent annually during healthy economic times, a TABOR would limit these annual growth rates to a more sensible 4 or 5 percent per year in most years. The extra revenue collected would not be spent, but rather set aside in a rainy day fund, to be made available to fill the budget shortfall when the next recession hits. As an added bonus, once the rainy day fund is fully stocked, further excess revenue could be returned to taxpayers.

Under a TABOR, the next time a recession hits state lawmakers wouldn’t need to panic. There would be plenty of funds set aside to draw upon to balance the budget without punishing taxpayers with another massive tax hike. Moreover, because spending growth would have been curbed during the growth years, any budget deficits that may materialize during recessions would be much smaller.

A TABOR is an essential tool for smoothing out the vicious roller coaster ride the state budget has experienced for decades. A smoother, more predictable budget cycle will also make it much easier for state agencies to plan their budgets ahead of time, rather than suffer through wild ups and downs.

TABOR is Highly Popular Among North Carolina Voters

By a 30 percentage-point margin, likely voters in North Carolina favor amending the state constitution to limit the growth in state spending to equal the increase in population and inflation. Fifty-four percent of respondents to Civitas polling said they strongly or somewhat support such a measure, compared to just 24 percent who strongly or somewhat opposed it.[ix]

Recent TABOR Legislation in North Carolina

Introduced in the 2011 session, House Bill 188 would serve as an excellent foundation for a much-needed TABOR in North Carolina. Features of HB 188 include:

• The creation of a “fiscal growth factor” to apply each year as an annual limit on the year-over-year growth of the state budget.
• The growth factor would be calculated using the average sum of inflation and population change for each of the preceding three calendar years.
  • If either population or inflation change for any of those years is negative, that change would be counted as zero.
• To calculate what the growth factor would be for the 2012-13 budget, for example, the years to look at would be 2009-10, 2010-11 and 2011-12.
• Examining past budgetary data and using the fiscal growth factor to create a comparison, we can see how much North Carolina could have benefitted if it had passed such a spending limit in 2000.[x]
  • Using the specific formula included in HB 188 (a three-year average of the combined inflation and population growth) as the annual spending limit shows that state government could have had more than $10 billion in extra, surplus revenue by FY 2010-2011.
    • Some of that excess revenue would have gone to fully fund the rainy day fund, but much of it would have been returned to taxpayers. That means billions of dollars back into the productive economy to help create jobs.
    • Also under this formula, North Carolina would not have overextended its state spending obligations during the boom years, making us much better poised to handle the great recession. In turn, citizens would have been able to avoid the massive billion-dollar tax hikes imposed on the economy.
• As shown in the chart below, TABOR spending limits would have smoothed out the dramatic growth in spending in the mid part of the 2000s, eliminating the budgetary “cliff” the state fell off of as the recession took its toll on revenues.

Improvements to HB 188

House Bill 188, however, could use some improvements. First off, it establishes a goal of 5 percent of the General Fund appropriation of the previous year for the rainy day fund, with excess revenues once that goal is met “reserved to provide tax relief to the citizens of North Carolina.” The bill should instead increase the savings goal to 8 percent of the prior year’s General Fund, and more clearly define the form of tax relief excess funds would take.

2. Voter Approval Over All New State Debt

North Carolina’s state constitution states that the General Assembly has no power to “contract debts secured by a pledge of the faith and credit of the State, unless approved by a majority of the qualified voters of the State.”[xi] State lawmakers, however, have exploited alternate forms of debt financing that supposedly don’t secure the debt with the “faith and credit” of the State (i.e. taxpayers), but rather use the project being financed itself as backing. The most popular of this form of debt used in North Carolina is called Certificates of Participation (COPs).

Unsurprisingly, state lawmakers have become quite fond of COPs because this kind of legislative sleight-of-hand allows them to avoid voter approval over increases of the state’s debt. The results have been predictable:

• North Carolina citizens have been denied a vote over new state debt since 2000.
• Since that time, state debt has skyrocketed.
  • Per capita state debt has more than doubled.[xii]
  • Annual debt service payments have tripled.[xiii]
• The borrowing binge has maxed out the state’s credit line. The 2010, 2011 and 2012 Debt Affordability studies produced by the State Treasurer’s office concluded that the state has “substantially exhausted” its capacity to issue new debt without threatening its credit rating.[xiv]
• The exclusive reliance on non-voter approved debt (such as Certificates of Participation) also threatens the state’s bond rating. The Debt Affordability Studies advise that the state once again use voter-approved debt (i.e. General Obligation bonds) as the preferred method of financing; failing to do so will put its “triple A” credit rating at risk.

Overwhelming Public Support

Eighty-three percent of likely North Carolina voters believe the General Assembly should not be allowed to borrow money without voter approval.[xv]

3. Zero-Based Budgeting

A significant factor contributing to out-of-control state budget growth is the fact that the majority of state spending continues year after year without being examined. As state Rep. John Blust (R – Guilford) remarked, “We only look at our proposed changes to the governor’s proposed changes in the budget.” The rest of the budget, according to Blust, goes on autopilot each year, receiving little if any scrutiny. This needs to change.

Instead, the entire budget – not just proposed changes – should receive regular scrutiny by budget writers. Zero-based budgeting would simply require all state agencies to produce a thorough description and justification of their expenditures, along with a ranking of each activity as it relates to the overall goals and purposes of the agency.

A 2009 bill (HB 45) sponsored by Blust and Rep. Bryan Holloway (R-Rockingham) would have implemented such a policy. The measure was realistic: Because of the massive size of state government, HB 45 would have required only a third of the budget to be subject to review every two years, so that every program would receive a zero-based budget review every six years.

Yet the bill died in committee. That’s unfortunate, because reviewing the entire budget over a reasonable span of time would go a long way toward pushing lawmakers to identify unnecessary spending and would better frame the difficult budgetary decisions they face every year.

What Specific Reforms are Needed?

The three recommendations listed here provide a general outline of checks and restraints necessary if North Carolina state government is to rein in its out-of-control spending growth. Actually achieving the savings, however, requires more specific recommendations identifying the chief drivers of state budget growth.

When one examines state government expenditures in the proper context, it becomes clear that the largest expenditure is state employee payroll. Wages, along with health and retirement benefits, for state government workers consume nearly $14 billion of North Carolina’s $20.2 billion General Fund budget. Specifically, wages come to $10.9 billion, health benefits for active employees (i.e. state-paid premiums for the State Health Plan) total $1.25 billion, contributions to pension, disability and death benefits come to $978.5 million, and state contributions for premiums for retirees enrolled in the State Health Plan amount to $579 million.[xvi]

The next largest expenditure in the state budget is reimbursements to providers of medical care to Medicaid patients. For FY 2012-13, the state is estimated to spend $2.6 billion on services used by Medicaid enrollees.[xvii]

Combining those two expenditures totals roughly $16.3 billion out of the $20.2 billion General Fund budget. In short, about 81 cents for every dollar spent belongs to those two categories. Clearly, any meaningful state budget reform must focus on state government payroll and Medicaid expenditures.

The next three installments in this series will offer specific and sensible recommendations that will produce billions of savings for taxpayers while not interrupting any core services of state government.