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Unbalanced: Why State Balanced Budget Requirements Are Not Enough

State Budget Solutions | by Cory Eucalitto | April 4, 2013

State level balanced budget requirements often serve as a source of pride for officials eager to distance themselves from a federal government creating tradition out of trillion dollar annual deficits. The mantra that "49 of 50 states" are required to balance their budget is so often repeated that it comes as a surprise to many to find out that state governments find themselves saddled with over $4 trillion in debt.

The reality is that state balanced budget requirements are far more complex than traditionally understood. Moving beyond these misconceptions is an important step in being able to recognize the many ways that policymakers manipulate state finances to "balance" budgets and put an end to the growth of state debt.

Origin

Balanced budget requirements have a long history in state government. They arose out of the recession sparked by the Panic of 1837, and were created largely as limits on a state's ability to issue debt. Rhode Island was the first state to institute a constitutional amendment of this type. Nineteen total states adopted similar requirements between 1842 and 1860. From there, these rather simple constitutional amendments developed into the complex systems understood (or misunderstood) as balanced budget requirements today.

Traditional Understanding

State balanced budget requirements are typically conceived of as sets of rules constricting the budget crafting process at several distinct points. This understanding has been reflected in at least two influential analyses, The Advisory Commission on Intergovernmental Relations' (ACIR) stringency index and the National Association of State Budget Officers' (NASBO) "Budget Processes in the States."

ACIR's scoring is heavily skewed towards the conception that most states have the strictest possible balanced budget requirements. Twenty-six states received a full ten points for stringency. One third score between eight and ten, and only one state, Vermont, received no points.

ACIR crafted its stringency index, one of the most frequently referenced taxonomies of state balanced budget requirements, in 1984. ACIR has not updated it since then. The system assigned to each state a score between one and ten, with ten signifying the most stringent balanced budget requirement. The five criteria used were:

  1. The governor must submit a balanced budget.
  2. The legislature must pass a balanced budget.
  3. The state may carry over a deficit but it must be corrected in the next fiscal year.
  4. The state may not carry a deficit over into the next biennium.
  5. The state may not carry a deficit over into the next fiscal year.

Under the index, each state received points according to the strictest of the five criteria that it had in place, along with one additional point if the rule was statutory and two if it was constitutional.

Map with DollarsNASBO found that 44 states require the governor to submit a balanced budget, 41 require the legislature to pass a balanced budget, 37 require the governor to sign a balanced budget, and 43 prevent the state from carrying over a deficit. This is the source of what has become a slogan of sorts in defense of state governments' supposed fiscal discipline: that 49 of 50 states are required to balance their budgets.  

NASBO last updated "Budget Processes in the States" categorizations in 2008. Their method for distinguishing the different facets of a balanced budget requirement is remarkably similar to ACIR's, although NASBO shies away from ranking states according to stringency. NASBO's criteria are:

  1. The governor must submit a balanced budget.
  2. The legislature must pass a balanced budget.
  3. The governor must sign a balanced budget.
  4. The state may not carry over a deficit.

Agreement exists on the first two points in the process at which balanced budget requirements exert influence over the budget process, before diverging, only slightly, when the budget moves from preparation to implementation.

The first point is upon the governor when submitting his or her budget request. Section V, Article 18 of the Michigan State Constitution, for example, reads:

The governor shall submit to the legislature at a time fixed by law, a budget for the ensuing fiscal period setting forth in detail, for all operating funds, the proposed expenditures and estimated revenue of the state. Proposed expenditures from any fund shall not exceed the estimated revenue thereof.

In statute, section 41-19-4 of Alabama's code requires that within the Governor's budget, "Proposed expenditures shall not exceed estimated revenues and resources." NASBO's 2008 survey lists forty-four states with either a statutory or constitutional requirement of this sort.

The second point at which balanced budget requirements are traditionally understood to constrain the budget process is when the legislature passes the budget. Constitutionally, these requirements often take the form of a requirement that the state raise enough money to cover the costs of estimated expenses. Section 171 of Kentucky's State Constitution, for example, states, "The General Assembly shall provide by law an annual tax, which, with other resources, shall be sufficient to defray the estimated expenses of the Commonwealth for each fiscal year." NASBO lists 41 states with this type of requirement.

NASBO also includes the requirement that the governor must sign a balanced budget as another point in the process. Their report found 37 states with this requirement.

The simplicity of ACIR and NASBO's classifications certainly contributed to their adoption as a standard for comparing states against one another. Their standing as definitive perspectives on state balanced budget rules, though, deserves to be called into serious question.

ACIR's stringency index is nearly thirty years old. Not only have related statutes undoubtedly changed in that time, but the overall fiscal health of state governments is dramatically different. Budgets are strained and the states face trillions of dollars in debt. This reality can create greater motivation for officials to skirt balanced budget requirements in order to preserve spending.

Further, the first two components of NASBO and ACIR's balanced budget requirement classification systems are practically irrelevant when it comes to the final budget document because those first two components deal exclusively with the budget crafting process. The first requirement is virtually meaningless when it comes to the final budget. Even the second can only be "balanced" in the long run if it is implemented in its exact form and all projections and estimates come to fruition.

ACIR and NASBO also focus heavily on political rather than technical rules. Yilin Hou and Daniel Smith of the University of Georgia wrote in their 2006 paper, "A Framework for Understanding State Balanced Budget Requirement Systems: Reexamining Distinctive Features and an Operational Definition" that three of the four variables considered to constitute "balanced budget requirements" in NASBO's classification are of a political nature. These political rules "are more concerned with the budgetary procedure, while technical rules are more about substance with regard to budgetary balance, use of debt, controls on supplementary appropriations, and deficits in order to achieve annual budgetary balance." Further, they found that these political rules "are ambiguous in that they are relatively more subject to circumvention and manipulation, whereas technical rules tend to be straightforward, rigid, and more difficult to circumvent."

Viewing state balanced budget requirements as sets of rules that act upon the budget process at various points vastly understates the more complex reality. As a result, citizens and unwitting lawmakers may be shocked to find their states slowly piling up debt despite the repeated assurance of "balanced budgets." The many flaws of popular categorizations like those compiled by ACIR and NASBO highlight the need to refocus the view of state balanced budget requirements. 

A New Framework

Hou and Smith's paper includes an alternative taxonomy of state balanced budget requirements that is more comprehensive and accurate. They found that balanced budget requirements "are each an interlocking network of multiple provisions in different parts of both the constitution and the code, covering the executive preparation, legislative review, and implementation phases of the budget cycle, incorporating a multitude of players and factors into both the political and budgetary processes of state administration." It takes into account both political and technical rules, understanding that the latter must accompany the former "to seal any possible leakage." 

Their "framework" involves nine different rules spanning the length of the budget process from executive preparation, to legislative review, to implementation.

Rule

Nature of rule

Phase of the budget cycle

States with constitutional provision

States with statutory provision

Governor must submit a balanced budget.

Political

Executive preparation

11

33

Own source revenue must match (meet or exceed) expenditures.

Technical

Executive preparation, legislative review

8

4

Own source revenue and general obligation (or unspecified) debt (or debt in anticipation of revenue) must match (meet or exceed) expenditures.

Technical

Executive preparation, legislative review

30

9

Legislature must pass a balanced budget.

Political

Legislative review

27

18

A limit is in place on the amount of debt that may be assumed for the purpose of deficit reduction.

Technical

Executive preparation, legislative review, implementation

19

3

Governor must sign a balanced budget.

Political

Legislative review

1

1

Controls are in place on supplementary appropriations.

Technical

Legislative review, implementation

7

14

Within fiscal year controls are in place to avoid deficit.

Technical

Implementation

6

29

No deficit may be carried over to the next fiscal year (or biennium).

Technical

Implementation

2

9

 

This classification rectifies many of the shortcomings present in other classifications like those by ACIR or NASBO. Four of the nine components are shared with other reports, but an additional five are unique to Hou and Smith's taxonomy. They are mostly technical requirements that fill in the gaps between political rules. The framework also extends further beyond the moment when a governor signs the budget. They ensure that implementation of the budget is consistent with the intent of those political rules.

In some cases, the paper found radically different rules on the books than did ACIR and NASBO. One reason for that may be that others have relied on self-reporting by state officials. Where NASBO listed 37 states with a provision requiring the governor to sign a balanced budget, Hou and Smith only identified Massachusetts and California. They attribute this to an assumption in many states of laws that "imply" that the governor must sign a balanced budget, or at least that what must be presented to him or her by the legislature must be balanced. Either way, "this does not stop a governor from unbalancing a budget before signing it."

Through this framework, the authors arrive at an operational definition of a full-fledged balanced budget requirement system. It offers a much higher standard from which to observe existing state law and takes into account the reality of state budgets as frequent vehicles for political manipulation:

A fully developed BBR system offers a three-line construct against imbalance, like a three-layer sandwich, each layer starting with a provision of political nature that is more procedural, and then going through one or more provisions of technical nature that are more substantial and specific. The process of political provisions being substantiated by technical ones, as the budget process unfolds, is to add constraint on the spending activities of government, and to limit and reduce the window of possible circumvention and opportunities of manipulation of BBRs by elected officials in the executive as well as legislative branch.

Avoiding Requirements and Use of Budget Gimmicks

The National Conference of State Legislatures has noted that the most important factor driving states to balance their budgets is not a particular enforcement mechanism or rule, but rather "the tradition" and "expectation" of balanced budgets. A full understanding of state budgeting requires one to acknowledge the role that budget gimmicks and debt play in that storied tradition, and how lawmakers use those gimmicks to circumvent the requirement that the budget be truly balanced.

Some evidence shows that "strict" balanced budget requirements, in the vein of NASBO and ACIR's classifications, are effective for restraining state spending. A working paper from The Mercatus Center at George Mason University noted that per capita spending was both $184 and $189 lower in states with strict requirements. Institutionally, only the existence of separate spending and tax committees, item reduction vetoes, and centralized spending committees were found to do more to reduce per capita spending.

Many state balanced budget requirements, however, have several glaring shortcomings that are more easily taken advantage of when absolute stringency is assumed but does not exist. In the end, balanced budget amendments that are less than comprehensive, yet still so complex that many expert budget officers themselves fail to grasp their whole nature, may encourage the repeated use of budget gimmicks. 

  • Shifting money from fund to fund

Shell game imageOne such gimmick is the use of different funds. State budget processes and rules that keep budgets in "balance" almost exclusively address only general fund budgets, leaving massive chunks of revenues and expenditures out of the limelight. Article 7, Section 5 of Hawaii's State Constitution says, "general fund expenditures for any fiscal year shall not exceed the State's current general fund revenues and unencumbered cash balances." Connecticut's State Constitution is similar, requiring "the amount of general budget expenditures authorized for any fiscal year shall not exceed the estimated amount of revenue for such fiscal year."

General fund budgets, however, are only one part of the fiscal story. Of $1.7 trillion in fiscal year 2011 total state spending, only 37.7 percent came from general fund budgets, down from 45.8 percent as recently as fiscal year 2008. Increases in federal funding drive much of this, but the trend can be seen even when excluding federal funds. In California, the general fund's portion of total spending excluding federal funding has fallen from 83 percent in fiscal year 1977 to 68 percent in fiscal year 2012.

With so much revenue divided up into separate funds exempt from balanced budget requirements, states are able to employ a gimmick that involves shifting money between funds when needed. If a fund required to end in balance sees a shortcoming, money can be transferred in from another fund not necessarily subject to the same rules. Somehow, many states count these types of transfers as new revenues. The Institute for Truth in Accounting (IFTA) calls the gimmick "funds sweeping," and describes it as "akin to a person transferring money from his savings account to his checking account and claiming he made money." For example, Alabama voters approved a transfer of more than $437 million over three years from a state trust fund to the state General Fund. Another example is lawmakers in Texas redirecting millions of dollars in fees collected away from the specific purposes for which they were collected and used instead to help balance the budget. Even lawmakers acknowledge that the practice is problematic at best, and Texas House Speaker Joe Straus said such maneuvers should be stopped.

Lawmakers will raid just about any fund, including the state's emergency or rainy day reserves. Hawaii's Rainy Day Fund balance dropped from $60 million to $6 million in 2011 after a majority of lawmakers and Gov. Neil Abercrombie raided the fund to cover a shortfall and balance the state budget. As part of the National Mortgage Settlement in February 2012, the states split $2.5 billion intended to provide a measure of restitution on behalf of homeowners who lost equity in the market collapse or lost their homes in the "robo-signing" foreclosure scandal. Six states - Missouri, California, South Carolina, Georgia, Alabama and New Jersey - ignored the agreed-upon uses for the money entirely by directing nothing for housing-related activities. Many other states diverted at least a portion of the funds.

  • Playing calendar games
    Calendar image

State balanced budget requirements also encourage gimmicks through shortsighted decision-making. Just like money can be shifted from one fund to another, so too can it be shifted from one fiscal year into the next to achieve budget "balance." Delayed payments effectively shift the burden of debt from one fiscal year until the next, to postpone payment of the debt (and potential political backlash). In the past, states delayed issuing state employee paychecks by one day, which shifted payroll costs to the next year, or postponed sales tax payments. For example, in 2011, California delayed $2.1 billion in payments to school districts, and Minnesota has also delayed school district payments so that they fall in the subsequent fiscal year.

A study from the Massachusetts Institute of Technology found that states with strict rules to prevent carrying forward a deficit "tend to defer payments when facing low net revenues." States with weaker restrictions did so less often. This trick changes nothing about the total amount received or spent by state government, but allows politicians to craft an illusion of fiscal responsibility.

The same study also examined whether or not states with strict balanced budget requirements tend to sell off assets to close budget gaps. It found that in states with weak anti-deficit rules, a $100 deficit prompted selling off $9.1 worth of assets. States with strong anti-deficit rules sold $23.6 in assets. Whether one agrees or disagrees with a decision to sell assets, whether buildings, bridges, or tolls roads, the decision should be made with an eye towards maximizing the state's return. Asset sales dictated by balanced budget requirements are based on the fiscal calendar, not maximized return, and taxpayers must bear the cost. Further, any one-time use of funds achieved by selling assets is necessarily depriving future generations of the revenues they might have earned.

  • Using debt to balance budgetsIOU image

Many states are also free to issue debt to balance their annual budgets. Hou and Smith included limits on the amount of debt that can be issued for deficit reduction as a factor in their balanced budget framework. They reported that only twenty-two states had these rules in place. Examples include Michigan, where the constitution stipulates that the state may issue debt up to 15 percent of undedicated revenues received in the prior fiscal year, and Tennessee, where the constitution prohibits issuing debt not repaid within the fiscal year for the current operations of state government.

Without limits on the ability to issue debt to "balance" annual budgets, states are free to impose harsh obligations on future generations. Connecticut Governor Dan Malloy's plan to deal with his states budget deficit, for example, would borrow $10 million to pay for required stem cell research funding and put the "savings" towards closing the deficit. In January 2012, Illinois sold $800 million in bonds to fund capital projects, one week after Moody's Investor Service slapped Illinois with the lowest credit rating of any state in the nation.

The use of cash-based accounting greatly aids the ability of states to issue debt as a way around loose balanced budget requirements. When trying to "balance" the annual budget, cash-based accounting allows states to report loan proceeds as "revenues," as IFTA describes. Both revenues and expenditures are accounted for as they are received and spent; essentially, as they come and go from the state's hypothetical checking account. A loan obviously has to be paid back, but many states are still free to "balance" their yearly budget by not counting debt simply because the next payment is not yet due. The gimmick assumes that no future costs are incurred by issuing debt.

  • Pension Funds Gimmicks

Finally, states have several gimmicks they use regarding public pensions and balanced budgets.

Lawmakers are required by law to make actuarially determined payments, annual required contributions, to employee pension and healthcare funds. As an ultimate gimmick, state officials have shown a propensity to skip these required payments entirely to meet balanced budget rules.

For example, between 2003 and 2012, New Jersey was supposed to contribute over $12 billion to its state pension system. Despite receiving a full ten points for stringency in ACIR's categorization of balanced budget requirements, the state underfunded these required payments by $11.8 billion.

Lawmakers also often rely on the gimmick of assuming return on investment that is unrealistic. In July 2012, the largest U.S. public pension system, California Public Employees Retirement System reported a 1 percent return on investments, even after the assumed rate of return was cut earlier in 2012 to 7.75 percent, a reduction that was obviously too timid.

Solutions

Despite widespread supposed understanding state balanced budget requirements, it is clear that enforcement of fiscally responsible principles is tricky business. Balanced budget requirements are immensely more complex than many assume. The tendency to over-simplify their ins and outs makes them particularly vulnerable to chronic avoidance. If anything, this realization should call attention to the need for greater state-by-state understanding of balanced budget requirements and the way their various components interact with the budget process.

Officials should learn more about their state's particular balanced budget requirement system. Examination should rely on a thorough framework and avoid the trap of falling back on political requirements as a sufficient guarantor of balanced budgets. States should fill in the easily exploitable gaps in their individual balanced budget requirement systems. Officials should also rely on local knowledge not available to outside observers to understand how balanced budget requirements play into each state government's particular fiscal culture.

More explicitly, there are certain items that legislators and the public should be aware of before adopting a "balanced" budget. The Institute for Truth in Accounting laid out a list of five things legislators and the public need to know before a vote takes place:

  • The amount of the state bills that will be incurred, but not paid during the budgeted year;
  • The amount the proposed budget's policies will increase the state debt, including the money
required to be borrowed to balance the budget on a cash basis;
  • The amount of the increases in the pension and other post-employment benefits promised;
  • The one-time revenue transactions that will be entered into, including the funds that will be
transferred from dedicated or trust funds; and
  • The annual fiscal deficit that is forecasted if the proposed budget is passed.

These specific areas could be addressed comprehensively through the adoption of reality-based budgeting. This should include recognizing the whole of state government as one entity, eliminating gimmicks like shifting money between funds to feign responsible budgeting. Budgetary assumptions should begin with the most critical needs of citizens, not the prior year's baseline.

Instead of asking themselves how to best exploit a fractured balanced budget requirement system, state officials should start each budget season with four questions: what must the state accomplish? How will the state measure progress and success? How much money does the state have available to spend? What is the most efficient and effective way to deliver essential services within available funds?

It may well be the case that any balanced budget requirement system is susceptible to manipulation by those who design it and carry the motivation to seek out loopholes. State legislative and executive leaders should begin holding themselves to a higher standard in the budget process. Activists and reporters alike can take several steps to increase accountability and encourage lawmakers to build better budgets, including:

  • Review the specific constitutional and statutory provisions that make up your state's balanced budget requirement system.
  • Learn how much state spending exists outside the general fund budget, and routinely examine capital and other fund budgets for overspending and gimmicks.
  • Publically acknowledge gimmicks and refuse to lend credibility to the budgets that rely on them to achieve "balance."

Ultimately, each state's balanced budget requirement system is only as strong as elected officials' capability for restraint and responsibility. When the will to hold true to these principles of good government falls short, true budget reform could accomplish what current budget requirements have so far failed to deliver: truly balanced state budgets. Balanced budget requirements work when leaders of integrity are committed to making the necessary, difficult choices and avoiding gimmicks entirely.

 

 

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Download file Unbalanced: Why State Balanced Budget Requirements Are Not Enough 

 

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