A Realistic Formula for the State Budget

MICHAEL J. BOSKIN <i> is Wohlford Professor of Economics at Stanford University</i>

Almost a decade ago, the voters of California decided to limit the total amount of state and local government spending. At the time the Gann spending limit--named for anti-tax crusader Paul Gann--was passed, inflation was accelerating into double digits, economic growth had slowed, we were barely out of a recession and about to enter another, and inflation was driving millions of Californians into higher federal and state income tax brackets, even when they had no real income gains at all.

California’s working, taxpaying population had smaller and smaller real income gains, taxed ever more heavily, with federal and state transfer payments and services provided primarily to others. It is not surprising that means were sought to constrain the power of state and local governments to tax and spend within reasonable limits.

Since the passage of the Gann spending limit and its predecessor, Proposition 13, which limited property taxes, the state and local governments have coped with fiscal restraint in various ways. Some have sought--and most of those have obtained--"super-majority” voting approval of any tax increases. Others have deferred capital spending, or maintenance, such as computer purchases, painting buildings, etc.


Last year, the spending limit was finally binding overall at the state level, and the governor and Legislature fought over the interpretation of what could be done with revenue in excess of allowable spending. The Legislature wanted the extra funds spent on schools, but the governor argued successfully that he was constitutionally required to return them to the taxpayers. Hence, many of us got modest tax rebates.

The Gann spending formula allows state spending to grow from a base level along with population and inflation. That is, when the state’s population increases or the national consumer price index rises, spending may increase accordingly.

However, the national CPI and the overall state population are probably poor indexes to use for these purposes: State and local government services have very different patterns of inflation from the overall national CPI, on the one hand, and the groups in the population on which the state spends most of its income (for example, for the health care of the elderly and the education of the young) may grow very differently than the overall population does. But even these technical problems pale in comparison with a more serious one.

There is no component of the formula used to adjust the limit to allow for productivity growth. If real income per capita grows in California--as it has done most years at about 2%--allowable spending will not increase. A 2% real per-capita growth rate over a generation would cause the share of income that the state is allowed to spend to shrink almost in half.

Clearly, this does not make sense, given the needs and wants of Californians. Indeed, the too-stringent limit might eventually impede economic growth for want of an adequate infrastructure or an adequately educated work force. We could keep the existing formula, but we are likely to have increasing efforts to override the limit; eventually it will bind every year and will need an annual override. A sensible alternative would be to allow some adjustment for real productivity growth in the spending formula itself.

There is nothing magical about the current ratio of state spending to state income. One can imagine a scenario sometime in the future where the state ought to be spending more or less, as a fraction of state income than it is now, for demographic or economic reasons. But if we put some allowance for growth, say half the productivity growth rate, back into the formula, this will accomplish the dual purposes of continuing to constrain state and local spending, albeit quite a bit less drastically than under the current formula, and allowing some growth.

If and when the one-half of productivity growth rule seems to be too generous or insufficient, overrides can be voted--district by district or statewide--once in a while rather than annually. I thus conclude that, while well-intentioned and desirable in the context of the economic and fiscal situation in California in the late 1970s, the existing Gann spending limit is badly flawed by its failure to allow sufficiently for real economic growth. We should work toward an improved formula through the initiative and/or legislative process.

Two initiatives on the June ballot seek to deal with the spending constraint’s severity by changing the formula, on the one hand, or by a special exemption for a portion of the sales tax to be devoted to highways, on the other. I believe that carefully selected increased spending on education may be desirable, and the same for highways, but that a massive infusion of funds would be wasted.

Everything should be in the state budget, and likewise for local governments. The budget process ought to create a situation where elected officials are forced to place priorities on our fiscal decisions. That is what we elect them for. We should not have a situation where they merely pass those items for which they can muster a certain amount of support, leaving the rest of the state to soak up the shortfall. One person’s belief that a program has a noble purpose is someone else’s ignoble waste. That is why the budget process ought to cover all state and local spending.

We could do a much better job of capital budgeting and planning at the state level. When government investment expenditures--on computers, for example--pass strict benefit-cost tests, we ought to make those expenditures and carry the depreciation and obsolescence of the capital stock on the books as current spending.

Thus, there may be times when an investment boomlet is warranted, whether in education, highways, hospitals or prisons. Any spending limit should be flexible enough to allow such public investments to occur, but if and only if, they can be demonstrated to have reasonable expected returns to our citizens.

California has a window on the future by looking at what has occurred at the federal level. The federal government budget is now two budgets: the regular budget and several trust funds. Even though we unified the budgets by law in 1969, the 1985 Balanced Budget Act removed Social Security from the budget. The Social Security trust funds, highway trust fund and airport trust fund are all running substantial surpluses. Thus, the deficit in the general budget has become a free common resource from which everyone tries to get funds for favorite programs, while at the same time, earmarking taxes for special purposes outside the regular budget. The most stringent evaluation, testing and accounting devices in the budgetary process clearly exclude those items outside the budget.

We should not go down this route in California. Everything should be in the budget. We should improve our capital budgeting and move to adjust the spending limit total to allow, at least partially, for productivity growth. Then our state and local elected officials can set priorities for the still-constrained allowable spending among education, highways, law enforcement, health and other items.