CHAPTER 13 THE STATE ECONOMY AND THE FINANCING OF STATE GOVERNMENT

1. CHAPTER 13 THE STATE ECONOMY AND THE FINANCING OF STATE GOVERNMENT

2. Introduction • Government's ability to generate needed revenues is directly tied to the economy, a fact that helps explain the boom-and-bust economy of the state and the effects of economic weakness on the budget making in 2003 and 2004. • Because the poor in Texas pay a higher proportion of their incomes in taxes than do the wealthy, a major issue is raised concerning the fairness of the state revenue system. • Because the budget is the best guide to policy priorities, it is a practical test of how well citizens’ interests are accommodated in state spending. • While the population of Texas has grown thirty-three percent between 1988 and 2003, the state budget, when adjusted for population growth and inflation, has been relatively flat during this period.

3. The Texas Economy • The Past • Historically, Texas had a strong economy based on natural resources and is still an important producer of oil and gas. • Although the economy of the state is shifting from one based on natural resources to one based on information and technology, it is still subject to the ups and downs of resource-based components such as oil and gas. • The erosion of the natural resource-based economy in the late 1980s meant high unemployment, which has been exacerbated by the collapse of financial institutions and cut-backs in the defense industry. • The state responded to the problems by consolidating economic development programs, developing aggressive marketing campaigns for farm and ranch products, and selling the high-technology capability of the state through industry-university partnerships. • By the fall of 1999 Texas was creating 26,000 new jobs a month, although many of them were in low-paying service industries.

4. The Texas Economy • The Present • Texas has not been immune to the national and international events that have rocked the nation---a sharply dropping high-tech sector, the September 11, 2001 terrorist attacks and their aftermath, and corporate scandals. • Although Texas has the eighth largest economy in the world, its unemployment was hovering around six percent through 2003 due to the failure of border cities to realize the economic hopes they had based on NAFTA, a prolonged drought in the southern part of the state, the economic woes of American Airlines, and the reeling tourism industry. • Because higher unemployment rates cause a demand for more government services, the economic situation that greeted the legislature in 2003 was not encouraging.

5. The Texas Economy • Analysis • At least six factors help explain the ups and downs of the Texas economy and the growth in the state budget over the past twenty-five years. • Overproduction of oil worldwide in the early 1980s and the 1990s led to price reductions that placed a strain on the Texas economy and when prices increased in 2003 it helped oil companies and increased severance taxes but hurt many citizens and businesses. • National policy has put pressure on state governments, in part because of the devolution of government. • Texans responded to the challenges posed by the economic doldrums of the 1980s and diversified the economy. • Both public and private spending increased in proportion to the double-digit inflation rate that existed during the 1970s, while during the 1980s and 1990s the national rate of inflation was much lower. • The Texas revenue system lacks elasticity, that is, it is not easily adjusted to ups and downs in the economy. • When state government did enjoy a surplus in 1997 and 1999, it chose to rebate the money to taxpayers in the form of reduced taxes rather than increase spending.

6. Where Does the Money Come From? • Introduction • For those in government, as for the rest of us, the budget is the "bottom line" of who gets what, when, and how. • The budget also involves philosophical disagreements about progressive and regressive revenue sources. • A progressive revenue source is rooted in ability to pay. • A regressive source extracts revenue from everyone at the same rate regardless of ability to pay. • For FY 2004-05, 45 percent of state revenues come from taxes; 37 percent from federal grants; 9 percent from fees, fines, and penalties; 3 percent from interest, investments, and land leases; 2 percent from the lottery; and 4 percent from other receipts.

7. Where Does the Money Come From? • Introduction • There has been a great deal of fluctuation in revenue sources over time due largely to economic ups and downs and changing budget priorities, but the trends have been a steady decline in revenues generated by the oil and gas industries, an increase in nontax sources of revenue, and variability of federal funding. • As the oil industry has declined, revenues from the severance tax (especially appealing because out-of-state purchasers paid for much of it) and from leases, interest, and investment income dropped off. • Seeking to avoid tax increases, the legislature has frequently turned to charges such as fees for professional licenses and college tuition and to the lottery. • The general sales tax, which tends to hit the poor the hardest, has declined in percentage, though not in dollars, of revenues generated from FY 1982-83 to FY 2004-05.

8. Where Does the Money Come From? • Collection and Administration • State revenues are collected in many ways by many people, but these two officials are most concerned with state financial administration: • The comptroller, who is responsible for tax collection, investments, and the safeguarding of public funds. • The auditor, who oversees state agencies to ensure the legality of their expenditures. • Once collected, state revenues are placed in various funds, including the following five major funds: • The General Revenue Fund, which supports the most state programs. • The Omnibus Tax Clearance Fund, which is allocated in part to two other funds--the General Revenue and Available School funds--and in part to specific functions. • The Available School Fund, which underwrites public school textbooks and part of the Foundation School Program, the major source of state aid for local school districts. • The Highway Motor Fuel Fund, a quarter of which goes to the Available School Fund and the remainder to highways and roads. • The State Highway Fund, which is used for purposes related to the construction and maintenance of highways and roads.

9. Where Does the Money Come From? • Nontax Sources of Revenue • Federal Grants • State and local governments have become heavily dependent on national budgetary policies that have distributed monies under several programs. • Categorical grants-in-aid could be used only for specific programs such as community-health centers. • General revenue sharing, whereby federal funds distributed by formula could be used by state and local governments for projects of their own choice, was enacted under Nixon, but ended for states in 1979 and for cities in 1986. • Block grants provided money for general use in broad programs such as community development. • Under Reagan's "New Federalism," many categorical grants were consolidated into block grants and "passed through" state agencies rather than being distributed directly to local governments, but the amount of funding for many programs, especially those affecting the poor and urban development, was reduced. • Federal funding has been increasing in recent years, but critics of state policy processes have continued to criticize Texas officials for not taking full advantage of national programs and even being willing to sacrifice considerable federal funds to avoid spending a lesser amount of state funds.

10. Where Does the Money Come From? • Nontax Sources of Revenue, cont. • Borrowing • Governments borrow money for a variety of reasons, including political expediency, and borrowing allows those who will benefit from a project in the future help to pay for its cost. • Because the framers of the Texas Constitution believed in "pay-as-you-go" government, a four-fifths majority vote of the legislature is needed to approve emergency borrowing. • Amendments have altered the constitution to allow the issuance of state bonds for specific programs. • In FY 2000, authorized state indebtedness was $19.2 billion, which translated into only Arizona, Georgia, Iowa, Kansas, and Tennessee having a lower level of indebtedness than Texas on a per-person basis.

11. Where Does the Money Come From? • Nontax Sources of Revenue, cont. • Other Nontax Sources • The budget deficits that began in 1985 have resulted in a pattern of raising money by increasing fees for almost everything, looking to gambling as a source of public revenue, and even manipulating state pension funds. • Senior college tuition--a type of user fee—has risen steadily, but what college students really noticed during the 1980s and 1990s was the great increase in fees, a situation that changed in 2004 after boards of regents were given discretion to set tuition locally with the result that tuition increased sharply. • Fees for everything from driver’s licenses, personal automobile tags, and car inspections to water permits and day-care center operator licenses have been increased. • Texas also receives revenue from the interest on bank deposits, proceeds from investments and sales, and leases of public lands.

12. Where Does the Money Come From? • Nontax Sources of Revenue, cont. • Other Nontax Sources, cont. • A constitutional amendment permitting pari-mutuel betting was approved in November 1987, but the state makes little from betting because its share of the proceeds was initially set at 5 percent, a percentage that discouraged most developers from building tracks. • After the legislature had rejected a state lottery in 1987, 1989, and 1991, Gov. Richards succeeded in getting a lottery proposal on the ballot and approved by the voters in November 1991. • Since then, whether the revenues were dedicated to education has been an issue. • Administrative scandals and some fall-off in betting have resulted in the lottery’s not meeting expectations. • In 2003 the legislature authorized the state’s participation in the Mega Millions multi-state lottery to try to improve revenues.

13. Where Does the Money Come From? • Taxation • Introduction • Taxes are the most familiar and controversial sources of government revenue. • Though citizens have long sought justice in the tax system, but in the conservative heritage of Texas it has not always been easy to find. • Taxes are collected for two principal reasons. • Revenue taxes provide the income necessary for government to carry out its programs. • Regulatory taxes, although also a source of revenue, were originally designed to punish undesired behavior or reward desired behavior, but they are also easier to raise because any given regulatory tax affects only part of the population. • Both individuals and business pay taxes, although some contend that ultimately only individuals pay because business passes its tax expenses on to the consumer. • Two great concerns with the Texas tax system are tax equity and the lack of elasticity.

14. Where Does the Money Come From? • Taxation • Introduction, cont. • The tax policies of individual states reflect their particular economic resources, political climates, and dominant interest groups. • Texas, unlike most states, has no personal income tax and no corporate income tax but it does have a business franchise tax which is tied to business revenues. • Texas relies heavily on the general sales tax and other forms of sales taxes which places a disproportionate burden on poor and middle-income taxpayers. • Discussions about taxation are seldom objective and the claims of governments regarding taxes and "the public interest" rarely ring true because of the readily apparent influence of dominant interests on tax policies. • One of the least successful aspects of American democracy is the tax system, which at both the national and state levels tends to favor those who are better off. • Texas's taxing and spending practices reflect the political conservatism of the state and the influence of special-interest groups in the legislature.

15. Where Does the Money Come From? • Taxation • Who Pays? • Taxes may be classified as either progressive or regressive. • Progressive taxation (e.g., the federal income tax) is based on ability to pay; that is, the rate of taxation increases as the object taxed grows larger. • Regressive taxation (e.g., the general sales tax) refers to a system in which lower income earners spend larger percentages of their incomes on commodities subject to flat tax rates. • According to Citizens for Tax Justice, Texas has one of the ten most regressive tax systems in the 50 states. • Although many believe a progressive income tax would be fairer than the general sales tax and could replace all or part of it, the state's conservatism and the dominance of the business lobbies have precluded the adoption of a progressive tax policy.

16. Where Does the Money Come From? • Taxation • Who Pays?, cont. • Taxes levied on businesses in Texas, which are often regulatory in nature but produce considerable revenue for the state, include severance taxes, the corporation franchise tax, and gross receipts taxes. • Severance taxes are levied on natural resources severed (removed) from the earth. • Because this removal depletes irreplaceable resources, part of the tax is dedicated to conservation programs. • With the decline in the oil business, revenue from severance taxes now produce barely three percent of the state’s total revenue. • Corporation franchise taxes are assessed against corporations as the price of doing business in the state. • It is regarded as a type of corporate income tax by some people because the business pays tax on whichever amount is greater, invested assets or income. • Restructuring of this tax in 1991 placed a much heavier burden than before on labor-intensive industries. • The corporation franchise tax is expected to provide at least 6.8 percent of the revenue for FY 2004-05. • Among other taxes levied on business in Texas are gross receipts taxes, the insurance premium tax, and special taxes and fees. • All business taxes account for 15 percent of the state’s revenues that come from taxes.

17. Where Does the Money Come From? • Taxation, cont. • Who Benefits? • A tax resulting in an exact ratio between taxes paid and benefits received would appear to be equitable, and in Texas some taxes are based on that philosophy. • The motor fuels tax in Texas is based in part on this idea with three-fourths of the revenues from this tax dedicated to the construction and maintenance of highways and roads. • However, the motor fuels tax suggests a problem with the "benefit theory" in that people who do not own automobiles or purchase gasoline nonetheless benefit from the transportation of goods to market on the state's highways. • Revenues from the state's tax on tobacco do not go toward cancer research and the treatment of lung disease as would be required by the benefit theory of taxation. • A strict benefit philosophy would have a disastrous effect on the poor because they would not be able to afford the state services, such as education, they need most in order to escape poverty.

18. Where Does the Money Come From? • The Tax Burden in Texas • Texas has prided itself on being a low-tax state. • According to the Federation of Tax Administrators, Texas ranks 50th in per capita state tax revenue and 48th in the percentage of personal income paid in state taxes. • Because many federal grant formulas include tax effort among their criteria, Texas does not fare well in the receipt of federal money, with only eight states having less per capita federal expenditure than Texas.

19. Where Does the Money Come From? • The Dawn of the Twenty-first Century • Perspectives from the Past • Relying on oil and gas production taxes as the major source of state revenue, Texas was able to go from 1971 to 1984 without raising existing taxes or adding new ones. • Since the crash of the world oil market, Texans have benefited from better revenue measures, a booming economy, and some additional federal funds.

20. Where Does the Money Come From? • The Dawn of the Twenty-first Century • What’s Next • For the future, Texas must find adequate and equitable revenue sources to support the services needed by a growing population and to make up for federal funding cuts. • Performance evaluation and management, including funding cutbacks, is recommended in the Texas Performance Review and is grounded in the movement to “reinvent government.” • A second strategy is the privatization of state services, such as private prisons and the increasing rate of tuition and fees paid by college students. • A third solution is to change the revenue structure to order to avert the revenue shortfalls that plagued the state in the 1980s and in the early 2000s. • Change would focus on making the system more elastic and better able to fund state services consistently. • Competition between national, state, and local governments over tax sources, particularly the general sales tax, makes the income tax an attractive new source of state income. • For tax restructuring to occur, the attitudes of both business and private citizens will have to change toward support of an income tax. • Though business has paid a greater share of taxes since 1991, the tax system in Texas is still regressive, placing an undue burden on those least able to pay and creating some tension with democratic theory. • Without an income tax, the state will always have trouble meeting its revenue needs in anything but a booming economy.

21. Where Does the Money Go? • The Politics of Budgeting • In general, how state funds are allocated depends on the results of compromises between interest groups and "swing vote" groups, with legislators, the governor, and the bureaucracy also having some impact on decisions. • Spending decisions are, in other words, the result of complex relationships among hundreds of political actors. • The biases of the political system are thus reflected in the biases of state spending.

22. Where Does the Money Go? • Planning and Preparation • Texas has a dual-budgeting system with governors preparing their own budgets even though the constitution gives the legislature budgetary responsibility. • The governor's budget is prepared by the Budget, Planning, and Policy Division and the legislature's by the staff of the Legislative Budget Board (LBB). • Although this duplicate effort is wasteful, budgets prepared by those with divergent political perspectives provide differing viewpoints on the ways that state programs should be funded. • Both budgets tend to be incremental, but the recent emphasis on performance may give legislators a better view of agencies' real priorities and how costs relate to benefits. • Budget planning begins a year before the biennial legislative session with state agencies submitting budget requests to both the governor's and LBB's staffs. • The LBB and the governor's staff conduct joint hearings to evaluate agency requests after which each staff independently prepares a budget reflecting the priorities of its office. • When completed, both budget documents are submitted to the appropriate legislative committees for consideration. • Biennial budgeting, which requires projections of state spending through August two years later regardless of economic changes that may occur, is a major reason why state budget planners lean toward incrementalism rather than rationalism.

23. Where Does the Money Go? • Authorization and Appropriations • The key legislative players at this stage are the House Appropriations, House Ways and Means, and Senate Finance committees, before which interested individuals, agencies, and groups may testify. • It is at this stage that past campaign contributions begin to pay off and the relative power of various interest groups is reflected in the state budget. • The House and Senate versions of the appropriations bill are submitted near the end of the session, but because the versions never agree, a ten-member conference committee, appointed by the presiding officers, is formed to produce a single conference report on the budget. • Following legislative approval, the appropriations bill goes to the governor. • The governor may then use his or her greatest budgetary power, the line-item veto. • The governor may not add to the budget or restore funding that the legislature has rejected.

24. Where Does the Money Go? • Execution/Spending • Although disbursement of the state’s income is rather technical and less interesting as a political process, two political issues are noteworthy. • Governors have attempted with only limited success to gain greater control over spending between legislative sessions. • The power of the state auditor to prescribe particular management practices for state agencies was limited by a 1988 attorney general's advisory opinion, but the performance-oriented reforms passed in 1991 have given the state auditor authority to perform management audits.

25. Where Does the Money Go? • Execution/Spending, cont. • Education • Education accounts for 42.2 percent of the FY 2004-05 budget. • More than two-thirds percent of the total was for the public elementary and secondary schools in the state’s 1,090 independent school districts. • The next largest portion--$16 billion--supported higher education in the state. • As of 1999, Texas ranked thirty-ninth among the states in per capita spending for all education programs combined.

26. Where Does the Money Go? • Execution/Spending, cont. • Health and Human Services • Health and human services, including welfare, unemployment compensation, employment services, services for special groups such as the blind and the aged, and mental health and retardation, substance abuse, and contagious-disease control programs account for $39.7 billion in the state's budget. • Of this total about 60 percent comes from the national government. • Although this is the second-largest category in the budget, Texas ranks forty-eighth in per capita expenditures for welfare services and fifteenth in hospital services among the fifty states.

27. Where Does the Money Go? • Execution/Spending, cont. • Business and Economic Development • Expenditures for business and economic development in FY 2004-05 are almost $14.4 billion. • Slightly less than 50 percent of the funding for this category comes from the national government, principally in the form of federal highway matching funds to maintain the federal interstate highways in Texas. • A cap placed on highway expenditures by the legislature in 1977 has resulted in a decline in the transportation portion of the budget from twenty-one percent to about nine percent. • Texas ranks forty-fourth among the states in per capita spending on highways.

28. Where Does the Money Go? • Execution/Spending, cont. • Other Major Expenditures • Public safety, including law enforcement, prisons, and related programs is, at $7.9 billion, or 6.7 percent of the total budget, the next largest category of state expenditures. • The remaining $5.9 billion of the FY 2004-05 budget is divided into general government--the expenses of the legislature, the judiciary, the governor, and various management offices--as well as parks, natural resources, and regulatory agencies.