01 February 2010

Colorado's Government Needs A Freezer Card

Unless voters agree otherwise, the State of Colorado has to fund its operating expenses from current tax and fee revenue. It isn't permitted to borrow money as the federal government does.

Most states require balanced state budgets, and in the long run, is is probably good policy to avoid getting the state too deeply into debt. But, an absolute fetish against borrowing for current expenses no matter how great the short term need for operating expenditures is bad policy. The state should be allowed to borrow money to partially make up for lost tax revenues on a short term basis in bad economic times.

At the household level, even financial planners who counsel against taking on too much debt, will sometimes advise clients to have a literal (or figurative) freezer card: a credit card encased in a block of ice in the freezer for use only in emergencies. Colorado's state government should do have the same kind of resource at its disposal.

State government expenditure demands are countercyclical. State government administers and funds, at least in part, the unemployment insurance system (whose costs go up with increased unemployment), Medicare (which provides health care for the poor), low income health care clinics and public hospitals (that get more use in bad economic times), food stamps, the welfare system, higher education and job training (which is always in higher demand when the job market is weak), mental health programs (whose clients needs are greater when jobs and hence private health insurance are more scarce). State government is also expected to ramp up public funded employment, particularly public works projects, when the private sector construction industry is weak, to buffer the industry in times of weak private sector demand.

State government revenues are cyclical. Sales tax revenues fall in tough economic times because people buy less. Income tax revenues fall because incomes are stagnant and people are losing their jobs. State government doesn't rely on property taxes as some local governments do, which provide more stable revenue streams.

The results are predictable. In tough economic times, state revenues fall and state expenses rise, requiring big budget cuts at a time when they don't make sense.

Raising taxes and users fees in tough economic times is another response. But, TABOR makes it hard to do that in a timely fashion, and from an political and economic perspective, a weak economy may not be the best time to increase government revenues from taxes and users fees significantly.

Recessions are also, frequently, times when interest rates are low, and when the interest rate spread between low risk and high risk debt is high. The Federal Reserve's instinctive response to a weak economy is to lower interest rates, as it has done now.

State governments, because they have the power to tax, because it isn't clear that they are permitted to go bankrupt and discharge their debts, and because they tend to have low debt loads, usually have relatively good credit ratings and thus, can borrow money with low interest rates.

Finally, recessions are typically short. Two or three years is a long recession. This means that the time available to response is too great for anything that requires voter approval to be timely. It also means that the budget crunches created by recessions tend to last for only a small number of fiscal years.

As a result, automatic stabilizers are one of the policy responses that seems to make sense to deal with recessions.

Nobody questions that a "rainy day fund", which sets aside some revenue growth for bad economic times, is good state fiscal policy. A state "freezer card" where the state is allowed to borrow some of the money it loses due to declining tax revenue (perhaps half or a third) in recessions on a short term basis is the same policy in reverse order. A roughly three to five year amortization period, similar to credit card debt, makes sense in this case, because most recessions clear up in that time frame and are followed by rising state revenue and reduced pressure on state operating expenditures. Recessions are rarely that close together.

An ability to raise funds with bond offerings is bad economic times also meets the increased investor demand for safe investment options in that time frame (the flight to safety is so great at the moment that Treasury bills are carrying negative interest rats), and may actually help the credit worthiness of the state. Political deadlock in the budget process is particularly prone to happen in times of decreasing revenues and increasing expenditures. And, state political deadlock on budget matters can produce defaults on a state's financial obligations as we have seen in California and Illinois, which issued IOUs for payments it was required to make, because it didn't have enough money to pay its obligations. Avoiding budget deadlock and the need to issue IOUs makes a state government more creditworthy.

This doesn't mean that the state should routinely have annual state budget deficits. The authority to borrow in order to make general fund spending should have a trigger, like declining government revenues, so that debt doesn't spiral out of control as it has at the federal level. But, a policy that prohibits any short term debt can do as much harm as one that allows debt financing on debt when it is poor fiscal policy.

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