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bbbbbhbhi Business Review Federal Reserve Bank o f Philadelphia January •February 1991 ISSN 0 0 0 7 -7 0 1 1 Business Review The BUSINESS REVIEW is published by the Department of Research six times a year. It is edited by Patricia Egner. Artwork is designed and produced by Dianne Hallowell under the direction of Ronald B. Williams. The views expressed here are not necessarily those of this Reserve Bank or of the Federal Reserve System. SUBSCRIPTIONS. Single-copy subscriptions for individuals are available without charge. Insti tutional subscribers may order up to 5 copies. BACK ISSUES. Back issues are available free of charge, but quantities are limited: educators may order up to 50 copies by submitting requests on institutional letterhead; other orders are limited to 1 copy per request. Microform copies are available for purchase from University Microfilms, 300 N. Zeeb Road, Ann Arbor, M I 48106. REPRODUCTION. Permission must be obtained to reprint portions of articles or whole articles. Permission to photocopy is unrestricted. Please send subscription orders, back orders, changes of address, and requests to reprint to Publications, Federal Reserve Bank of Philadelphia, Department of Research, Ten Independence Mall, Philadelphia, PA 19106-1574, or telephone (215) 574-6428. Please direct editorial communications to the same address, or telephone (215) 574-3805. JANUARY/FEBRUARY 1991 DE NOVO BANKING IN THE THIRD DISTRICT Patricia Brislin and Anthony M. Santomero Much is made of the dwindling number of banking organizations, but a less pub licized story is the rapid growth in the number of new banks that have opened. In an evident trend, the number of "de novo" banks—banks that have been in existence for less than five years—has in creased both across the nation and in the Third Federal Reserve District. Thus far, new institutions in the District have achieved profitability for the most part, but challenges remain. COPING WITH STATE BUDGET DEFICITS Janet G. Stotsky In recent years, state budgets have been the bright spot amid government budget troubles. But now, like the federal gov ernment, many states are finding them selves in precarious budget situations. States in the Northeast are feeling the effects most keenly. And the states that have so far slid by with only minor ad justments may not be immune much longer. What's behind the budget prob lems in many states? And are there ways in which states can cope? De Novo Banking in the Third District Patricia Brislin and Anthony M. Santomero* M uch has been written about the num ber of bank failures and mergers in the last decade. To read the newspapers, one would think that the banking industry was losing members without end. It's true that the number of banking organizations in the United States has declined over time, but this isn't the entire story. As some banks go, others come. ^Patricia Brislin, formerly with the Federal Reserve Bank of Philadelphia, is a bank analyst at the Federal Reserve Bank of Boston. Anthony M. Santomero, a Visiting Scholar in the Philadelphia Fed's Research Department, is Professor of Finance at the University of Pennsylvania's Wharton School. In fact, a major story is the rapid growth in the number of new banks that have opened. Institutions that have been in existence for less than five years are termed "de novo" banks for purposes of the quarterly Call Reports all banks must file with their federal regulators. In an evident trend, the number of de novos has increased both across the nation and in the three states of the Third Federal Reserve District—Pennsylvania, New Jersey, and Dela ware. As the number of de novos in the Third District grows, the local press heralds their arrival. But little has been written about these banks' strategies for success or about the pit 3 BUSINESS REVIEW falls they may face along the way. Previous studies have shown de novo banks having high mortality rates. Remarkably, all institutions chartered in the Third District since January 1985 still exist today. However, as will be shown below, special conditions are required for new entrants to do well in the banking industry. These include good man agement, rapid growth in assets, good credit decisions, and a healthy economy. Thus far, the institutions in the Third District have achieved profitability for the most part, but challenges remain. DE NOVO ACTIVITY IN THE THIRD DISTRICT While the total number of Third District banks has declined slightly over the past five years— to 283 from 298— some 38 new com mercial banks (excluding special-purpose in stitutions) started operations in the Third Dis trict between January 1985 and December 1989. Of this total, an overwhelming percentage have been concentrated in the greater Philadelphia metropolitan area. In the last quarter of 1989, these de novo institutions represented 13.4 percent of all banking institutions in the Dis trict, and their assets have grown rapidly. (For the 38 institutions' dates of establishment and asset sizes as of January 1,1990, see New Banks Established.) Growth in Assets. Despite representing more than 10 percent of the District's banking organizations in the last quarter of 1989, the 38 de novos held assets that accounted for only 1.26 percent of the District's total assets. Addi tionally, the average de novo was 9 percent the size of the average Third District bank in that quarter. This contrast owes primarily to the de novos' infancy. Assets of de novo banks have grown rapidly over the last five years. In the final quarter of 1989, the average growth rate for the de novo group's assets was 82 percent (annualized), compared to 17.3 percent for the Third District 4 JANUARY/FEBRUARY 1991 as a whole. As a de novo bank grows, however, its annual growth rate of assets declines. For a typical de novo, annual asset growth is 85 percent at the end of its second year of opera tion and declines to 35 percent by the end of its fifth year. Assets and Liabilities Composition. In the early stages of operation, each of the 38 banks had a substantial portion of its assets in money market instruments, securities, and the "other assets" category—primarily premises and equip ment. It takes time for new firms to find good loans and other profitable opportunities. Over time, however, they continuously increase the fraction of their assets in loans, at the expense of the fraction devoted to securities. In addi tion, fixed assets decline as a percentage of the total. For a de novo at the end of its first quarter of operation, total loans on average represent 30.7 percent of assets. This figure rises to 72.7 percent by the end of the second year. After making this transition, the average de novo holds approximately the same percentage of assets in loans as the average Third District bank. Within the securities category, the aver age de novo consistently holds more U.S. Treas ury securities and fewer municipals than the average Third District bank. The funding of de novos evolves much like their assets. Starting with primarily capital investment, the liability structure expands in both core deposits and money market liabili ties. By the end of the first year of operation, 68 percent of the average de novo's liabilities are in these categories. This number had risen to 86 percent by the end of the fifth year of the study, but even then amounted to only 79 percent of the average figure for Third District banks. On the other hand, the ratio of demand deposits to assets was simultaneously about the same for the average de novo in the group as for the average Third District bank. Income and Expenses. De novo banks see noticeable growth of interest income over the first few years of operation. For the 38 de novo FEDERAL RESERVE BANK OF PHILADELPHIA Patricia Brislin and A nthony M . Santomero De Novo Banking in the Third District New Banks Established in the Third District Since March 1985* Name of Bank Berks County Bank Bank of Brandywine Valley Bank of Delaware Valley Bank of Gloucester County Burlington County Bank Carnegie Bank Chestnut Hill National Bank The Coastal Bank Constitution Bank Commerce Bank of Harrisburg Commonwealth State Bank Community National Bank of NJ Equitable National Bank First Bank of Philadelphia First Capitol Bank First Commercial Bank of Philadelphia First Executive Bank First Pennsylvania Bank (NJ), N.A. First State Bank First Sterling Bank First Washington State Bank Freedom Valley Bank Founders' Bank Glendale Bank of Pennsylvania Jefferson Bank of New Jersey The Madison Bank Metrobank, N.A. National Bank of the Main Line Pennsylvania State Bank The Pocono Bank Regent National Bank Republic Bank Rittenhouse Trust Company Security First Bank Security National Bank Sun National Bank Trust Company of Princeton United Valley Bank City, State Reading, PA West Chester, PA Fairless Hills, PA Deptford, NJ Burlington, NJ Princeton, NJ Philadelphia, PA Ocean City, NJ Philadelphia, PA Camp Hill, PA Newtown, PA Westmont, NJ Upper Darby, PA Philadelphia, PA York, PA Philadelphia, PA Philadelphia, PA Marlton, NJ Wilmington, DE Devon, PA Windsor, NJ West Chester, PA Bryn Mawr, PA Upper Darby, PA Mount Laurel, NJ Blue Bell, PA Philadelphia, PA Wayne, PA Camp Hill, PA Milford, PA Philadelphia, PA Philadelphia, PA Philadelphia, PA Media, PA Pottstown, PA Medford, NJ Princeton, NJ Wayne, PA Established Assets (1/1/90) 12/01/87 08/01/88 10/31/89 11/06/89 03/02/88 03/09/88 05/09/85 02/26/88 06/02/86 06/01/85 04/08/87 10/02/87 04/13/87 07/22/87 11/21/88 10/24/89 11/03/88 11/02/87 11/21/88 06/01/88 12/04/89 06/09/86 07/14/88 12/18/87 08/25/88 08/16/89 06/01/89 03/18/85 04/24/89 11/09/88 06/05/89 09/06/88 04/01/87 08/01/88 09/27/88 05/06/85 01/24/87 02/04/88 $76,111,000 $20,350,000 $4,441,000 $6,569,000 $26,623,000 $45,723,000 $50,927,000 $42,926,000 $124,980,000 $59,161,000 $37,975,000 $39,449,000 $15,146,000 $73,778,000 $18,590,000 $5,517,000 $45,503,000 $64,449,000 $30,531,000 $42,319,000 $6,569,000 $81,826,000 $33,319,000 $37,330,000 $29,964,000 $12,459,000 $21,149,000 $109,395,000 $8,205,000 $15,200,000 $90,614,000 $35,887,000 $18,974,000 $28,368,000 $21,173,000 $39,188,000 $45,082,000 $68,918,000 T h is list excludes savings banks, credit-card banks, other special-purpose banks, and one subsidiary of an existing holding company that entered the market at an unusually large size. It does, however, include several subsidiaries of existing bank holding companies that were created to enter new markets but that appeared in other respects to behave similarly to the independent banks in the de novo sample. 5 BUSINESS REVIEW JANUARY/FEBRUARY 1991 banks, interest income accounted for 74 per 20 quarters of operation. ROA measures how cent of total income in the initial quarter of well the bank is utilizing its assets. ROE meas operation and 98 percent in the most recent ures the return on invested capital in the bank. quarter. Both are used to evaluate an institution's prof The composition of expenses for all de no- itability. In the Third District, de novo banks' vos changes substantially over time. Overhead average ROA and ROE turn positive around expenses account for 92 percent of total ex the seventh quarter of operation. However, penses in the first quarter of operation of a ROA stays approximately constant over the typical de novo. Interest expenses in the first remaining quarters in our sample, while ROE quarter are only 5.3 percent of total expenses, fluctuates and continues to grow. as the bank has not yet had time to attract a substantial deposit base. But in subsequent FURTHER COMPARISON quarters, the relative importance of interest TO THIRD DISTRICT PERFORMANCE The first two years of a bank's life are unique expenses increases; overhead falls proportion ately. For de novos at the end of their fifth year in many ways as it struggles to become profit of operation, the expenses on average consist able. By looking at a special subset of de of approximately 70 percent interest and 27 novos—those in existence at least two years as of December 1989— we can learn more about percent overhead. New organiza tions inevitably run losses at early FIGURE 1 stages of their de velopment. Then, Income and Expenses of De Novo Banks as assets increase, (38-Bank Sample) interest incom e Percent of Average Assets grows to more than offset these ex penses. These re sults are not sur prising. Of note, however, is the speed with which Third District de novos have reached profitability (Figure 1 ). ROE and ROA. This performance can be illustrated by exam ining the sample institutions' average return on assets (ROA) and return on equity (ROE) for the first 6 * Net of interest expenses, to normalize for interest rate movement across the sample. Source: Federal Financial Institutions Examination Council, Quarterly Reports of Condition and Income for Insured Commercial Banks FEDERAL RESERVE BANK OF PHILADELPHIA De Novo Banking in the Third District Patricia Brislin and Anthony M . Santomero the challenges facing de novos and the strate tate loans, more commercial and industrial gies by which they confront those challenges. (and other) loans, and fewer consumer loans Nineteen of the 38 de novos established since than the average Third District bank. These 1985 meet this criterion. Let's restrict the com proportions, however, appear to change over parison of performance in this section to these time. For example, the concentration in real 19 banks and the average Third District institu estate loans changed from approximately 23 tion. Profitability. Average FIGURE 2 ROA and ROE of all Third Average ROA of Banks District banks have been rela in the Third District tively stationary over the R O A (percent) entire sample period, at ap proximately 1 percent and 12 percent, respectively. Like those of all 38 de novos de scribed above, the ROA and ROE of the 19-bank sub sample grew rapidly at first, then remained constant over the last year of operation, at approximately half the aver age for the Third District (Fig ures 2 and 3). This results in an ROE for the sample of near 5 percent, which might Source: Same as Figure 1 seem a less-than-stellar re turn to the average investor FIGURE 3 in these new banks and un Average ROE of Banks acceptable as a long-run re turn to invested equity capi in the Third District tal. Such a judgment, how ever, may be premature given the recent origin of these banks. Portfolio Composition. The fraction of assets these de novos held as loans in the last quarter of 1989 (66.5 percent) was only slightly greater than the percentage held by Third District banks in general. Within this loan category, de novo banks hold, on average, approximately Source: Same as Figure 1 the same amount of real es 7 BUSINESS REVIEW percent of total loans in the first quarter of op eration to over 47 percent in the last quarter, while the proportion of commercial and indus trial loans fell from 38 percent to 30 percent (Figure 4). As researcher James Me Andrews points out in an article on Third District banks in the 1990s, high loan-to-asset ratios are typical of Third District banking. The new entrants seem to have followed their District counterparts in maintaining high loan-to-asset ratios and low securities-to-asset ratios. In the absence of defaults, loan yields exceed securities yields, making this a profitable strategy. At the same time, however, high loan-to-asset ratios and correspondingly low securities-to-asset ratios generally suggest that a bank is relatively illiq uid and may therefore have difficulty adjust ing to changing economic conditions. Securities-to-Assets Ratios. Besides hav ing slightly higher loan-to-asset ratios than the District average, the older de novos also tend to substitute "other assets"—a category that includes these banks' own brick and mortar—for securities. This emphasis may be regarded as a strategy of investing in the means of both attracting additional deposits and generating additional loans. Overall, the average de novo bank seems to focus its growth of assets in the direction of acquiring loans and other assets as opposed to securities. The composition of securities held by these de novos, moreover, differs from Third Dis trict averages (Figure 4). Compared to the District average, the 19-bank de novo sample holds more U.S. Treasury securities and fewer municipals and other securities. This is proba bly due to de novo banks' special need, at least initially, for high-quality liquid assets that can be quickly converted to loans as opportunity arises and yet pose no credit risk of their own. However, they seem to be decreasing their holdings of other securities and increasing their holdings of municipals over time. Deposit Financing. The average de novo 8 JANUARY/FEBRUARY 1991 FIGURE 4 Comparison of Asset Composition of De Novo and Third District Banks 1989Q4 (19 Banks) Total Loans De Novo Banks Total Loans Third District Banks Total Securities De Novo Banks Total Securities Third District Banks FEDERAL RESERVE BANK OF PHILADELPHIA De Novo Banking in the Third District bank's liability structure is similar to that of the average Third District bank. In the last quarter of 1989, the established de novos' average core deposits per average assets were approximately 87 percent of the Third District average, while average demand deposits of de novos were 98 percent of the Third District average. These comparisons provide some indica tion of what de novos have accomplished and where they are headed. The growth rate of these banks has been rapid, more than four and a half times the District's average asset growth rate as of the end of 1989. Together, the sub stantial asset growth, high loan-to-asset ratios, and reliance on core deposits suggest that de novos provide a useful function in their mar ketplace. Their profits, however, while posi tive on average, have yet to achieve a level comparable to the industry average or to their established Third District counterparts. ARE ALL DE NOVOS ALIKE? In the comparisons above, we have been treating all de novos as a group. But that treatment may mask some significant differ ences in their strategy and performance. Winners and Losers. While the average de novo has reached profitability by the end of the second year, this has not been true for all the institutions. In fact, the return on assets after two years of operation varied from -1.22 per cent to 1.58 percent for the 19-bank sample. A median value of 0.32 percent therefore masks substantial differences. For new institutions these differences are most important, for they may indicate the ability of these banks to find a long-run place in the Third District market place. In addition, average balance-sheet structure and loan-to-asset ratios overlook significant differences in strategy within the de novo group. For the 19 banks operating for at least two years, the loan-to-asset ratio averages 66.5 percent of total assets. The range, however, is between 45 percent and 83 percent. Four Patricia Brislin and A nthony M. Santomero institutions—First Pennsylvania Bank (NJ), N.A., Chestnut Hill National Bank, Glendale Bank of Pennsylvania, and United Valley Bank—had more than 75 percent of their total assets in the form of loans. Loan Specialization. Within the loan cate gory, most banks tended to specialize. The most common specialization was in the area of real estate lending, to which these institutions, on average, devoted more than 50 percent of their loan portfolio after two years of opera tion. Carnegie Bank, Trust Company of Prince ton, and Equitable National Bank committed more than four-fifths of their lending activity to this segment of the market. On the other hand, Sun National Bank and Rittenhouse Trust Company reported no such loans, and First Pennsylvania Bank (NJ), N. A., had less than 20 percent in this category. Commercial and industrial lending made up one-third of the loan portfolio, on average, but varied widely within the sample. Constitution Bank clearly targeted this area for concentration by devoting 92 percent of its loans to this category, and Burlington County Bank devoted 57 percent of its portfolio to this segment. By contrast, Community National Bank of New Jersey, Commonwealth State Bank, Glendale Bank of Pennsylvania, and Equitable National Bank had less than 10 percent of their portfolio in commercial loans. Consumer lending traditionally begins slowly for new banks. Accordingly, it is not surpris ing that, after two years of operation, less than 10 percent of these banks' loans were made to consumers. Consumer lending at Constitution Bank, First State Bank, and Equitable National Bank was negligible. However, Rittenhouse Trust Company, First Pennsylvania Bank (NJ), N.A., and Chestnut Hill National Bank had more than twice the average percentage in their consumer portfolio. While this evidence suggests that many de novos have been trying to specialize in various ways, the measures of product specialization 9 JANUARY/FEBRUARY 1991 BUSINESS REVIEW De Novo Market Entry: How Is it Done? Unlike most businesses, entrepreneurs wishing to enter the banking market cannot do so without constraint. They must first obtain a charter from either the State Banking Commissioner or, if a na tional bank, from the Office of the Comptroller of the Currency. In addition, in order to obtain deposit insurance, new entrants must make application to the Federal Deposit Insurance Corporation. In judging the merits of a charter request, the State Banking Commissioner and the Comptroller of the Currency have traditionally used two criteria. The principal criterion is the proposal's worthiness, as evidenced by the financial capital behind the new venture, the expertise of manage ment, and the intended business strategy. In addition, the charter proposal must satisfy a "conven ience and needs" test, which considers the social desirability of the proposed institution. In essence, the regulators ask if there is a demonstrated need for a new entrant in the marketplace. The relative importance of these two criteria has changed over time and may differ across chartering authorities; for example, in 1984 the Comptroller of the Currency reduced the emphasis on the "convenience and needs" test in the evaluation process. If the charter is accepted by the banking authorities as potentially viable, the relevant regulatory authority interviews the applicants and reviews the management team. Community reaction to the proposal is solicited at this point and, in some states, public hearings are held. Recommendations re sulting from this process are forwarded to either the State Banking Commissioner or the Comptroller of the Currency. If the authorities view the application favorably, the organization is granted a charter and the management team is permitted to proceed to serve the market. Clearly, banking is viewed as an activity that requires supervision. At both the state and national levels, attempts are made to restrict entry so that only entities meeting certain criteria operate in the market. Some contend that such a process is overly restrictive and that it enhances existing banks' monopoly positions. Others argue that entrance to the payments system must be restricted to only the highest-quality participants. The perceived likelihood of successfully obtaining a new charter has changed over time. Prior to 1984, new applications were rarely filed and, some observers contended, not encouraged by the regu latory authorities. Since then, however, some have argued that new entrants should be encouraged because they enhance the competitive environment. This may have contributed to the spate of de novo applications both in the Third District and in the nation over the past five years. available in the Call Reports fall short of iden tifying a single banking strategy. For example, the data do not reveal such customer speciali zation as a full-service private-banking strat egy, which might include concentrated lend ing to high-income customers, or a commer cial-lending strategy, which emphasizes busi ness lending to middle-market customers. Some researchers have suggested that suc cessful established banks tend to follow one of these specialized strategies; on the other hand, a bank serving more than one market may be able to achieve a more stable earnings flow. 10 The dynamic tension between a narrow focus for higher average profitability and diversifi cation for safety in adverse times remains a challenge for de novo banks in the Third Dis trict, and each bank must find its own way. Funding from Deposits. On the funding side, the average bank had raised, by the end of its second year, more than two-thirds of its funds from demand deposits and retail sav ings accounts. These quantities, which are typically from local sources, included both consumer and commercial deposits. The re maining one-third was obtained from owners' FEDERAL RESERVE BANK OF PHILADELPHIA De Novo Banking in the Third District equity and borrowed funds in the regional money market. However, institutions such as Trust Company of Princeton, Commerce Bank of Harrisburg, First State Bank, and National Bank of the Main Line needed little additional money to support their activities. Each had more than 80 percent of its portfolio supported by core deposits. In summary, the de novo trend in the Third District includes institutions of various charac teristics. They share a common experience: entrepreneurial adventure in a dynamic bank ing market. Yet each institution has chosen its own path, as illustrated by significant differ ences in financial performance, asset composi tion, and liability structure. Changes in the economic conditions under which these insti tutions function may have a further impact on relative performance and the ability to survive and prosper. THE FUTURE OF DE NOVO BANKS Previous studies find that de novo banks have had difficulty creating a stable market niche and that their profitability has been in consistent.1 Moreover, recent studies suggest that nearly half of de novos cease to exist within 10 years.2 Many reasonable explanations have been offered for the relative vulnerability of de novos. These banks need time to acquire a customer base and consumer loyalty. Meanwhile, they incur losses associated with large fixed costs and a general lack of experience in their chosen markets. Further, to break even requires sub 1Douglas V. Austin and Christopher C. Binkert, "A Per formance Analysis of Newly Chartered Commercial Banks," The Magazine of Bank Administration (January 1975) pp. 34-35. 2William C. Hunter and Aruna Srinivasan, "Determi nants of De Novo Bank Performance," Federal Reserve Bank of Atlanta Economic Review (March/April 1990) pp. 1425. Patricia Brislin and A nthony M. Santomero stantial asset growth, good credit judgment, and, at times, good luck. Their small size and vulnerability due to lack of loan diversification make them less likely to survive an economic downturn in their region or their area of con centration. Thus far, the Third District has been fortu nate in that no de novo in the group chartered since 1985 has failed. This fine record owes not just to the nation's long economic expansion, but to the strength of the regional economy. However, signs of a national economic slow down are clearly on the horizon. Already there have been impacts on reported earnings at regional banks throughout the country, as well as on money-center institutions. It will inevitably have a greater impact on new en trants here and elsewhere. At least partially because of the change in economic environment, de novo activity in the Third District has declined substantially over the last calendar year. Regulators granted only four new charters for full-service commercial banks within the Third District over the first three quarters of 1990. This decline in the trend may signal an end to the recent wave of new en trants into the banking market as prospective entrants await calmer waters to launch their new institutions. SUMMARY De novo banks are an important force in American banking. In many respects, they dif ferentiate the American system from its more concentrated counterparts worldwide. Entry, even if regulated, adds an entrepreneurial spirit to any industry and allows the industry to serve its market more efficiently. Within the Third District, fully 13.4 percent of operating institutions are less than five years old. These new entrants have entered a mature market and have performed well. On average, they break even in approximately two years and maintain a positive, if low, return on assets in the subsequent period. The secret to their li JANUARY/FEBRUARY 1991 BUSINESS REVIEW performance is substantial growth of highquality assets in the first few years, coupled with the development of a strong core deposit base. In addition, successful banks exhibit a competitive strategy that exploits market niches left open in a consolidating industry. These institutions should be encouraged to continue serving their market. Yet, the prospects for de novo banks are not all rosy. By their nature these institutions can not be broadly diversified and they face an uncertain future. Previous studies have shown that nearly half disappear, usually through consolidation, within the first decade. Whether this will be the fate of the Third District de novos is an open question. For the present, however, the customers and stockholders of these banks appear to find value to their pres ence in the Third District market. REFERENCES Arshadi, Nasser, and Edward C. Lawrence. "An Empirical Investigation of New Bank Perform ance," Journal of Banking and Finance 11 (March 1987) pp. 33-48. Austin, Douglas V., and Christopher C. Binkert. "A Performance Analysis of Newly Chartered Commercial Banks," The Magazine of Bank Administration (January 1975) pp. 34-35. Dunham, Constance R. "New Banks in New England," Federal Reserve Bank of Boston New England Economic Review (January/February 1989) pp. 30-41. Fraser, Donald R., and Peter S. Rose. "Bank Entry and Bank Performance," Journal of Finance (May 1972) pp. 65-78. Heaney, Christopher K. "The New Banks in Town," ABA Banking Journal (October 1986) pp. 10409. Huyser, Daniel. "De Novo Bank Performance in the Seven Tenth District States," Federal Reserve Bank of Kansas City Banking Studies (1986) pp. 13-22. Hunter, William C., and Aruna Srinivasan. "Determinants of De Novo Bank Performance," Federal Reserve Bank of Atlanta Economic Review (March/April 1990) pp. 14-25. McAndrews, James J. "How Will Third District Banks Fare in the 1990s?" this Business Review (January/February 1990) pp. 13-25. McCall, Alan S., and Manfred O. Peterson. "The Impact of De Novo Commercial Bank Entry," Journal of Finance 32 (December 1977) pp. 1587-1604. 12 FEDERAL RESERVE BANK OF PHILADELPHIA Coping with State Budget Deficits Janet G. Stotsky* n recent years, state budgets have been the economy. After recovering from a severe re bright spot amid government budgetary cession in 1981-82, much of the nation, espe problems. But now, like the federal govern cially the East and West coasts, experienced ment, many states, especially those in the robust economic expansion. Many coastal states Northeast, are facing budget problems. And used this opportunity to increase spending more bad news may be on the way for states rapidly for a wide range of programs. But that have so far slid by with only minor adjust other regions, such as the Midwest, did not ments. prosper to the same degree. Unable to engage The primary reason for these budgetary in the same spending splurge, they were left imbalances is the slowdown in the national with healthier budget situations as the econ omy slowed. Meanwhile, states heavily de pendent on energy industries never experi *Janet G. Stotsky is an Assistant Professor of Economics enced the boom at all, instead sinking into at Rutgers University in New Brunswick, N.J. She wrote this recession as oil prices fell in the mid-1980s. article while she was a Visiting Scholar in the Research Department of the Federal Reserve Bank of Philadelphia. These states are finally emerging from their I 13 JANUARY/FEBRUARY 1991 BUSINESS REVIEW budget problems just as others tumble in (Fig ure 1). What are the causes of recent state budget problems? How do states manage these prob lems? And are there ways in which states can minimize these problems? WHY ARE THERE PROBLEMS? Economic slowdowns cause budget prob lems for state governments by reducing reve nues and increasing some expenditures above expected levels. (See How States Forecast Reve nues, p. 16.) In the past decade, this fiscal stress during economic downturns has been com pounded by cutbacks in federal government aid, increased demands from local govern ments, relentlessly rising costs for certain basic services, and the inability of states to accumu late sizable reserves. The Impact of Economic Growth on Ex penditures and Revenues. During slowdowns, state spending rises above expected levels as people lose their jobs or face reduced work weeks and become eligible for unemployment compensation, welfare, and other income-trans fer programs.1 Moreover, slowdowns cause tax revenues to decline below expected levels. States are cushioned somewhat from the full impact of these cyclical changes because they share funding responsi bility with the federal government. States currently pay approximately 44 percent of the two largest means-tested FIGURE la Regions in Which State Expenditures Grew More Slowly in the 1980s... (Fiscal 1980 -1988) % Growth of General Expenditures 4.4 1 I I i Tt T i I I I I I I I Far West South West Rocky Plains Mountain 19k Great Lakes SouthEast MidEast New England Note: Balances are budget stabilization and Rainy Day Funds. Because of inconsistencies that arise from definitional changes in General Fund data at the state level, we have chosen to use General Expenditures for the time series in Figure la. Source: U.S. Bureau of the Census 14 FEDERAL RESERVE BANK OF PHILADELPHIA Janet G. Stotsky Coping With State Budget Deficits States can make the transition from boom to bust very quickly and unexpectedly. "Over the last 18 months, tax revenues have fallen pre cipitously and we still don't know where the bottom is," said S. Stephen Rosenfeld, chief secretary to former Governor Michael S. Dukakis of Massachusetts, one of the states with the income-transfer programs, Aid to Families with Depend ent Children (welfare) and Medicaid (medical assistance for the poor). This raises the issue of what is the appropriate role of the federal and state governments in providing income insurance. The federal government has been seen as the principal provider of this insurance because it has greater capacity for countercyclical spending and a broader tax base. See Wallace E. Oates, Fiscal Federalism (Harcourt Brace, 1972) for further discussion of this point. worst budgetary problems.2 The sensitivity of revenues to changes in the level of economic output or income is meas ured by what economists term the income elas ticity of revenues.3 The more sensitive tax 2A s quoted in Michael deCourcy Hinds, "Half of States Strive to Avert Perilous Deficits," New York Times, March 4, 1990. 3The income elasticity of revenues is given by the per centage change in revenues divided by the percentage change in income. An elasticity greater than 1 indicates that revenues change by a greater proportion than income, which is termed an elastic response. An elasticity less than 1 indicates that expenditures or revenues change by a smaller proportion than income, which is termed an inelas tic response. FIGURE lb ... and Had a Better Cash Balance in 1990 (Fiscal 1990) Balances as a % of General Fund Expenditures 10 - - Far West South West Rocky Plains Mountain Great Lakes SouthEast MidEast 2.8 New England Source: Marcia Howard, Fiscal Survey of the States, National Governors' Association and National Association of State Budget Officers (March 1990) 15 BUSINESS REVIEW JANUARY/FEBRUARY 1991 How States Forecast Revenues State governments base spending on revenue forecasts, so it is essential that they have a precise method for forecasting revenues. Unfortunately, forecasting revenues is an imperfect science. State budget offices use several different methods. A common one is to simply extrapolate previous trends into the near future. This method, however, fails to incorporate all of the information about future economic conditions that may be available to budget planners. Another method, which has become more widespread in recent years, is to use regression analysis and formal econometric models.3 Two recent studies1find that state revenue forecasts tend to have a downward bias, meaning that * revenues tend to be underestimated. This bias should, in theory, help states guard against budget shortfalls. Several reasons have been suggested for a downward bias to revenue estimates.c First, uncertain tax revenues mean that states cannot be assured of meeting revenue targets. With a bal anced-budget requirement, a downward bias to the forecast protects against an unexpected shortfall. Second, a downward bias to the revenue forecast means that a state is likelier to end up with a surplus and may create discretionary funds for the executive. In separate studies, William Klay and William Gentry suggest that a downward bias to revenue forecasts is undesirable because, with a balanced-budget requirement, such a forecast constrains spending. An upward bias (revenues are overestimated) may allow states with balanced-budget re quirements to realize budget deficits when the state runs out of money at the end of the fiscal year. But politicians come under pressure when either a large deficit or surplus occurs. Large deficits must be eliminated, and surpluses suggest that taxes were set too high. This bias against either deficits or surpluses should mitigate the tendency for either a pronounced downward or upward bias. Politics may unduly influence economic forecasts and budget policy. Even if a state budget office were successful in predicting an economic downturn, it might be hard to convince elected officials to cut spending plans or raise revenues before the downturn had actually materialized. Thus, the political bias may be to ignore the signs of a downturn until the budgetary situation has become dire and support can be galvanized for cutbacks in spending or for revenue increases. aSee Daniel R. Feenberg, William Gentry, David Gilroy, and Harvey S. Rosen, "Testing the Rationality of State Revenue Forecasts," The Review of Economics and Statistics (May 1989) pp. 300-08. They find little evidence to suggest that econometric techniques provide superior forecasts, though their sample is limited to only three states. bSee Feenberg and others (1989) and William M. Gentry, "Do State Revenue Forecasters Utilize Available Information?" National Tax Journal (December 1989) pp. 429-39. cSee William E. Klay, "Revenue Forecasting: An Administrative Perspective," in J. Rabin and T.D. Lynch, eds., Handbook of Public Budgeting and Financial Management (Marcel Dekker, 1983). revenue is to changes in income, the greater the elasticity. Personal and corporate income taxes are generally regarded as having the greatest income elasticities, followed by the general sales tax, wealth taxes, and selective sales taxes.4 4See "Federal-State-Local Fiscal Relations," Office of State and Local Finance, Department of the Treasury (Sep tember 1985) p. 341. 16 Since state governments derive a large part of their tax revenues from a mix of income taxes and the general sales tax, their tax revenues tend to be elastic. This dependence on incomeelastic taxes exerts a destabilizing influence on the budget because revenues grow more rap idly than income in expansions and revenues shrink more rapidly in recessions.5 In recent decades, state governments have relied increasFEDERAL RESERVE BANK OF PHILADELPHIA Coping With State Budget Deficits Janet G. Stotsky ingly on income-based taxes, making state taxes more sensitive to economic fluctuations.67 * Intergovernmental Pressures. State bud- ^ h is was first noted in Harold M. Groves and C. Harry Kahn, "The Stability of State and Local Tax Yields," Ameri can Economic Review (March 1952) p. 88. William F. Fox and Charles Campbell, in "Stability of the State Sales Tax Income Elasticity," National Tax Journal (June 1984) pp. 201-12, investigate the stability of the sales tax income elasticity over the business cycle and argue that a varying elasticity may provide more stability than a constant one. ^The cyclical sensitivity of the income tax depends in part on the degree of progressivity of the tax. The more pro gressive the income tax system, the greater the cyclical sen sitivity. As incomes rise, taxes rise more than proportion ately as people are pushed into higher tax brackets; as incomes fall, taxes fall more than proportionately as people fall into lower tax brackets. It is difficult to gauge the pro gressivity of any particular income tax system because it can have so many dimensions. Some states, such as Pennsylva nia, do not have highly graduated tax rate structures, mak- getary problems have resulted not only from cyclical changes but also from substantial cut backs in federal aid to state governments. Over the decade, federal aid has fallen as a share of state and local outlays, declining from 26 per cent in 1980 to 17 percent in 1989 (Figure 2)7 As ing them less progressive than the federal code, which has a more graduated structure. On the other hand, some sys tems may disallow most deductions that primarily benefit higher-income taxpayers, enhancing their progressivity compared to the federal code, which allows many deduc tions. 7We aggregate state and local aid because the break down between state and local responsibilities varies from state to state and because some of the federal aid to states is passed through to local governments. An increasingly large percentage of the aid is direct grants to individuals through income-transfer programs, rather than aid for state and local government programs. FIGURE 2 Federal Grants-In-Aid Decline as a Percentage of Total State-Local Outlays (Fiscal 1970 -1989) Percent 30 ------------------------------------------------------------- ------- ---------------- _ 1970 1975 1980 1981 1982 1983 1984 _ 1985 _ --------- ----------------- 1986 1987 1988 1989 Source: "Significant Features of Fiscal Federalism," Advisory Commission on Intergovernmental Relations, Vol.l (January 1990) 17 BUSINESS REVIEW a result, states must depend more on their own resources to pay for public services. One recent change in the federal tax law has compounded the effects of these aid cutbacks. The Tax Reform Act of 1986 eliminated the de ductibility of the state sales tax for federal tax purposes. This deductibility had lowered the cost of the sales tax for taxpayers who itemized deductions on their federal income tax returns. In effect, these taxpayers did not pay federal taxes on income used to pay the state sales tax.8 The elimination of deductibility means that states cannot shift part of the burden of the sales tax to the federal government.9 Another source of pressure on state govern ments has come from local governments. In recent years, state governments have been under pressure from hard-pressed cities, counties, and school districts to assume responsibilities for certain programs and to increase intergov ernmental aid. This aid is substantial, compris ing more than one-third of state general expen ditures. Revenues from the local property tax, the mainstay of local tax revenues, have been unable to keep up with demands for local public services. The pressures stem also from demands at the local level for redistribution 8For every $1 the taxpayer pays in deductible state and local taxes, federal taxable income is lowered by $1. Thus, the effective price of a dollar of state taxes is 1 minus the taxpayer's marginal tax rate. If the taxpayer faces a mar ginal tax rate of 28 percent, the effective price of $1 of state tax payments is $1 minus 28 cents, or 72 cents. See Harvey S. Rosen, "Thinking About the Deductibility of State and Local Taxes," this Business Review (July/August 1988) pp. 15-23, for a discussion of this issue. 9Another change was limiting the use of tax-exempt state debt for private purposes, which state governments use to subsidize private businesses. The tax-exempt feature of this debt allows state governments to issue it at a lower interest rate than prevails in the market because its return must only be competitive with the after-tax return to taxable debt. By curtailing the use of this debt, state governments will have to find other means to provide these subsidies. 18 JANUARY/FEBRUARY 1991 from wealthier communities to poorer com munities.1 0 Cost Pressures. In addition to the intergov ernmental pressures, state governments face relentlessly rising costs for many important public services. Medicaid is one such area. In recent years, health care costs have been rising more rapidly than inflation. In addition, Con gress has mandated new benefits for Medicaid enrollees or expansion of coverage, and federal courts have ordered states to increase reim bursement rates to hospitals. States are also spending an increasing share of their budgets for corrections because of severe prison over crowding. In fact, many states are under courtordered mandates to improve conditions in their prison systems. Low Levels of Reserves. A contributing factor to states' current budgetary problems is the low level of cash reserves they hold. Many states have Rainy Day Funds in which they hold surplus revenues for times of budgetary stress. A generally accepted rule of thumb in state government budgeting is that reserves be equal to approximately 5 percent of the current budget. Cash reserves can be used to create a countercyclical fiscal policy. As revenues fall in a downturn, previously accumulated cash reserves can be used to cushion the impact of 10Public education is one area where most state govern ments are under pressure to increase their funding respon sibilities. Although public primary and secondary school education was once largely the responsibility of local gov ernments, approximately half of the funding for it now comes from state governments. In some cases, this spending results from court-ordered mandates to equalize spending across school districts. An example is the June 1990 New Jersey Supreme Court decision that requires substantial increases in funding to poor school districts. In 1990, the New Jersey legislature enacted an increase in the state income tax for the purpose of funding equalizing aid to school districts across the state, with the lowest-income communities scheduled to receive a larger share of this aid. Litigation, currently under way in many states, may require similar actions elsewhere. FEDERAL RESERVE BANK OF PHILADELPHIA Coping With State Budget Deficits Janet G. Stotsky this shortfall. As revenues rise in an upturn, surpluses can be allowed to accumulate.1 1 In recent years, the arrangements for Rainy Day Funds have become more formalized, even though most states have not met their reserve goals. As a practical matter, it is difficult for state governments to maintain reserves, since there are always pressing needs and political pressure for government spending. Thus, the n See Richard Pollock and Jack P. Suyderhoud, "The Role of Rainy Day Funds in Achieving Fiscal Stability," National Tax Journal (December 1986) pp. 485-97, for a dis cussion of how states can use Rainy Day Funds to achieve fiscal stability. Also see Peter D. Skaperdas, "State and Local Governments: An Assessment of Their Financial Po sition and Fiscal Policies," Federal Reserve Bank of New York Quarterly Review (Winter 1983-84) pp. 1-13. levels of these reserves tend to be lower than needed to ease any but the most minor budget shortfalls (Figure 3). LIMITATIONS ON STATE GOVERNMENTS Unlike the federal government, states can not submit a budget that will be balanced by the issuance of debt. All, except Vermont, face balanced-budget requirements on their oper ating budgets. In contrast to the federal gov ernment, state governments separate their budgets into a current (or operating) budget and a capital budget. The operating budget refers to expenditures and revenues for the current year. Operating expenditures include general expenditures for all functions, some utilities expenditures, pension contributions, and payments for debt service. Operating FIGURE 3 The Sizes of Total State Year-End Balances Are Low as a Percentage of Expenditures (Fiscal 1978 -1991) Percent 10 1918 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990* 1991* * Estimated Source: Fiscal Survey of the States (March 1990) 19 B U S IN E SS R EV IE W revenues include taxes, fees, intergovernmen tal aid (mostly from the federal government), and interest on investments. The capital budget refers to expenditures and revenues for long term capital projects, such as the construction of schools and highways. Capital projects are typically financed by borrowing. Stringency of the balanced-budget require ment varies from state to state. Some state gov ernments are required only to submit a bal anced budget, but may be allowed to borrow at year-end if they run out of funds. Other state governments are required not only to submit a balanced budget, but to realize a balanced budget at year-end. This requirement is more restric tive since it means that states must act immedi ately to bring their budgets into balance if expenditures exceed or revenues fall short of expectations. The advantage, however, is that states are forced to address their problems immediately and cannot compound fiscal woes by pushing off deficits into the future. The Third District States—Delaware, New Jersey, and Pennsylvania—all share the limita tion that the governor must submit a balanced budget, the state legislature must pass a bal anced budget, and the governor must sign a balanced budget. Of the three, only Pennsylva nia is allowed to carry over the deficit into the next fiscal year, which gives it greater budget flexibility. Although balanced-budget requirements limit a state government's flexibility in times of budget shortfalls, this limitation on the uses of govern ment debt is important. The use of long-term debt to finance capital projects, for example, spreads out the cost of these projects over a long-term horizon. If the benefits of these projects accrue over the same or a similar hori zon, then it is fair that future taxpayers pay part of the cost of these projects. The use of long term debt to finance current expenditures is not justified unless the government seeks to make an explicit transfer from future taxpayers to present taxpayers. 20 JA N U A R Y /FE BR U A R Y 1991 To avert cash-flow problems under normal budgetary conditions, some state governments may issue short-term debt. But states may create fiscal dilemmas if they issue large vol umes of short-term debt and carry this debt over into subsequent years to hide persistent budget deficits. States may also create fiscal problems if they redefine current expenditures as capital expenditures, in order to circumvent balanced-budget requirements.1 2 High levels of long- or short-term debt can impose undue debt-service burdens on gov ernment. For instance, high levels of debt and debt per capita have been linked to lowered bond ratings and higher interest costs on debt.1 3 These higher interest costs can substantially raise the cost of capital projects, possibly lead ing to inadequate investment in infrastructure. Tax Limitations. State governments fight a difficult battle to obtain tax increases. The points President Bush scored with his "no new taxes" pledge suggests the hostility taxpayers have to tax increases. And voters convey this message loudly and clearly at the polls, having frequently voted to overturn tax increases and budgets in recent years. In addition, the tax revolt of the late 1970s and early 1980s led to the passage of tax and expenditure limitations in many states. The most common form is to limit the growth of revenues or expenditures to the growth of state personal income. Several states limit growth to the sum of the inflation rate and the growth in population, or to fixed 12See Robert P. Inman, "Anatomy of a Fiscal Crisis," this Business Review (September/October 1983) pp. 15-22, for a discussion of how this and other practices led to local fiscal crises during the 1970s. Also see Edward M. Gramlich, "The New York City Fiscal Crisis: What Happened and What Is to Be Done?" American Economic Review (May 1976) pp. 415-29. 13See Pu Liu and Anjan V. Thakor, "Interest Yields, Credit Ratings, and Economic Characteristics of State Bonds: An Empirical Analysis," Journal of Money, Credit, and Banking (August 1984) pp. 344-51. FED ERA L R E SE R V E B A N K O F PH ILA D ELPH IA Coping With State Budget Deficits annual percentage increases. Evidence sug gests, however, that these limitations have not been very effective in constraining state gov ernments.1 Nevertheless, state officials work 4 within a constrained environment, having lim ited ability to raise additional revenues. CURES FOR BUDGET DEFICITS If a budget deficit arises, it can be financed in several different ways.1 One way is to draw 5 down any reserve funds. Large deficits, how ever, require spending and revenue adjust ments that can either be short or long term in nature. Postpone or Cut Spending. On the spend ing side, a large deficit may require states to postpone or cut spending. States may have some short-term flexibility in paying their obli gations. One well-known tactic is to move expenditures— such as payments to state gov ernment employees, to vendors, or to local governments— into the next fiscal year. This tactic may allow a state to avoid a current-year operating deficit; however, it is at best a stop gap strategy because the additional revenues must be raised in the following year. States may also defer or eliminate capital expendi tures, though delaying needed projects may raise their ultimate cost. Other tactics include undermaintaining the infrastructure and un 14See Daphne A. Kenyon and Karen M. Benker, "Fiscal Discipline: Lessons from the State Experience," National Tax Journal (September 1984) pp. 433-46, and Dale G. Bails, "The Effectiveness of Tax-Expenditure Limitations: A Re-evalu ation," American Journal of Economics and Sociology (April 1990) pp. 223-38. Bails presents evidence suggesting that tax limits appear to resemble floors more than ceilings. He does not, however, address the issue of how high taxes would have risen in the absence of these limitations. Cali fornia and Massachusetts would seem to be the two excep tions where tax revolts did result in a significant impact on tax and spending levels. 15See Corina L. Eckl, "State Deficit Management Strate gies," National Conference of State Legislatures (November 1987) pp. 1-74. Janet G. Stotsky derfunding the contribution to the employees' pension system or borrowing from it. But these tactics, while they may result in some short term gains, only thrust the problems onto fu ture taxpayers.1 6 State governments can also cut spending. The main problem on the spending side is that states have little flexibility for cutting their budgets in the short term. A large proportion of state spending goes for goods and services, including contractual wages and salaries, leav ing state governments with little room for dis cretionary spending cuts. Even in the long term, employees will not typically accept cuts in their nominal wages. It may be possible, however, to cut spending by imposing a hiring freeze or by reducing the size of the work force. Since state governments provide sizable aid to local governments, this is one area in which they may have some flexibility in cutting spend ing, although, in the case of education, the largest aid component, they may face restric tions on short-term cuts. In addition, reducing aid to local governments may help a state government tackle a budget crunch, but it ends up pushing the problem onto local govern ments. Where state governments have budget flexi bility, they may choose either across-the-board or selective cuts. Across-the-board cuts give the appearance of distributing the burden equi tably, but they are not typically justified on economic grounds unless the last dollars spent on all programs are equally valued. The prob lem state governments face with spending cuts is that the need for these cuts generally appears well into a fiscal year. Thus, the burden of cutbacks falls more heavily on departments and programs than if the cutbacks were spread out evenly over the entire fiscal year. A cut- 16See Robert P. Inman, "Paying for Public Pensions: Now or Later?" this Business Review (November/December 1980) pp. 3-12. 21 BUSINESS REVIEW back of 4 percent for the year translates into an 8 percent cutback if it applies only to the latter half of the year. In the long term, states may have to rethink priorities for state spending and redirect money to programs that they feel are the most essen tial. These changes require a certain degree of political consensus between the governor and the state legislature, however. Raising Taxes. On the revenue side, a large deficit may require governments to take such short-term measures as accelerating their col lection of taxes or raising taxes or other reve nues. State governments can accelerate tax collection by changing the interval for collec tion from annual to quarterly or from quarterly to monthly. This creates a bonanza in the first year because of the earlier collection of taxes. But unless the collection is slowed thereafter, this tactic can only be used once. State govern ments may also increase tax revenues by rais ing the rate of existing taxes, by broadening the base to which a tax applies, or by instituting a new source of tax revenues altogether. None of these methods is easily accomplished. To raise substantial amounts of additional revenues, state governments generally turn to the general sales or income taxes, the largest state taxes, comprising approximately 20 and 23 percent of general revenues, respectively. Even a small change in these tax rates can produce large increases in revenues. The sales tax is typically viewed as falling dispropor tionately on lower-income households and the personal income tax as falling disproportion ately on higher-income households, which may enhance the political appeal of the personal income tax. Selective sales or excise taxes may also be used as a source of revenues and are sometimes easier to raise expeditiously be cause they are perceived as involving smaller amounts of revenues than the more broadbased taxes. State governments can also raise taxes by broadening the base of the tax. Although the 22 JANUARY/FEBRUARY 1991 general sales tax originally applied only to goods, many states have now extended it to services as well— potentially a large source of revenues. Taxing services would be likely to reduce cyclical variation in sales tax revenues because purchases of many services are less cyclical than purchases of consumer durables. Moreover, the general sales tax can be broad ened by adding goods to the base that are now exempt. This would also reduce cyclical vari ation in sales tax revenues because exempt items tend to be necessities and expenditures on them would be less likely to vary with economic conditions. This would have the undesirable effect of increasing the tax burden on lower-income households. The elimination of sales tax deductibility for federal tax pur poses has made sales taxes a less attractive source of new revenues for the states. They are more likely to cut back spending or shift to ward other forms of revenues.17 The base of the income tax can be broadened by eliminating deductions, exclusions, and other preferences. State governments also face the following dilemma: although in the short run raising taxes may help balance budgets or fund public services, in the long run these taxes may inhibit businesses and households from wanting to locate or remain in the state. Thus, the long-run tax base may be hurt by high taxes. But the effect may be mitigated to the extent that higher taxes pay for better public services.1 8 17See Janet G. Stotsky, "The Effect of the Elimination of State Sales Tax Deductibility on State Fiscal Decisions," Public Finance Quarterly (January 1990) pp. 25-46, for evi dence that this change should lead to less reliance on the state sales tax. 18See Michael Wasylenko and Therese McGuire, "Jobs and Taxes: The Effect of Business Climate on States' Em ployment Growth Rates," National Tax Journal (December 1985) pp. 497-511, and L. Jay Helms, "The Effect of State and Local Taxes on Economic Growth: A Time Series-Cross Section Approach," The Review of Economics and Statistics (November 1985) pp. 574-82. FEDERAL RESERVE BANK OF PHILADELPHIA Coping With State Budget Deficits User Fees. Another way to raise revenues is by charging or increasing user fees for services. These fees could be tolls for highways, bridges, and tunnels, or tuition at state universities. The advantage of user fees is that they are paid in proportion to the use of the service and thus resemble payments for private goods. The disadvantage is that they tend to discourage the use of these services, which may be basic services, and their burden falls disproportion ately on lower-income households. States may thus use many different methods to correct budget imbalances. On the spending side, they may delay spending or make cuts in already budgeted programs. On the revenue side, they may raise taxes or other fees. Some states may also issue short-term debt. Budget balancing usually requires a combination of methods, all of which involve a certain amount of discomfort. HOW SOME STATES ARE COPING State governments in the Northeast have dealt with their recent budget difficulties in different ways. In Massachusetts, budget defi cits have all but paralyzed the state govern ment for the past two years. The state has faced budget problems since midway through fiscal year 1989 and in 1990 ran a deficit of approxi mately $661 million, the largest of any state in the nation. After relying on a temporary tax in crease in 1990 to prevent this deficit from being even wider, the state legislature passed a taxincrease plan that will substantially raise state income taxes and extend the sales tax to cover, for the first time, some professional services. Nevertheless, the fiscal discord remains. Massachusetts recently elected a governor who campaigned on a platform of rolling back some of the tax increases, though a voter referendum to roll back taxes was defeated. Meanwhile, the rating agencies have given Massachusetts the lowest bond rating of any state. In New York State, state government offi cials faced a large deficit in fiscal year 1990, but Janet G. Stotsky could reach no budget resolution until com pelled by the severe downgrading of the state's bond rating to its lowest level ever. The legis lature finally opted, in a budget accord seven weeks overdue, to forgo the last phase of a scheduled reduction in state personal income tax rates and to raise taxes on corporations, professional services, and various other items. Nevertheless, it is not clear that New York State officials will address some important management issues, particularly the state's extensive reliance on short-term debt and its unusually high ratio of state government employees to state residents.1 9 In New Jersey, the legislature made tempo rary cutbacks in spending to close a fiscal year 1990 budget gap and passed a tax increase to close an expected deficit for 1991. This plan ex tended the sales tax to certain exempt items and raised the general sales tax and some ex cise taxes.20* Swift passage of the bill allowed New Jersey to get by with its credit rating intact. Nevertheless, critics assert that the increases in taxes will ruin New Jersey's image as a low-tax state and discourage economic growth. After what was perceived as "anti tax" voting in the November elections, the governor has now raised the possibility of roll ing back some of the tax increases. In Pennsylvania, state government officials were able to make some spending cuts and generate enough additional revenues to erase a fiscal year 1990 deficit; however, they severely restricted increases in spending to forestall tax 19Apparently, New York State has a long history of cir cumventing balanced-budget requirements. See Allen J. Proctor, "Tax Cuts and the Fiscal Management of New York State," Federal Reserve Bank of New York Quarterly Review (Winter 1984-1985) pp. 7-18, for a discussion of how New York State manages its budget. 20These changes are part of a comprehensive plan that also includes an increase in the state income tax with the revenues dedicated to funding state aid to local communi ties for public education. 23 BUSINESS REVIEW increases in 1991. There are two reasons why Pennsylvania has so far avoided severe budget problems. First, coming out of the 1980-82 re cessions more slowly than most of the other Northeastern states, it did not increase spend ing as rapidly. Second, its economy is not rooted in a dominant industry that experi enced a boom-and-bust cycle. CONCLUSION Macroeconomic fluctuations make state gov ernment budgets inherently cyclical, and peri ods with varying degrees of budget stress are inevitable. A recent report prepared by the National Conference of State Legislatures con cludes that, even in the absence of a recession, states should prepare for tight budgets.2 1 State governments can take several steps to cope with the lean years ahead: • Make use of sound budgeting practices, in stead of spending more than they have and 21See Ronald Snell, "The State Fiscal Outlook: 1990 and the Coming Decade," National Conference of State Legislatures (February 1990) pp. 1-10. 24 JANUARY/FEBRUARY 1991 relying on short-term debt or accounting de vices to circumvent balanced-budget require ments; • Attempt to put money into Rainy Day Funds that provide some cushion against economic slowdowns; • Improve their ability to forecast expendi tures and revenues so that they can plan ahead and avoid serious budgetary short falls; • Broaden and diversify their tax bases to minimize cyclical variability in their bud gets and provide ample revenues for state spending without high tax rates. Extending the sales tax to services seems like a useful step toward this goal; and • Invest in education, transportation, and other public infrastructure to enhance the climate for business growth and development, which will lead to a large and diversified tax base.22 22See Wasylenko and McGuire (1985). See also Gerald Carlino and Edwin S. Mills, "The Determinants of County Growth," Journal of Regional Science (February 1987) pp. 3954, for evidence on the effectiveness of these investments in encouraging county growth. FEDERAL RESERVE BANK OF PHILADELPHIA Philadelphia/RESEARCH Working Papers Institutions and libraries may request copies of the following working papers, written by our staff economists and visiting scholars. Please send the number of the paper desired, along with your address, to Working Papers, Department of Research, Federal Reserve Bank of Philadelphia, Philadelphia, PA 19106. For overseas mail requests only, a $2.00 per copy prepayment is required; please make checks or money orders payable (in U.S. funds) to the Federal Reserve Bank of Philadelphia. 1990 No. 90-1 Gerald A. Carlino and Richard Voith, "Accounting for Differences in Aggregate State Produc tivity" No. 90-2 Brian J. Cody and Leonard O. Mills, "Evaluating a Commodity Price Rule for Monetary Policy" No. 90-3/R Loretta J. Mester, "Traditional and Nontraditional Banking: An Information-Theoretic Ap proach" No. 90-4 Sherrill Shaffer, "Investing in Conflict" No. 90-5/R Sherrill Shaffer, "Immunizing Options Against Changes in Volatility" No. 90-6 Gerald A. Carlino, Brian J. Cody, and Richard Voith, "Regional Impacts of Exchange Rate Movements" No. 90-7 Richard Voith, "Consumer Choice With State-Dependent Uncertainty About Product Qual ity: Late Trains and Commuter Rail Ridership" No. 90-8 Dean Croushore, "Ricardian Equivalence Under Income Uncertainty" No. 90-9 Shaghil Ahmed and Dean Croushore, "The Welfare Effects of Distortionary Taxation and Government Spending: Some New Results" No. 90-10 Joseph Gyourko and Richard Voith, "Local Market and National Components in House Price Appreciation" No. 90-11 Theodore M. Crone and Leonard O. Mills, "Forecasting Trends in the Housing Stock Using Age-Specific Demographic Projections" No. 90-12 William Lang and Leonard Nakamura, "Optimal Bank Closure for Deposit Insurers" No. 90-13 Loretta J. Mester, "Perpetual Signaling With Imperfectly Correlated Costs" No. 90-14 Sherrill Shaffer, "Aggregate Deposit Insurance Funding and Taxpayer Bailouts' No. 90-15 Dean Croushore, "Taxation as Insurance Against Income Uncertainty" No. 90-16/R Loretta J. Mester and Anthony Saunders, "When Does the Prime Rate Change?' No. 90-17 James J. McAndrews and Richard Voith, "Regional Authorities, Public Services, and the Location of Economic Activity" No. 90-18 Sherrill Shaffer, "A Test of Competition in Canadian Banking" No. 90-19 Brian J. Cody, "Seignorage and the European Community: Is European Economic and Monetary Union in Danger?" No. 90-20 John Boschen and Leonard O. Mills, "The Role of Monetary and Real Shocks in NearPermanent Movements in GNP" No. 90-21/R Mitchell Berlin and Loretta J. Mester, "Debt Covenants and Renegotiation' No. 90-22 Richard Voith, "Transportation, Sorting, and House Values in the Philadelphia Metropolitan Area" No. 90-23 Gerald A. Carlino and Leonard O. Mills, "Persistence and Convergence in Relative Regional Incomes" No. 90-24 Sherrill Shaffer, "Stable Cartels With a Cournot Fringe" No. 90-25 Ahmed Mohamed, "The Impact of Domestic Market Structure on Exchange Rate Pass through" No. 90-26 Loretta J. Mester and Anthony Saunders, "Who Changes the Prime Rate?" No. 90-27 Sherrill Shaffer, "The Lerner Index, Welfare, and the Structure-Conduct-Performance Link age" No. 90-28 Sherrill Shaffer, "Regulation and Endogenous Contestability" No. 90-29 Brian J. Cody, "Monetary and Exchange Rate Policies in Anticipation of a European Central Bank" No. 90-30 Leonard Nakamura, "Reforming Deposit Insurance When Banks Conduct Loan Workouts and Runs Are Possible" 3 FEDERAL RESERVE B A N K O F PHILADELPHIA BU8INE88 REVIEW Ten Independence Mall, Philadelphia, PA 19106-1574 Address Correction Requested
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