Full text of Chicago Fed Letter : Changing Fiscal Policy in the Seventh District, No. 128

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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

APRIL 1998
NUMBER 128

Chicago Fed Letter
Changing fiscal policy in
the Seventh District
State governments make major changes
to their fiscal systems only infrequently.
When they do take place, changes are
driven by such forces as recessions,
changing demographics, regional decline, and sustained revenue growth.
The Seventh District has experienced
all of these events over the past 15–20
years.1 A period of sustained economic
and revenue growth during the mid1990s has followed on the heels of
regional decline, rising costs of public
services, and recession. District states
have reacted to their good fortunes by
initiating innovative changes to both
their tax systems and spending programs. This Chicago Fed Letter discusses
how the current economic expansion
is lifting state government revenues
in the District and the varied fiscal
responses of state governments.
The 1980s through the recession of
1990–91 was a period of almost unrelenting fiscal pressure on state and
local governments in the Midwest.
During the recessionary early 1980s,
downturns in both manufacturing and
agriculture hampered revenue growth
while driving upward the demand for
cyclically sensitive services, such as welfare, public health care, and unemployment insurance. Although the
economy improved later in the decade,
federal government (nondefense)
downsizing, along with the trend toward
devolution of responsibilities to state
and local governments, pressured the
spending side of the fiscal equation.
In some areas, such as prisons and
environmental regulation, federal
courts or the U.S. Congress pushed
costly mandates onto state government
spending. On the revenue side, federal
grants to state–local governments generally declined in importance during
the 1980s. In addition, rising costs for
state–local government services, such

as Medicaid, tended to
push budgets upward.
Consequently, most
District state governments entered the 1990s
in less-than-perfect
shape. Budgetary balances were low entering
the 1990–91 recession,
and reserves were quickly
exhausted, causing state
governments to scramble to make ends meet.

1. State and local surplus
percent of GDP (excludes social insurance funds)
1.2

0.8

0.4

Since that time, two
trends have benefited
0.0
District states’ budget1987
’89
’91
’93
’95
’97
ary health. First, the U.S.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
economy has experienced its third longest
expansion in the modern era. Second,
Michigan
the Midwest economy outperformed
During the 1990–91 recession and its
the nation during the first several years
immediate aftermath, Michigan expeof the expansion. Over the past two
rienced one of the sharpest budget
years, the region’s economic growth
imbalances, ending fiscal 1992 with a
has fallen short of the nation’s. Nonegeneral funds deficit of over $700 miltheless, state governments have shared
lion. However, a surging state economy
in what has been an unexpected nain 1993 and 1994 helped the state to
tionwide revenue surge from incomeavoid major tax increases or expendirelated tax sources. What began as a
ture cuts, and it ended fiscal 1994 with
worrisome decade for Seventh District
a surplus of $400 million; revenues
states has unfolded into much improved
continued to exceed estimates well
fiscal positions, as shown by endinginto 1995. Against this backdrop, voters
year general fund balances in individapproved a profound change in the
ual states and by the overall surplus
state’s tax structure and its system of
position of the state–local government
school funding. “Proposal A” improved
sector in the U.S. (figures 1 and 2).
school funding, especially to low-spendGovernments have seized this opporing districts; transferred funding relitunity to remedy unfinished business
ance from local to state funding sources;
from the 1980s and to undertake a few
and remedied a perceived imbalance
bold innovations. Most commonly,
in the state’s revenue structure by
they have used unexpected revenue
shifting from property taxation to
surpluses to shore up education fundsales taxation (along with other tax
ing. On the tax-side, adjustments have
system changes).
taken two primary forms. First, states
Michigan had adopted a “power equalhave lowered tax rates or broadened
izing” system of state funding to school
exemptions on existing taxes. Second,
districts in 1974. Under power equalthey have adjusted their aid to local
izing, state aid was set to guarantee a
governments, usually local school sysschedule of revenue yields to any two
tems, to alleviate the tax citizens find
school districts that taxed locally with
the most onerous—the property tax.

2. State govt. ending balances
20

percent of expenditures

FY91

FY97

15

10

5

0
U.S.

IL

IN

IA

MI

WI

Note: Figures are estimates, general funds only.
Source: National Association of State Budget Officers
and National Conference of State Legislatures.

the same amount of effort. However,
the system failed to meet expectations
of greater spending fairness; by 1994,
the ratio of per student spending between Michigan’s highest spending
districts and its lowest had climbed
back to its 1974 level. Beginning in
1994–95, Michigan reverted to a system
of “foundation” school grants-in-aid,
whereby, with a minimum of required
local tax effort, low-spending local
school districts are funded by the state
up to a minimum foundation level of
per pupil spending. Consequently, in
1994–95, the group of lowest-spending
school districts experienced a 17.5%
increase in average per pupil spending,
reaching $4,288. Largely as a result of
this feature, inter-district variation in
spending was narrowed, with other
features expected to narrow spending
disparities further in future years.
Prior to the changes, Michigan’s tax
system was one of the most skewed in
the nation. In fiscal 1994, the state
revenue share ranked sixth lowest in
the use of state–local sales taxation
but sixth highest in dependence on
property taxation.2 Of the latter, much
was due to school districts tapping the
local property tax base for funding;
the state aid (i.e., non-property) share
of local spending amounted to only
28.7%, versus 45.2% for the nation.
For 1995, Proposal A raised the state
sales tax two percentage points, from
4% to 6%, which, along with tax hikes
on tobacco, replaced the bulk of locally
raised property taxes. In addition,

significant local property taxation was
replaced by state (single fixed-rate)
taxation of property earmarked for
state school aid funding. The result
has been a shift of revenue sources,
along with greater centralization of
school funding. However, at least
one school system feature has become
highly decentralized. Proposal A authorized public school districts and
public colleges or universities to establish “charter schools,” which are funded
under the state’s new funding system
but need not adhere to all of the restrictions and guidelines of state and local
education authorities.
Michigan’s partial replacement of sales
taxation for property taxes to fund
local schools raises a concern about
the long-run stability of the revenue
stream; sales taxes tend to be more
responsive to short-term swings in the
economy than do property tax revenues. At the same time, current and
prospective revenues are being reduced
through the state’s reshaping of its
personal income and “single business
tax.” So far, this has presented no major problem because of the economy’s
buoyancy.3 Personal income growth
in Michigan exceeded that of both
the nation and the region from 1993
through 1995. Since then, however, the
state’s income growth has slowed relative to the nation.

Indiana
Much like Michigan’s, Indiana’s economy and revenue streams were significantly affected by the 1990–91 recession.
Indiana avoided tax increases during
and immediately following the recession, in part because it had built up
substantial reserves during the 1980s.
The state shared fully in the recovery,
with personal income growth exceeding that of the nation from the fourth
quarter of 1991 through the fourth
quarter of 1993. Since then, Indiana’s
income growth has only slightly lagged
the nation’s.
During the recovery and expansion of
the 1990s, state budget surpluses have
steadily widened. At the end of fiscal
1997, the state’s ending surplus was
almost 23% of the year’s revenues, up
from 8.1% in 1993. Indiana’s growing
budget reserves have come about

largely because the state has tended to
underestimate both economic growth
(and its attendant tax bases) and the
responsiveness of its tax system to economic growth.
Indiana plans to spend down part of
the surplus in 1997–99, forecasting a
general fund balance of approximately
14% for the end of fiscal 1999. Some
$700 million will be whittled away
through revenue cuts and state spending, including state and local road improvements and shoring up public
employee pension funds. Enacted tax
cuts include shaving the inheritance
tax by exempting the first $100,000
left to children and grandchildren and
lowering income taxes for parents by
increasing the standard deduction
for dependent children and supplementing the earned income tax credit.
The state has cut property taxes for
homeowners by increasing the “homestead credit.”
In all likelihood, property taxes will
be scaled back further and partially
replaced by one of several state tax
sources. Surveys reveal that Indiana
residents are dissatisfied with property
tax levies, which increased by an average of 7.3% per year from 1990 to 1995.
Enhanced county welfare services to
children lay behind much of the increase, as did increased school spending. Population growth and attendant
school enrollment have accelerated
in the 1990s, requiring additional
school construction and enhancement
of school services. Rising incomes may
also be financing movement of students’ families from urban to suburban areas, thereby requiring new
school construction.
A pending court case may bring the
issue of property tax relief to the fore.
Depending on the outcome, taxable
property values could be brought up
to par with market values in the state.
This would raise property taxes on
residential property by an estimated
39%, on average. The Governor’s Commission on taxes stands ready to examine alternatives to such an outcome.

Illinois
In contrast to Indiana, Illinois entered
the 1990–91 recession with its state
finances in a precarious position.

A modest increase in the state’s flat
rate personal income and corporate
taxes in 1989 was too little and too
late to counteract problems that had
developed during the 1980s. Consequently, the recession resulted in several deficit years and weakened fund
balances. Strong downside spending
measures from 1991 onward allowed
the state to avoid significant tax increases, and economic recovery took
over where fiscal discipline left off. In
recent years, revenue gains have outpaced expectations, while costs associated with Medicaid, welfare caseloads,
and the prison population have grown
more slowly than expected. As a result,
Illinois’s general funds balances ended
fiscal 1997 at a record high level, and
fiscal 1998 revenues are running well
ahead of forecasts.
The fly in the ointment for Illinois is
the familiar problem of property taxes
and school funding. The state’s share
of state–local funding for elementary
and secondary education fell from
38.1% to 29.9% from 1985 to 1996,
and its dependence on property taxation moved from 20% greater than the
national average in 1985 to 22% by
1994. As local school districts have
increasingly determined local school
spending, many low-spending school
districts have chosen to spend even
less relative to state norms.
Acting on a gubernatorial commission’s
recommendation for a minimum level
of per pupil spending, the state legislature considered a proposal in mid1997 that would have raised $600
million through the state’s individual
income tax for aid to low-spending
school districts and replaced $900 million in local property taxation across
most school districts. The legislation
failed to pass, but a late 1997 session
of the legislature did approve an alternative plan, which raises the state-guaranteed minimum per pupil spending
and funds construction of new schools,
without raising the individual income
tax or providing across-the-board property tax relief. This legislation, which
implements important education reforms such as lengthening the time
between hiring of teachers and tenure
decisions, funds its planned expenditures through tax increases on cigarettes,

telecommunications, and river boat
casino gambling, along with revenue
growth from the existing tax structure.

Wisconsin
If Illinois came to the property tax
reform issue late, Wisconsin came to
it early. The state’s per pupil funding
for education is perennially among
the highest in the nation, ranked
twelfth in 1995. Until recently, most
of these funds derived from local
property tax sources; the state share
of school (non-property) revenue in
1994 was 48%. State aid increases to
education more than doubled prior
to 1994. Yet, because of rapid rises in
spending per pupil, these monies were
insufficient to raise the state’s share
of funding, and local property tax rates
continued to rise. In response, during
1994, the state committed to substantial property tax relief by increasing
the share of school funding derived
from state aid to two-thirds. Property
taxes have fallen from approximately
5% of personal income to 4% since
1993, which is much closer to the
national average.
The wherewithal to fund property
tax relief has been assisted by a surging economy. Revenues slowed in
Wisconsin during the past recession,
but not to the same extent as elsewhere. Payroll employment growth
rates in Wisconsin exceeded national
levels in every year from 1987 to 1992,
and for 1997, the state’s unemployment rate averaged almost 1.5 percentage points below the U.S. average.
Since 1996, employment and income
growth have slowed relative to the
nation, largely reflecting constrained
work force capacity. Although state
officials recently expressed concern
about the potential effects of slowing
growth on revenues to fund continued property tax relief, fiscal 1997
brought surprisingly strong revenue
growth, especially from the state’s
individual income tax. Observers suspect that the growth in capital gains
income arising from rapidly appreciating equity markets is behind some
of the upturn in tax receipts in Wisconsin, as elsewhere. For 1997–99,
Wisconsin is counting somewhat
on continued revenue growth to

complete the funding of its property
tax relief effort, while paring down individual income tax rates.
Sinking welfare caseloads have also
contributed to budgetary health in
Wisconsin. The state made history by
negotiating with the federal government
to end the right to Aid to Families with
Dependent Children, and was given a
federal waiver before the congressional
reform of 1996 ended the federal entitlement to welfare nationwide.4 Under
Wisconsin’s new program, W-2 (Wisconsin Works), parents are required to work
to qualify for assistance. However, the
new program provides augmented services to families on assistance, including free medical services and subsidized
child care, which raise the cost of supporting each family some 60%. Hence,
it cannot be casually termed an austerity
measure on government’s part.

Iowa
While the late 1990s have brought significant economic progress and improving
fiscal health in Iowa, the decade did not
start out that way. Economic recovery
in the farm sector took hold somewhat
later than it did in manufacturing during
the 1980s. Due to its heavy dependence
on the farm sector, Iowa’s fiscal position entering the recession of 1990–91

Michael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research;
Douglas Evanoff, Vice President, financial studies;
Charles Evans, Vice President, macroeconomic policy
research; Daniel Sullivan, Vice President, microeconomic
policy research; William Testa, Vice President, regional
programs; Vance Lancaster, Administrative Officer;
Helen O’D. Koshy, Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are
the authors’ and are not necessarily those of
the Federal Reserve Bank of Chicago or the
Federal Reserve System. Articles may be
reprinted if the source is credited and the
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was more fragile than other District
states, and its subsequent budget deterioration was more palpable. The flood
of 1993 put further stress on the state’s
economy and budget. In response to
budget deterioration, the state legislature passed an increase of 1% in the
state sales tax rate in mid-1992.
Economic recovery took a much stronger hold after 1993, and the state has
since enjoyed a falling unemployment
rate—currently two percentage points
below the nation’s. State revenues have
accelerated off of both stronger growth
and a larger sales tax. Iowa has chosen
to use expanding revenues to provide
more explicit property tax relief, increase the state portion of foundation
aid to schools and other property tax
relief, and add modest income tax
relief for senior citizens and families
with children. As a consequence, property taxes as a share of all state–local
taxes in Iowa are forecast to fall from
40.5% in fiscal 1992 to 36.7% by the
end of 1998.
Following four years in which revenues
have exceeded expectations, the state
plans to provide further property tax
relief and across-the-board cuts in
personal income taxes. Notably, the

legislature approved the Governor’s
proposal for a 10% across-the-board
reduction in personal income taxes,
effective January 1, 1998.

in states that have back-loaded the
very popular tax cuts they are promising voters.
—William Testa
Senior economist and vice president

Conclusion
What began as a stressful decade for
state governments in the Seventh District has become one in which surging
revenues are allowing elected officials
to please their constituents by offering
continued tax cuts; innovative programs
for services, such as welfare and education; and a shifting of revenue sources
away from those taxes—especially on
property—that are most unpopular.
While governments are also using this
period of growth to replenish their
budget reserves, there are some worries
on the horizon. Economic growth has
slowed, perhaps as a result of limits on
the availability of workers in the region.
So far, strong national growth continues to lift incomes, while income tax
revenue growth is being buoyed by
realizations of capital gains on equity
portfolios. The worry is that both economic growth and capital gains may
change direction in a hurry, especially
in a region noted for its cyclically sensitive economy. If so, budgetary reserves
could be drained quickly, especially

1

The Seventh District comprises parts of
Indiana, Illinois, Michigan, and Wisconsin,
and all of Iowa. This article draws from a
November 11 session, “Recent revenue
performance and the economic conditions
of midwestern states,” of the 1997 Annual
Meetings of the National Tax Association,
held in Chicago, Illinois. Session presenters
included Mitchell E. Bean, Michigan House
Fiscal Agency; Yeang-Eng Braun, Wisconsin
Department of Revenue; Larry DeBoer,
Purdue University; J. Fred Giertz, University
of Illinois; and Joel Lunde, Iowa Department
of Management.

2

In this article, dependence is measured
by a revenue source’s share of total state–
local tax revenue.

3

However, Proposal A increased state funds
to local school districts while accelerating
payments. This contributed to a cash flow
concern, which has since been allayed by
lengthening the payment schedule.

4

"Where Wisconsin goes, can the world
follow?,” The Economist, November 1, 1997,
pp. 25–26.

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