The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO SEPTEMBER 1995 NUMBER 97 Chicago Fed Letter Public finance in the Midwest: The calm before the storm? Since 1990, state and local govern ments in the Midwest have fiscally outperform ed their counterparts in many other regions of the country. During the 1990-91 recession, most midwestern governments avoided major tax increases and received high marks from analysts for institut ing conservative budgeting tech niques to rein in expenditure growth. During the current expan sion, many have begun to amass sig nificant budget reserves that suggest that state and local finances will continue as a source of economic stability even if the overall economy declines. The question that remains is, does this newfound stability reflect the beginning of a new era for Mid west public finance? Are the old days of fiscal crises a thing of the past, along with the massive tax increases and patched-together budgets that were so com m on during the reces sions of 1975, 1980, and 1981-82?1 In this Chicago Fed Letter, I review the current fiscal conditions of the five midwestern states that com prise the Seventh Federal Reserve District (Illinois, Iowa, Indiana, Michigan, and Wisconsin) and discuss the chal lenges that await their state and local governm ents. While these states are currently plying calm fiscal waters, conditions may be starting to deteriorate, and at the very least the states will need to navigate several nasty reefs. The good news: Rebuilding balances In fiscal years 1994 and 1995, Dis trict state governm ents showed con siderable progress in rebuilding their fund balances, as figure 1 shows. As a group, District states have taken advantage of higherthan-anticipated revenue growth over the last couple of years to shore up their reserves, rather than initiate a significant num ber of new program s. Particularly impressive has been the progress of the state of Michi gan. As recently as 1991 the state was facing a $1.8 billion deficit; it has turned that around to a $1.1 billion surplus. Part of the motiva tion for building such a large sur plus was the state’s education/tax reform package, which shifted m uch of the responsibility for fund ing elementary and secondary edu cation to the state. This increased responsibility, coupled with legisla tion designed to cut state taxes by $1.5 billion over five years, makes the size of the surplus critical to the state’s ability to m eet prospective fiscal demands. Indiana has also built impressive com bined reserves of over $750 mil lion and plans to add to this total through 1997. Wisconsin, while in no immediate danger, will face a serious challenge in FY1997 when a new state law goes into effect requir ing the state to pay two-thirds of the cost of elem entary and secondary education. (State categorical and equalization aid currently covers roughly 40% of education costs). Funding is planned to be covered by a com bination of natural revenue growth and tight budgeting, but analysts are already predicting that budget reserves may be needed if the state is to m eet all of its spending commitments in 1997. Iowa has been using very conserva tive revenue growth projections in an effort to improve its fiscal condi- 1. Year-end combined fund balances billion dollars 1.2 ----------------- 0.8 ___ i_____ i_____ i_____ i_____ i___ IL IN IA Ml Wl Source: The Bond Buyer, April 6, 1995, p. 9a. tion. The state has reached its goal of having a balanced budget accord ing to generally accepted accounting principles (GAAP) and is aiming to build a budget reserve of 5% of state spending by the end of FY1996. Clearly, the state with the most press ing fiscal problem is Illinois, which recorded a GAAlP deficit of almost $1.6 billion by the end of FY1994. While strong revenue growth over the last two years has helped reduce this deficit by more than $500 mil lion, Illinois’s fiscal position remains precarious. Its inability to establish a significant ending balance means that the state is essentially working without a safety net. The Illinois budget office hopes to further re duce its deficit to $960 million by the end of FY1996. In the meantime, however, this poor fiscal situation has not gone unnoticed by bond ratings agencies. Moody’s cited the state’s backlog in Medicaid bills as a prim a ry motivation in downgrading the state’s bond rating in February from Aa to A1. private-sector cost control program s local governments as the prim e rea such as health m aintenance organi son why state expenditures are grow The threats to financial stability lie zations (HMOs) and preferred pro ing faster than anticipated. both within state and local govern vider organizations (PPO s). Massa m ent and in external forces. One Finally, there is always the threat of chusetts was am ong first to internal threat is the growing tenden tax-cut fever, although the midwest- institute a m anaged the care system for cy for states to incur structural defi ern states appear to be avoiding this Medicaid. While the program has cits, that is, for current and projected potential budget problem . W henev helped restrain spending increases, revenues to fall short of the operat er state revenues swell and large it has not provided the level of sav ing costs of government. fiscal surpluses are established, ings that originally had been pro states have a tendency to start con jected. Last year, Illinois proposed a Structural deficits may result from tax cuts. While these can similar m easure for its Medicaid two causes. First, both state and local sidering reasonable during good eco program , but its application for a governments are being asked to take seem ic times, they erode the tax base federal waiver to institute the pro on broader responsibilities. This has nom and can make budgeting in times of gram was denied. tended to drive up expenditures as econom ic downturns even m ore new programs bring new costs, par For local governments, the cost of difficult. ticularly in health care and environ complying with federal environm en m ental regulation. Second, in seek Some states with recent weak eco tal standards tends to raise the great ing reasons why revenues have not nomic perform ance, such as New est concern. Standards for air and kept pace with expenditure growth, Jersey, have ignored this convention water quality as well as for solid waste many analysts have cited the reluc al wisdom. They have made head handling often require significant tance of governm ent to revise state lines with aggressive tax cuts de expenditures. As these standards are and local revenue systems. These signed to shrink the size of currently scheduled to become more systems are often poorly designed to governm ent and increase economic stringent over the next decade, local capture revenue from the fastestactivity by lowering the tax costs of spending for compliance is likely to growing portions of the economy.2 living and doing business in the state. increase considerably. Because Dis a group, the states in the Seventh The best example is the general sales As trict states have significant environ Federal Reserve District have em pha m ental challenges as a result of their tax, which is still heavily weighted to sized expenditure control over reve industrial legacy, they will face espe the taxation of goods rather than nue as a means of reining in services. With services making up an state change cially high costs. spending and currying favor ever larger portion of economic ac Finally, perhaps the biggest external tivity, it will be necessary to include a with voters. threat is the new federal budget. In broad range of them in the sales tax The external threats an effort to balance the budget, the base if that base is to grow at accept federal governm ent may hand the able rates. In Illinois, studies have The term “unfunded m andates” is states another problem . Funding estimated the fiscal impact of extend often used to describe a host of fed for program s such as mass transit, ing the sales tax to a selected group eral program s, from Medicaid to highways, low-income housing, and of consum er services ranging from environm ental regulations, that welfare is likely to be sharply cur dry cleaning and auto repair to recre require expenditures by state and tailed. Particularly worrisome given ation. The findings suggest that the local governm ents. M edicaid costs recent fiscal trends is a proposed state could raise $500 million in reve have proven particularly vexing. In cap on increases in federal Medicaid nues in the first year and expect a the case of the five District states, expenditures to 5% annually. Since 5% annual growth rate from this federal M edicaid assistance m atch expenditures have consis source.3 ing ratios range from a high of 63% Medicaid tently been growing at double-digit in Indiana to a low of 50% in Illi O ther internal threats to financial levels annually until recently, a 5% The states have com plained stability come from self-imposed state nois.4 cap represents a cut in available not because they m ust share the programs whose expenditure levels resources. All of this points to ei responsibility for paying for Medic have grown faster than predicted. ther an outright reduction or a slow aid, but rather because federal law Prison spending has been a prime down in federal funds available makers have often expanded the list state and local governm ents for to budget-buster for almost every state, of services available to Medicaid with the growth in prison expendi these program s. Those govern recipients. This has led to an in tures often due to new state laws m ents will have to decide w hether crease in costs which is largely be creating m andatory sentencing provi yond they are willing to make up the gap. state control. sions. Still, most states cite the Difficult decisions will have to be changing roles of the federal govern In response, several states have tried m ade as to which program s will be m ent and the devolution of formerly to institute m anaged care program s sustained at current levels and federal responsibilities to state and for M edicaid recipients, introducing which will face cuts. Internal dangers Derivatives: Special challenge or red herring? One concern in the area of state and local public finance that has received considerable m edia attention has been the use (and misuse) of deriva tive investments by state and local governments. Recent events include a record-setting loss of nearly $1.7 billion by an investment pool adm in istered by the Treasurer of Orange County, California, as well as prob lems in District states. Losses by Chi cago’s community college system and the Wisconsin State Investment Board have heightened awareness that public finance investments have been becom ing more complex and m ore risky. Part of the reason why public funds are being invested in riskier financial instrum ents, including derivatives, is the desire to gain higher returns on public funds. In the case of Orange County, the decision was clearly mo tivated in part by the desire to offset slowly growing tax revenues. Rather than levying increases in tax rates, the county used its increased invest m ent revenues to fund its operating expenses. If public pressure contin ues to be exerted on officials to avoid tax increases at virtually all costs, pressure to increase returns from similar non-tax revenues is also likely to continue. Studies by the U.S. General Ac counting Office and the Govern m ent Finance Officers Association suggest that the use of derivatives in state and local governm ent invest m ents is limited. Moreover, anec dotal evidence suggests that the negative publicity surrounding the O range County situation has led some state and local governm ents to elim inate derivatives from their portfolio of investments. In fact, the huge losses in O range County were m ore a product of the leveraging of fund assets than strictly from the use of derivatives. In contrast, the m ore com m on limit ed use of derivatives was dem onstrat ed in the case of the Wisconsin State Investment Board. The Board m an ages an investment fund for 1,000 local governments and the retired governm ent employees’ pension fund. While the Board did an nounce a $95 million loss on interest rate swaps in March, this loss is rela tively small against the fund’s $6.7 billion in assets and is expected to trim the fund’s investment return by only .25 percentage points. In response to these derivative-related losses and riskier investment strate gies, public finance investment offic ers have been pursuing efforts to clarify the use of derivatives for public funds. Proposals from the Govern m ent Finance Officers Association have recom m ended better disclosure rules for derivative brokers (in terms of the risks of these investments as well as the brokers’ own positions) and better accounting methods, so that the value of derivatives in gov ernm ent portfolios will be better understood. State and local treasur ers also need to understand better how derivatives work and what their role is when it comes to investing public funds. In nearly a dozen states, legislation has been proposed to clarify if and when state or local governm ent may invest in any form of derivative. Tor more on the historical performance of state and local governments in the Seventh Federal Reserve District, see Richard H. Mattoon and William Testa, “State and local governments’ reaction to recession,” Economic Perspectives, Feder al Reserve Bank of Chicago, March/ April, 1992, Vol. 16, No. 2, pp.19-27. Tor more on this, see National State Legislatures, Financing State Government in the 1990s, Denver, CO, 1993. 3Center for Urban Research and Policy Studies (University of Chicago) and Met ropolitan Planning Council, Payingfor State and Local Government, Report of the Chicago Assembly, August 1994, p. 26. Specifically, federal Medicaid assis tance matching ratios for FY1995 are estimated at 50.00% for Illinois, 63.21% for Indiana, 62.74% for Iowa, 56.73% for Michigan, and 60.25% for Wiscon sin. The range for federal reimburse ment varies from a minimum of 50% to a maximum of 83% (Advisory Commis sion on Intergovernmental Relations, Significant Features of Fiscal Federalism, 1993, Volume 2, M-l85-11, Washington, DC, September 1993). Conclusion Most of the District’s state and local governments find their immediate fiscal condition better than it has been in some time. However, one need not look too far into the future to see some difficulties that lie ahead. Certainly, m ore scaling back of feder al programs is bound to be difficult for states and localities to absorb. In addition, as many states actively pur sue m ore responsibility, they are at the same time often trying to hold tax bases static. It is clear that state and local governments will continue to be asked to do more. The ques tion is whether they have the resourc es to carry out all that is being asked of them. —Richard H. Mattoon Senior Economist Michael H. Moskow, President, William C. Hunter, Senior Vice President and Director of Research; David R. Allardice, Senior Vice President, regional programs; Douglas Evanoff, Assistant Vice President, financial studies; Charles Evans and Kenneth Kuttner, Assistant Vice Presidents, macroeconomic policy research; Daniel Sullivan, Assistant Vice President, microeconomic policy research; Anne Weaver, Manager, administration; Janice Weiss, 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 Research Department is provided with copies of the reprints. Chicago Fed Letter is available without charge from the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois, 60690-0834, (312) 322-5111. ISSN 0895-0164 Light vehicle assemblies declined relatively sharply in the second quarter, after rising interest rates on auto loans and several other im portant factors put a chill on sales in the first half of the year. Interest rates on auto loans have been falling back since the second quarter, however, and incentive policies have grown somewhat more liberal. Partly as a result, industry analysts have expressed greater confidence in inventory positions in recent weeks. Current build plans imply output will remain flat in the third quarter, although these schedules are subject to revision. Sources: The Midwest Manufacturing Index (MMI) is a composite index of 15 industries, based on monthly hours worked and kilowatt hours. IP rep resents the Federal Reserve Board industrial pro duction index for the U.S. manufacturing sector. Autos and light trucks are measured in annualized units, using seasonal adjustments developed by the Board. The purchasing managers’ survey data for the Midwest are weighted averages of the sea sonally adjusted production components from the Chicago, Detroit, and Milwaukee Purchasing Man agers’ Association surveys, with assistance from Bishop Associates, Comerica, and the University of Wisconsin-Milwaukee. I l l 9~ZZ>£ (6l£) ££80-06909 siouini ‘oSvjjqj f£8 xog O d J31U33 UOpBUIJOJUJ 3Hcln d[ OOVOIH3 3 0 "3NV9 3AU3S3^I 3V33<333 TiiTT] paq aoP iiq q
@FedFRASER