"... mistakes made by politicians during good years are often the cause of big headaches down the road."

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It's not the economy, it's the politicians
By Dean Stansel, January 16, 2015

Like last year at this time, many states are opening their legislative sessions with revenues pouring in faster than expected. In Florida, a $1 billion annual surplus is projected. A similar size surplus is projected in Minnesota for their two-year budget. There's even talk of a surplus in California, and New York has a $5 billion windfall from bank settlements. Those unexpected windfalls will provide great temptation for governors and state legislators.

During recessions, politicians typically blame a poor economy, unemployment, or reductions in federal aid for budget shortfalls. But when the money is flowing in, they often choose to go on a spending spree rather than to heed the lessons of the past and exercise fiscal discipline.

According to our new research on state fiscal crises published through the Mercatus Center at George Mason University, mistakes made by politicians during good years are often the cause of big headaches down the road. How a state's windfall revenues are allocated can make a big difference in how it fares the next time the economy hits a recession and it again faces a substantial budget shortfall.

Faced with extra revenue, politicians have three options for how to use the money: First, they can increase spending, on either new or existing programs. Second, they can cut taxes, returning the windfall to the taxpayers from whence it came. Finally, they can deposit the extra revenue in a rainy day fund.

The first option creates higher expectations for the level and growth of spending in the future, so it creates a bigger problem when revenue growth returns to normal. The second two options, returning or saving the unexpected windfall, do not change future budget expectations, so they reduce the severity of any "crisis" that occurs during the next recession. Moreover, since reductions in marginal tax rates specifically encourage productive activity, the tax cutting option also tends to have the advantage of leading to higher economic growth.

Economists measure the amount of "fiscal stress" a state is experiencing during a recession by adding up the amount of tax increases and reductions in spending growth that are necessary to close their budget shortfalls. Using nearly 20 years of state data, our new research examines that fiscal stress along with the various factors that are often claimed to contribute to it. We found that states that increased spending faster experienced greater fiscal stress. States with larger rainy day funds experienced less fiscal stress. Interestingly, states with higher unemployment rates did not necessarily experience more fiscal stress, nor did states that received less federal aid. Previous research has found similar results.

So while politicians like to blame external factors like higher unemployment rates for fiscal stress, we found no evidence that they make much of a difference. Instead, the politicians' own actions - mainly, spending new revenue rather than saving or giving it back - had a great deal of influence.

These findings provide an important lesson about the benefits of using extra budgetary resources wisely. As state legislatures open new sessions in the coming weeks, politicians would be smart to return any unexpected revenue windfalls to the taxpayers by cutting taxes or making contributions to rainy day funds. That can go a long way toward ensuring a less severe crisis the next time there is a downturn.
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