Preparing For an Even More Demanding Future

American Experiment's 2010-11 Budget Recommendations
 

by Peter J. Nelson, J.D.
Policy in Detail, No. 4 | April 8, 2009
Full Text in PDF
 
 

Introduction

Grim tends to be the word of choice to describe the massive $6.2 billion structural deficit projected for Minnesota’s 2010-11 biennial budget.  This deficit represents a brow-raising 17 percent of what the state hopes to spend.  And this is no one-time imbalance.  Spending is projected to outpace revenues for as far as economists’ models can project.  Federal stimulus funds bring the actual deficit down to $4.6 billion, but these funds do nothing to fix the widening structural imbalance in future biennia.  Making matters worse, stimulus rules force the state to delay some opportunities to address these long-term problems.  These facts create a Herculean chore for state lawmakers: Balance the 2010-11 biennial budget while tipping future budgets into balance, as well.

Likewise, state lawmakers should take this budget as a rare opportunity to reassess state programs and  refit Minnesota’s government to meet the actual needs that lie ahead. 

The work began when Governor Tim Pawlenty released a detailed budget last January.  Since then, new budget forecasts and additional funding from the federal stimulus bill have resulted in a revised budget from the governor and Democrats in the House and the Senate have released their respective budget targets.  Most of the discussion to follow centers on the governor’s budget simply because it has been open for analysis longer and it offers the most detail. 

Erasing the $4.6 billion shortfall will require substantial changes to how the state operates.    Public programs will be cut or reshaped.  New programs may be added.  Taxes will be rearranged—some taxes may diminish and others may grow—to match future spending needs.  All of these changes will, one way or another, affect the economy, and, with a recession in full swing, the stakes for average Minnesotans are high. 

To keep the economy on the right track, budget proposals should aim to advance at least four objectives: First, promote job growth; second, expand economic freedom; third, bring balance beyond the biennium; and fourth, obtain more value from government services.  This report evaluates how well the governor’s budget meets these objectives. 

Overall, the budget moves Minnesota in the right direction by prioritizing job growth, improving the business climate, not raising the tax burden, and making certain government programs more efficient.  However, there are some misfires and missed opportunities.  Recommendations throughout this report address these problems and identify key ways for the budget to maximize economic growth in Minnesota.

The Governor’s Budget Plan

The governor’s original plan employs four major tools to balance the budget: Spending cuts ($2.4 billion), K-12 payment shifts ($1.3 billion), tobacco appropriation bonds ($983 million), and federal stimulus aid ($920 million).  All of these items add up to something more than the actual deficit  because the budget needs to also balance $860 million in tax cuts and new spending initiatives.  However welcome or unwelcome, the federal stimulus injected more money and attached more strings to the budget than originally projected, which prompted some revisions.  These revisions primarily use the new money to scale back certain spending and program cuts while leaving intact the basic budget-balancing strategy.

Spending cuts in the budget represent permanent reductions in state spending that will help control the long-term growth of the state budget.  By far the largest share of spending cuts comes from reductions in the health and human services budget.   To reduce the budget, the plan proposes to cut the price Medicaid pays for health care provider services, eliminate certain health benefits, reduce the number of adults eligible for Medicaid by tightening income eligibility guidelines, consolidate county administration into 15 regional administration systems, and restructure the state health care program for indigent adults.  Stimulus strings forced some of these provisions to be delayed, but they all remain part of the long-term strategy to contain spending growth.  Revisions also allowed the governor largely to restore funding to higher education.  With higher education off the chopping block, state aids to local governments and homestead market value credits remain the only other budget items shouldering substantial cuts. 

Tax cuts and new spending initiatives also represent long-term changes.  Tax cuts include halving Minnesota’s corporate franchise tax from 9.8 percent to 4.8 percent; adopting sales tax exemptions for capital equipment purchases; instituting capital gains tax exemptions; allowing the immediate expensing of certain business property purchases; and offering tax credits for investing in small businesses and business investment funds.  New spending flows mostly to K-12 education and expanding Q-Comp—a pilot program that links teacher performance to pay—statewide.   The budget also adds $250 million to the budget reserve that was drained to zero in the current biennium. 

The remaining parts of the budget, totaling $3.2 billion, rely on one-time money.  K-12 payment shifts free up money by shifting obligations to school districts to the next year.  Tobacco appropriation bonds turn a future revenue stream into a one-time payment.  Minnesota receives an annual payment under the 1998 tobacco settlement that tobacco companies must pay in perpetuity.  Presently, Minnesota receives around $200 million from these payments annually. The tobacco appropriation bonds create a way to transform a portion of this future revenue stream into a single lump sum today by selling the rights to the future revenue stream.  Though the stimulus funds will be spread out over a few years, these funds are a one-time injection into the economy. 

This budget plan represents the governor’s vision for moving Minnesota forward.  Creating the annual budget is actually a profound political exercise.  The budget explicitly establishes the scope and operations of the government.  The need to balance such a large deficit provides an exceptional opportunity for lawmakers to engage in a serious top-level discussion of what the government should aim to do, especially in a time of severe economic recession. 

Four Key Objectives

The governor’s budget plan recognizes four key objectives that outline what the government should aim to do.  While the budget does not specifically identify each objective, all objectives are reflected in various policies set forth in the proposal.  These objectives are important because they help identify priorities and assess the merit of various budget provisions.  Without this sort of guide, it would be difficult to sort through the various claims made by interest groups asserting their funding needs.  Considering the recession and the deficit, it should be no surprise that the following objectives focus on economic growth and protecting future budgets.  

§  The budget should promote job growth.  This objective does take from the top-line of the governor’s talking points.  Jobs are vital to the economy and the well-being of all Minnesotans.[2]  Yet, jobs are being lost across Minnesota, pushing the state’s unemployment rate higher than at any time in over two decades.  The budget should promote policies to help replace these jobs. 

Budget policies, however, should not try to curb job losses now underway.  Job losses are, in fact, essential to reposition Minnesota’s economy for growth.  The housing bubble lifted many people into jobs that are now unnecessary and unproductive such home builders and investment bankers.  These jobs need to be eliminated and replaced by more productive pursuits.  This adjustment is not welcome or easy for individuals who lose their jobs, but the freedom of the market to make this adjustment—to quickly adapt and redeploy workers—is exactly what makes the U.S. economy so vibrant and powerful.   

It is also critical that lawmakers avoid any attempt to create these replacement jobs.  Government programs that aim to create jobs through spending programs or subsidizing specific companies or industries only work to forestall or delay the market’s ability to match people with the right job.  A government created job is a job that the marketplace did not deem worth supporting, which means these jobs are also unnecessary.  Moving someone from one unnecessary job to another unnecessary job does nothing to help the economy adjust to a more productive future.

Instead, the government should promote an economic environment where good jobs flourish by educating the workforce and maintaining a fair and friendly business climate.  

§  The budget should expand economic freedom.  Put simply, a smaller government footprint on the economy leads to stronger economic growth.  In February, Minnesota State Mankato professor Atrayee Ghosh Roy published research that examined the relationship between government growth and economic growth in the United States between 1950 and 1998.  Her conclusion: “The results … indicate a highly significant negative relationship between economic growth and government size.”[3]  The theory underpinning these results is that a smaller government footprint—lower taxes, controlled spending, less participation in markets, and fewer regulations (especially in the labor market)—gives individuals more economic freedom to work and invest in careers and companies that grow the economy. 
 
This boost to the economy is further borne out by a number of studies that compare economic growth against various indexes that measure the degree of economic freedom relative to other states and countries.  According to one index of economic freedom, gross domestic product in states with the best records of economic freedom grew by 18 versus 5 percent in states with the worst records between 2000 and 2005.[4]  The same study found that a one-point increase along its economic freedom index increases venture capital investments by $32.12 per capita, the number of patents by 8.2 per 100,000 people, and the growth of sole proprietorships by 4.2 percent. 

§  The budget should bring balance beyond the biennium and structure a stable and predictable revenue stream for future budgets.  The depth of the current deficit can  be attributed, in part, to certain structural issues in the budget, such as volatile revenue streams and inadequate reserve funds.  In addition, a recent report to the legislature by the Budget Trends Study Commission—a 15-member commission appointed by the governor, the senate, and the house—identifies a long-term mismatch in predicted spending and revenue trends.  Not surprisingly, spending outpaces revenue.  Waiting to address this mismatch could trigger more severe budget crises than even the current one.   

§  The budget should advance innovative reforms that obtain more value from government programs and expenditures.  The governor’s Drive to Excellence initiative already coordinates an aggressive (and impressive) set of programs aimed at reducing red tape, increasing efficiency, and improving the quality of government services.  However, if future budgets are to be balanced without severe program cuts or tax increases, these ambitious efforts to remake government need to be redoubled.  Indeed, as baby boomers contribute less and demand more from government budgets, government programs must continually do more with less.
 

Some people may think this list is incomplete and, no doubt, good arguments can be made in favor of other objectives and priorities.  Arguments will be made that the budget, in addition to creating more job opportunities, should do more to support the growing number of unemployed Minnesotans while they remain jobless. 

Certainly, supports for those with no job or low-wage jobs are important, but this is one area where Minnesota does not need to do more.  Minnesota already leads the nation in taxing and spending on many of these programs.  Minnesota’s unemployment taxes are the ninth highest per employee in the country and, with the ninth highest duration rate, Minnesotans stay on unemployment insurance longer.[5]   Of the 22 states that offer a state earned income tax credit, Minnesota’s is the most generous.[6]  Minnesota also extends low-income health benefits more broadly and generously than nearly any other state.  The reality is, Minnesota needs either to trim or get more value from these programs to be able to balance future budgets without burdensome tax increases.
 

Assessing the Governor’s Budget

Just because the governor’s budget recognizes the right objectives does not mean that it follows them as closely as it should.  Budget provisions run the gamut from strongly supporting the above objectives to undermining them.  This section assesses how well the governor’s budget meets the four objectives just outlined and recommends some improvements.
 
 

High Marks for Promoting Job Growth

The budget earns high marks for promoting job growth by reducing business taxes and maintaining a commitment to reform K-12 education.  As already discussed, the government does not create jobs, and the budget generally recognizes that.  Most notably, the budget reduces the tax burden on Minnesota businesses, making Minnesota’s business climate more competitive with other states.  At a time when revenues are scarce, it may seem like the wrong time to reduce taxes, but these reductions will ultimately lead to more jobs, and, consequently, more revenue to offset at least a portion of the loss.  Though these tax cuts represent a strong first step, the cuts should be deeper and other cuts should be considered as well.

However, not all of the budget’s tax cuts support job growth.  A small portion of the tax provisions tries to create specific jobs through targeted tax incentives.  Because they’re targeted, jobs in one sector gain at the expense of jobs elsewhere, which, on net, weakens job growth.

The budget also promotes job growth through a strong commitment to improve K-12 education.  The budget substantially expands efforts to improve teacher performance.  The budget commits to placing higher quality teachers in the classroom by bolstering standards in teacher preparation programs at Minnesota colleges, opening licensure to those with alternative professional degrees and experience, and expanding teacher recruitment efforts.   Further, Q-Comp—a program that pays teachers for achieving certain performance goals—is expanded statewide and K-12 funding increases are linked to improved performance.  These performance initiatives are open to criticism and improvement—Q-Comp generally pays teachers more for following process than for actual performance—but they remain key first steps on the path to dislodging the stifling status quo that binds teachers and students from achieving their true potential. 

Even Pres. Barack Obama endorses merit pay for teachers.  In a March 2009 speech, Obama declared that “it is time to start rewarding good teachers and stop making excuses for bad ones.”[7]  He goes on to be quite candid, saying: “if a teacher is given a chance but still does not improve, there is no excuse for that person to continue teaching.”  The President is directly challenging the current public school tenure system that makes it virtually impossible to fire low-performing teachers.

Missing from the education budget is a more immediate tool to help students trapped in disparately difficult public learning environments: State-issued low-income scholarships to private schools.  On top of providing new education opportunities, scholarships would likely save public schools money.

The total cost of the budget’s K-12 education commitments add up to a 1.3 percent spending increase over the forecasted budget, one of two major budget items spared from cuts.  While this fact may seem to undergird a commitment to job growth, it may do more harm than good if it leads to job dampening tax increase or spending cuts elsewhere, such as higher education. 

As originally proposed, the budget cut higher education spending by 9.9 percent, but this cut was downsized to a 1.2 percent reduction after the addition of federal stimulus money.    Though higher education gets nearly full funding, the original cuts reveal how close it is to a real belt tightening. 

Consequently, it’s still important to underscore higher education’s importance to job growth.  In addition to educating tomorrow’s workforce, Minnesota’s colleges and universities attract students from out of state who come to study and then stay to work.  Moreover, university research is often a source for innovative ideas that, when commercialized, spawn new products and businesses in Minnesota. 

Still, just pumping more money into higher education doesn’t automatically translate into high quality results that promote strong job growth.  In fact, research by Richard Vedder finds that “greater public spending on higher education is actually associated with lower rates of economic growth and an out-migration of population.”[8]  Rising tuition rates with no appreciable improvement in quality demonstrate that efficiency is on the decline.  Instead of limiting the policy discussion to funding adequacy, the budget should also address these performance declines. 

Also, universities may not focus enough on the sort of research that can be readily commercialized into job-creating businesses.  Professors and those who collaborate on university research may not have strong incentives to undertake the sort of research that leads to jobs.  Developing commercial products is not a university’s primary purpose and this research must be balanced with other research and its primary purpose, to teach.  
 
 

RECOMMENDATIONS 

§  Implement the Governor’s 21^st Century Tax Reform Commission’s tax relief recommendations.    The commission’s report offers the following tax relief recommendations: repeal the corporate income tax; exempt 20 percent of “pass-through” business income from taxation; conform to federal tax write-off provisions for business-related assets; replace the capital equipment sales tax refund with an upfront exemption; and extend the capital equipment exemption to businesses that provide services subject to sales tax.  The governor’s budget does not fully implement the Tax Reform Commission’s recommendations.  While the commission recommends repealing the corporate income tax, the budget would only halve the corporate income tax.  The commission supported these recommendations with a strong body of evidence and the budget should follow them with limited exceptions. 
   

§  Broaden the sales tax exemption for business purchases.  Limiting the sales tax exemption to only certain business purchases distorts investment decisions by creating an incentive to invest in exempt purchases at the expense of taxable purchases.  Some of the distinctions between exempt and taxable purchases can be quite nonrational.  For instance, a label used for shipping is taxable, but the stuffing material for the package is exempt.  These distinctions are especially problematic in regard to technology purchases.  Technology purchases for inventory management, production tracking, warehousing and other support or administrative activities are taxable while technology purchases used for manufacturing are exempt.  But investments in support activities and administrative activities may contribute more to business growth and efficiency.  Consider that the past success of Dell Computers was due largely to superior inventory management, not manufacturing advances.    
 

§  Refrain from creating new targeted tax incentives that aim to promote green jobs and investments in small businesses and venture capital funds.  Targeted taxes generally make for bad tax policy.  Special exemptions, deductions, and credits make the tax code more complex and skew private economic behavior.  As the Budget Trends report recommends, they should be minimized.  This is especially true for tax advantages bestowed on businesses.  While targeted tax benefits are often used to make the tax code fairer—e.g., the Earned Income Tax Credit—targeted taxes that benefit businesses are often quite unfair because they give the business an advantage over competitors.  

§  Implement a next generation Q-Comp program that offers an optional merit pay alternative to the traditional tenure track teacher contract.  As just referenced, even President Obama calls for substantial changes to America’s public school tenure system so that high-performing teachers can be rewarded and bad teachers can be let go.  Michelle Rhee, the chancellor of Washington, D.C. public schools, made quite a stir last year with her proposal to give teachers a choice between two compensation systems—the standard tenure system and a new merit-pay system.  In the merit-pay system, a teacher would need to give up tenure and in return their compensation would rise substantially.[9]  A similar merit-pay alternative that benefits both teachers and students—call it Q-Comp 2.0—should be developed and tested.  It’s difficult to foresee substantial improvements in Minnesota public schools without substantially upgrading teacher pay from depression-era tenure contracts.[10]   

§  Expand the governor’s on-line learning initiative to a comprehensive and on-going teacher and learning productivity initiative.  The National Center for Academic Transformation is a nonprofit organization that redesigns higher education learning environments using technology in order to increase student performance and lower costs.    The Chronicle of Higher Education reports that the implementation of the National Center for Academic Transformation course-redesign program in 30 initial programs on average reduced student costs by 37 percent.[11]  At the same time, learning performance was improved in 25 of the 30 projects.  The article referenced the University of Minnesota at Rochester’s Center for Learning Innovation as an example of a successful course-redesign program.  These programs would likely mesh well with the Online Learning Initiative because they also rely on technology as a key tool to drive efficiency.   

§  Make patents and the commercialization of research a formal factor to consider in granting tenure for appropriate faculty positions.  The number of patent applications by University of Minnesota faculty peaked at 104 in 2005.[12]  Since that time, patent applications have sunk to only 51 in 2007 and 52 in 2008, the lowest number of applications in the past decade.  To encourage more research that leads to business start ups and commercialized inventions, universities should make patents and technology commercialization a formal factor when granting tenure for certain teaching positions.  This policy was instituted in the Texas A&M University System in 2006.[13]  Just a year later, the university system reported a significant increase in the number of invention disclosures.[14]  While care must be taken not to focus too much on commercialization, the revenue generated by commercialization will support the core missions at Minnesota universities.  At the University of Minnesota, these revenues totaled $86.9 million in 2008—$11.4 million more than the budget’s originally proposed $75.5 million annual cut.
 
 

Budget Advances Economic Freedom

Economic freedom is vital to ensuring strong economic growth.  The budget advances economic freedom and, thereby, advances economic growth, on a number of important fronts. 
 

The government can encroach on economic freedom in at least three ways.   

§  First, the government can set taxes and spending too high.  Increasing the portion of income that a person or business must devote to taxes reduces the income that can be freely spent, saved, or invested in the economy.   

§  Second, the government can take responsibility for areas of the economy that are best left to the private sector.  When the government participates in a market, the control that individual consumers freely exercise over the market diminishes.  Less consumer control makes these markets less responsive to people’s needs and, thereby, less efficient.   

§  Third, the government can obstruct the freedom to pursue various economic activities through excessive regulation.  While regulations ostensibly protect the public good, regulations often protect one set of economic players against free competition from other players, restrict mutually beneficial contracts, and unnecessarily increase the cost of doing business.
 

Set against these three encroachments on economic freedom, the governor’s budget advances freedom on all fronts.  Not only does the budget hold the line on taxes, it actually reduces them.  Businesses generally pass the cost of taxes on to consumers and so the end result of these business tax reductions will be lower prices and higher wages—i.e., more money in consumers pockets.  Spending is also held in check by permanent cuts to almost every major component of the state budget.  Only K-12 education, corrections, veteran affairs, and military affairs are not being tapped to help alleviate the problems.  These spending cuts come on the heels of a number of years where the state exhibited substantial spending restraint relative to other states.[15]  Nonetheless, various spending initiatives can be further cut.
 

Further, the budget reduces the number of Minnesotans eligible for traditional public health care programs, which, in turn, reduces the government’s influence over the health care market.  Medicare and Medicaid are government-sponsored health insurance plans that now account for nearly 50 percent of the health plan market.  As a consequence, the demands made by government health plans shape the health care provider market at least as much as private plans.  This severely limits the average health care consumer’s influence in the market.   Though delayed some by the stimulus strings, the budget reduces the government’s share of the health care market by eliminating MinnesotaCare eligibility for parents and childless adults, effectively making MinnesotaCare a state health care program solely for children.  The budget also includes a restructuring of General Assistance Medical Care—the state health care program serving indigent adults—that replaces inpatient hospital benefits with clinic payments and a new fund for uncompensated care.  These cuts bring Minnesota’s eligibility income limits more in line with the average state.  Nonetheless, many people will argue that these cuts are too severe.  As an alternative to broad eligibility cuts, the government could instead transition enrollees to a less costly premium assistance program that enables low-income Minnesotans to afford a private health plan. 
 

Occupational licensing and certification often restricts a person’s freedom to pursue various jobs and the budget helps reduce these barriers for those wanting to teach.  Specifically, the budget opens teacher licensing to mid-career professionals who lack the standard teacher certification, yet clearly have the education and experience to be high-quality teachers.  The fact is, research uncovers little to no difference in the effectiveness of certified versus uncertified teachers.[16]  However, teaching is not the only occupation with overly restrictive licensing.  Health care, cosmetology, law, architecture, engineering, plumbing, accounting, among other occupations require various licenses and certifications that can restrict qualified people from working in those fields.   Indeed, reducing barriers to teaching is just a small first step.   
 

RECOMMENDATIONS 

§  Reduce the overall tax burden in order to maintain the price of government.  To keep the government from crowding out productive private investments and entrepreneurial activity, reducing or, at the very least, maintaining the current price of government needs to be a top priority for lawmakers.  That not only means taking tax increases off the bargaining table; it means tax reductions will almost certainly be needed to just maintain the price of government.  This is because current tax revenue growth is already projected to outpace economic growth.[17]  As tax revenue growth outpaces economic growth, the price of government—state revenues as a percent of state income—will creep up with tax reductions.  Therefore, lawmakers should seriously consider tax reductions, as long as spending reductions can keep Minnesota living within its means.
 

§  Make additional permanent spending cuts by eliminating or reducing the scope of more state programs.  While this report will not itemize all of the state programs in the budget that could be trimmed or eliminated, here are some places to start.   

»      Eliminate the Integration Revenue program.  This program provides extra funding to school districts for racial integration activities such as magnet schools, busing, and multicultural events.  According to the legislative auditor, most of the school districts that receive this funding have become less integrated.[18]   

»      Eliminate the JOBZ economic development program.  This program can cost more to create a job than the job pays and puts other businesses at a disadvantage.[19] 

»      Eliminate the health promotion grants to community programs that target obesity and tobacco use.  The budget already reduces funding for this program substantially, but most research shows that these programs are not effective.[20]   

»      Cut back on funding for agricultural marketing.  Business marketing is not government’s strong suit.  Funding for portions of the program that coordinate with the USDA or collaborate on research with universities should remain; all other funding should be cut.   

»      Eliminate the home ownership loan program.  By subsidizing home ownership, this program risks putting people in homes that they cannot afford.  It was suspended to help balance the budget deficit in 2003, and it should be eliminated now.   

§  Reduce spending on public employee benefits by aligning benefits with employee benefits in the private market.  A report from the Minnesota Taxpayers Association’s shows that many public sector workers receive higher wages than their private sector counterparts.[21]  While collective bargaining agreements make it difficult to adjust wages, the report explains how the state can effectively reduce wages by requiring employees to fund a larger portion of their pension without changing collective bargaining agreements.  The report estimates that the state could conservatively save $658 million by requiring employees to fund 50 percent of their pensions for the biennium.   

§  Refrain from reducing health care provider reimbursement rates in public programs.  One provision to balance the budget would reduce the reimbursement rates paid to health care providers who treat people in public health care programs.  This rate reduction effectively operates as a tax increase on all Minnesotans that pay for health care privately.  Research clearly demonstrates that when the government reduces reimbursement rates for public health programs, providers then charge higher rates to private payers to compensate for the revenue loss.  This increase in private rates operates as a hidden tax that subsidizes public health care programs.   

§  Require more public members on various occupational boards.  Occupational boards can act to restrict competition within their respective occupations in order to guarantee higher wages for themselves and their occupation.  To help give consumers a louder voice in these actions, the portion of public members that sit on these boards should be increased.
 
 

No adequate plan to solve long-term problems
 

Budget projections for the 2012-13 biennium and the findings of the Budget Trends Study Commission reveal serious long-term structural problems in the budget.   While the budget acknowledges these problems, it does not mount an adequate or coherent plan to solve them.  While some budget provisions indeed help, others will aggravate long-term budget problems.
 

Budget imbalanced over long term.  On top of Minnesota’s substantial short-term deficit, state spending—without any policy changes—is projected to surpass revenue as far as economists can reasonably predict.  According to the February 2009 budget forecast, revenues for the 2012-13 biennium “are now expected to be $5.133 billion less than projected expenditures before adjusting for inflation.”[22]  Further, over the next 25 years, the Budget Trends Study Commission projects that spending will grow at 5.4 percent per year while revenue will grow at 3.9 percent per year.[23] 
 

Why the disparity in spending versus revenue? The spending side of the disparity is primarily due to projected increases in health care expenditures due to medical inflation and increased utilization.  Revenue growth will decline because Minnesota’s economy is projected to grow more slowly than in the past and retirees, who tend to pay less income tax and less sales tax, will make up a larger portion of the tax base.
 

The governor’s response.  The governor’s administration is clearly working hard to address these long-term budget imbalances.  This work started years ago through successful efforts to keep spending and the growth of government in check.  Comparing six-year spending trends from 1999-2000 to 2005-2006, growth in state and local government spending in Minnesota ranked the third lowest among the states.[24]  As a consequence, the price of government—state and local revenues as a percentage of Minnesota personal income—remains, on average, over a percentage point lower (15.85 percent) in this decade versus the 1990s (17.0 percent).[25]  One percentage point might not sound like much, but, if the price of government were another point higher in FY2009, then the state would need another $2.2 billion in revenue.  Also, in recent years the governor’s administration advanced a number of reforms that hope to dampen the growth in health care spending.

The present budget begins to tackle long-term imbalances primarily by cutting spending, tightening income eligibility limits for health care programs, consolidating government programs and modernizing various government services.  Combined, these changes help reduce the FY 2012-13 budget deficit by about half.  Further, provisions that might appear to add to long-term imbalances—e.g., business tax reductions and increased funding for teacher performance initiatives—may actually expand revenues by increasing future economic growth.
 

Budget does not solve long-term problems.  Unfortunately, these budget provisions fall far short.  As just noted, the FY 2012-13 budget deficit is nearly halved, meaning it’s still not even close to balanced.  Further, with the exception of health care eligibility reductions, most of the spending cuts are one-time cuts or efficiency gains that will not control future spending growth rates.  At some point, high annual growth rates in spending will erase any savings achieved by most of the budget’s spending reductions.  
 

The reality is, the budget relies primarily on one-time funding sources—federal stimulus, K-12 payment shifts, and tobacco bonds—and leaves long-term solutions for another day. 
 

By relying on these one-time funds, the budget delays solving the problem and creates future obligations, which only aggravates long-term imbalances.  Essentially, these funds are just loans from future budgets.  K-12 payment shifts move obligations to public schools from one year to the next and simply delay the inevitable.  These payment shifts will likely revert back in better times.  Tobacco appropriation bonds trade a portion of future tobacco settlement revenue, presently valued at $100 million per year, for a one-time pay out.  Of course, the stimulus funds will be financed by increasing the federal deficit.  All of these payment sources violate the spirit of Minnesota’s constitutional restrictions against borrowing to meet current financial obligations.
 

Sidestepping long-term problems is understandable.  Fixing long-term imbalances is understandably a tall order for the budget.  Remember that the primary drivers for the imbalance are health care spending growth and demographic shifts—i.e., retiring baby boomers.  With these two facts in mind, it’s understandable that the governor’s budget sidesteps long-term problems.
 

Health care reformers have spent decades trying to dampen health care spending growth with little to show for it.  It would be fantastical to think that the governor’s budget could somehow cure this part of the problem and succeed where everyone else has failed.  This is especially true because federal laws bind states from adopting reforms that can work.  By reducing MinnesotaCare eligibility, consolidating county health care programs, and reshaping GAMC, the budget takes reasonable steps to control health care spending.
 

Demographic shifts are more like a force of nature that can’t be tamed.  Instead, the budget must adapt to these demographic changes.  However, recommended adaptations will upset long-held policies.  While these policy changes have been known to lawmakers for decades, no lawmaker has yet demonstrated the leadership to successfully adopt them.  Consider that major state tax study reports or commissions in 1984, 1986, 1992, 2001, and 2009 all recommend that the state should broaden the base of goods and services subject to the state sales tax.   Despite these repeated recommendations, nothing changed.   The budget just follows this trend. 
 

Now is the time to begin fixing long-term problems.  The middle of a severe budget crisis may seem like the wrong time to begin fixing long-term imbalances, but there really is no better time to do it.  Why?  Because tough times make tough decisions for the public easier to swallow.  In good times, the public might logically understand the need for tax and spending reforms, but they don’t feel the need because they feel comfortable.  The public is definitely feeling it these days.  Today, the public better understands that the government cannot afford to provide all things to all people.  Knowing that the budget faces a severe shortfall, the public should also accept the need for uncomfortable tax changes more easily.   While the overall tax burden should not be raised, a number of dramatic changes to the tax code should be considered.  These changes will upset the status quo and will not be comfortable. 
 

Fortunately, lawmakers now have two new reports to help guide them as they sort out how to keep revenues in line with spending.  These reports are the product of two commissions, the Budget Trends Study Commission, created by law in the 2007 session, and the 21^st Century Tax Reform Commission, created by executive order in 2008.  The Budget Trends report assesses how long-term demographic trends will impact the budget and recommends broad principles aimed at achieving long-term balance and reducing volatility in the budget.  The Tax Reform report focuses more narrowly on recommendations to modernize business taxes to promote economic growth. 
 

RECOMMENDATIONS 

§  In addition to implementing the Governor’s 21^st Century Tax Reform Commission’s recommendations to reduce business tax burdens, implement the Commission’s recommendations to improve business tax transparency and extend the sales tax base.   This Governor’s 21^st Century Tax Reform Commission reflects months of careful consideration and most of its recommendations deserve to be included within a comprehensive tax reform package that positions Minnesota for economic growth, while at the same time helps protect future budgets from revenue shortfalls.  However, the Commission’s recommendations that use tax policy to attract and target investments should generally be rejected for the reasons previously discussed under the recommendation to not create new targeted tax incentives.  One exception may be the R&D tax credit, and only because every other state seems to be doing it.  This may seem like a cop-out to sound tax principles, but, as long as Congress and the federal courts allow states to compete for businesses, Minnesota must be alert and responsive to other states’ business tax incentives.  Further, the R&D credit does not distort the economy by favoring certain industries by sector or size to the same degree as other proposed tax incentives.   

§  Avoid phasing in tax changes over multiple years, but, rather, make any changes immediate and permanent.   The budget recommends phasing in corporate tax reductions over six years.  The reason for phasing in tax reductions is so that the full revenue impact will not be experienced in the midst of the current budget shortfall.  However, research shows that a phased-in tax cut can reduce economic activity over the phase-in period because some taxpayers will delay productive activity until the tax cut takes full effect.[26]  Now is the wrong time to create an incentive for people and corporations to shift productive activity to the future when tax rates will be lower.  Tax changes should be immediate and permanent.  That means that if a certain tax is cut, then there must also be an immediate and permanent cut in spending or tax increase elsewhere to compensate for the revenue loss.  For instance, the 21^st Tax Reform would offset corporate income tax reductions by broadening the sales tax base.  

§  Implement the Budget Trends recommendations to increase the size of the budget reserve, periodically assess the adequacy of the reserve, and replenish the reserve within two biennia.  Clearly the budget reserve is not large enough to compensate for the inherent volatility of the state budget.  Indeed, the FY08-09 biennium’s deficit—small relative to the FY10-11 biennium’s $6.2 billion structural imbalance—depleted the reserve, leaving nothing to help weather the current crisis.   

§  Replace K-12 payment shifts with permanent spending cuts.  The Budget Trends report recommends that, in order to “manage long-term obligations, the State should begin by spending no more in the current biennial budget than can be supported  by ongoing revenues.”  By shifting K-12 payments to the next year, the budget relies on revenues from the next year to fund K-12 expenditures in the current year and, therefore, fails to match current K-12 spending with current revenues.  Put simply, the state must spend within its means.  To do so, and as already recommended, the state must cut spending more deeply and some cuts must come from the education budget.    Senate Democrats proposed cutting education by $1 billion, which would account for nearly the entire proposed payment shift.[27]  This is a reasonable number in light of the fact that education accounts for 38 percent of the budget.  A billion dollars only asks education to account for 22 percent of the budget deficit.   While K-12 deserves to be a priority, restricting cuts to K-12 funding places a substantial burden on the remaining 62 percent of the budget. 

§  Roll back eligibility for state health care programs to lower income levels.  Minnesota extends more generous health care assistance to people at higher income levels than nearly any other state.[28]  As Minnesota faces long-term budget imbalances primarily caused by state health care programs, the state cannot afford to be substantially more generous than its neighbors.  While the federal stimulus package will requires the state to delay eligibility changes, the state should still move forward and put eligibility reductions in place that makes Minnesota more comparable to other states.  At the very least, this means lowering eligibility for childless adults to 150 percent of FPG and parents to 200 percent of FPG.  Though lowering eligibility does not reduce the rate of health spending growth, it reduces the portion of the budget devoted to health care, which reduces the influence that health spending growth will have on total spending growth.  Consequently, total long-term spending growth rates should decline.  

§  Limit the use of tobacco appropriation bonds to provisions that provide long-term returns.   The  Budget Trends report also recommends that “any additional one-time revenues should be used strictly for building reserves, paying off shifts, capital projects, or other one-time purposes.”  If the state uses one-time revenues for ordinary expenditures, then the state would be spending more than ongoing revenues support, violating the aforementioned principle.  Funds for one-time revenues are often raised through some type of borrowing and so it may be appropriate to use one-time revenues for expenditures that can be appropriately financed with debt, such as expenditures with a useful life or long-term return beyond the current biennium.  Most of the expenditures that the Budget Trends list deems appropriate for one-time revenue do provide a long-term return.  Some expenditures within the governor’s budget that create long-term returns include accounting system upgrades, county human services program consolidation, and education assessment improvements.  

§  Reallocate revenues to the general fund that are currently dedicated to specific government programs when there is no direct link between the revenue source and the government program.   The state dedicates certain revenue sources, such as fishing licenses and gas taxes, to specific government programs so that those who benefit most from those programs also pay the most.  Heavy road users appropriately pay more in gas taxes dedicated to fund the roads they drive.  However, sometimes taxes are dedicated to programs when there is no appropriate link to a beneficiary of the program.  In these cases, the dedication of funding only serves to guarantee a level of funding and, therefore, establishes that program as a priority over other programs.  For instance, the state public health care programs receive dedicated funding that prioritizes them ahead of other programs like K-12 education. 
 

»      As the governor’s budget recommends, the state should merge revenues dedicated to the Health Care Access Fund with the General Fund.
 

»      In addition, lottery in-lieu of sales tax receipts should be deposited in the general fund.  These tax receipts—$21.7 billion in 2008—are currently diverted toward natural resources programs when there is no special connection between lottery sales and the natural environment.   
 

Getting more value from government programs
 

The deficit and the Budget Trends report make one thing clear: Business as usual cannot continue.  Recall that government spending is projected to grow by 5.4 percent per year over the next 25 years, compared to 3.9 percent annual revenue growth.  Health care spending will grow the most at 8.5 percent per year, followed by education at 4.8 percent per year.  Under these growth rates, health care will account for two thirds of the budget in 25 years.  Obviously, that is not sustainable.  Substantial spending reductions, revenue increases, or some combination of the two will be needed to balance long-term spending with revenues. 
 

Unfortunately, simple tax increases and program cuts will not go far enough to keep the budget in long-term balance.  As already recommended, taxes increases should be dismissed because taxes are already projected to outpace economic growth.  Further, tax increases are especially troublesome because they do nothing to control projected spending growth, which allows the government’s footprint on the economy to grow larger.  Program cuts prove difficult because they usually involve trimming back popular government programs, such as programs that provide health care to the needy, reduce class sizes, and put more cops on the street.   And, while program cuts can reduce spending growth rates, more often cuts just lower the spending baseline without lowering growth rates. 
 

Aside from tax increases and program cuts, the only alternative strategy to keep future budgets in balance is for the government to get more value from every dollar it spends.  Indeed, if the state expects to maintain the price of government at present levels—i.e., no new taxes—and expects to cut state programs only moderately, the state must adopt innovative reforms that radically transform how state programs deliver services.  This is especially true for programs with high growth rates like health care and education. 
 

Transforming government is no easy task.  Innovative and value-enhancing ideas are incredibly scarce.  Further, innovations upset settled expectations, relationships, and entrenched bureaucracies.  Moreover, radical transformations involve plenty of risk.  What if the state invests money to transform a program and it ends up costing more?  Thus, these transformations require serious scrutiny.  Nonetheless, innovative and transformative policies must be adopted if the state expects to continue balancing future budgets without burdensome tax increases or draconian program cuts. 
 

Various proposals from lawmakers do advance some notable policies that aim to transform business as usual.  The governor’s budget includes policies that begin to pay teachers for their performance, consolidate county human services programs, and restructure General Assistance Medical Care.   Further, in an attempt to control the largest cost driver, lawmakers last session began a process that could radically transform how Minnesotans access and pay for health care.  Most recently, Democrats in the House and the Senate proposed additional legislation to broaden these health care reforms.
 

These proposals are indeed transformational, and, as noted, involve risk and require serious scrutiny.  This is especially true regarding health care reform proposals, because they affect the entire health care industry, not just government programs.  Unfortunately, last session’s health care reform policies tend to create more layers of government regulation that narrow options available to patients.  In other words, they’re government-mandated cost controls, not patient-directed cost controls.  While certain aspects of these reforms do work to engage health care consumers in making more cost effective decisions, these aspects risk being overshadowed by more government mandates and control over the health care sector.
 

While endless scrutiny and debate can help avoid making the wrong move, it can also mean costly delay.  The following recommendations suggest avenues that can move Minnesota forward toward a new way of doing business. 
 

RECOMMENDATIONS 

§  Convert federal funding for Medicaid into a block grant in order to give Minnesota the flexibility and the incentives necessary to implement reforms that can control long-term spending growth.   Funding Medicaid through a block grant would free Medicaid from federal rules that encourage spending growth and obstruct lawmakers from implementing the sort of Medicaid reforms that can control spending growth.   Medicaid is currently funded as an individual entitlement program where the federal government matches state funding.  This creates the perverse incentive for the state to game the system and expand state funding in order to maximize the federal match.  Furthermore, federal rules restrict the state from making significant programmatic reforms related to eligibility, cost-sharing, and benefit design.  A state generally needs to negotiate a waiver from these rules to implement reforms.  This need to negotiate a waiver every time state lawmakers want to implement a good idea seriously hampers Medicaid reform efforts.  While a block grant will initially require these same negotiations, the end result will be the freedom from further negotiations.   

In general, a block grant will provide Minnesota with a fixed allotment of federal funds each year to spend on health care programs.  Taking a fixed allotment versus a federal match removes the state incentive to maximize federal funding because the funding is fixed.  Importantly, with fixed funding, the state retains 100 percent of any cost savings whereas under the current federal match, the state retains 50 percent or less of any savings.  By giving the state more flexibility to implement cost-saving reforms—the following recommendation would be good for starters—and rewarding the state budget with 100 percent of any cost savings, a block grant gives the state the power to control its own destiny.   

§  Convert MinnesotaCare into a premium subsidy program that enables enrollees to afford individual health insurance.  MinnesotaCare is administered through private managed care health plans, which, being private, might seem to be similar to a subsidy program.  However, managed care perpetuates most of the problems found under traditional fee-for-service Medicaid, including private coverage crowd out, below-cost reimbursement, cost shifting, reduced access, second-class care, overuse of medical services, lack of coverage continuity and portability, low patient engagement, and few competitive forces driving quality improvements and cost reductions.  MinnesotaCare is also very expensive for the benefit it provides.  A premium subsidy program could offer expanded benefits at lower cost.  Most important, future premiums would be subject to true competition among health plans in the individual market, which will do better at containing long-term spending growth in MinnesotaCare than annual benefit and eligibility tweaks.   

§  Implement a state-issued private school scholarship program for low-income Minnesotans trapped in underperforming schools.  While there may be a number of good ideas to reform public schools—including proposals like Q-Comp—private school scholarships are the only immediate answer for today’s struggling low-income students.  Moreover, a scholarship program will save money.  A recent analysis of Florida’s Corporate Income Tax Scholarship by the Florida legislature found that “the state saved $1.49 in education funding for every dollar loss in corporate income tax revenue due to scholarship contributions.”[29]  For the 2007-08 school year, scholarships provided to 21,493 students resulted in a net savings of $38.9 million.  These savings did not come at the expense of public school students.  Research almost universally demonstrates that these programs improve public school performance.[30]   

§  Improve accountability/performance measures for state agencies by measuring and publishing the cost of achieving specific goals, and audit goals to be sure they accurately reflect the mission and statutory responsibilities of state agencies.  Lawmakers and the public require meaningful, accurate, and understandable information about state agencies and their programs in order to discuss how the state’s budget should allocate funds.  While the state Web site, www.accountability.state.mn.us, provides a useful resource that publishes state agency goals and performance data, the performance metrics used on the Web site can be significantly improved.  Ideally, performance measures will evaluate the cost to accomplish particular results in comparable ways across agencies.  Knowing the actual cost of a result gives lawmakers and the public a powerful tool to understand the tradeoffs in funding one result over another.  As funding becomes more scarce, understanding these tradeoffs becomes critical to the budget process.   

Unfortunately, most agency performance measures only evaluate quality or quantity delivered.   For instance, one performance measure shows how many supportive housing opportunities were funded from year to year and neglects to reveal how much each supportive housing opportunity costs.  To improve performance measurement, agencies and Accountability Minnesota should be required to measure and publish the cost of the resources devoted to achieving specific goals.[31]  Understandably, a cost cannot be attached to every performance measure, but this information should be reported where possible.  In addition, the state auditor should audit goals to be sure that they accurately reflect the mission and statutory responsibilities of the agency or program. 

§  Create an Office of Competition & Privatization Policy under the auspices of the Drive to Excellence in order to identify and evaluate privatization initiatives that can deliver more value to taxpayers or that remove unfair government competition from the private sector.  As previously noted, the governor’s Drive to Excellence initiative coordinates a set of programs to “reinvent” state government and improve the way government services are delivered.  Privatization is a key component to reinventing government and Minnesota could be doing more of it.  Privatization initiatives invite private companies to compete to provide government services.  This competition adds new and powerful incentives to innovate, increase performance, and lower costs.  
 

Not all government services should be privatized and those that can be beneficially privatized need careful planning, which is why it makes sense to create an office devoted to analyzing whether and how government services should be privatized.  To identify and evaluate privatization initiatives, the Office should create a state inventory that quadrennially identifies those services that only the government can provide and those services suitable for competition in the private sector.  The Federal Activities Inventory Reform Act of 1998 requires federal agencies to maintain a similar inventory of “inherently governmental” and “commercial” activities and can provide a model for developing a state inventory.[32]  In addition, the Office should direct the creation of similar inventories for local governments.   

§  Enable the Department of Transportation to enter into public private partnerships to fund transportation projects.  A well-functioning transportation system is essential to economic growth and, therefore, essential to revenue growth.  However, most people agree that transportation investments in Minnesota fall short.  This is largely because transportation projects require enormous amounts of capital, which transportation taxes and the general fund are not equipped to raise.  Governments across the globe face the same problem and increasingly rely on public private partnerships to raise the necessary capital to build and maintain their transportation networks.  There are legitimate concerns over whether these partnerships adequately protect the public interest in traditionally publicly held assets. However, there is now a growing track record that demonstrates how to create these partnerships through long-term leases and contracts where the public sector retains strong and ongoing oversight and regulatory power.   

§  Assess the wisdom of leasing the airport.  To be clear, this is just a recommendation to explore the idea of leasing the airport and not an endorsement of putting the airport up for auction.  Indeed, leasing the airport under the gun of a substantial deficit would not be prudent.  Rather, the state should take the necessary time for a thorough investigation of the long-term impacts of leasing the airport.  Investigating the wisdom of leasing the airport could be the first task for the Office of Privatization and Competition Policy.  Sen. Geoff Michel and Rep. Laura Brod, who originally promoted the idea, roughly estimate that a lease might raise $5 billion for the state.  In addition to this money, putting a private company in charge of the airport with financial incentives to meet the demands of travelers will improve the airport’s services.  While selling the airport might seem over the top, major European airports have been sold or leased, such as Paris DeGaulle, Frankfurt, Belfast,  and London Heathrow. 
  

Conclusion

If there’s a silver lining to the budget deficit, it’s that it gives lawmakers an opportunity to squarely address fundamental tax and budget issues too often ignored.  It’s easy for lawmakers to focus their attention on feeding the hungry, educating students, defending the unborn or a woman’s right to choose, keeping cops on the streets, providing health care to children, and protecting pheasant habitat.  These issues are more personal or they benefit a more concentrated group of voters, which makes voters more passionate and vocal.  Consequently, lawmakers pay attention.  Voters rarely rally for less volatile revenue sources, more efficient government, competitive business taxes, and long-term structural balance in the budget.   While, even now, voters are not rallying around these issues, they understand them more clearly than ever before.  What this means is that voters, who might otherwise be rallying full force for education or pheasants, understand that lawmakers have difficult work to do this year and will allow lawmakers to go about that business.  Consequently, lawmakers should take this opportunity to get as much of that work accomplished as possible.  As this report outlines, Minnesotans will be better served if lawmakers focus on promoting job growth, advancing economic freedom, bringing balance beyond the biennium, and obtaining more value from government services. 

-- Peter Nelson is an attorney and Policy Fellow at Center of the American Experiment. Center of the American Experiment is a nonpartisan, tax-exempt, public policy and educational institution that brings conservative and free market ideas to bear on the hardest problems facing Minnesota and the nation.

Notes