One Step Forward, One Step Back

August 01, 2006

Oklahoma has had an astounding budget year.

Despite an unprecedented $1 billion in new revenues and surplus cash, the legislature could not manage to forge a budget deal by the end of the regular legislative session. One would think that with such tremendous resources available, coming to agreement on Oklahoma's priorities would be easy, but like a young child standing in the mall holding a crisp hundred-dollar bill and giddy with purchasing power, lawmakers found this to be too much for them. For the first time, the governor had to call the legislature into special session to avoid a government shutdown.

A highly contentious budget year, marked by partisan fighting and some minor internal Republican squabbles, ended with both landmark tax cuts and landmark spending increases. Lawmakers passed a strong tax cut agenda which will create a more pro-growth environment for Oklahoma - one step forward. Yet at the same time they took a quick - and bigger - step backward by passing massive spending increases which by themselves will damage economic growth. Moreover, they have harmed Oklahoma's position in a highly competitive global economy where such missteps are ill-afforded.

This is a troubling parallel to what I see every day here in Washington, where budget deliberations have been highly partisan and marked by rancor in the Republican ranks. But Washington's misguided philosophy on fiscal policy has been schizophrenic. The strong federal pro-growth tax cuts do not make up for - or excuse - enacting the largest expansion of the welfare state since Lyndon Johnson's Great Society via the Medicare drug benefit. Nor do they make up for increasing the federal budget by 45 percent since 2001. Oklahoma's lawmakers should take great care not to repeat these policy mistakes.

New Money
In February, it was estimated that two-thirds of a billion dollars in new revenues would pour into the state treasury in FY-2007 - an increase of 12.5 percent. But that didn't include huge cash surpluses piling up in the general revenue fund for FY-2006. By the time the dust settled, the legislature had more than $1 billion in new money or cash. That's nearly $750 per household. That's 16.5 percent more than last year after paying for tax cuts which reduced the top marginal income tax rate, increased the standard deduction, and repealed the estate tax.

Much attention has rightly been focused on the surge in revenue from gross production taxes. Anyone who pumps his own gas or pays his own gas bill knows that prices are up, and as these high revenues flow into the state coffers, many people are rightly leery of basing new spending on such a volatile revenue source. After all, it's not the first time Oklahoma's oil and gas sectors have provided booming state revenues which were followed by a precipitous decline, with the effects of a devastated industry wreaking havoc on state agencies.

Yet gross production taxes account for only 22 percent of new general fund revenues. The more important story is the growth in individual and corporate income taxes, which together account for more than half of all new general revenue. Before the income and estate tax cuts, revenues from individual income taxes - the state's largest source of revenue - were estimated to grow by 13.8 percent in FY-2007.

The legislature and governor rightly focused fiscal policy on tax cuts, especially the pro-growth tax cuts bringing the top marginal rate from 6.25 percent to 5.5 percent, with a further reduction to 5.25 percent possible. This will make Oklahoma a more competitive state, stimulate job formation, and provide incentive to work. And because the top marginal rate is paid on all income, these cuts will also help to lower taxes on things like capital gains and interest. Lowering the cost of capital to those wanting to save and invest in Oklahoma is important to economic growth and a key step toward increasing Oklahoma's competitive position. Increasing the standard deduction to the federal level over four years will also benefit all Oklahoma taxpayers, though it will not have the same economic benefit as lowering the top marginal rate.

Sadly, the marginal rate tax cuts - those with the biggest economic value - will not take full effect immediately. Rather, they will be phased in over a period of three years, resulting in more money to spend in this and future budgets. The legislature also rightly included repeal of Oklahoma's estate tax, a known contributor to capital flight, though it will take three years to reach full repeal. Next year's legislative leaders should consider speeding up these tax reductions, rather than pass large spending increases.

New Spending
The legislature's spending side of the ledger was disturbing. There are always pressing needs in the budget for things like corrections, public safety, education, or Medicaid, but in an exceptional year like this one, there are always numerous claims for a piece of the spending action, whether it's economic development schemes or programs for low-income Oklahomans. Such demands seem to spur competition among legislators anxious to please special-interest constituents, and this year was no different. Indeed, this legislature's strong record on pro-growth tax policy is directly at odds with the rhetoric from the governor and legislative leaders surrounding record spending as "pro-growth." Spending on a litany of new or expanded programs has been rationalized as "investment" rather than as industrial planning or handouts to a broad array of special interests.

The budget for FY-2007 weighs in at $6.6 billion - half a billion dollars or 8.7 percent larger than last year's appropriation. Adding transfers of nearly $0.5 billion in cash to various agencies brings the total to $7.1 billion. These are transfers of cash that came in faster than estimated last year; agencies do not have the ability and/or the authority to spend it. In some instances, these are one-time transfers for things like equipment or establishing a special economic development fund. But some transfers were for ongoing operations such as the $85 million appropriation to the Regents for Higher Education, even though this cash is likely a one-time source of funds. This is nearly $5,300 per household and a rise of 16.25 percent - the largest increase since the state was recovering from the oil bust years - after a 12.5 percent increase last year. By contrast, inflation is projected to be under 3.5 percent this year,1 while Oklahoma's projected population growth is 0.69 percent.2 Oklahomans should be incensed that the state's budget will grow nearly four times faster than inflation and population combined - and faster than other economic indicators. At this rate, spending will far outstrip the state's income growth and taxpayers' ability to generate new tax revenues.

By most reports, the lion's share of the cash transfers was not counted as appropriations and thus was excluded from total state spending, making it difficult for citizens and lawmakers to realize the budget's magnitude. But there was even more spending that took place "off budget." For example, most of the funding for the "Road to Progress" transportation initiative will occur outside of the legislative budget process. In FY-2007, this ROADS fund will receive $50 million, or $35 million more than last year.3 This money essentially comes from individual income taxes that otherwise would have gone to the general revenue fund. It is the legislature's prerogative, of course, to direct funds wherever they see fit, but it is also disingenuous for lawmakers to trumpet investments they have made through spending programs they have created outside the scrutiny and transparency of the budget process.

Budget Winners
Predictably, state employees and teachers lined up for salary increases, which were passed out after competition and dickering among groups like corrections officers. To be fair, the only way these workers can receive wage increases is through the power of the legislature's purse, so it is not unnatural for them to be in line for a handout. But research by Heritage Foundation adjunct scholar Wendell Cox has shown that Oklahoma's state employees are well-compensated, especially when compared with Oklahoma's private sector.4 Nonetheless, given the usual procedures, it was inevitable in such a banner year that state and school workers would go home with raises. What is astounding is that with more than $1 billion in new revenues and cash, these raises will not take place until October, three months into the fiscal year. This maneuver saved budget writers millions of dollars to spend elsewhere and created an automatic hole in next year's budget.

Rather than merely handing out raises, however, the legislature could have used some of this year's revenue glut to reform the compensation system by allowing managers and schools broader authority to grant merit increases rather than simply to come hat in hand to the capitol every election year. This would promote better performance and efficiency by Oklahoma's public servants because performance standards would become more meaningful. Additionally, there would be competition among employees to outperform each other in return for more generous increases. Legislators could have seen fit to restructure the state's overstaffed employment ranks, which comfortably exceed the national averages, to retain a leaner, more efficient workforce.5 Perhaps they valued the power of the purse and a larger, grateful public sector more than enhanced public service.

State employees were not the only winners in this year's budget. The legislature gave broad increases across much of the state budget. The largest winner was the Oklahoma Center for the Advancement of Science and Technology, with an 81 percent increase. This agency will receive huge increases as part of lawmakers' efforts to improve Oklahoma's capacity for research. Lawmakers also shoveled mountains of cash into several different funds to be used for economic development.6 Critics point out that such efforts are little more than corporate welfare and often fail to deliver on promises made. States often overpay for the jobs they have created, and projects sometimes are abject failures.7 Demonstrating again their propensity for budget gimmickry, the legislature increased Medicaid compensation rates for hospitals and physicians by $13 million. Rather than making these increases immediate, they will not take effect until January 1, 2007, halfway through the fiscal year. This preserved yet more to spend this year and will cause another multi-million budget hole next year.

In addition, most agencies also received large funding increases, some of them remarkable. Some, such as the University of Oklahoma, Oklahoma State University, and the Department of Veterans Affairs, will receive still larger funding from cash transfers not included in the table below.

The legislature also took a pass on fixing one of its biggest fiscal challenges, the Teachers Retirement System (TRS). According to the TRS annual report, it has enough assets to pay for only 49.5 percent of its pension liabilities. TRS gives Oklahoma the dubious distinction of having the nation's second worst-funded state retirement system.8 Governor Brad Henry rightfully proposed putting $92 million of this year's record revenues into TRS.9 Safely invested, this windfall could have grown to nearly $1 billion over the next 30 years,10 vastly improving the system's financial viability. An even better action would have been to create a more flexible system for new teachers. Record cash and revenues could have been used to pay the costs of transitioning to a new system and to enhance funding for the existing system. But rather than adopting one or both of these sensible solutions, the legislature gave present and future retired teachers not one dime of pension protection.

Government Spending Growth
The budget increases of the past two years, while remarkable in their excess, are nothing new. Past years have often been marked by the same inclination to spend every available dollar, use budgetary gimmicks to create more, and routinely pile on spending from the Rainy Day fund.

While it is necessary to forge compromise in the political process, this penchant for enriching the state through budget patronage is one that can be seen at all levels of government.

For example, this has been my experience at the local level. California's highly prosperous Orange County experienced one of the nation's largest municipal bankruptcies when the treasurer lost $1.7 billion of the county's portfolio through a series of increasingly questionable and unwise investments. County executives, anxious for a robust budget, unwittingly collaborated with the treasurer's risky investment schemes in an effort to generate more revenues outside the state's Proposition 13 property tax limit.

This has also been my experience here in the nation's capital, where the runaway federal budget grew by 33 percent from 2001 to 2005 - and not just because of the war in Iraq or homeland security. Appropriations for other spending increased 38 percent for all manner of programs, and total spending growth is projected to reach 45 percent at the end of this fiscal year.11 Just as Oklahoma has failed to address Teachers Retirement System insolvency, Congress has done little to address long-term insolvencies from Medicare and Social Security. Instead, it has only made matters worse by passing an unwieldy Medicare drug benefit - the largest expansion of the welfare state since the Great Society and projected to cost more than $8 trillion over the long run, or about $72,000 per household in today's dollars. What would go a long way toward a mortgage on a small house in Oklahoma is instead a liability the nation's taxpayers must now shoulder.

Why Worry About Government Spending?
Those who seek to restrain spending are not just curmudgeonly conservatives. Rather, for important economic and societal reasons, they are concerned about limited government and the need to limit spending.12 Government spending crowds out productive private-sector activity by taking away resources and reallocating them based on political considerations rather than economic decisions. Funding state research capabilities is a laudable goal, as is funding for economic development, but government is inherently less adept than the private sector at picking winners. Bidding wars between states for businesses and jobs often deliver disappointing results.

Government spending also encourages unproductive choices and discourages productive choices, such as choosing welfare over work and relying on subsidized programs like retirement and housing rather than saving for such things. Finally, government spending inhibits innovation because government is more centralized and bureaucratic than the private sector, which is always seeking new opportunities and improvements to maximize the bottom line.

Conclusion
By passing tax cuts that will eliminate the estate tax and reduce the top marginal income tax rate, Oklahoma's lawmakers have demonstrated their understanding that the state's high taxes on work and capital are economically damaging. There is still room for improvement in Oklahoma's tax laws, but lawmakers clearly do not understand that high government spending, in and of itself, damages the economy.

To restrain lawmakers from their natural propensity to spend, strong meaningful limits are necessary. If Oklahoma is to avoid the federal government's mistakes, there should be a constitutional limit on total spending that forces lawmakers to set priorities and make tough choices about how to allocate precious resources. Though Oklahoma does have a constitutional appropriation limitation, it is unreasonably high: 12 percent plus inflation. This year, the limit provided for 15.79 percent growth, but this is not a limit on total spending, since a growing number of large spending streams are excluded.

Oklahoma's families would be better served with a more meaningful, comprehensive spending limit that would still allow the budget to grow, but much more rationally. The child with that crisp hundred-dollar bill should have strong guidance from his parents in order to make wise choices. Lawmakers too should have strong limits to force wise spending choices for Oklahoma's future.

Alison Acosta Fraser is the director of the Thomas A. Roe Institute for Economic Policy Studies at the Heritage Foundation. Before that, she worked as Deputy Director of the Oklahoma Office of State Finance. Roe Institute intern Calley Means contributed to this article.