Michigan’s Fiscal Future

 

2008 Report 349

In Brief

It has been apparent for several years that Michigan state government and its constituent governmental units are faced with a structural deficit that requires significant changes in revenue and spending policies. This report is intended to measure the size of the challenge that will face policymakers in the future and to identify actions that might be taken to mitigate some of the structural deficit pressures.

Michigan state government has not, as a regular practice, measured the future consequences of current decisions.  Generally, the analyses of proposed changes in tax and program polices do not include projections that would help identify problems with sustaining the policy changes in the long run.  Michigan’s fiscal history is littered with examples of policy changes, such as the aggressive tax cuts implemented in the late 1990s, that were believed to be affordable without significant changes in programs.

This report provides information on the past decade of spending and revenue changes and a review of the State’s economic performance to help set the stage for projections into the future.  Three scenarios describing Michigan’s economy, under varying sets of assumptions about sectors especially important to the state, are computed within a background of a continuously moderately improving national economy.

The analysis accepts the changes that have occurred in the State’s expenditure and revenue structure and incorporates those changes into the spending and revenue base.  It then makes calculations to determine where spending pressures from existing programs would take the budget if sufficient resources were available.  Similarly, projections of the revenues paying for the program spending are calculated.  The projections go to 2017, nearly a decade into the future.  As a starting point, the January 2008 consensus revenue projections of the State are used as are the appropriations for Fiscal Year 2008 (FY08).

The projections are not predictions of spending and revenue outcomes, however, since the projected spending pressures exceed revenues, requiring actions to achieve the legally required balanced budgets each year.  Virtually every budget area faces spending pressures increases that outpace revenue growth.  Combinations of spending and revenue policy changes will be required to force the rates of growth in both sides of the budget to approximate one another.

Spending pressures in two areas stand out as major causes of the structural deficit: corrections and health care.  Both areas are likely to grow at more than twice the rate of increase in revenues, unless policies are implemented that substantially reduce the rate of growth.

Major tax revenues are not growing as fast as the economy and the share of the overall economy claimed by state taxes will continue to fall.  The two largest taxes, income and sales (and use), are projected to increase about 3 percent per year in the mid-range growth scenario.  Neither the State’s consumption nor income taxes are strongly connected to the economy of the 21st century.  The State’s Sales and Use taxes together tax most goods purchased, except food for home consumption and prescription medicine, and very few services.  By not taxing services at a 6  percent rate the forgone tax dollars exceed the revenues derived from the current Sales and Use taxes.  The services sector of the economy has grown faster than goods consumption, and services growth is projected to outpace goods consumption growth into the foreseeable future.  Expanding into services taxation would make consumption taxes grow more in line with the overall economy, even after making the starting point revenue-neutral.

Revenues from the Personal Income tax are exceeded only by revenues from the combined Sales and Use taxes.  The Personal Income tax is the largest revenue producer for the General Fund.  It is a flat rate tax that produces revenue that grows more slowly than the overall economy.  Of the 41 states with an income tax, 35 states have income taxes with graduated rate structures (the rate of tax on successively higher increments of income rises).  The revenues from graduated income taxes grow faster than revenues from flat rate taxes.  If Michigan were to substitute a graduated income tax for its current flat rate tax, revenues would grow at a faster rate, even after making the starting point revenue-neutral.  A change to a graduated income tax would require amending the state Constitution.

When the projections of spending pressures and revenues are combined, an increasing gap appears.  Spending pressures in public K-12 education are projected to grow about 4.7 percent annually while revenues are projected to grow 3.0 percent per year.  The gap of 1.7 percentage points amounts to about a $300 million annual shortfall in system-wide resources, when all revenues and spending are factored into the calculations.  In the General Fund, revenue growth averages 1.7 percent per year.  General Fund revenue growth is lower than School Aid Fund revenue growth because of tax cuts already in state law that pare the growth from a baseline rate of 3.0 percent.  General Fund spending pressures are projected to grow 6.7 percent annually, leaving an average shortfall of 5 percentage points or about $500 million in contemporaneous General Fund dollars annually.  Similar calculations result in an annual shortfall of about $xxx million in state transportation programs.

The magnitude of the structural deficit facing Michigan’s policymakers is daunting.  The calculations are made against an assumption of a continuously improving national economy.  Departures from an environment of steady improvement in the national economy will likely cause significant fluctuations for Michigan.  Our state is ill-equipped to deal with downturns in the national economy: the combination of cyclical and structural deficits have taken a huge toll on Michigan’s financial health and eliminated the reserves needed to weather another economic storm.

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