Editorials and Opinion Pieces

No Gain in Mythical Forecasting

We can't rely on sudden-boom indicators

BY: Emily Sedgwick, Special to National Review Online
DATE: July 12, 2002
WORD COUNT: 792

Forty-four states ran up deficits this year, and as the new fiscal year begins there are two big lessons for state governments (and the federal one, too): first, capital-gains revenue is not dependable and should not be used to calculate budget forecasts, and second, cutting spending and eliminating capital gains from the equation altogether will save taxpayers the grief of another long year of high taxes and little return.

Using volatile sources of revenue such as capital gains, stock options, hiring bonuses, and other indicators of the 1990s boom to calculate forecasts artificially inflated these forecasts by assuming that these indicators were and are dependable, high-dollar sources of revenue. The Congressional Budget Office (CBO) and state budget analysts failed to anticipate that these sources would dry up as fast as they have, and almost without exception everyone involved is scrambling to make up the difference.

And yet irresponsible reliance on sudden boom indicators is really just a symptom of a much more serious problem: spending. State and federal governments are doing little to curtail it, however, while they continue to base their calculations on capital gains and other highly volatile indicators. All of it spells tough news for taxpayers in years to come.

Capital-gains tax receipts as a percentage of federal income revenues doubled between 1993 and 2000, from 6% to 12%. As the stock market began to decline in early 2000, investors cashed in and generated a $118 billion capital-gains revenue windfall. CBO used that windfall to determine future years' forecasts and predicted a mild decline of just $3 billion. As the stock-market decline created capital loses, investors used those losses to offset gains, exacerbating the drain on capital-gains revenue. Consequently, the current CBO forecast could be off by as much as $40 billion, or about a third of this year's likely federal deficit.

In the meantime, federal spending has ballooned. The new Aviation Security and Homeland Defense Administrations, the defense and transportation budgets, the farm bill, temporary unemployment insurance, and an eventual prescription-drug benefit will cost taxpayers hundreds of billions of dollars over the next five years. Thus the recent trend: the cost of federal taxes and regulations has increased both of the last two years, after an unprecedented eight-year decline in the 1990s.

Spending continues unmitigated as state and federal analysts grapple with reconciling capital-gains-heavy forecasts and the stark reality of tax receipts. State budget analysts did expect capital-gains revenue to dry up, although gradually, and to an extent that could be cushioned by rainy day funds and other reserves. A crushing and rapid collapse of expectations, however, has left most states with deficits amounting to billions even as they continue to spend as if the bubble hasn't burst - much like the federal government.

In California, where budget battles this year have reached epic proportions, capital-gains and stock-options revenue climbed 530% during the 1990s boom. As revenues spiked in the mid-to-late 1990s, capital gains as a percentage of total revenue also increased, while expenditures spiked the same year that the capital-gains bubble burst. State general-fund expenditures jumped $10 billion from 2000-2001, even as capital gains as a percentage of total revenue fell from 23.8% to 8.75% the same year. The state spent, or is projected to spend, $78 billion each of the following three years, 2001-2003, while capital gains bottomed out at roughly 10% after 2001 and the state deficit has climbed to $24 billion.

California still relies on capital-gains revenue to continue as a permanent, high-dollar fixture of state budget calculations and meanwhile, while everyone waits for an overnight recovery, taxpayers are expected to bear the brunt of it, demonstrate a stiff upper lip, and swallow tax increases on vehicle licensing and cigarettes.

Thirteen other states that either recently concluded their legislative sessions or are still engaged in the process all face spending shortfalls this year. Arkansas, Delaware, Indiana, Massachusetts, Michigan, New Hampshire, New Jersey, New York, North Carolina, Oregon, Pennsylvania, Rhode Island, and Tennessee in total collected $28.6 billion less revenue than anticipated in fiscal year 2001-02. With the exception of New Hampshire and Tennessee, all rely in part on capital-gains revenue to estimate revenue forecasts. These states could make significant progress toward reliable forecasts by removing capital-gains revenue from their lists of expectations.

Many states did cut some spending and the federal government implemented President Bush's tax-relief plan. But it's clearly not enough. Spending cuts in response to honest forecasts supported by the best available information are the keys to taxpayer-friendly budgeting. Decoupling capital gains from income-tax revenue, if necessary, and eliminating it at the state and federal levels in addition to stabilizing spending cuts, will provide a viable, long-term solution to revenue fluctuations and deficits. Post-boom, taxpayers need honesty and spending restraint, not bigger government.